Patrick Nolan: The pension system needs reform, but "raiding" funds is not the way to build a culture of savings

Dr Patrick Nolan is the Chief Economist of the independent think tank Reform. Its new research report Entitlement Reform is released today.

On the Andrew Marr show on 7 October David Cameron quite rightly put welfare reform at the centre of the Government’s plans to rescue the public finances. The government spends more on welfare than on anything else and it is simply not possible to fix the public finances without getting the welfare budget under control. Yet there is a major blind spot in the Government’s plans. The Prime Minister has continued to rule out saving money in the largest part of the welfare budget – that relating to pensioner benefits. As a Reform report released today shows, this is not only the wrong thing to do but is a political mistake.

Reform’s research looked at the welfare states in Australia, New Zealand and the United Kingdom. These countries provide an interesting comparison given their similar social policy traditions. They also provide important lessons – on what to do and on what not to do – for each other.

Australia has done the most to encourage a nation of savers and private contributions to services like healthcare. In the United Kingdom and New Zealand pensioners rely to a greater degree on the government for their incomes. A similar bias is present in their health systems, with both countries having relatively low levels of private health funding.

The Australian approach of encouraging people to make provision for themselves and their families provides real benefits. Private funding creates the space that makes public programmes affordable in the long run and lowers the risk of deficits returning and debts increasing. Emphasising the role of saving and products like insurance and equity release can also highlight the options that families have. They do not just have to rely on what the State provides but can make arrangements that reflect their circumstances.

But it is perhaps the political effects of a mixed model of funding that are among the most important. Sharing the costs of welfare helps build the consensus that funding is not just the job of the government. This means that voters do not only demand further expansion of the welfare state but also look to governments to introduce pro-growth policies, such as more competitive tax systems, which will help grow the value of their savings over time. As the voting power of the elderly lobby is only going to increase (by 2020, 45 per cent of voters will be 55 or older), ensuring they have an interest in pro-growth policies is vital.

This raises the question of what should the government do to encourage people to make provision for themselves? The key lesson from Reform’s study is that the answer is not tax breaks or subsidies, but clarity and consistency. Decisions regarding savings and the purchase of private income support policies are by their nature long-term ones. The more uncertain the environment, the harder it will be for families to make the decisions that are in their longer-term interests and for private providers to complement State programmes.

This is why George Osborne risks scoring an own goal with plans to raid pension tax relief in the Autumn Statement. There is little doubt that the current system of pension tax relief is expensive (equivalent to around 2% of GDP) and poorly targeted (much of the relief goes to people who would have saved anyway). The system needs reform. Yet rather than a naked tax rise on the rich, any changes should be part of a coherent package that aims to increase saving and lower the cost to the taxpayers.