IEA Blog

Sombre sound bites about the scale of the deficit, the need for deep cuts and the opportunity to use this as a time for comprehensive reform deliver huge promise, but the last hundred days provide precious little evidence that this promise will translate into much else.

The problem of government debt cannot be underestimated. The national debt is officially around £800 billion, but if pension liabilities are included it rises to about £4.8 trillion. Accordingly, we face grave economic problems. The last hundred days have shown a government willing to acknowledge this in its rhetoric, but in actual fact the cuts announced so far only serve to curb planned real terms increases in spending, rather than reducing it. The comprehensive spending review coming this autumn provides an opportunity to actually deliver, but the big question is will the coalition seize it?

Reform alongside cuts has been a mantra of the coalition, but again the policy so far simply doesn’t bear this out. Each government department, especially those of health and international development, should have been gone through, its functions, structures and budgets reassessed - which services should be delivered by the state and which by the voluntary and private sectors? Innovative thinking and an eye to successful policies in other countries is needed. Entire departments such as BIS could and should be closed.

This is indeed an opportunity to improve society - reform combined with cuts can deliver more for less. Again, though, the coalition falls short. The only area where wholesale change is being implemented is education policy, but even here the coalition has failed to endorse for-profit schools, an important component of successful reform.

What of the Big Society? Here again the coalition has tried. The vision has spoken deeply to what good government looks like – small and limited, giving people the ability to run their own lives. But the communication and policy do not reflect this. The mainstream public interpretation of the Big Society has become, “my community needs more government money”, hardly what Burke meant by “little platoons”. Fostering community does not mean government intervening further and directing more taxpayers’ money into projects. It requires putting the onus back on people, letting them keep more of their money in the first place to invest in those around them and reducing the bureaucracy which makes it hard for individuals to get involved with their communities.

To be fair, it is possible to point to some areas where the coalition is delivering to some degree (such as education) and at least the last hundred days have finally put paid to the idea that fiscal stimulus works. But what of the next hundred days and the ones after that? Much needs to be done to create a freer Britain where people have a greater sense of responsibility over their own lives and of those around them, where services are delivered better because funding and delivery is moved out of the public sector and into the private realm, and where the country’s economic problems are resolved. Deep cuts and the wholesale reform of government and its responsibilities must be the standards by which the coalition is judged. The first hundred days has seen the coalition acknowledge this, but now it must develop and implement policy that bears this out.

Under the heading “British Film Industry in Peril”, 55 actors signed a letter of protest in The Daily Telegraph at the proposed abolition of the UK Film Council. Their motives may indeed be “not out of personal gratitude” but they are certainly out of this world.

We have here a classic case of the “broken window” fallacy, described by the economist Frederic Bastiat in 1850. A shopkeeper suffers a broken window and pays a glazier to fix it, and the glazier spends his fee on a new shirt (say). This sets in motion a whole new round of spending, kick-started by a broken window.

What is forgotten is the loss to the shopkeeper, which removes another round of spending which he would have started. Nor is the “equation” a balanced one; the broken window represents a net loss of wealth. Were this not so, we should be encouraging, or at least looking benignly upon, the activity of breaking windows.

This parable highlights what good economists call “the seen and the unseen.” What is unseen, or purports to be unseen, by our posse of actors? They have no difficulty with what is seen; the enhancement (yes we’ll accept enhancement for the sake of argument) of the film industry in the UK, which can therefore provide more jobs and more and better British films than would otherwise be the case.

The unseen is what has been displaced. Any industry (or any interest group) that you care to name could have had the leg-up instead, and claimed similar enhancements.

How do we assess the relative gains and losses? The actors are in no doubt: “For every pound it invests, the country gets £5 back.” A likely story; have 55 actors really researched such an incredible claim? Why shouldn’t all industries achieve such a result via similar subsidies? 

Unfortunately, we must start at the beginning – a very good place to start, as we learn in one of the greatest movies of all time. The beginning is that a government has no money of its own; it takes it from you and me, whether we are shopkeepers, glaziers or actors. At this point, we are all down as a result of the tax taken. Any of us can go cap in hand and try to get some of it back; and indeed try to get some of somebody else’s while we’re at it. That descends into lots of unedifying spectacles and squabbles – especially unedifying in this case, as I’m sure the likes of Emily Blunt and Bill Nighy aren’t short of a bob or two.

