Mystery of the state's missing billions

WHY ARE governments so strapped for cash? Two of the big news stories of the week highlight the pressure on public finances. One was the dismay of two large groups of public sector employees, the teachers and the health staff, when they learned of the very small pay increases proposed for them - "increases" that may well turn out to be cuts in real terms once inflation takes its bite. The other story was that excellent Rowntree report Income and Wealth, which showed that inequality had risen sharply in the UK since 1977.

Both stories raise questions which go beyond simple pressure on public spending. The pay levels for teachers and medical staff raise questions about the efficiency and management of these two giant service industries. And the rise in inequality has much to do with changing family structures and changing demand for different types of skill. But the plain fact remains, if there were not so much pressure on the Government's finances it would find it easier to do what the vast majority of people would like it to do: pay teachers and health workers better, and seek to alleviate more effectively the worst effects of the rise in inequality. Whatever one's political position on the Government's taxing and spending priorities, it is hard to deny that were the cash available, there would be plenty of really worthwhile things on which to spend it. The days of the 1960s, when governments seemed to have vast amounts of money for everything from the new universities to Concorde, seem a distant dream.

Yet taxes in the 1960s, expressed as a percentage of GDP, were actually lower than they are today, and much lower in the early 1960s. The first graph below shows how between 1969 and on present projection 1999 there has been no long-term change in the level of taxation in this country expressed as a percentage of GDP. True, the level has ducked around a bit, and true, there has been a rebalancing of taxation, with more coming from taxes on spending and less on taxes on income. But if you iron out the fluctuations, there has been no clear trend either way for 30 years - a whole generation.

So what has gone wrong? I think there are at least three reasons for the increased perception of financial pressure. The first is that to some extent the dream of a golden past is a misperception. Look back at the newspapers of the 1960s and they were full of rows about cuts in public spending and stories about angry teachers and health workers. But there are two more substantive reasons for the increased pressure. One is demography, while the other is the social and economic change charted by the Rowntree Foundation.

Demographic change is such a slow process that it frequently escapes attention. The second chart shows how the population not just of Britain but also the other Group of Five countries has been ageing since 1950 and will continue to do so through to 2020. An ageing population puts a two-way squeeze on governments: as the proportion of people of working age falls, revenue is cut. And as the proportion of people of pensionable age rises, extra public spending is required on two large areas: health care and pensions. If this is a problem for Britain, it is a much more serious one for Germany, France and, most of all, Japan. The proportion of over-65s has risen sharply since 1950, but we now have breathing space for the next few years, when the proportion actually falls a little. This gives an opportunity to buttress public-sector pensions with expanded private-sector schemes. For most other large industrial countries (which, with the exception of the US, have less developed private pension provision) the position is far worse.

There are no similar simple graphs that can chart the other reason for pressure - the complex web of social and economic changes that have combined to increase inequalities. This is obviously and properly an extremely important political issue: Gordon Brown, the shadow chancellor, identified some changes to the tax and benefits system that a Labour government would seek to introduce, in a speech on Friday afternoon. The present Government will find it hard to counter claims that it has been insensitive on the question of inequalities: upping the pay of top civil servants in the same week as clamping down on the pay of nurses. But to see this in purely political terms is as myopic as to see it in purely economic or social terms. And it is very difficult to discern the economic or social causes of the rise in inequality.

For example, something has clearly happened to the return on skills: people with skills demanded by the marketplace have done relatively much better than those without: many of those without have become unemployed. But if one asks why this should be, one runs into a quagmire. Rising competition from low-wage countries in East Asia? To some extent maybe, but we import only a tiny proportion of our goods from those countries. Fall in manufacturing employment? Yes, but why should new jobs in fast-growing service industries be worse paid than old ones in manufacturing? (And actually some studies suggest they are not.)

Or take the changes in family structure, in particular the rise both in dual- income professional families and the rise in single parenthood. It is easy to see that these changes will increase inequalities. It is easy too to see that a rise in the divorce rate will put pressure on public finances: a study by Relate in the late 1980s put the cost to the taxpayer of each divorce of a family with children at more than £10,000. It will be much higher now.

But if you ask why these changes in family structure are happening, it is very hard to give a satisfactory answer. All we can be absolutely clear about is that the state is having to take on an additional burden as a result.

So that is why governments are under pressure. What can be done?

There is no simple solution to such a vast and complex problem. But there are some ways forward. One is to identify the extent to which the burden on taxpayers is rising and will continue to rise. Amazingly, hardly any government in the world identifies in its annual budgetary accounts the unfunded liabilities that it is building up in future pensions. This is enormously important if one is concerned - as one should be, with fairness between generations. A handful are looking at ways of accommodating such future liabilities - the handful includes Britain, which put out the Green Paper Better Accounting for the Taxpayer's Money last year.

The next thing is to explain to voters why government liabilities are rising Growing unemployment, self-evidently, is a burden on taxpayers. But how many people appreciate that divorce costs public money, too? To identify a problem is not to solve it, but until it is identified it is impossible even to think about ways in which it might be addressed.