Global Aging Pressures: Impact of Fiscal Global Aging Pressures: Impact of Fiscal Adjustment, Policy Cooperation, and Structural Adjustment, Policy Cooperation, and Structural

ReformsReforms

Dennis Botman and Manmohan S. KumarDennis Botman and Manmohan S. KumarFiscal Policy and Surveillance DivisionFiscal Policy and Surveillance Division

Fiscal Affairs DepartmentFiscal Affairs Department

International Monetary FundInternational Monetary Fund

Prepared for the conference “Fiscal Policy Challenges Prepared for the conference “Fiscal Policy Challenges in Europe”, organized by the German Federal Ministry in Europe”, organized by the German Federal Ministry

of Finance and the Center for European Economic of Finance and the Center for European Economic Research (ZEW), Berlin, March 22 and 23.Research (ZEW), Berlin, March 22 and 23.

Debt Sustainability ChallengesDebt Sustainability Challenges

a.a. Demographic pressures in EuropeDemographic pressures in Europe

b.b. Current structural deficits, and high initial debt in EuropeCurrent structural deficits, and high initial debt in Europe

c.c. Demographic pressures elsewhere: United States, Japan, and Demographic pressures elsewhere: United States, Japan, and several emerging marketsseveral emerging markets

d.d. Globalization: spillover effects of (fiscal) policies increasingly Globalization: spillover effects of (fiscal) policies increasingly importantimportant

e.e. Other UncertaintiesOther Uncertainties

Projected Debt Dynamics in Germany From Projected Debt Dynamics in Germany From “Global” Demographic Pressures...“Global” Demographic Pressures...

(Current Policies Scenario)(Current Policies Scenario)

0

50

100

150

200

250

300

350

400

2007 2018 2029 2040

Aging in Germany alone (4 percent aging costs)

Maastricht debt limit

Aging in Germany, euro area, and U.S.

Projected Debt Dynamics in Germany From Its Projected Debt Dynamics in Germany From Its Own Demographic Pressures...Own Demographic Pressures...

(Current Policies Scenario)(Current Policies Scenario)

0

50

100

150

200

250

300

350

400

2007 2018 2029 2040

Baseline: 4 percent of GDP aging costs by 2050

Maastricht debt limit

High aging costs (7.75 percent of GDP by 2050)

Low aging costs (2.75 percent by 2050)

Policy OptionsPolicy Options

a.) Fiscal adjustment: revenue/expenditure based—a.) Fiscal adjustment: revenue/expenditure based—effects on output, consumption, investment, trade and effects on output, consumption, investment, trade and financial markets, and debt;financial markets, and debt;

b.) Cooperative action: spillover effects of fiscal b.) Cooperative action: spillover effects of fiscal adjustment (trade and financial market channels) in adjustment (trade and financial market channels) in light of “global” aging pressures; benefits and costslight of “global” aging pressures; benefits and costs

c.) Lisbon Agenda: complementarities between fiscal c.) Lisbon Agenda: complementarities between fiscal adjustment and structural reform—labor participation, adjustment and structural reform—labor participation, R&D spending, and product market competition.R&D spending, and product market competition.

Rigorous Modeling Framework: Global Fiscal ModelRigorous Modeling Framework: Global Fiscal Model

Absence of Ricardian-equivalence:Absence of Ricardian-equivalence: Short planning horizons; distortionary taxation (consumption-Short planning horizons; distortionary taxation (consumption-

leisure, investment); heterogeneous consumersleisure, investment); heterogeneous consumers

Rich fiscal structure: Rich fiscal structure: Wide menu of taxes/social security contributions;Wide menu of taxes/social security contributions; Government spending and social security transfers.Government spending and social security transfers.

Interdependence:Interdependence: Four country blocks/regions: trade and financial market channels.Four country blocks/regions: trade and financial market channels.

Other features:Other features: Microfoundations; Microfoundations; Market imperfections (imperfect competition);Market imperfections (imperfect competition); Labor or capital augmenting productivity growth;Labor or capital augmenting productivity growth; Wage and price flexibility; capital mobility;Wage and price flexibility; capital mobility; Traded/nontraded goods (“home bias”—government spending).Traded/nontraded goods (“home bias”—government spending).