In fact, it’s far worse than this. As mentioned above, government takes its funds from you and me. Furthermore, whatever the name of a particular tax, they all come down to taxes on the exchange of goods and services. The greater are those exchanges, the greater can be the tax. But here lies the rub; the greater the overall tax, the smaller is the exchange of goods and services! At 100% tax, we all have to resort to DIY; nobody will exchange goods and services. At 50% we are halfway there – where we are now. By my calculations every marginal pound of extra tax results in a black hole of 70p – simply gone, as the division of labour silently unwinds. And this is net of any waste on the way through.

That is the bottom line. If some of you actors out there are prepared to finance me, I’ll prove it in a film. Or maybe I should ask the government to finance me directly. Perhaps I’ll call it “All the world’s a stage.” It’s a better motto than Secrets and Lies anyway.

The present Democratic leadership of the United States avoids owning up to the “progressive” philosophy it adheres to. This may be because the US government’s finances are expected to deteriorate dramatically in the medium term, largely as a result of entitlement programmes such as Medicare, Medicaid and Social Security.

The ideological roots of the Obama administration’s response to the current fiscal crisis lie in the progressive movement of the late 19th and early 20th century, explains Tiffany Jones Miller in the National Review. The takeover of the American constitutional arrangements was inspired by Germany’s “Iron Chancellor” Bismarck. Between 1820 and 1920 thousands of budding American social scientists and others had studied at German universities. According to Miller:

“…[T ]he movement consciously sought to supplant the authority of the principles of the American founding with a new conception of Freedom, History, and the State inspired by early-19th-century German idealism. The progressive refounding of America thus had both a destructive and a constructive aspect.”

German-trained economists such as Richard T. Ely triggered a philosophical revolution which dispensed with notions of limited government and accepted the fundamental underlying role of collective morality. Other influential progressives in the same vein were Theodore Woolsey, John Dewey and James H. Tufts. The “father” of the progressive American Political Science Association, Charles Merriam, later to become the head of FDR’s National Resource Planning Board, wrote:

“The individualistic ideas of the ‘natural right’ school of political theory, endorsed in the Revolution, are discredited and repudiated…In the refusal to accept the contract theory as the basis for government, practically all the political scientists agree. The old explanation no longer seems sufficient, and is with practical unanimity discarded. The doctrines of natural law and natural rights have met a similar fate.”

The progressives were heavily under the spell of Hegelian idealism that replaced the Lockean guarantee of individual property and liberty under the law as stated in the Declaration of Independence. Following Hegel, the progressives believed in a lofty promise of freedom that “materialised” in self expression and perfection of one’s spiritual potential. Perhaps candidate Obama’s campaign visit to Hegel’s Berlin was an ominous sign.

Salary sacrifice pensions have become a popular choice for pension saving. They are beneficial for both individuals and businesses that often make huge savings by reducing their national insurance contributions. The basic concept is simple. It is well known that paying money into a pension attracts tax relief. However, it is less well known that how that money is paid into your pension scheme matters too.

Let’s assume that your salary is £20,000 and you pay £2,000 into a pension scheme. Currently you pay national insurance on the whole of the £20,000 (whilst getting tax relief on £2,000). However, your employer could offer to pay you £18,000 rather than £20,000 in salary. This way they only pay national insurance on just £18,000 rather than £20,000. Furthermore, you, as an employee, might avoid national insurance contributions too.

The costs of salary sacrifice to the Exchequer are obvious. The employee can save up to 11% of earnings and the employer 12.8% of earnings. Employers are not, of course, obliged to pay the national insurance contributions savings they make from the scheme into the employees’ pensions. Often employers that do make the payments will only pay part of the savings into the employees’ pensions with the justification that they are using the rest to cover the cost of running the salary sacrifice scheme. In addition to this, in some cases, the national insurance reduction has stopped the employee from being able to receive full state pension entitlements, although this is rare.

As it happens, the direct gain from salary sacrifice is much greater to those on lower earnings (because employee national insurance contributions are much reduced once the employee’s earnings are in the higher tax bracket). The gain to the employer is more or less proportionate to an individual’s earnings. Although, salary sacrifice is of greater benefit to lower earners, you could argue that it is, in the first place, advantageous only to those who work for the select employers that offer it, thus making it far from egalitarian.

