Sunday, October 17, 2004
Higher taxes won't solve the pensions paradox
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

Anybody who has studied economics will have misty recollections of Keynes’s so-called paradox of thrift. This was the conundrum, identified by the great man, in which a decision by everybody to save more would actually — and paradoxically — result in total savings in the economy falling.

How so? A big increase in saving now would mean less spending, slower growth, higher unemployment, weaker incomes and, ultimately, lower saving. Prudence would have come at a price, and that is worth bearing in mind in the current debate.

While the paradox of thrift, like a lot of Keynes’s thinking, has suffered with the passage of time, it is an observable fact that economies can have too much saving and too little spending. Think of Germany and Japan over the past decade.

I thought of this last week when I heard Adair Turner, chairman of the Pensions Commission, being asked whether we should be saving an extra £57 billion a year towards pensions. His answer was a horrified no.

Not only would the loss of demand of more than 5% of gross domestic product send the economy tumbling into recession, but such a wall of money would severely test the capacity of the savings industry and probably result in lower returns.

We do, however, have to save some more, or be forced to through higher taxes or compulsory pension contributions. The question is how much. And the answer depends on the extent other things change.

One eye-catching figure in the commission’s report was £57 billion. This is the annual amount the government would have to add to state provision through higher taxes and National Insurance contributions, at current prices, to guarantee that pensioners in 2050 are “on average as well off as today”.

But there were other eye-catching figures too, notably the £2,250 billion people own in housing equity. We are supposed to be sniffy about the idea that “housing is your best pension”, but the Turner report suggests we should rein in our contempt. The amount of housing equity is nearly twice the £1,300 billion held in occupational and personal pension funds. Drawing down housing wealth will not provide a retirement income solution for all, but it will for many.

The report also draws out the huge inequalities in pensions. This is not just that some current pensioners are enjoying the fruits of the “golden age” of occupational pensions while others are not. It is not just the fact that, according to Turner, more than 9m people are under-saving, some severely. But there are also inequalities, depending which part of the economy you work in.

Britain’s public sector accounts for 18% of jobs and earnings but 36% of accrued pension rights — and the latter share is predicted to increase over time. Superior public-sector pension rights are in danger of becoming a hugely distorting factor in the job market.

There is one other fact, among many, worth recounting.

Compulsion, in terms of pension contributions, has had a bad name, the argument being that if you compel companies and individuals to pay into pensions, other savings will collapse. But the report leaves open the door to compulsion, quoting evidence from the Reserve Bank of Australia that net savings have risen, particularly among lower earners.

However, compulsion has to be handled with care. Relying on employers for compulsory contributions, as in Australia, just increases the burden of employing people. Compulsory contributions from individuals are just a disguised form of tax.

Even more undesirable are explicit extra taxes to pay for better pensions. Had Labour conceded the scale of the future pensions crisis in 1997, and directed its efforts — and higher taxes — towards it, that would have been one thing. But we have had the increases in taxes and spending, on health, education and the chancellor’s misdirected tax credits. Not only would more taxes be damaging, but people are no longer prepared to believe pension promises from this government.

So what is the solution? There is no doubt that in economic terms the most desirable response is later retirement. It adds to the supply of labour and the length of time in which people are paying into the system — private and public — rather than taking from it. It is the logical response to greater longevity.

But it is not as straightforward as it looks. One of the Turner report’s fascinating findings is that, because of the effect of baby boomers passing through working age and into retirement, any increase in retirement ages in the coming years would need to be greater than the rise in longevity to guarantee adequate pensions.
Men currently retire at an average age of 63.8, but this would need to rise by six years to 69.8, on top of equalising the male and female retirement ages at 65.

That is possible for a substantial part of the workforce, and employers have to rethink the way they treat older workers — a gradual glide into retirement being much better than a sudden jump. But later retirement on its own will not solve the problem.

This means it must be combined with higher saving. While an enormous increase in saving would take us towards Keynes’s paradox of thrift, some increase would be healthy. It would help rebalance the economy away from consumer spending and provide funds for productive investment. How to achieve it?

Brown is never going to reverse his £5 billion annual raid on pension funds, but he should be locked in a dark room until he agrees to restore some decent savings incentives.

The barriers between pensions and other assets, including housing, need to be broken down. The corrosive impact of means testing, in effect the renationalisation of pensions, needs to be lifted, mainly by scrapping Brown’s pension credit.

There is a solution to the pensions crisis, through later retirement and reviving the “voluntarist” approach to saving. Whether this government has the wit to do it is another matter.

PS: A game of hard cop/soft cop is going on at the Bank of England. In the past month two members of the monetary policy committee (MPC), Kate Barker and Steve Nickell, have suggested that interest rates are close to their peak. But last week Mervyn King, the governor, generated headlines by suggesting that there were further rises to come.

Actually, King appears to have been playing a bit of hard cop/soft cop of his own. A reading of the speech he delivered at the Eden Project in Cornwall suggests that it was straight down the middle.

He said, elaborating on points discussed here last week, there were reasons to think that the pressure for rate hikes had subsided — notably slower growth in the world economy. But there were also counterbalancing factors, in particular a weaker pound.

His message was a neutral one: “If you are interested in the future path of interest rates, don’t read my lips, read the economic data.”

A slightly harder message appeared to emerge, however, when the governor went off-script in an interview for the Western Morning News. Asked whether we were at the peak, he said: “It is not fair to say that they have peaked because I don’t know where interest rates will go, nor does anybody else.”

But while the language may have been different, the message was essentially the same. If the figures on growth and inflation come in weak, rates may not rise much, if at all.

The “softer patch” acknowledged by King, and inflation of just 1.1% — admittedly on the government’s dodgy new target — should mean no more hikes this year.

Whether anything more needs to happen next year depends on how long we get bogged down in the soft patch. It may be some time.

From The Sunday Times, October 17 2004