GFM: Versatile FrameworkGFM: Versatile FrameworkFiscal policy analysis:Fiscal policy analysis: The effects of revenue and non-revenue neutral tax reform;The effects of revenue and non-revenue neutral tax reform; The effects of fiscal adjustment through raising taxes or reducing The effects of fiscal adjustment through raising taxes or reducing

government expenditure, or a combination of the two;government expenditure, or a combination of the two; Evaluating social security reforms;Evaluating social security reforms; Addressing long-term fiscal sustainability concerns, including the Addressing long-term fiscal sustainability concerns, including the

pace, timing, sequencing, and size of adjustment;pace, timing, sequencing, and size of adjustment; Analyzing the sensitivity of the results to the behavioral and Analyzing the sensitivity of the results to the behavioral and

structural assumptions;structural assumptions; International spillover effects of fiscal policy.International spillover effects of fiscal policy.

Other policies and applications: Other policies and applications: Effects of structural reforms;Effects of structural reforms; Debt (domestic and external) debt sustainability;Debt (domestic and external) debt sustainability; Financial market policies (risk-premium, patience);Financial market policies (risk-premium, patience); Effects of productivity convergence;Effects of productivity convergence;

CalibrationCalibration

Macroeconomic and fiscal variables calibrated to actual values for:Macroeconomic and fiscal variables calibrated to actual values for:

(1) Representative large euro area economy (Germany):(1) Representative large euro area economy (Germany):- Aging costs (incl. health) by 2050: 4 percent of GDP;Aging costs (incl. health) by 2050: 4 percent of GDP;- Higher VAT in 2007, tax reform, initial structural deficit;Higher VAT in 2007, tax reform, initial structural deficit;

(2) Euro area excluding Germany:(2) Euro area excluding Germany:- Aging costs (incl. health) by 2050: 4.5 percent of GDP;Aging costs (incl. health) by 2050: 4.5 percent of GDP;

(3) United States:(3) United States:- Aging costs (incl. health) by 2050: 6.0 percent of GDP;Aging costs (incl. health) by 2050: 6.0 percent of GDP;

(4) Rest of the World:(4) Rest of the World:- Assumes no adjustment.- Assumes no adjustment.

Fiscal Adjustment in Germany: PrefundingFiscal Adjustment in Germany: Prefunding

1.)1.) Achieves structural balance by 2011;Achieves structural balance by 2011;2.)2.) Further adjustment: debt below Maastricht limit until 2050.Further adjustment: debt below Maastricht limit until 2050.

Alternative Adjustment measures:Alternative Adjustment measures:

a.) a.) Higher direct taxation:Higher direct taxation: social security contributions social security contributions workers/employers (default policy response), CIT, PIT—base workers/employers (default policy response), CIT, PIT—base broadening;broadening;

b.)b.) Higher indirect taxation:Higher indirect taxation: higher VAT—base broadening; higher VAT—base broadening;c.)c.) Expenditure measures:Expenditure measures: government spending, entitlement government spending, entitlement

reforms;reforms; Authorities’ intention: package of measures, with weight on Authorities’ intention: package of measures, with weight on

expenditure measures/entitlement reforms, avoid higher expenditure measures/entitlement reforms, avoid higher direct direct taxes.taxes.

Alternative Adjustment Strategies: PrefundingAlternative Adjustment Strategies: Prefunding

2006 2007 2011 2017Indirect taxationStatutory rate 16.0 19.0 24.7 26.6 Effective tax rate 10.1 12.0 15.6 16.8 Revenue (in percent of GDP) 6.2 7.2 9.2 9.8

Direct taxation Effective tax rate 29.0 29.0 34.9 38.7 Revenue (in percent of GDP) 8.1 8.1 10.1 11.0

Social security transfers In the absence of fiscal adjustment (aging effect) 3/ Spending (in percent of GDP) 19.7 19.6 19.1 19.8 With fiscal adjustment Spending (in percent of GDP) 19.7 19.6 17.1 17.6

Government consumption Spending (in percent of GDP) 18.6 18.6 16.6 16.4 Percentage reduction (relative to 2007) -10.8 -11.8

Package of measures (in percent of GDP) Spending 18.6 18.6 18.1 18.1 Social security transfers 19.7 19.6 18.0 18.0 Revenue from income tax base broadening ... ... 0.5 1.3 VAT (in percent) Effective rate 10.1 12.0 12.6 12.6 Statutory rate 16.0 19.0 20.0 20.0

Germany: Alternative Fiscal Adjustment Strategies: 2006-17 1/(In percent unless otherwise indicated)

Alternative Fiscal Adjustment StrategiesAlternative Fiscal Adjustment StrategiesEffects on Real GDP (Germany)Effects on Real GDP (Germany)