The amount saved by employers by the Treasury not charging national insurance on employer pension contributions is £8.2 billion per year. This could finance a reduction in the main employer’s rate of national insurance of about 2%. The government should aim for a simple, flat tax system with few exemptions. Equalising the national insurance treatment of empoyer and employee contributions would be a step in that direction.

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Like most people interested in politics I have been following the financial crisis and the manner in which politicians have tried to deal with it. I quite agree that deep cuts are needed in public spending, and needed now, and that some rebalancing is needed between the public and private sectors. So, for instance, when I read items on the IEA blog about the need to increase student tuition fees I heartily agree.

But then I hear a little voice nagging away in the back of my head. It reminds me that I have two children aged 17 and 15 and so wouldn’t it better if serious reform was put off for, say, 6 years? But also as a university lecturer, I also would like my job to be there, if only so I can afford to fund my kids through their still partially subsidised higher education. So, to misquote St Augustine: “Make me economically liberal, but not yet, Lord!”

I don’t think I’m being particularly selfish here, and nor do I think that I am guilty of being a fair weather economic liberal. Instead, I think this points to a very serious problem about the manner in which governments have to face up to difficult and unpopular decisions on public spending. Speaking rationally, and in general terms, it eminently possible to show that spending needs to be cut and this applies to the university sector as well as anywhere else. But, each student and lecturer is an individual, with a family and friends, all of whom have feelings and a vote. For them, being specific and subjective, it is more rational to argue against cuts that might adversely affect them.

What this shows is the economics and the politics of deficit reduction need to be brought together. If they clash, I think that it is inevitable that the politics will win. When Nigel Lawson was asked in the mid 1980s why, as Chancellor of the Exchequer, he didn’t introduce a more stringent form of monetarism into the UK, he apparently responded, “We can’t use water cannon”. What this means is that the coalition has to take the voters with them and so use arguments that many of us – when we forget we are parents of children with expensive tastes – might find to be mealy mouthed and lacking in rigour. In other words, we have to make sure that dealing with the deficit is seen as a political and cultural problem rather than just an economic one.

Today, the Public Sector Pensions Commission - which was established in autumn 2009 by the IEA, the Institute of Directors and other groups - has released its report, Reforming Public Sector Pensions: Solutions to a growing challenge.

A key finding is that the true value of the main unfunded public sector pension schemes is over 40 per cent of salary. However, the combined employer and employee contribution rates are set at around 20 per cent of salary – the result of the government using artificially high discount rates in its calculations.

The report calls for greater transparency on the true costs of public sector pensions and sets out a series of reform options that would bring costs down. These include:

• increasing employee contribution rates
• switching from final salary to career average earnings
• reducing accrual rates
• raising pension ages
• reducing index-linking
• ending the contracted-out status of public sector pensions
• switching to funded defined contribution arrangements

 Click here to download the report.

The Emergency Budget included a proposal to raise the state pension age for males from 65 to 66 by 2016. This increases the retirement age significantly earlier than the original schedule. The previous Labour government had planned to increase the male pension age to 66 by 2024 and to 68 by 2048.

Existing legislation is gradually increasing the female retirement age from 60 so it matches the male pension age of 65 by the end of 2020. It is unclear whether the coalition will equalise the male and female pension ages at 66 in the future. 

The first widespread government pension provision was established in 1908 with the Old Age Pensions Act which set the collection age at 70. But this scheme was established at a time when the average manual labourer died by the age of 50 – so relatively little had to be paid out. Later on, though, with the passing of the Contributory Pensions Act of 1925 the collection age was lowered to 65, allowing more people to receive the benefit. This was the last significant change made to the retirement age; with the exception of the 1946 National Insurance Act which lowered the female pension age from 65 to 60. From 1946 to 2010 there were no changes in the pension age. 

Today, not only are people living longer than they were sixty years ago; pensioners now comprise 19% of the population, a larger proportion than the under 16s. This is a problem because sixty years ago when the average male was born, he was expected to live until 63 or so. However, advances in healthcare have allowed people to live – and claim state pensions – for around fifteen years longer.

Providing these prolonged benefits places an enormous strain on the public finances. For example, in 2010 the government will spend £4 billion to support public sector pensions. By 2015, this figure will increase to £10 billon. According to Nick Clegg, the present and rising cost of these pensions is simply “not affordable”. Since 2001 the cost of state pensions has increased by 38%.

