This Selected Issues paper on the United Kingdom reviews the IMF's Global Economy Model, which incorporates energy to examine the impact of rising energy prices on the United Kingdom. The model incorporates energy as a final consumption good as well as a primary input in the production process. With energy entering the production process, increases in energy costs affect overall aggregate supply capacity as firms reduce output and factor-utilization rates given the real increase in their cost structures.

Abstract

This Selected Issues paper on the United Kingdom reviews the IMF's Global Economy Model, which incorporates energy to examine the impact of rising energy prices on the United Kingdom. The model incorporates energy as a final consumption good as well as a primary input in the production process. With energy entering the production process, increases in energy costs affect overall aggregate supply capacity as firms reduce output and factor-utilization rates given the real increase in their cost structures.

IV. Long-Term Health Care Costs: Will They Make the Budget Sick?32

The U.K. government projections, which factor in only demographics and changes in health status, suggest that health care spending will rise by just 1½ percent of GDP between 2007–50. Using the government’s estimates as a baseline, this paper shows that, taking account of both demographic and non-demographic factors, health spending could rise by nearly 6 percent of GDP. While the U.K. is among the few countries that regularly provide comprehensive long-term scenarios to assess the impact of population aging on fiscal sustainability, there is scope for improving these exercises by disclosing full extent of risk and uncertainty surrounding health care spending projections.

A. Introduction

1. The United Kingdom, like most industrialized countries, faces significant challenges associated with the aging of the population. While cross-country comparison shows that the U.K. population is projected to age less rapidly than in many developed countries, demographic pressures from higher life expectancy and the impact of post-war baby boom remain substantial. The number of people over the age of 65 is projected to increase by 90 percent by 2050, from 16 percent of the population to 25 percent. As a result, the old-age dependency ratio is set to rise to about 40 percent over the next five decades.

uA04fig01

UK Population by Age Group

(2004=100)

Citation: IMF Staff Country Reports 2006, 087; 10.5089/9781451814309.002.A004

Source: UK GAD
uA04fig02

Old-age Dependency Ratio

Citation: IMF Staff Country Reports 2006, 087; 10.5089/9781451814309.002.A004

Source: UN

2. Population aging will have significant budgetary implications, especially on health care expenditure. The average person aged 65 or over costs the U.K. health system about 5 times more than the average person under 65, excluding costs associated with birth. However, demographic factors will not be the only important driver of future heath care expenditures. In fact, a wide literature has stressed the crucial role that will be played by non-demographic factors—such as technological advance, productivity, health status, and changes in the coverage of the public health system—in driving health care spending over the long run.

3. The U.K. government’s long-term fiscal projections do not factor in the potential impact of demand and technology advances on health costs. Since 2002, the government has published a Long-Term Public Finance Report (LTPF Report) at the time of the Pre-Budget Report. The report provides detailed scenarios and sensitivity analysis to evaluate the long-term risks in meeting the Sustainable Investment Rule—40 percent of GDP debt ceiling.33 In the 2005 LTPF Report, health care spending rises by one percentage point of GDP by FY2007/08, consistent with the 2004 Spending Review, and then is projected to increase by another 1½ percentage points of GDP by 2050, reflecting only the effects of demographic changes and health status. In contrast, studies done for some other countries project more dramatic increases in health care spending, on the order of 5 percentage points of GDP or higher, when both demographic and other major non-demographic factors are considered. These studies also stress the substantial uncertainties involved in long-term projections of health care expenditures. They point to the need to look at all cost drivers and to consider uncertainties in assessing long-term fiscal sustainability.

4. This paper focuses on the magnitude and uncertainties surrounding the impact of non-demographic factors on future health care spending in the United Kingdom. The basic conclusion is that, taking account of both demographic and non-demographic factors, health care spending could rise by about 6 percentage points of GDP between 2007 and 2050, significantly higher than the government’s projections of 1½ percentage points of GDP. Large uncertainty, however, surrounds these projections, especially associated with non-demographic factors. While the United Kingdom is among the few countries that regularly provide comprehensive long-term scenarios to assess the impact of population aging on fiscal sustainability, there is scope for improving these exercises. To enhance fiscal transparency, and potentially enhance the credibility of policy decisions to tackle these long-term issues, especially with regard to health care spending, the government could disclose the full extent of risk and uncertainty surrounding its long-term projections.

