Under pressure

The state is growing, and so are debates about the extent and consequences of that growth. The current row about government plans to raise National Insurance to fund additional spending on health and social care is not a one-off event, but a sign of what is to come, as pressures on the size of the state build and politicians grapple with how to manage them.

The 2020s are set to see the pressures from ageing intensify, healthcare costs rise, and the state investing to drive the net zero transition. These trends will take place against the backdrop of significant economic change, placing further pressures on the state to do more in the decade ahead. This report assesses these demands in detail; considers what we can learn from the strategies employed to deal with the spending pressures of the past; and evaluates these and other strategies available to governments over the next decade as they seek to manage existing and emerging fiscal pressures.

The pressures pushing up on the size of the state in the 2020s are significant, requiring policy makers to respond.

Increasing longevity represents a major human achievement, but the UK’s ageing population is also among the largest sources of these fiscal pressures. In 2020, for every 100 adults aged 20-64, there were 32 adults aged 65 and over; by 2030, this ratio is set to have climbed to 38:100. This is projected to be the fastest pace of ageing in any decade from the 1960s to the 2060s, as higher longevity combines with the powerful effect of the large baby boomer cohort moving into retirement.

Many focus on the implications of ageing on health spending, but the largest demographic effect is likely to come from the social security system: demographic change on its own is set to push social security spending on the over-60s up by £22 billion a year between 2022 to 2030. These pressures are compounded by the ‘triple lock’ which will continue to ratchet up the value of the State Pension.

An ageing society is not new, but a major increase in the cost of the State Pension will be. In recent years, such cost pressures have been mediated by increases in the age at which men and (especially) women can claim their pension, but this change has now fully fed through and will no longer provide a large brake on future pension spending. All told, spending on the State Pension is forecast to increase, in real terms, from just over £108 billion in 2022-23 to £132 billion by 2030-31.

Longer lives do matter for health spending, although less than is often assumed. Much more important is our morbidity – the length of time spent in ill health –which has been rising recently: 34 per cent of 85-to-89-year olds had two or more diagnosed long-term conditions in 2006, rising to 44 per cent by 2015.

The rising costs of providing healthcare also play a key role. Technological innovation in health tends to be cost-increasing; studies estimate that technological change accounts for anywhere from 27 per cent to 75 per cent of health care spending growth in recent decades. The good news from a spending perspective is that the latest evidence suggests that healthcare costs in developed countries (including the UK) are not increasing one-for-one with national income. Income growth need not, on its own, imply a greater share of spending on health.

Overall, the latest long-term forecasts suggest that health spending could increase from 7.3 per cent of GDP pre-pandemic to 9 per cent of GDP in 2030-31 and 10 per cent of GDP by 2035-36. This would imply a real-terms increase in health spending of £70 billion on pre-pandemic levels by 2030-31, or a £52 billion increase (a 40 per cent increase) compared to 2022-23 levels.

A new pressure on public spending is the cross-party consensus on the need to make significant progress towards our decarbonisation, in line with the UK’s international and domestic commitments to reach net zero by 2050. This will require making progress during the 2020s to reap the pay-off in future: the Climate Change Committee’s net zero investment estimates imply annual net investment across the public and private sector of £27 billion per year in the 2020s, £16 billion per year in the 2030s, before an average annual net payback of £11 billion in the 2040s. There are limited robust estimates of the amount of new public spending needed in this area in the decade ahead, but the OBR’s indicative scenario suggests that additional public sector investment on net zero may have to climb to somewhere in the region of £14 billion a year (in 2020-21 prices) by the end of the 2020s.

The amount of investment that will ultimately be required is still highly uncertain, as it depends heavily on the pace of cost reductions in emerging technologies. The Government should now build on the ideas in the Net Zero Review to confirm how much investment it thinks will be required and how higher costs will be shared between households and firms, higher energy bills, or tax revenues, given that this will be a central policy challenge in the years ahead.

If governments in the 2020s were to maintain Public Sector Net Investment (PSNI) at 2.7 per cent of GDP – which seems to be this Government’s intention – then funding £14 billion a year of net zero investment would still allow for other public investment to reach around 2.2 per cent of GDP (around £60 billion, 2020-21 prices) – a higher level than has been sustained at any time since the late-1970s.