The growth in expenditure on pensions is a direct consequence of the widening gap between retirement age and life expectancy. In the context of Britain’s worst ever peacetime fiscal crisis, it is imperative that the government raises the retirement age more rapidly to reflect longer life spans.

By far the best contribution to the parliamentary debate on the Emergency Budget was by the MP for Wycombe, Steve Baker. Using impeccable analysis and respected (ONS and Bank for International Settlements) data sources, Mr. Baker painted a frightening scenario in which the fiscal policies of western governments are unsustainable, and were even before the recent crisis erupted.

The government can’t borrow much more, it can’t spend much more and it can’t tax much more; nor can it grow the economy out of its current mess (as if it ever could!). The only other way to pay off its debts is by massive inflation, which would produce a catastrophe reminiscent of the Weimar Republic after World War One.

The implications are national insolvency down the road and it is against this background – and the failure of Keynesian spend-your-way-out-of-it policies that the historic Emergency Budget must be judged. Keynesian policies of fiscal and monetary excess have brought the country to the brink of ruin and need to be repudiated … again, as they were after the IMF crisis in 1976, before the vampire reawoke.

The figures Mr. Baker cited are truly worrying: official debt of £772 billion, itself a not inconsiderable sum, but utterly dwarfed by the government’s existing pension obligations, which raise the total to £4,771 billion, about six times as much. And, if you add in the obligations of the banks, now a ward of the state in more ways than one, you get a figure (using ONS data) of about £6.3 trillion or £6,300 billion – or if you prefer, £6,300,000,000,000. Figures of this magnitude have so many zeros they become incomprehensible, but to give this last figure a sense of magnitude, it is over four times UK GDP.

A billion here, a trillion there, and we are soon talking about real money…

These figures make national bankruptcy inevitable, unless the most drastic measures are taken to avert it.

One hates to add to the general cheeriness, but I would like the suggest that these numbers – though truly frightening, and based on solid sources – are in fact not nearly frightening enough:

1. Most ‘experts’ think that real returns in future will be lower than in the past (lower equity premium, etc) so we should downscale our projections of future real financial returns. This makes the outlook considerably worse.

2. Most projections of pensions obligations ignore longevity risk – the risk of people living longer, unexpectedly, so drawing more from the pension system. (This problem blindsided the supposed experts, the actuaries until post-2000 – think of Equitable Life.) My point is that mortality improvements are much stronger than most people realise and the implications for future pension schemes are very considerable. To give a rough idea, over the next forty years, we might be looking at an increase in pension costs from this factor alone of perhaps 40-50%. Experts are already talking about the ‘toxic tail’ of how many older people will make it to their nineties: this will itself bankrupt many schemes that managed to survive Gordon Brown’s notorious pension fund raids, which wrecked the non-state pension system.

3. Most important of all, the PAYGO pensions/social security nexus is, in essence, just a Ponzi or pyramid-selling scheme. Once one accepts this point, then the rest follows with an unstoppable almost mathematical certainty, i.e. the young get suckered paying ever more into a system that will give them nothing back, the problem gets worse over time, and collapse is inevitable anyway – remember Madoff?

4. One is looking a future of intergenerational warfare, in which the oldsters (who benefited from the system) become more numerous and want ever more entitlements (expensive medical care, etc) for ever longer periods, and expect their children and grandchildren to honour up debt obligations incurred well before they were born. This was always an unpleasant deal but the kitty is now empty. The youngsters meanwhile have their college debts to pay off, can’t get on the housing ladder, face ever more difficult labour market conditions, face higher tax burdens and have none of the economic security (guaranteed pensions, medical care, etc) of their predecessors, which they will have paid for, but won’t get themselves.

In 1930, Maynard Keynes wrote a splendid essay (”Economic Possibilities for our Grandchildren“) in which he looked forward 100 years hence. His musings did not age well: he anticipated that by then the economic problem – endless toil – would be resolved and we would be working 3 hour days to keep our hand in as it were, and he worried about the effects of so much leisure time and boredom on our mental health. This was the same genius who told us the government should spend its way out of recession and that in the long run we were all dead anyway.

Update: Click here to read Toby Baxendale’s review of Kevin Dowd’s new book, Alchemists of Loss, which will be launched at the IEA on 30 June (details of the event here).