OBR rings alarm on pensions, climate change and the fiscal rule
The government received another reminder of its perilous fiscal situation on Tuesday, when the Office for Budget Responsibility rang the alarm on the ballooning trajectory of public debt and the widening budget deficit.
The OBR’s annual fiscal risks and sustainability report comes at a particularly sensitive time for Labour, which marked one year in office with a humiliating climbdown on proposed welfare cuts and suffered a mini-panic in the gilt markets over the future of the chancellor.
Such is the fragility of market sentiment about the UK, that gilt yields rose on the back of the OBR’s conclusions, with ten-year borrowing costs gaining 0.04 percentage points to 4.64 per cent.
The fiscal watchdog’s annual exercise in modelling long-term risks and policy challenges is almost always apocalyptic. It is designed to be so. It is a chance for the OBR, which produces two annual forecasts on the economy for the chancellor of the day, to take a step back and analyse the bigger, structural forces at play in the UK economy.
The issues are little changed over the past few years: low growth, anaemic productivity, escalating demands on the state, and a tax burden that hits new records in every parliament.
The OBR’s conclusion — that the government has vanishingly small buffers to meet its fiscal rules — will further stoke the speculation about looming tax rises this autumn. “The government will need to raise taxes to cover these soaring spending needs,” Stephen Millard, interim director of the National Institute of Economic and Social Research, said. “If it does not, then, with demographic changes acting to reduce the tax base and increase pension and healthcare costs, the debt to GDP ratio is likely to rise to unsustainable levels.”
Stephen Millard says taxes will need to rise
Every year the OBR focuses on a handful of policy challenges to produce stylised models on the impact they could have on the public finances stretching into the 2070s. This year it highlighted pensions spending, climate change and Labour’s new fiscal rule, targeting a novel measure of public debt. Here’s what it found:
The OBR focused on two risks related to pensions: the level of spending on the state pension in the coming decades, and the changing behaviour of pension funds in the gilts market.
On the fiscal outlays, the watchdog said the commitment to the pensions triple lock had ended up costing the state three times more than it expected on the state pension.
The triple lock is a promise to raise the state pension every year in line with the highest of consumer price inflation, average earnings, or 2.5 per cent. Raging inflation and wage growth since 2021 has meant that the policy will end up costing £15.5 billion by the end of the decade, compared with forecasts of £5 billion. This could drift to as high as £43 billion if consumer prices and earnings behave as they have done this decade for the next 40 years, the OBR said.
The triple lock was introduced by George Osborne during the coalition government in 2010 as a way to help raise the state pension for Britons compared with their European peers. Labour committed to the triple lock in last year’s election campaign but previous Tory governments have tried to lessen the costs of the policy by changing the earnings thresholds used to index the pensions jump. Sir Mel Stride, a former pensions minister and current shadow chancellor, has previously said the triple lock is “unsustainable”.
• The exact year that the triple lock will bankrupt the state pension
The Institute for Fiscal Studies estimates that the state is paying an additional £11 billion a year by maintaining the triple lock compared with a system in which the state pension rises in line with either inflation or earnings every year.
The OBR also warned about changing dynamics in the UK gilt market, where defined benefit pension schemes are no longer a significant buyer of longer-dated bonds. This is because these schemes are largely closed to new entrants and the growing defined contribution pension schemes are more likely to hold riskier, shorter-dated gilts. The result is a “pushing up of the government’s financing costs”, the OBR said.
Other respected voices such as the International Monetary Fund have also warned about the changing nature of gilt holders from longer-term “patient” investors, to highly leveraged, short-term actors such as hedge funds. David Miles, a member of the OBR’s executive committee and a former Bank of England rate-setter, also warned that the central bank’s bond selling was outstripping the pace at which pension funds could absorb new gilts — a factor that could put further upward pressure on borrowing costs.
The watchdog made its biggest forecast changes to estimates on the role that climate-change policies will have on the public finances. The OBR now thinks the transition to net zero will have a far more damaging impact on borrowing, raising debt needs by 2 per cent of GDP, rather than an earlier estimate of 0.7 per cent. The total level of UK GDP could now be hit by 8 per cent in the 2070s, up from a previous forecast of 3 per cent.
Projections on the cost of meeting net zero targets will be a challenge for Ed Miliband, the energy and climate-change secretary, and Sir Keir Starmer
CHRISTOPHER FURLONG/GETTY IMAGES
This is based on a new baseline where global temperatures rise by just below 3C. The cost of climate change could be measured through the fiscal pressures to achieve the net zero transition and the damage that rising temperatures posed for the economy more broadly, the watchdog said.
• Daniel Yergin: Net zero by 2050 struggles with reality
The biggest fiscal pressure is the huge loss in fuel duty revenues from the switch to electric vehicles, with the government target of having no more new internal combustion engine sales after 2035 for cars and 2040 for heavy goods vehicles.
This fuel duty revenue loss makes up two thirds of the estimated £30 billion a year average cost of climate-change mitigation over the next 25 years. It was not clear whether the government would devise new green taxes to compensate for the loss of fuel duty with other forms of motoring taxes, the OBR said.