These pressures will be accommodated in various ways and to various extents by governments in the 2020s, but today’s decision makers should have a sense of the potential size of the increase in the state if the pressures identified here were incorporated ‘in full’ in the years ahead.

Combined, relative to 2022-23, these imply additional spending of £76 billion by 2030-31 and £150 billion by 2035-36 (in 2020-21 prices). Potential spending increases on healthcare and State Pension alone would make the UK government more similar in size to Germany’s pre-pandemic state (45 per cent of GDP) than Canada’s (41 per cent of GDP) by 2030.

Since the Second World War, the size and the shape of the public sector has shifted substantially as the modern welfare state was built. These changes are best understood not as inevitable shifts that policy makers and the public passively accepted, but as the result of the choices made or ‘coping strategies’ adopted by governments managing them.

The long-run picture is of a rise in the size of the state, with total managed expenditure (TME) having risen from 38 per cent of GDP in the late 1940s to an expected level of around 42 per cent of GDP in the 2020s. Underlying that rise have been three main sources of upwards pressure. First, social security spending, which doubled from 5 per cent of GDP in the mid-1950s to reach 10 per cent of GDP in 1982-83 and has remained broadly stable since. Second, health spending, which has risen from around 3 percent of GDP in 1955-56 to an expected level of over 8 per cent by 2024-25 – a nine-fold increase in real per person spend. Finally, education spending, which rose from 4 per cent of GDP in 1999-2000 to reach 5.6 per cent of GDP in 2009-10. This was a 55 per cent increase in real per person spending. These increases reflect the public spending implications of building and maintaining a modern welfare state, so it is not surprising that similar pressures were seen in other advanced economies. Indeed, the UK is far from exceptional in the level of spending on these areas, with the increases in spending in the 2000s serving to bring our health and education spend in line with that of other rich countries.

To meet the fiscal pressures created by this extension of the state, policy makers have responded in three major ways.  The first has been to squeeze spending on other functions, in particular defence. Between the 1950s and late 1970s, defence spending declined from around 8 per cent of GDP to 4 per cent, before falling to 2 per cent more recently. But spending has also fallen thanks to lower debt interest payments: in 2023-24, they are set to be half the level seen in the 1980s, when they amounted to over 3 per cent of GDP. This decline reflects the ultra-low interest rates, which have more than offset higher debt levels.

Second, the state has done a lot less investing. In the mid-1970s, public sector net investment (PSNI) amounted to over 5 per cent of GDP. By the mid-1990s. it had fallen below 1 per cent, thanks to the reduction in some kinds of investment and the outsourcing of others to the private sector. The type of investment the state engages in also changed, with a sharp decline in spending on housing – which comprised nearly 2 per cent of gross investment in the 1960s and 1970s, compared to less than half a per cent in the 2010s – and a rise in capital spending on science and technology. Keeping public investment low has been an enduring way in which the UK state has avoided growing despite greater welfare state spending, but this has recently reversed, and a new political priority to invest means that PSNI in the 2020s is set to reach its highest sustained level since the 1970s.

Finally, governments have opted to raise taxes to fund higher spending. Since bottoming out at 28 per cent in 1993-94, the tax take as a proportion of GDP has risen considerably and is expected to reach 36 per cent by 2026-27 – levels which were last seen in the immediate aftermath of the Second World War. Increasing existing taxes, rather than introducing new ones, has been the main route to a higher tax take. In particular, taxes on income – and, more specifically, on earnings – have increased, with higher rates of National Insurance (NI) being the path chosen most regularly in recent decades. Indeed, all of the increase in income taxes as a share of GDP this century has come through NI, reinforcing the longer-term trends that will mean NI is set to have risen from 3 to 7 per cent of GDP from the war to 2026-27 even as Income Tax falls from 12 to 10 per cent.

The most obvious option to manage the fiscal pressures of the next decade is to take steps to limit the size of the spending increase that they bring about. Given the amount of pressure coming from social security spending on pensioners, one obvious example would be to end the triple lock, for example. Curbing spending in a major way will require breaking taboos, such as accelerating the increase in the State Pension Age to 68 currently pencilled in for the late-2030s. On healthcare, effective policies to stem the rise in morbidity or treat those with long-term health conditions more cost effectively would, of course, be welcome. But, with the gains here difficult to achieve, policy makers might seek more ways to shift healthcare costs onto individuals directly. None of these strategies is politically appealing, though, and all of them will leave the vast majority of pressures still to be addressed.