5. The paper is organized as follows. Section B describes the key characteristics of the U.K. population and the main features of the U.K. health system. Section C provides a brief survey of approaches used in projecting health care spending. Section D discusses the government’s projections of long-term health care costs presented in the December 2005 Long-Term Public Finance Report. Section E presents illustrative alternative scenarios to quantify the magnitude of uncertainties in the U.K. projections. Section F provides some concluding remarks.

B. Some Characteristics of the U.K. Population and the Health System

6. The U.K. population is aging. The proportion of the population over 65 has increased from about 11 percent to 16 percent over the past five decades. The pace of aging is expected to intensify in the coming decades, as the post-war baby-boom generation reaches retirement age, fertility rates remain subdued, and life expectancy continues to increase steadily. The U.K. Government Actuary’s Department (GAD) projects that the number of people in the United Kingdom aged 65 or over will increase by 90 percent over the next fifty years. The pace of aging is projected to accelerate from 2007 to 2030, reaching nearly a quarter of the total population by 2050. The number of very elderly people (aged 85 or over) will rise even more rapidly, with its proportion of the population more than tripling from today. The prospect of an aging population in future decades will clearly have implications for the costs of providing healthcare, as the need for health care is greatest among very elderly people. In FY2002/03, health care spending on those aged 65 and over accounted for about a half of total health expenditure.

uA04fig03

The Share of the aged 65+

(Yearly change in levels)

Citation: IMF Staff Country Reports 2006, 087; 10.5089/9781451814309.002.A004

uA04fig04

Health Spending Per Capita 2002/03

(pound sterling, in thousands)

Citation: IMF Staff Country Reports 2006, 087; 10.5089/9781451814309.002.A004

7. The pace of aging will be relatively less rapid in the United Kingdom than in many other countries. Unlike many countries, the U.K. population has already undergone much of its aging. Cross-country comparison of long-term population projections show that the projected increase in the old-age dependency ratio over the next five decades is relatively mild for the United Kingdom, rising to about 40 percent. By 2050, the U.K.’s old-age dependency ratio is projected to be roughly the same level as in the United States, Canada, New Zealand, and Australia, but far below that of the continental European countries.

uA04fig05

Projected Old-age Dependency Ratio

(in percent)

Citation: IMF Staff Country Reports 2006, 087; 10.5089/9781451814309.002.A004

Source: UN

8. The United Kingdom spends a relatively small share of its national income on health care. Total U.K. health care spending (both public and private) was 7.7 percent of GDP in 2003, compared to a 10 percent average for G7 countries. Indicators of life expectancy and infant mortality in the U.K are less favorable than the G7 average. Measures of service quality, including hospital waiting lists and waiting times (which may be inversely related to “quality of life”) are also worse for the United Kingdom. Available cross-country information about waiting times suggest that all patients in the United Kingdom had to wait more than a month for non-emergency surgery, compared with only one in three patients in Australia, Canada, and New Zealand and just one in ten in the United States.

Increase in Health Care Spending

(in percentage point of GDP)

article image
Source: OECD Health Data 2005.
uA04fig06

Income and Health Spending per Capita

(in thousands, US dollar)

Citation: IMF Staff Country Reports 2006, 087; 10.5089/9781451814309.002.A004

uA04fig07

Health Outcome 2003

Citation: IMF Staff Country Reports 2006, 087; 10.5089/9781451814309.002.A004

9. The U.K. health system is characterized by a high degree of public sector involvement. Of total health care spending, over 80 percent is provided by the public sector. The U.K. National Health Service (NHS) since its establishment in 1948 has been one of the most centrally managed and financed health care system in the world. The U.K.’s large public sector involvement in health care is similar to New Zealand. In contrast, the private sector plays a larger role the countries like United States and Switzerland.

uA04fig08

Total Health Spending

(Public and Private)