-3

-2

-1

0

1

2

3

4

2007 2017 2027 2037 2047

Adjustment packageIndirect taxation

Direct taxation

-3

-2

-1

0

1

2

3

4

2007 2017 2027 2037 2047

Adjustment packageSpendingTransfers

Prefunding: Effect on Debt DynamicsPrefunding: Effect on Debt Dynamics

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100

150

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350

400

2007 2017 2027 2037 2047

Debt dynamics with prefunding

Maastricht debt limit

Debt dynamics unchanged policies

Effects of Adjustment PackageEffects of Adjustment Package

1.) Entitlement reform: higher saving by “optimizing consumers” as 1.) Entitlement reform: higher saving by “optimizing consumers” as compensation; lower consumption by “rule-of-thumb” consumers;compensation; lower consumption by “rule-of-thumb” consumers;

2.) Higher saving by the government; reduced consumption of 2.) Higher saving by the government; reduced consumption of (nontraded) goods;(nontraded) goods;

3.) Base broadening and higher VAT reduce hours worked and 3.) Base broadening and higher VAT reduce hours worked and consumption (but, inelastic labor supply);consumption (but, inelastic labor supply);

As a result, consumption declines more than growth, interest rates As a result, consumption declines more than growth, interest rates decline, investment boom, higher capital-labor ratio, and substantial decline, investment boom, higher capital-labor ratio, and substantial improvement in current account balance and net foreign asset improvement in current account balance and net foreign asset position.position.

Global Aging: Joint Action?Global Aging: Joint Action?

Assumptions:Assumptions:

1.) Germany maintains debt below Maastricht limit until 2050 through 1.) Germany maintains debt below Maastricht limit until 2050 through package of measures;package of measures;

2.) Euro area implements its own package to maintain debt below 60 2.) Euro area implements its own package to maintain debt below 60 percent of GDP;percent of GDP;

3.) U.S. package includes further increasing indirect taxation given 3.) U.S. package includes further increasing indirect taxation given starting structural deficit and higher costs from aging; maintains debt starting structural deficit and higher costs from aging; maintains debt somewhat below current level until 2050.somewhat below current level until 2050.

Choice between early adjustment or delaying (assume 10 year Choice between early adjustment or delaying (assume 10 year delay) for each country/region.delay) for each country/region.

The Benefits of Joint Action I The Benefits of Joint Action I (GDP effects)(GDP effects)

-2

2

6

10

2007 2017 2027 2037 2047

Germany early, euro area and U.S. delay 10 years

Early cooperated adjustment

10 year delay Germany, euro area and U.S. early

10 year delay Germany, euro area, and U.S.

The Benefits of Joint Action II The Benefits of Joint Action II (NPV of GDP effects)(NPV of GDP effects)

Sensitivity AnalysisSensitivity Analysis

Parameter values based on empirical estimates from microParameter values based on empirical estimates from microstudies/selected to match the national accounts of a country.studies/selected to match the national accounts of a country.

However, uncertainty about consumers and firms responses to macroHowever, uncertainty about consumers and firms responses to macropolicies remains. The benefits of joint action are robust to alternativepolicies remains. The benefits of joint action are robust to alternativeparameter estimates. But .they are smaller if consumers are moreparameter estimates. But .they are smaller if consumers are more““Ricardian”:Ricardian”:

The planning horizon of consumers is very long; The planning horizon of consumers is very long; Labor supply is not sensitive to changes in the after-tax real wage;Labor supply is not sensitive to changes in the after-tax real wage; If all consumers have access to financial markets;If all consumers have access to financial markets;

Or if consumption is not sensitive to changes in the real interest rate.Or if consumption is not sensitive to changes in the real interest rate.

Other factors matter as well, such as: a firms’ flexibility to substituteOther factors matter as well, such as: a firms’ flexibility to substitutebetween capital and labor; how costly it is to change the capital stock;between capital and labor; how costly it is to change the capital stock;degree of monopolistic competition; bias towards domesticallydegree of monopolistic competition; bias towards domesticallyproduced tradables; bias towards nontradables; or economic size.produced tradables; bias towards nontradables; or economic size.

Effects of Joint ActionEffects of Joint Action

Early Joint Action relative to delayed action, while entailing someEarly Joint Action relative to delayed action, while entailing someoutput and consumption losses in the near-term, has significantoutput and consumption losses in the near-term, has significantbenefits over the medium and longer run. benefits over the medium and longer run.

Financial market effects dominate spillover effects throughFinancial market effects dominate spillover effects throughinternational trade channels—decline in the world real interestinternational trade channels—decline in the world real interestrate more than offsets declining exports following a fiscalrate more than offsets declining exports following a fiscalconsolidation.consolidation.

