Fears of the future should not be a burden on the present

The Intergenerational Report (IGR) is a valuable exercise. Australia faces a significant ageing of its population. This prospect of ageing has led some people to make very pessimistic assessments of the future. An objective assessment of the future should help to improve our understanding of the impacts of demographic change and thereby improve our policy response.

The report points out that Australia is well placed to meet the ageing of the population, through its government pension system, its superannuation arrangements, its efficient health system and its well-targeted social welfare system. We share this sanguine view. However we find fault in the projections in the IGR of future government outlays and the interpretation of the meaning these projections have for current government policy.

The IGR projects under unchanged government policy an increase in government outlays of 5.3 per cent of GDP by 2041-42. On the basis of this projection, the IGR recommends that "forward planning for these developments is important to ensure that governments will be well placed to meet emerging policy challenges in a timely and efficient manner". The IGR goes on to argue for the desirability of "sustainable government finances". In his budget speech, the Treasurer, in discussing the IGR, argued that "we must start now to put in place measures that will sustain a decent health system and aged care system into the future. If we ignore moderate changes now the challenges will only become greater, the decisions will get harder and the solutions will slip outside our grasp". Following this, the Treasurer justified the increase in prescription charges as a measure that would help "put the PBS on a more sustainable basis".

In our view, the suggestion that action is needed immediately to ensure that government finances do not blow out in the future is not warranted. Instead the appropriate interpretation of the IGR is that the ageing of the Australian population does not present a challenge that needs to be addressed by immediate fiscal tightening. The report shows, when appropriately interpreted, that the increase in 40 years' time in government outlays caused by ageing is slight. Furthermore, although ignored in the report, this slight increase pales into insignificance when considered in the light of the very large increase in living standards that can reasonably be expected to occur. And if we find in the future that government outlays - health or any other - are getting to levels which cast doubt on their value at the margin, then that will be the time to act. As the government’s increase in prescription charges shows, we are not locked into a situation where changes cannot be made.

The government outlays considered in the report are health, aged care, social security and education. These are the components most likely to be influenced by demographic change and so are the reasonable components on which to focus. The projections are scaled as percentages of GDP. Because GDP gives some measure, albeit not as good as living standards, of the capacity of the economy to pay for government outlays, using this metric is reasonable. However the components differ radically in the soundness of the basis used to project them.

For example consider the major element of social security, aged and service pensions. This is a component for which, as a percentage of GDP, there is a good basis on which to make projections. There is bipartisan agreement that pensions should be 26 per cent of average weekly earnings. So as GDP per worker and thus wages increase, pension payments will rise automatically. Should productivity growth slow then the increase in pension payments per person will slow. So as a percent of GDP there is some constancy. The pension payments from the public purse will be influenced, under Australia’s means tested system, by the growth of superannuation payments. But given that a significant component of super is related to wages by the 9 per cent compulsory super charge and that the rest of super payments are reasonably stable as a percent of wages, the projected effect on government pension payments as a per cent of GDP is fairly well based. Finally there will be demographic change. The proportion of pensioners in the population will no doubt increase. But again this number is not subject to a great deal of variation in 2042. A total fertility rate (TFR) of 1.75 implies 2.6 working age per old person by 2041-42. If the TFR falls by the very large amount to 1.3 for the next 40 years, the ratio of working-age per old person falls slightly, to 2.4. So uncertainties about future fertility do not cause much possible variation in old age pension payments by government.

To sum up for pensions, the basis on which an increase in payments of 1.7 per cent by 2041-42 is made is fairly sound, in as far as anything about the 40 years ahead can be sound. Crucially it is based on ratios, the 26 per cent of average weekly earnings and the nine per cent compulsory super charge, that are thought to be desirable at the present time and can reasonably be thought to remain as desirable outcomes. We now see from the IGR that the cost of these policies, taking into account ageing, are not likely to cause their broad-based support to change.

However the projections for the Pharmaceutical Benfits Scheme (PBS) are less soundly based. The PBS is projected to rise by 2.8 per cent of GDP by 2041-42. This is a much greater increase than for pension payments. But this projection for PBS is not based on a concept of what people may think is desirable or affordable. Instead, on the basis of historical trends, the PBS is projected to grow at 5.64 per cent per person per year, some 4 percentage points greater than the projected growth rate of GDP. As a result PBS spending increases from 0.6 per cent of GDP in 2001-02 to 3.4 per cent of GDP by 2041-42. At these relative growth rates, the PBS scheme will account for a little over one third of GDP by 2100 and 100 per cent of GDP by 2126!

The IGR emphasises the role of technological change in medicine as the justification for this assumed growth rate. They find that the growth of PBS per age-adjusted person for the period 1983-84 to 2005-06 is 5.64 per cent. This is projected to continue. But of course neither the Treasury nor any one else has any idea of the nature of technological change in the future. So, compared to the pension projections, the PBS projection has a very weak basis.

Even although the soundness of the basis on which these projections are made varies enormously, the IGR simply adds them up into an aggregate figure. This is misleading. It would be better to strip out the PBS projections. Then the bottom line conclusion on the projections is that non-PBS will increase by 2.5 per cent of GDP in 40 years time.

What is the "burden" of 2.5 per cent in 40 years time? It is in fact miniscule when another factor ignored by the IGR is factored in. That is the growth of living standards. Indeed even 5.3 per cent in 40 years is too small to require cuts today when considered in the light of future living standards.

By 2042 living standards in Australia will be much higher than they are now. Using the assumption made in the report that labour productivity will grow at 1.75 per cent per year, we project, using our model of prospective demographic change and living standards, that by 2042 living standards will be 76 per cent higher than they are today. This calculation allows for the change in demographic structure, the ageing of the population and the high levels of health expenditures devoted to old people.

To realise that living standards will increase substantially rather changes one’s view about the future. There is no dark cloud. An increase in taxation of even 2.5 per cent of GDP does not look like a terrible impost on people who are to be so much better off than we are today. Indeed to deny someone today health expenditures on the basis that there will be an increase in taxation of 2.5 per cent of GDP in 40 years time is inequitable.

But where does this leave the PBS scheme? The answer is that this scheme should be managed today on considerations about today, not on some poorly based notion of what will happen in 40 years time. Even the current level of spending on the PBS, 0.6 per cent of GDP, is a considerable sum. The allocation of that amount of GDP should be done to ensure that people are getting value now. It may be that the efficient size of the PBS today is greater than 0.6 per cent of GDP. If so it should be expanded. And it maybe that increased co-payments for benefits under the PBS will increase the efficient allocation of the resources used. It is this argument, not a budget deficit in 40 years time, that is relevant.

Of course, health experts, economists and public servants have been working and will continue to work on ways to improve the efficient allocation of resources in the PBS and indeed in health in general.

In summary, a reasonable interpretation of the IGR is that the future ageing of the Australian population is shown to be not a problem. The idea that if we do not act now things must get worse and even out of control is not supported. Instead we should focus on the benefits people get today from government outlays, attempting by efficient allocation of resources to maximise these benefits. And we should not penalise people alive today in order to further increase the well-being of people alive in the future.