Citation: IMF Staff Country Reports 2006, 087; 10.5089/9781451814309.002.A004

uA04fig09

Public Health Spending

Citation: IMF Staff Country Reports 2006, 087; 10.5089/9781451814309.002.A004

10. U.K. health care expenditure has risen less quickly than other G7 countries. The pace of increase accelerated in the early-1970s and again in the late 1990s. Since 1999, health care spending has grown on average by 7½ percent in real terms, compared to a historical average of 4½ percent. As a result, health care spending as a share of GDP Increase in Health Care Spending (in percentage point of GDP) increased by nearly 1¾ percentage points to about 7½ percent in 2004. Most of the other industrialized countries have experienced similar or even stronger pick-ups in health care spending during this period.

uA04fig10

GDP and NHS Spending per capita 1/

(1949=100)

Citation: IMF Staff Country Reports 2006, 087; 10.5089/9781451814309.002.A004

1/ In real terms, adjusted by GDP deflator.
uA04fig11

NHS Spending 1/

(Annual increase in percent)

Citation: IMF Staff Country Reports 2006, 087; 10.5089/9781451814309.002.A004

1/ In real terms, adjusted by GDP deflator.

C. Survey of Health Care Cost Projections

11. Traditionally, long-term health care projections have been derived by multiplying the last actual observation on health care cost per age group by projections for population by age group. In this way, projected changes in real health care spending reflect only changes in demographics. A cross-country comparison of age-related health care spending projections taking into account only the impact of demographic changes shows that the increase in the United Kingdom is moderate in relation to other European countries. This is consistent with the U.K.’s relatively slower pace of aging and lower per capita health care spending.

12. Recent literature suggests, however, that demographic changes may not be the key driver of future health care expenditure. Bjornerud and others (2005) show that demographic change accounts for only about 10 percent of the average growth in health care expenditure across the OECD over the past 30 years. Seshamani and Gray also find that the effect of aging has accounted for only a small share of the observed increases in health care spending between 1985 and 1999, especially in England and Wales with 2 percent—compared to 6 percent in Australia, 14 percent in Canada, and 56 percent in Japan.

uA04fig12

Projected Increase in Health Care Spending

(in percent of GDP)

Citation: IMF Staff Country Reports 2006, 087; 10.5089/9781451814309.002.A004

1/ European Commission, Stability Report.

13. Non-demographic factors play a major role in determining health care costs. The European Commission’s Aging Working Group identifies five key non-demographic factors driving health care spending: (i) health status; (ii) economic growth; (iii) technological and medical progress; (iv) the organization and financing of the health care system; and (v) health care resource inputs.34 Among these non-demographic factors, technological advances have been identified as the major factor affecting the level and rate of change in health care spending. OECD (1998) indicates that continued advances in technology has accounted for between 50 and 75 percent of increases in health care costs in the recent past. Other studies that examined specific medical procedures in the United States show that the rapid health care cost increases have been associated with the diffusion of existing technologies, rather than the emergence and implementation of new technologies (Fuchs (1998) and Okunade and Murthy (2002)). Similarly, in the case of the United Kingdom, Wanless (2002) shows that while medical innovations and more advanced procedures have reduced unit costs, increased demand by a greater segment of the population due to lower prices resulted in higher total health care spending.

14. More recent studies have attempted to incorporate the effects of both demographic and non-demographic factors in projecting long-term health care spending. To better characterize the impact of non-demographic factors (i) a life expectancy adjustment has been introduced to capture the health status of the population, reflecting different assumptions regarding whether the projected gains in life expectancy are spent in good or bad health; (ii) alternative assumptions regarding proximity to death have been included; and (iii) projections made regarding unit costs in the health care sector to reflect the influence of technology and other factors affecting costs. Recent health care projections for Australia (Productivity Commission (2005)) and New Zealand (Bryant et al. (2004)) incorporate all three of these elements.

D. The U.K. Government’s Projections

15. The 2005 Long-Term Public Finance Report projects that U.K. health care spending will rise only slightly over the coming decades. Initially, health care spending is projected to increase by one percentage point of GDP by FY2007/08 consistent with the government spending plan envisaged in the 2004 Spending Review. Then, based on the Government Actuary’s Department (GAD) principal population projections and assumed improvements in the health status of the elderly as life expectancy increases, the government projects that age-related health care spending will increase by about 1½ percentage points of GDP by 2050.

uA04fig13

Spending Projections 1/

(in percent of GDP)

Citation: IMF Staff Country Reports 2006, 087; 10.5089/9781451814309.002.A004

1/ 2005 Long-term Public Finance Report.