Nevertheless, output and consumption (especially of “rule-ofNevertheless, output and consumption (especially of “rule-ofthumb” consumers) still decline over the next decade: canthumb” consumers) still decline over the next decade: canstructural reforms help to offset the contraction?structural reforms help to offset the contraction?

Lisbon Objectives: GermanyLisbon Objectives: Germany

I: Increase Labor Participation to 70 percent by 2010 (from 65 I: Increase Labor Participation to 70 percent by 2010 (from 65 percent):percent):

Higher labor demand: due to tax reform;Higher labor demand: due to tax reform; Higher labor supply: reducing incentives for non participation, and Higher labor supply: reducing incentives for non participation, and

reduction of tax distortions.reduction of tax distortions.

II: Higher R&D spending, raising productivity growth:II: Higher R&D spending, raising productivity growth: Increase in R&D spending to GDP from 2.5 to 3 percent by 2010; Increase in R&D spending to GDP from 2.5 to 3 percent by 2010;

TFP elasticity to R&D spending in the middle of existing estimates.TFP elasticity to R&D spending in the middle of existing estimates.

III: Higher product market competition:III: Higher product market competition: Gradual reduction in markups by 2015 by one quarter.Gradual reduction in markups by 2015 by one quarter.

Analyze the contribution of each of these objectives, and as a package,Analyze the contribution of each of these objectives, and as a package,in complimenting fiscal adjustment.in complimenting fiscal adjustment.

Lisbon I: Higher Labor Participation Lisbon I: Higher Labor Participation (Germany)(Germany)

Significant increase in output and consumption; rule-of-thumb Significant increase in output and consumption; rule-of-thumb consumption increases later (as real wage declines)consumption increases later (as real wage declines)

Real GDP

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

2007 2017 2027 2037 2047

Cooperation and labor market reform

Cooperation

Consumption (percent)

-5.0

0.0

5.0

10.0

15.0

20.0

2007 2017 2027 2037 2047

Lisbon II: Higher R&D Spending Lisbon II: Higher R&D Spending (Germany)(Germany)

Significant increase in output, smaller increase in consumption (real Significant increase in output, smaller increase in consumption (real exchange rate depreciates)exchange rate depreciates)

Real GDP

-2.0

0.0

2.0

4.0

6.0

8.0

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12.0

14.0

16.0

18.0

2007 2017 2027 2037 2047

Cooperation and higher R&D spending

Cooperation

Consumption (percent)

-5.0

0.0

5.0

10.0

15.0

20.0

2007 2017 2027 2037 2047

Lisbon III: More Competition Lisbon III: More Competition (Germany)(Germany)

Significant increase in output and consumption, especially of rule-of-Significant increase in output and consumption, especially of rule-of-thumb consumers (as prices and equity values decline)thumb consumers (as prices and equity values decline)

Real GDP

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

2007 2017 2027 2037 2047

Cooperation and product marketreformCooperation

Consumption (percent)

-10.0

-5.0

0.0

5.0

10.0

15.0

2007 2017 2027 2037 2047

Implementing the Overall Lisbon Agenda Implementing the Overall Lisbon Agenda (Germany)(Germany)

Real GDP

-5.0

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15.0

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25.0

30.0

2007 2017 2027 2037 2047

Germany implements full Lisbon Agenda

Cooperation only

Euro area implements full Lisbon Agenda

Consumption (percent)

-10.0

-5.0

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25.0

30.0

2007 2017 2027 2037 2047

Consumption by optimizing consumers (percent)

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15.0

20.0

25.0

30.0

2007 2017 2027 2037 2047

Capital stock (percent)

-5.0

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35.0

40.0

2007 2017 2027 2037 2047

Labor effort (percent)

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

2007 2017 2027 2037 2047

Consumption by rule-of-thumb consumers (percent)

-10.0

-5.0

0.0

5.0

10.0

15.0

20.0

25.0

30.0

35.0

2007 2017 2027 2037 2047

Effects of Implementing the Overall Lisbon AgendaEffects of Implementing the Overall Lisbon Agenda

Significant increase in output and consumption, offsets the Significant increase in output and consumption, offsets the contractionary effects of fiscal adjustment;contractionary effects of fiscal adjustment;

Spillovers of structural reform mainly through international trade Spillovers of structural reform mainly through international trade channels, and both consumer types (“constituencies”) benefit;channels, and both consumer types (“constituencies”) benefit;

Effects of euro area as a whole achieving the Lisbon objectives Effects of euro area as a whole achieving the Lisbon objectives even more positive as average starting position weaker, for some of even more positive as average starting position weaker, for some of the objectives: the objectives:

(i) labor participation from 62.5 to 70 percent; (i) labor participation from 62.5 to 70 percent; (ii) R&D spending from 2.1 to 3 percent (and further international R&D (ii) R&D spending from 2.1 to 3 percent (and further international R&D

spillovers);spillovers);

Effects of Delayed and Partial Attainment of Effects of Delayed and Partial Attainment of the Overall Lisbon Objectivesthe Overall Lisbon Objectives (Germany)(Germany)

Still substantial benefits, but cannot offset short-term adjustment costs of Still substantial benefits, but cannot offset short-term adjustment costs of prefunding future aging costsprefunding future aging costs

Real GDP

-2.0

2.0

6.0

10.0

14.0

18.0

22.0

26.0

30.0

2007 2017 2027 2037 2047

Full implementation

Partial and delayed implementation

Consumption (percent)

-5.0

0.0

5.0

10.0

15.0

20.0

25.0

30.0

2007 2017 2027 2037 2047

Conclusions: Debt SustainabilityConclusions: Debt Sustainability

(i)(i) There is little doubt that debt is unsustainable under current There is little doubt that debt is unsustainable under current policies in the euro area as well as in the United States. policies in the euro area as well as in the United States.

(ii a) Debt in any particular country or region is seen to be even (ii a) Debt in any particular country or region is seen to be even more unsustainable if the trading partners are also aging.more unsustainable if the trading partners are also aging. The The spillover effects of global aging occur through both financial and spillover effects of global aging occur through both financial and trade channels, with the former dominating.trade channels, with the former dominating.

(ii b) There is very substantial uncertainty about the costs of (ii b) There is very substantial uncertainty about the costs of aging. aging. But even with low estimates of higher costs of health care But even with low estimates of higher costs of health care and pensions, debt will be on an unsustainable path.and pensions, debt will be on an unsustainable path.

(ii c) Substantial fiscal adjustment inevitable.(ii c) Substantial fiscal adjustment inevitable.

Conclusions: Fiscal AdjustmentConclusions: Fiscal Adjustment

(iii) Fiscal adjustment that combines both revenue and (iii) Fiscal adjustment that combines both revenue and expenditure measures is the only feasible and relatively expenditure measures is the only feasible and relatively efficient method to maintain debt sustainability.efficient method to maintain debt sustainability. Such a package Such a package should aim for a modest surplus in the primary balance over the should aim for a modest surplus in the primary balance over the next decade, to prefund future aging costs, and maintain next decade, to prefund future aging costs, and maintain intergenerational equity.intergenerational equity.

(iv a.) The short-term contractionary consequences of Germany (iv a.) The short-term contractionary consequences of Germany implementing such an early fiscal reform by itself can be implementing such an early fiscal reform by itself can be substantial.substantial.

(iv b.) Early Joint Action relative to delayed action has (iv b.) Early Joint Action relative to delayed action has significant benefits over the medium and longer run.significant benefits over the medium and longer run. Financial Financial market effects dominate spillover effects through international trade market effects dominate spillover effects through international trade channels. If all countries that face aging pressures delay channels. If all countries that face aging pressures delay adjustment, the consequences for each and collectively would be adjustment, the consequences for each and collectively would be highly adverse.highly adverse.

Conclusions: Structural ReformsConclusions: Structural Reforms (v) Achieving the Lisbon objectives in Germany and the euro (v) Achieving the Lisbon objectives in Germany and the euro

area is likely to overcome the adverse short-term effects on area is likely to overcome the adverse short-term effects on real GDP and consumption of the fiscal response.real GDP and consumption of the fiscal response.

(vi) There are significant benefits for all constituents of (vi) There are significant benefits for all constituents of pursuing the Lisbon Agenda as a package.pursuing the Lisbon Agenda as a package. Each of the Each of the components imply different timing of the benefits, and differential components imply different timing of the benefits, and differential effects across income groups. effects across income groups.

(vii) A partial and delayed attainment of the Lisbon objectives (vii) A partial and delayed attainment of the Lisbon objectives has the negative consequence that the short-term output and has the negative consequence that the short-term output and consumption losses from prefunding of future aging costs consumption losses from prefunding of future aging costs cannot be mitigated.cannot be mitigated.

(viii) Regardless of actions by other countries, it is in each (viii) Regardless of actions by other countries, it is in each country’s own interest to take early resolute measures both in country’s own interest to take early resolute measures both in terms of fiscal adjustment and structural reforms. terms of fiscal adjustment and structural reforms.