CPP’s latest report, Funding fair growth, suggests that public spending will need to increase by £142bn per year over the next parliament just to maintain current levels of public services. In the face of a rapidly deteriorating state of public finances, the increased levels of spending projected for health, social protection as well as education sectors certainly present formidable challenges. This blog is dedicated to unpacking some of the leading economic, demographic and political factors that may drive these increases.

Demography as a key of driver of increased spending

The most pronounced driver of increased public spending in the UK is demography.^[1] Naturally, healthcare demand tends to increase as populations age as older people, on average, have higher health care needs than their younger counterparts, with health care demand per person being four times higher for older people. This is compounded by the increasing incidence of chronic conditions in older age and a greater demand for social care such as at-home services. Additionally, an ageing population also requires more pension spending.

Dealing with these increased demands is, however, not straightforward. Often, government finances are affected by the economy’s employment rates as tax revenues increase with employment.^[2] With population ageing, a relatively smaller pool of people are employed and pay taxes, and coupled with increased need for spending on pension, health and social care, this presents significant challenges to the fiscal integrity of an economy. Though it is possible that population ageing may encourage digitalization and use of robot technologies at a faster pace, thus ultimately boosting labour productivity and economic growth,^[3] this remains more of a theoretical proposition at this point as empirical evidence on this topic is fairly mixed.^[4]

The role of low-productivity sectors

Another major factor behind the increased need for public spending is what has been termed by economist William Baumol as the "cost disease”.^[5] In the 1960s, Baumol observed that productivity varies between different sectors of the economy. However, in less productive sectors, wages must rise proportionally to the rest of the economy to prevent workers from leaving for more productive ones. A substantial portion of government expenditure is directed toward sectors such as education and healthcare that are characterized by slow labour-productivity growth. As the real wages of professionals like doctors, nurses, and teachers increase in line with other economic sectors, government spending in these areas also rises.

Economists generally think of education and healthcare as "superior" or “luxury” goods, meaning that as individuals become wealthier, they allocate a larger portion of their income to these areas. When these services are provided by the government, this could lead to demand for increased public spending. Several studies have concluded that there indeed exists a strong and positive relationship between national income and health expenditure, with this relationship being particularly strong for high-income countries like the UK.^[6] As far as education and training is concerned, one sector that is projected to see increased demands in the future is higher education.^[7] Though most public spending on education is concentrated around primary and secondary schooling, government expenditure on tertiary education is not negligible, and may need to rise to meet the demands of the future generations.

Rising challenges of security and climate

Several new factors are at play too. Given the rising geopolitical tensions, several countries have ramped up their defense expenditures, with global military spending reaching a record high of $2240 billion in 2022 (constant 2021 US$ billion).^[8] The deteriorating security situation in the face of Russo-Ukrainian War led the UK's current government to set out an ambitious plan to increase defense spending to 2.5% of GDP in the longer term.^[9] Adding to these pressures is the ever-rising threat of climate change, and the consequent need to invest in mitigation and adaptation infrastructure. According to OBR, the government would need to invest around £327 billion over the next 30 years in the transition to net zero (in 2019 prices).^[10]

Up until 2010, UK health and social protection spending increased substantially not by raising taxes but, effectively, by reducing the share of national income spent on defence since the end of the Cold War.^[11]

Post-2010, as the government’s budget deficit rose to a then-record high, policymakers responded by employing significant spending cuts. However, as new challenges arise and austerity reaches its limits, governments no longer have the cushion provided by being able to raid other budgets such as defense to cover rising costs in other areas. The situation is compounded by the already high debt levels and interest rates that make borrowing more difficult. All of which means there are no quick fixes or easy answers to funding the UK‘s future public services but CPP has unpacked some of the plausible policy responses in our recent report - Funding fair growth. This outlines options on tax reform alongside new rules which govern how much national and local governments can tax, borrow and spend.^[12]