Public debt and intergenerational equity

With government borrowing set to rise above £175bn this year and total public sector debt already approaching 60% of GDP and set to surge much higher in the coming years, attention is now focusing on who will pay for this almost total collapse of fiscal discipline. There truly is no such thing as a free lunch - next year the costs of servicing the national debt will be over £60m a day.

The latest National Institute report makes for somber reading. They project that an economic recovery built around exports may do little to reduce the size of government borrowing and escalating debt and that a structural budget deficit in excess of 6% of GDP is likely to persist. Ray Barrell’s quote in this article in the Times is a classic example of the problem of inter-generational equity:

“We are stealing from our children if we do not address the debt stock. There either needs to be very significant tax rises over the next ten years, or we need to change the structure of the economy and get people to work longer.”

Raising the retirement age is just one of the options available to a government that needs to raise extra tax revenues or cut spending to stabilise and improve the public sector finances. The NIESR has also floated the idea of a 7% rise in the standard rate of income tax, an extension of VAT, a five year wage freeze for public sector workers or an across the board cut in government spending of 10%. All of these have potentially painful economic consequences in the short and the medium term. Higher taxes mean that the current generation has less to consume, raising the retirement age allows us to consume more now and burdens our children less. Is this fair?

Raising the retirement age will increase the number of effective years work that we contribute to the economy - although assumptions have to be made about how many people will be willing and able to do this and what proportion of the population aged between 65 and 70 will actually find work or continue in their current jobs. Another consequence would be an initial surge in unemployment that would have to be dealt with especially for the young.

Government bond yields continue to be very low and intuitively it makes sense for the state to borrow long term if it can do so at favourable terms - it is a better option that a fire-sale of profitable state assets that generates a return every year for the Treasury. But when the national debt reaches a very high percentage of GDP, the risks of crowding out become more severe. The key is the impact of higher government borrowing and ultimately higher taxes on the savings of the private sector. According to the new National Institute report, a 1 per cent of GDP increase in the current budget deficit reduces national saving by about ½ per cent of GDP.

The NIESR predicts that the UK economy will contract by 4.4% in 2009.