The prospect of “greying” populations in many developed economies is raising concerns about the sustainability of economic growth. According to these concerns, rising old-age dependency ratios translate into growing tax burdens while generous pension and healthcare benefits crowd out public investment spending for infrastructure or education, with negative effects for capital accumulation and productivity growth. Policymakers have already moved in response, with the EU launching its “Europe 2020” proposal calling for measures conducive to overcoming these challenges (see, for example, Council of the EU 2010).
This raises at least two questions. First, how justified are these concerns? The demographic transition has been ongoing for a while – developed economies have experienced a marked decrease in fertility and increase in longevity for several decades – without producing clear evidence that this transition has caused a fall in per-capita growth. The evidence is similarly mixed as far as government budgets are concerned. While the GDP share of transfers to the elderly has increased, the share of public investment does not show a clear trend in most countries, see Figures 1 and 2. Second, we might ask how realistic it is to expect policy intervention to improve the situation?
Figure 1. Public expenditure on pensions, % of GDP
Figure 2. Public expenditure on education and infrastructure investment, % of GDP
In recent research (Gonzalez-Eiras and Niepelt 2011), we address these questions by developing a tractable model that captures several effects of demographic ageing on government budgets and per-capita growth. Some of these effects arise directly, independently of policy changes. In particular, since slowing population growth requires a lower investment rate to keep the capital stock per worker constant, per-capita output growth tends to rise. At the same time, lower fertility increases the share of older workers who save little relative to younger workers with a high savings rate. The resulting fall in the average savings rate tends to slow down per-capita growth. Higher longevity has a similar, growth dampening effect by raising the share of older workers. Moreover, lower fertility and higher longevity also cause the savings rate and labour supply of younger workers to change.
In addition to these direct effects, falling fertility and rising longevity induce policy changes in the political process, thereby indirectly affecting economic outcomes. On the one hand, demographic ageing fuels the political support for social security transfers by increasing the relative political power of the old. On the other hand, higher longevity raises the political support by younger voters for productive public investment because these voters may enjoy the benefits of such investment over a longer time. And with the share of elderly in the population rising, the political process increasingly perceives the benefits of later retirement to outweigh the associated (political) costs.
The model predicts that the political conflicts between older and younger voters are resolved by compromise, with all policy instruments being adjusted upward. Simulations for a rich OECD economy, a rich European OECD economy, the US, and Japan all forecast a strong increase in the social security transfer share of GDP between the years 1970 and 2000, flattening out thereafter but increasing further up to the year 2080. The public investment share of GDP increases much more slowly, consistent with the evidence presented in Figures 1 and 2. Retirement age in the model rises by roughly 6 years between 2000 and 2080, to be compared with a predicted increase in life expectancy at age 65 of more than 8 years.
The growth effects induced by these policy changes are negative in sum although higher public investment rates foster productivity growth. Intuitively, increased tax rates for both transfers and public investment depress growth because they lower disposable income of savers, as do retirement benefits because they lower the incentives to save. Later retirement has an additional negative effect on growth, since by increasing labour supply it lowers wages and thus savings of younger workers.
Figure 3 illustrates the magnitudes of the direct and indirect growth effects of demographic ageing. The leftmost bar (denoted by “basis”) indicates the long-run annual per-capita growth rate subject to the demographic structure in a rich OECD economy around the year 2000. The other bars indicate the predicted growth rates after the completion of the demographic transition, under different assumptions about the adjustment of policy instruments. The bar denoted by “direct” indicates the new growth rate if only the direct effects are accounted for and the bar denoted by “total flex” indicates the new growth rate if direct and indirect effects are considered. The rightmost bar, denoted by “total fixed,” indicates the new growth rate if direct and indirect effects are accounted for but the retirement age is held fixed at its year-2000 value.
Figure 3 shows that the direct effects are positive, summing to 57 basis points of annual per-capita growth. In contrast, the indirect effects working through adjustments in policy are negative and amount to roughly 10 basis points, due to higher transfers and later retirement and in spite of higher public investment. With a capped retirement age, the indirect growth effects would be much more negative (37 rather than 10 basis points).
This last point is worth emphasising. While in isolation, the increase of the retirement age works towards reducing growth, fixing the retirement age would not improve growth prospects but, to the contrary, would go hand in hand with an even stronger downward pressure on growth. Intuitively, with a fixed retirement age, the transfer share of GDP would increase much more steeply in response to demands by elderly voters, rendering taxation costlier and triggering a decline in the GDP share of growth enhancing productive public investment. The scenario with a fixed retirement age thus closely corresponds with fears voiced in the policy debate. While the model encompasses the mechanisms underlying such fears, it predicts a different resolution of intergenerational conflict because of adjustments along the retirement margin.
Figure 3. Long-run growth effects of demographic ageing
The picture thus emerging is only partly consistent with the view underlying policy initiatives of the “Europe 2020” kind according to which the political process will implement measures to raise productivity in order to “outgrow” the burden imposed by demographic change. According to the model, demographic ageing indeed induces the political process to raise public investment in order to foster productivity growth. However, the main positive effects on growth arise directly, for example through capital deepening, and the net effect of endogenous policy on growth is negative. Viewed in isolation, the increase of the retirement age works towards reducing growth. However, when also considering the interaction with other policy instruments, flexibility along the retirement margin plays an important positive role for growth.
Council of the European Union (2010), “Conclusions on Innovation Union for Europe”.
Gonzalez-Eiras, M and D Niepelt (2011), “Ageing, Government Budgets, Retirement, and Growth”, European Economic Review, forthcoming.
OECD (2008), Economic Outlook (government fixed capital formation).
OECD (2008), Education At a Glance, (direct public expenditure, subsidies to households and other private entities).
OECD (2009), Society at a Glance, (old-age cash benefits, disability pensions and survivors' pensions).
Tanzi V and L Schuknecht (2000), Public Spending in the 20th Century: A Global Perspective, Cambridge University Press.