As such, the strategies deployed in the past will be looked at by governments in the 2020s as they seek to cope with the looming fiscal pressures. On the spending side, the 2010s strategy of reducing many areas of working-age social security and day-to-day public spending to protect (in relative terms) health and pension spending has reached its limit. Even after increases in recent Spending Reviews, day-to-day public service spending is set to be 20 per cent lower in real terms per person in 2024-25 than in 2009-10.

But some past approaches could be deployed once again. Although the huge reductions in defence spending seen since the Second World War cannot be repeated, defence spending remains higher in the UK than in all other G7 countries bar the US. Public investment is set to reach a fifty-year high for the UK, even if it remains lower than countries such as the US, Canada, France and Japan. The temptation to cut spending further in both of these areas may persist, even if doing so would be unwise: cutting defence spending would breach the UK’s NATO commitments at a time of rising geopolitical risks, and reductions in investment spending would be unwise given both historically low investment levels in the UK and the need for additional investment to accelerate the net zero transition in the 2020s.

These limits to the ability of policy makers to repeat the spending-reduction strategies of the post-war period means that the state is likely to grow in the decade ahead.

If spending is on an upward path, some may look to additional borrowing to take the strain, but that is unlikely to be a viable strategy. Fiscal policy has played a major role in two recent crises in that it helped avoid the collapse of the banking sector in 2009 and limited the rise in unemployment and the broader economic damage in the face of Covid-19. This lays bare the importance of future governments having the fiscal space to respond similarly when the next downturn inevitably occurs.

But these two crises have also reduced the fiscal space available: public sector debt has surged from around a third the size of national income before the financial crisis to be roughly equal to it. This is a significant rise by historical standards, returning debt to levels last seen in the aftermath of the Second World War. Where the safe limit is for levels of public debt in the UK is highly uncertain, but reducing – or, at the very least, maintaining – debt levels is highly desirable, given the likelihood of future crises. In so far as most cost pressures relate to ongoing day-to-day public spending, it is also the case that they should be covered by tax revenues during normal economic times. This tighter setting for fiscal policy to reduce debt levels will curtail the use of borrowing in response to the pressures of the 2020s. And while ultra-low borrowing costs provide some downward pressure on the public finances, history tells us that we should not rely on this continuing indefinitely, particularly given the prospect of an inflation-driven rise in interest rates.

There will be pressure for higher taxes later in the 2020s

The constraints on other potential strategies explains why a Conservative Government is already planning to increase the tax take over the coming four years from 33 per cent of GDP in 2021-22 to 36 per cent by 2026-27. But it is highly likely that more tax increases will be necessary to accommodate fiscal pressures later in this decade. Looking at other comparable developed economies suggests this is feasible, as it is clear that the UK raises relatively low levels of tax as a share of GDP. In 2019, our tax take was comparable to that of Canada at 33 per cent of GDP: Germany raises 38 per cent of GDP in taxes, and other European comparators raise far more.

An economic strategy relying on higher taxes does, however, increase the need for an efficient system. That is not the system we have today, and nor would we move towards one if we continued the focus on raising additional revenues through National Insurance. Different allowances, rates and coverage between the Income Tax and National Insurance (NI) systems drive perverse behaviours; capital gains and inheritance taxes contain large unnecessary reliefs; property taxes impede mobility and, in the case of council tax, have morphed into the worst features of the tax (the Poll Tax) that they were designed to replace. The result is a highly complex and often distortionary system in need of reform.

The fairness of the tax system is also brought into sharp relief as taxes rise. For example, continuing to increase taxes on earnings but not other forms of income is indefensible. Doing so amidst a prolonged, and rapidly worsening, pay squeeze, while tax revenues from wealth-related taxes have remained largely stable as a proportion of GDP even as the value of household wealth has grown from three times to nearly eight times GDP, is an approach that has run out of road.