16. The small projected increase in health care spending from the impact of aging leads to only limited fiscal pressures in the medium-term. The government’s projections show that under the central assumptions, the U.K. public finances will satisfy the Sustainable Investment rule over the long term.35 The required improvement in the primary balance, the so-called fiscal gaps, to meet the 40 percent of GDP net debt ceiling is small and manageable. While substantial uncertainties surround these estimates, alternative scenarios in the Report suggest that the fiscal adjustments required to meet the debt rule would not be large, in the range of ¼ to ½ percentage point of GDP per decade starting in the 2040s.

17. The relatively favorable outlook owes much to the fact that it is based only on demographic changes and assumed improvements in health status. The latter assumption serves to reduce the potential impact of aging. At present, there is no clear evidence that there is a significant positive relationship between increases in life expectancy and the health status of the population. The government’s projections do not factor in the potential impact of demand and technology advances on per capita health costs, which is one of the key non-demographic drivers in projecting health care spending.

18. In contrast, projections of health care spending that incorporate these likely per capita cost effects suggest more substantial increases.

  • The 2002 Wanless report assessed the required health care spending to secure high-quality health services in the United Kingdom over the next two decades taking into account both demographic and non-demographic factors. The report concludes that the United Kingdom will face significant increases in health care spending to first catch up and then keep pace with the level of health care provided in other developed countries. In three different scenarios, Wanless projects that real health care spending would need to rise by 3-5 percentage points of GDP over the next 20 years.

  • Australia: the Productivity Commission (2005) projects that the government health care expenditure will increase from nearly 6 percent of GDP in FY2002/03 to about 10½ percent of GDP by FY2044/45, with population aging accounting for a little less than half of the projected increase. The Commission emphasizes that its projections are particularly sensitive to assumptions about the growth in prices of health services. With different assumptions regarding the rate of inflation in these prices, projected health expenditure in FY2044-45 are found to possibly range from 9 percent to close to 12 percent of GDP.

  • New Zealand: Bryant et al. (2004) explores the relationship between population aging, health, and health care prices to estimate future fiscal pressures for New Zealand. Their results suggest that non-demographic factors will have greater effects on long-term health care spending than demographic factors. Assuming a modest annual increase of 2.1 percent in prices of health services, which is slightly higher than the assumed overall inflation rate and significantly lower than the 3-4 percent annual increase in recent years, government health care expenditure would rise from 6 percent to about 12 percent of GDP in FY2050/51.

uA04fig14

Health Care Cost Projections

(in percent of GDP)

Citation: IMF Staff Country Reports 2006, 087; 10.5089/9781451814309.002.A004

1/ 2005 Long-term Public Finance Report.2/ Based on the “Solid” scenario.

E. Illustrative Alternative Scenarios

19. To illustrate the possible effects of non-demographic factors as embodied in the prices of health services, alternative projections can be derived based on the 2005 Long-Term Public Finance Report’s estimates. As constructed, the government long-term health care projections can be seen as implicitly assuming that the health care prices will rise at the same rate as overall inflation. Alternatively, based in part on historical experience, illustrative scenarios can be constructed based on different assumptions regarding the differential between the average annual rate of increase in health services prices and the economy’s overall inflation rate. This differential effectively embodies some of the key non-demographic factors effecting health care spending.

uA04fig15

Real NHS Pay and Price Index 1/

(Annual changes in percent)

Citation: IMF Staff Country Reports 2006, 087; 10.5089/9781451814309.002.A004

1/ Adjusted by the GDP deflator.

20. NHS per capita spending has increased significantly over the past 25 years across all health services. To a large extent, the steady increase in NHS per capita spending was attributable to increases in the prices of health services. The NHS measure of pay and price inflation (a weighted average of the annual changes in the pay cost index and the health service cost index in hospital and community health services (HCHS)) has exceeded the annual rise in the GDP deflator by 1.4 percentage points on average over the past 25 years.36 This differential in the inflation rate of health services has been more subdued in recent years, amounting to 0.7 percentage points on average since FY1993/94. Comparable price indexes are not available for the other major components of health care spending. Most notably, there is no index for pharmaceuticals, which is a large and rapidly growing component. Data for other countries (2005 OECD Health Data) suggest that pharmaceutical prices are increasing significantly faster than other health care services. For illustrative purposes here, three scenarios are constructed assuming that the annual differential in health service inflation and overall inflation in per capita terms is 0.7 percentage point in a low case, 1 percentage point in a medium case, and 1.4 percentage point in a high case.

