Illustrative Long-term Fiscal Projections

A6 Tax revenues are subject to a number of effects in both the short and long term. For example, patterns of income and spending are changing frequently, giving rise to considerable uncertainty about taxation bases. For this reason, the approach used is to project total current receipts as a constant share of GDP without making assumptions about the source of that revenue. This provides a simple, but workable, assumption about the long-term resources available to meet the Government's spending programmes.

Spending assumptions

A7 The assumptions about spending relate to the growth in transfer payments. The largest transfer is social security spending where projections of spending have been developed in consultation with the Department of Social Security and the Government Actuary's Department. The projections represent a plausible outcome based on the interaction of the current social security system with demographic, economic and other factors. They do not pre-empt policy decisions beyond this Budget and so cannot be interpreted as reflecting the direction of future policy.

A8 Debt interest payments are calculated based on an assumed average interest rate and the path for the debt stock. In the baseline projections, net investment is assumed to continue at its 2003-04 share of GDP. The effect of higher investment is shown as an alternative scenario. For simplicity, other transfers are projected forward at a constant share of GDP.

The baseline projections

A9 The baseline long-term fiscal projections are set out in Chart A2. These illustrative projections show that, given the assumptions for transfer payments, public current consumption can grow at an average real rate of around 2½ per cent for the next 30 years and still remain consistent with the fiscal rules. On average, this equates to rises of around £5 billion each year, or £126 billion in total (in 1998-99 terms) from 2004-05.

Health

A12 The cost of providing hospital and community health services is expected to rise along with the number of people aged over 65. This reflects the fact that, at present, the average annual cost of providing health care to each person aged over 65 is over 3½ times the average for the remainder of the population. Satisfying this demographically-driven demand for services would require real health spending to grow by 2/3 per cent each year, independent of current policies to improve the speed and quality of treatment.

Education

A13 At the same time, demographic trends will also reduce the pressure in some spending areas. For example, the falling proportion of children in the population is expected to reduce primary and secondary school pupil levels over time and thus be reflected in lower education spending than would otherwise be the case. While this would partly offset the increase in health spending, it takes no account of current initiatives to raise standards in schools that can be expected to lead to increased participation in tertiary and higher education.

Uncertainties

A14 These data, therefore, need to be interpreted with caution as the impact of current policies and future demographic trends on the public finances is uncertain over such a long period. Changing mortality, morbidity, fertility or migration trends may produce a different population profile from that currently expected with effects on the demand for social security, health and education services. Similarly, the figures do not take account of improvements in the effectiveness or efficiency with which public services are delivered. In addition, the demographic trends provide no information on 'expected healthy life', which adds uncertainty to the projections of health and social security spending. The impact of an ageing population on the public finances will depend on the extent to which longer life shifts health care costs to later ages, rather than extending the period of care.

A15 Aside from demographic uncertainty, there are a number of expenditures which the Government will face in the future for which the cost is uncertain, for example, nuclear decommissioning. In addition, there are uncertainties about the demand for, and cost of providing, public services over time. For example, changes in the structural level of unemployment and deviations in public sector pay, particularly relative to productivity, may affect spending pressures. Similarly, efficiency gains in all spending areas should reduce the cost of providing services.

Policies for the long term

A16 These future uncertainties require the Government to develop policies that take the ageing of the population into account and minimise the risk of the public finances becoming unsustainable. The future increase in the retirement age for women from 60 to 65 will play a key role in reducing long-term spending pressures. In addition, the Government has announced:

• programmes to raise productivity and labour market participation, and hence increase trend economic growth;
• policies to deliver welfare reform and service modernisation;
• assistance for people to provide for retirement incomes for themselves through the State Second Pension and stakeholder pensions; and
• reforms, such as Public Service Agreements and the Public Service Productivity Panel, aimed at raising productivity throughout the public services and ensuring resources are used to their best effect.

A17 These developments will all play an important role in ensuring sustainable public finances in the long term.

ALTERNATIVE SCENARIOS

A18 This section examines the sensitivity of these projections to economic growth and the rate of public investment.

Stronger economic growth

A19 The Government's central economic objective is to maintain high and stable levels of growth and employment. The productivity and labour market reforms designed to achieve this objective are set out elsewhere in this report. However, one of the benefits of this objective becomes evident in looking at the long-term projections - even a small increase in productivity or labour market participation can be demonstrated to have a substantial effect on the public finances over time.

A20 Table A3 shows the effect of higher economic growth on the public finances. The first scenario shows the effect of achieving long-term growth of 2¼ per cent. The second scenario represents the top of the growth range shown in Table A1 (2¾ per cent in the long-term). These scenarios clearly show that higher economic growth substantially improves the public finances, primarily because higher growth not only benefits individuals through greater wealth and employment opportunities but also results in higher receipts for the Government. This outcome occurs even though the overall tax burden is unchanged as a proportion of income.

A21 The gains from higher growth are many times greater than the additional costs projected to arise from demographic trends in the UK. For example, achieving long-term economic growth of 2¾ per cent would allow public current consumption to rise, on average, by almost an additional £5 billion (in 1998-99 terms) each year. This would nearly double the sustainable rate of real growth in current consumption in the baseline projection.

A22 In each of these scenarios, the benefits of higher growth show up as higher current consumption. However, this does not mean that this is the only choice available to the Government. Indeed, the Government would be able either to fund greater expenditure (either as consumption or transfers) or cut taxes or do a combination of both. For example, in the high growth case above, the Government could maintain the existing level of public services but reduce the effective tax rate by around 16 per cent from what it would be otherwise.

Higher public investment

A23 In determining its spending plans, the Government considers options for both current and capital spending. Both types of spending have roles to play in providing public services and achieving higher economic growth. However, current spending generally provides immediate benefits while capital spending typically provides benefits over time. In recognition of this difference, the fiscal rules and the new spending regime make a clear distinction between current and capital spending.

A24 Decisions about current and capital spending, however, cannot be taken independently. This is reflected in the fact that the surplus on current balance includes the cost of not only current spending but also the costs of financing and consuming capital. The mix of current and capital spending, therefore, has implications for intergenerational equity, as well as for the fiscal rules and economic growth.

A25 The level of net investment from 2003-04 (1·4 per cent of GDP) is consistent with the net debt to GDP ratio stabilising at around 33 per cent of GDP (given the baseline economic assumptions). This is compared in Chart A3 with a scenario in which net investment is increased by a further ½ per cent of GDP. This higher level of investment would stabilise net debt at around 44 per cent of GDP.