Demographic transition, taxes and sustainability of public finances: simulations of alternative policies to smooth the burden across generations

A number of developed countries are starting to grey, some – like Finland – sooner than others. Moreover, as these countries advance in age, the worst may not be the physical impact but rather the impact on economic health. How exactly will these economies fare given that, relative to the present, there are, in the not so distant future, perhaps twice as many elderly persons relying on just 15 per cent more workers for their financial support? This support will be delivered primarily through publicly funded programmes, such as Social Security and Medicare in the USA, which, in many countries, will start paying benefits to baby boomers in just a few years from now. One of the key problems facing the present governments is that the underlying funding gap could be very non-trivial so that, given the current and future benefits, the implied increase in effective taxes would sharply increase the lifetime tax burden and labour supply disincentives of current and future generations.

The projections for the US economy discussed by Gokhale and Kotlikoff (2000) are in this context highly suggestive¹. To eliminate the funding gap in the USA, without cutting current or future benefits, requires an immediate and permanent 10 percentage point increase in the Federal Insurance Contribution Act (FICA) payroll tax – currently 15.3 per cent of total payroll. As it is, today’s newborns in the USA are projected to hand over about a quarter of their lifetime earnings to the government in taxes net of transfers. A 10 percentage-point payroll tax hike would raise this lifetime net tax rate to more than one-third. It would also substantially raise the marginal tax rates of US taxpayers, most of whom are currently paying nearly 50 cents of each dollar earned to the federal and state governments. Since the economic costs of tax distortions increase with the square of the tax rate, moving workers from 50 per cent to 60 per cent effective marginal net tax rates increases the tax-system excess burden due to distortion of the labour supply by 44 per cent. Furthermore, one should bear in mind that delay in implementing reform will necessitate even larger tax increases or benefit cuts in the future.

While these calculations indicate that the excess burden of distorting taxes can be large, they do not reveal the full dynamic macroeconomic implications of using these taxes to fill the funding gap. Furthermore, because the US economy is large and not so open, lessons drawn from studying the macroeconomic effects of alternative policies for closing the US funding gap may have to be scrutinized for application to a small open economy like Finland. In any case, it is clearly worthwhile to learn about these dynamic macroeconomic effects in a small open economy by reading a forthcoming Bank of Finland discussion paper "Government Funds and Demographic Transition – Alleviating Ageing costs in a Small Open Economy" by Helvi Kinnunen. As the author notes, population ageing is one of the hottest policy issues in almost all of the European countries. That the average old-age dependency ratio in Europe is projected to double over the coming four decades gives one a taste of the underlying demographic trends. European countries do not differ in these broad demographic trends, but do display differences in the extent and timing of major demographic shifts. Many European countries are set to encounter the initial shifting in the late 2020s. Finland is already grappling with the big changes. Current demographic trends in Finland will raise the old age dependency ratio from the present 25 per cent to about 40 per cent by 2015, after which the ratio will begin to level off at roughly 45 per cent.

As the author notes, policy measures have been taken in Finland to address the underlying pressure on the financing of the pension liabilities. The pension system has been reformed. A series of smaller revisions to the system were implemented in the 1990s, and in 2005 some more fundamental changes were introduced: labour supply incentives were strengthened and benefit ratios were effectively lowered by tying them to life expectancy and to expected retirement time. A second fundamental change was an increase in the degree of funding of the pension system as well as a reduction in government indebtedness. These latter measures increased government net financial wealth effectively to 30 per cent of GDP in 2006 from -20 per cent of GDP in the early 1990s. According to current projections, government funds will increase further to some two and a half times total wages by 2030, and will remain at that level even after the demographics have stabilized. Despite all this, sustainability of public finances will require increases in pension contributions and taxes.

Kinnunen focuses on simulating the role of public funding in intertemporal smoothing of the implied tax burden of population ageing and on studying the small open economy effects of these policies. A number of similar simulations on the effects of pension reforms have been performed in the literature, which tempt one to the conclusion that the implied deadweight losses from tax increases depend on how tightly households perceive the link to be between taxes or contributions and benefits. The earlier referred-to simulations suggest that if households see the link as a tight one, the efficiency losses in terms of employment can be very small indeed. In the Finnish case, the outcome is not obvious since, as argued by Kinnunen, the perceived link between taxes and benefits is very weak or even absent. Furthermore, many of the referred-to simulations use a closed-economy macro-model, whereas Kinnunen uses the Bank of Finland's dynamic general equilibrium model, which is a modification and extension of Mark Gertler's (1999) model of a life-cycle economy². Gertler's model, in turn, is a generalization of the model of finite horizons by Olivier Blanchard (1985)³, in that, instead of simply assuming a constant periodic probability of an agent dying, as in Blanchard, Gertler's model posits a constant periodic probability for a worker to retire and, conditional on retirement, a constant periodic probability of an agent dying. The model also allows for a non-zero labour supply for retirees. More importantly for the issue at hand, the Bank of Finland model incorporates a fairly detailed structure of government finances. Also, the model has been calibrated using Finnish data. In particular, the population dynamics in the model are based on calibration using Finnish population data.

So, what do the simulation results suggest about the dynamic macroeconomic effects of using public funding to smooth tax increases called for by the funding gap due to population ageing? First of all, on a transition path to an older steady-state population public funding can be used to spread over time, and even reduce, the tax-related ageing costs. From the perspective of labour market tightness, lower taxes stimulate labour supply just at the right time, ie when the labour markets suffer from substantial tightness. Increased use of public funds helps to reduce the pressure on wages when the population is ageing, which in turn tends to sustain higher employment and productivity growth. The author also finds that, given the collective nature of public funding, no redistribution of wealth between workers and retirees could be observed. All in all, the model experiment promises perhaps even substantial welfare gains from using public funding to reduce the pressure for employing distortionary taxes to close the funding gap. Furthermore, given the small open economy setup, even temporary tax cuts may have long-term effects on factor prices that would imply a more labour-intensive production structure for the economy. Surely we will see more results from experiments like that of Kinnunen being published in the future. These will use dynamic macro-models tailored to the specific questions one is seeking to answer. It may turn out that it is not easy to compare these models and hence it may be difficult to get an informed debate on the results of the various simulations. However, it behooves researchers to continue working with these models and doing the simulations. Established and well known principles are being followed in constructing these dynamic optimizing models, and this will ensure a common approach and language among researchers for their debate on simulations related to crucial policy issues such as the funding of pension and social security systems.