Policy makers will need to consider the prospects for future tax rises in the context of the large reduction in fuel duty revenues which will take place over the next two decades. The shift towards Battery Electric Vehicles (BEVs) will mean that around £35 billion of motoring tax revenue will disappear in the coming decades, and the latest data on uptake of BEVs suggests this is set to happen faster than current forecasts imply. The Government’s Net Zero Strategy assumes that 24 per cent of all cars will be BEVs by 2030, but if BEV adoption takes place as fast over the next five years as has taken place in Norway since 2018, then this share could climb as high as 60 per cent by 2030-31. Were this punchy forecast for BEV take-up to materialise, it would imply revenue losses from car fuel duty alone of £8 billion by 2030-31 and £14 billion by 2035-36 (in real terms, 2020-21 prices), compared to the OBR’s more cautious assumptions that imply losses of £5 billion and £13 billion respectively. So new taxes on motoring will be required to avoid falling revenues and a narrowing of the tax base at the same time as higher taxes are required to deal with spending pressures.

If the economic growth rate could be raised, it would provide a large tax boost in the 2020s

Anything that increases growth will make a huge difference to these pressures. A simple thought experiment illustrates its importance: if the economy had continued to expand at pre-financial-crisis rates from 2007, the economy would be around a quarter larger by the eve of the pandemic in cash terms. Simply extrapolating from the long-run relationship between the size of the economy and overall spending suggests that the latter could have been sustainably higher by an order of £200 billion in 2019-20. So growing the economic pie in the 2020s is crucial to funding spending priorities and limiting the extent of tax rises.

The emerging and evolving fiscal pressures on the horizon are of a scale and nature that means they cannot be simply wished away or ignored. The 2020s will see us facing up to long-term health and demography pressures, as well as the need to make new net zero-related investments. The realities of a decade of spending restraint, political support for higher spending in priority areas, and the economic benefits of maintaining high levels of public investment mean that today’s debates about tax rises are likely to be a regular feature of the 2020s. A bigger state and higher tax take is what the future has in store for us. Accepting that prospectus should encourage policy makers to ensure that a higher tax take is raised in a more efficient and fair way. But it also puts up in lights the need to renew the UK’s wider economic strategy, as smaller tax rises would be needed if we could avoid an extended period of relative economic underperformance and slow growth in the decade ahead.

• Increased spending on the State Pension and healthcare could push up public spending by £76 billion by 2030-31 and £150 billion by 2035-36 (in 2020-21 prices), relative to its level in 2022-23.
• Potential spending increases on healthcare and State Pension alone would make the UK Government more similar in size to Germany’s pre-pandemic state (45 per cent of GDP) than Canada’s (41 per cent of GDP) by 2030.
• Looking to the past: health, education and social security spend have been the largest upward pressures on spending over the past seventy years, together nearly doubling as a proportion of GDP between 1955-56 and 2019-20.
• Governments have coped with these pressures primarily by: shrinking defence spending from 8 per cent of GDP to just under 2 per cent; cutting investment spending (although this has now been increased back to recent highs for the UK); and raising taxes – total tax revenues are expected to reach 36 per cent in the early-2020s, up from 28 per cent of GDP in the mid-1990s.
• The success of Government’s response to Covid-19 in limiting the economic hit illustrates the importance of fiscal space. This means policy makers start the 2020s needing to reduce – or at least stabilise – high levels of public debt levels which are the result of the weakest 15 years of growth since the Great Depression. This will limit their ability to borrow in response to these pressures.
• Strategies which increase growth will make a huge difference in terms of easing fiscal pressures. But the inability of successive governments to achieve this suggests that spending and tax measures, which are much more likely to be in their gift, will be needed.
• Some of the spending strategies used in the past could be deployed again, although cutting either defence or investment spending would be unwise. Investment levels are still lower than in the majority of the G7.
• Higher taxes – on wealth not earnings – seem likely to take most of the strain in the 2020s. Tax revenues from wealth-related taxes have remained largely stable as a proportion of GDP even as the value of household wealth has grown from three times to nearly eight times GDP.
• The shift towards electric vehicles means that £35 billion of motoring tax revenue will disappear in the coming decades. A reasonable, if punchy, forecast for electric vehicle take-up based on the recent history in Norway would imply revenue losses from car fuel duty alone of £8 billion by 2030-31 (real terms, 2020-21 prices).