21. In all three of the illustrative alternative scenarios, health care spending relative to GDP rises substantially more than in the government’s long-term health care projections. From 2008 to 2050, the increases range from 4½ to nearly 9 percentage points of GDP, compared to 1½ percentage points in the government projections. In the absence of appropriate fiscal adjustment these higher estimates of health care spending, in turn, suggest that—when interest costs are also factored in—government debt will exceed the 40 percent debt to GDP target in the Sustainable Investment Rule over a large part of this period Consequently, in contrast to the government’s long-term projections, these scenarios would suggest that significant policy adjustments would be needed. Without fiscal adjustment, the net present value of the additional debt that would be accumulated over the period would range from about 60 percent of GDP in the low case scenario to 140 percent of GDP in the high case scenario.

uA04fig16

Projected Health Care Spending

(in percent of GDP)

Citation: IMF Staff Country Reports 2006, 087; 10.5089/9781451814309.002.A004

1/ 2005 Long-term Public Finance Report.
uA04fig17

Additional Financing Requirements

Citation: IMF Staff Country Reports 2006, 087; 10.5089/9781451814309.002.A004

Projected Increase in Health Spending 2008-2050

(in percent of GDP)

article image

Includes additional debt stock reflecting non-demographic factor and compounded interest payments.

F. Concluding Remarks

22. The alternative scenarios presented here illustrate that long-term health care spending in the United Kingdom could rise significantly over the next five decades. In particular, they emphasize the importance of non-demographic factors in projecting health care spending. When factoring in the full effect of non-demographic drivers, U.K. public finances may face considerable challenges in meeting the net debt ceiling, which suggests that significant policy adjustments could be needed. To assess the possible magnitude of such fiscal costs adequately, more complete projections for health care expenditures are essential.

23. However, significant uncertainty surrounds health care projections. In addition to risks associated with non-demographic factors, population projections are subject to significant uncertainty. There are also uncertainties regarding how health status will change as life expectancy increases. It is not clear, a priori, whether an aging population with a longer life expectancy will enjoy more or less ill health. Even in an optimistic case where the aging population lives longer in better health, Pellikaan and Westerhout (2005) suggest it will not alleviate the fiscal problems, as it may just shift the composition of public expenditure from health to either longer-term care or pension expenditure.

24. The United Kingdom is among the few countries that regularly provide comprehensive long-term scenarios to assess the impact of population aging on fiscal sustainability; however, there is scope for improving these exercises. To draw implications for fiscal policy from such projections, it is essential to incorporate the uncertainty, particularly with regard to non-demographic factors such as the future prices of health care services. Such analysis would facilitate the policy responses over the medium term. In addition, in forming an appropriate policy response, consideration has to be given to the question of intergenerational equity. Doing the analysis now will help ensure those reaping the benefits of the spending have born an appropriate share of the cost. This will enhance fiscal transparency, raise the level of public debate on these issues, and potentially enhance the credibility of policy decisions to tackle these problems.

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32

Prepared by Keiko Honjo.

33

In addition, Budgets provide “Illustrative long-term fiscal projections” over the period of 30 years.

34

The Aging Group has not yet reached a consensus on how to incorporate such factors; however, it has identified that the health care projections are highly sensitive to the assumptions on unit costs.

35

Sustained Investment rule—the government’s fiscal rule aimed at assuring fiscal solvency—requires net public sector debt to be kept at a stable and prudent level, which the Treasury regards as below 40 percent of GDP.

36

The HCHS accounts for about 60 percent of total NHS expenditure. The pay cost index (PCI) is a weighted average of increases in unit staff costs for each of the staff groups within the HCHS. The Health service cost index (HSCI) is calculated to measure the price change for each of 40 sub-indices of goods and services purchased by the HCHS.

United Kingdom: Selected Issues
Author: International Monetary Fund