Paying for the welfare state without raising taxes

LONDON — The current value of the US government’s unfunded pension and Medicare liabilities is $46.7 trillion, or roughly two-and-a-half times US GDP. Other estimates put that figure much higher. In the United Kingdom, a similar calculation by the Adam Smith Institute yields a £1.85 trillion “hidden debt time bomb”. And the situation in Switzerland, France, Belgium, Germany, Austria and Spain is little different. It seems that all advanced economies are facing public-finance trouble ahead.

Or maybe not.

What if there really is such a thing as a free lunch? What if there was a way to raise the money to pay for social-welfare programmes, such as pensions and healthcare, without imposing extra taxes? In fact, there is: national treasuries should establish Social Care Funds that borrow money at low interest rates and invest the proceeds in the stock market.

According to one study of a century’s worth of data from 16 advanced economies, the return from investing in stocks was 6.96 per cent higher, on average, than the return on government bonds. And there was remarkable consistency across countries. Denmark had the smallest equity premium, of 3.8 per cent, while Japan’s was the largest at a whopping 9.89 per cent.

There is some evidence that the equity premium has been a little lower in recent years, so let us conservatively assume that it will be approximately 4 per cent over the next 50 years. This implies that governments will be able to borrow from the public at a rate of 4 per cent below the level of stock-market returns. How can that be, and why has not some rich investor arbitraged this equity premium away?

Here, it helps to think of asset markets as existing to allow trades between different kinds of people and specifically to allow the young to save for their old age. Taking that approach implies that market volatility has nothing to do with economic fundamentals. Rather, it reflects the animal spirits of investors, who engage in orgies of buying and selling stocks and shares, fuelled by self-fulfilling waves of optimism and pessimism. According to this view of markets, volatility exists because almost all the people that you and I will trade with in the financial markets are not yet born.

In my book ”Prosperity for All”, I call this the absence of a prenatal contract. Suppose, counterfactually, that such contracts did exist. In this make-believe world, the unborn would buy assets that pay off in bad states of nature, and they would pay a premium in good states. And perhaps surprisingly, the very existence of those trades would eliminate market volatility in the first place. In reality, however, asset markets are volatile because the unborn are not able to exploit arbitrage opportunities. Those opportunities are reflected in the equity premium.

But, although future generations are not yet around to trade in the asset markets, national treasuries can trade on their behalf. There is a massive free lunch staring us in the face. You and I cannot exploit it, and nor can Bill Gates or George Soros. Only the treasury of a sovereign country is rich enough to arbitrage away the equity premium, because only it can trade on behalf of the unborn.

To see how it would work in practice, consider the UK. Its GDP is approximately £2 trillion and the value of all traded equities in the FTSE 100 index is roughly the same. The UK Treasury would first need to decide which assets it was willing to buy. I have previously suggested that it should purchase a broad value-weighted index fund consisting of every publicly traded share. The treasury would then borrow money and invest in the index fund.

I would also propose that the UK Treasury start small, for example, by establishing a Social Care Fund of £100 billion. Assuming a 4 per cent equity premium, investing this amount in shares would return £4 billion per year on average, or roughly what the UK currently raises in inheritance taxes each year. That is not peanuts, but nor is it enough to fill the pension gap.

Still, if a trial of that size were successful, the scheme could be ramped up. If the Treasury were to borrow £1 trillion, equivalent to roughly 50 per cent of UK GDP, and invest this sum in index funds, the expected revenue would be around £40 billion per year, not far short of what the UK currently raises through corporation tax. That is serious money and has a present value of £1 trillion if capitalised at 4 per cent.

What if the government lost its shirt? Would not a market crash of 10 per cent or 20 per cent devastate UK public finances?

No. In most advanced economies, governments take in the equivalent of at least 40 per cent of GDP in tax revenues. The net present value of that revenue, capitalised at 4 per cent, is ten times GDP. Governments therefore have very deep pockets with which to move markets if needed. Alternatively, a national treasury could choose to absorb its losses by riding out a major recession. After all, markets cannot remain irrational for longer than the treasury of a large advanced economy can remain solvent.

I am not a big fan of government intervention in markets. Anyone who suggests that there is a free lunch must first explain what governments can do that private individuals cannot. The explanation, in this case, is simple: governments can make trades on behalf of the unborn that leave all of us better off. Surely that is a better way for national treasuries to pay for social welfare than trying to squeeze another £40 billion per year from an already overtaxed population.

Roger E.A. Farmer is professor of Economics at the University of Warwick, research director at the National Institute of Economic and Social Research, and author of “Prosperity for All: How to Prevent Financial Crises”. Copyright: Project Syndicate, 2019. www.project-syndicate.org