Most countries face an ageing problem, as the elderly (65+) population increases relative to working age population. Driving this demographic shift are the baby boomers’ retirement and increases in longevity. Public finances will be strained as more persons depend on pension expenditures and old-age care, while a stagnating or shrinking labour force produce matching revenues.
A few years of deficits are no problem if they are matched by budget surpluses in other periods so that the debt level does not explode. However, many countries face a sustainability problem since budget deficits have become systematic and are therefore causing growing public debt levels. As part of the Stability and Growth Pact, EU member countries assess the long-term sustainability of their fiscal policies. Monitoring fiscal balances and tackling reform are major concerns.
The pre-funding strategy
A quite common view in policy reports from the IMF (2004), OECD, EU (2006), and researchers is that the appropriate response to fiscal sustainability problems is to consolidate public finances. That is, when there is a trend deterioration in the budget, sufficient surpluses should be ensured in the initial phase to be able to finance deficits arising later. This pre-funding strategy ensures that the intertemporal budget constraint can be met. Two arguments are usually given in favour of this strategy – an efficiency argument and an equity argument.
The efficiency argument is based on the tax smoothing argument advanced by Robert Barro. Tax distortions are minimised by adopting a constant tax rate that is consistent with long-run revenue requirements. Temporal variations in expenditures should be allowed to affect the budget balance. Applying this reasoning to the ageing problem suggests that a once-and-for-all strategy is needed to ensure that sufficient consolidation takes place prior to the demographic changes taking full effect.
The equity argument is often phrased as the claim that no bills should be left to future generations. The presumption is thus that a trend deterioration in public finances is caused by current generations not paying sufficient attention to the implications of current policies for future generations.
The pre-funding view is often uncritically adopted, perhaps because the standard metric of sustainability problems is expressed in terms of the permanent improvement in the budget balance (as a percentage of GDP) needed to meet the intertemporal budget constraint for the public sector. Given the trend decline in the budget balance, this automatically implies pre-funding.
This metric of sustainability problems is quite useful in identifying whether there is a policy problem and its order of magnitude, but it becomes problematic when it is turned into a normative target for public finances.
There is reason to question both the efficiency and equity argument underlying the pre-funding strategy. While tax smoothing is unchallenged, an overly narrow interpretation would be unwise. While it may not be appropriate to close a budget by a trend increase in tax rates, there are other possible reform avenues. Likewise, it is not obvious that future deficit problems are equivalent to current generations leaving “unpaid bills” for future generations.
In discussing policy responses to the ageing problem, it is important to distinguish between its two drivers, fertility and longevity. The temporary spike in fertility in the 1940s and 1950s caused a baby-boom effect, resulting in large generations approaching retirement today while smaller generations enter the labour market. These variations in fertility and thus the dependency ratio are irreversible, but in a demographic sense, they constitute a temporary phenomenon (presuming that fertility has now reached a new long-run level). The consequences of this fertility change have to be shared or smoothed, and the pre-funding strategy is in order here.
For longevity, the situation is different. First, increases in longevity constitute a more permanent change (ruling out epidemics causing steep increases in mortality). Most countries have experienced and are forecasted to experience further increases in longevity. Second, longevity differs from changes in fertility as it has a direct welfare consequence for individuals, and increasing longevity is a fundamental indication of improved living standards (e.g. weighted by 1/3 in the Human Development Index calculated by the UNDP). The policy issues raised by increases in longevity are therefore fundamentally different from those caused by variations in fertility.
Figure 1. Longevity trends
Source: UN Population forecasts
For longevity, the real issue is that there has been and will continue to be a widening gap between the number of years people spend inside and outside the labour market. When longevity increases and retirement ages stay constant or even fall, it is implied that each generation tries to benefit from existing schemes by taking all of the longevity gain as an increase in retirement (leisure). Obviously this is not possible, and this is the main reason for the projected trend decreases in the budget balance. A much more straightforward reform agenda would thus be to ensure that retirement increases alongside longevity. Linking retirement ages to longevity will remove a significant part of the trend deterioration in public finances, and it will ensure that the burden of adjustment is carried by those gaining from increases in longevity.
Raising retirement ages may not be an easy political task. One reason is that some past policies have sought to solve unemployment problems by reducing the labour supply through early retirements. This was a mistake, and today’s challenge is not only to repair the consequences of these policy failures but also to ensure that retirement ages increase as we move forward. The precise way by which to increase effective retirement ages will differ across countries depending on specific institutional arrangements. One element would be to not subsidise early retirement. Another would be to increase statutory ages in the pension scheme alongside increases in longevity; for example, Denmark’s scheme is explicitly indexed to longevity.
Whereas a pre-funding strategy implies that current, relatively short-lived generations finance some of the cost of future generations enjoying longer longevity, an alternative reform strategy would ask those reaping the gains from increases in longevity to pay for them.
Andersen, T.M., 2008, Demographics and fiscal sustainability – should we save or work more; CEPR Discussion Paper 7044.
European Commission, 2006, The Long-Term Sustainability of Public Finances in the European Union. A report by the Community Services.
IMF, 2004, World Economic Outlook - The Global Demographic Transition, September 2004.