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Developed countries around the world are experiencing ageing of their populations arising primarily from changes in fertility and mortality. These changes in the age structure of populations have important implications for the economies of the countries in question and, in particular, for the fiscal policies of their governments, since they are likely to experience budgetary stress as a consequence of having public expenditures that depend heavily upon age-related public programs. Foremost amongst these are social security retirement, long-term (aged) care and health programs, each of which induces greater expenditures with an ageing population. Against this backdrop, policy questions arise as to how fiscal authorities can prevent unsustainable expenditures.

Figure 1: Proportion of people aged 65+ in Australia’s total population

DemographyFig1

Source: CEPAR (2015).

In Australia, population ageing will accelerate in the next few decades, driven partly by falling fertility rates in the past and partly by projected mortality improvements in the future. The proportion of people aged 65+ in the total population is growing fast and will be above 25% by 2050 (see Figure 1). Although almost all developed countries need to deal with similar fiscal issues associated with population ageing, the problems facing Australia and the policy settings are quite distinct. First, the Australian population is projected to increase significantly in size due mainly to high net migration inflows. Despite growing fast due to migration, ageing will still be a distinctive feature of the demographic trend in Australia over the next 50 years. Second, Australia’s fiscal setting is different from most countries in that its government’s age pension program is not funded by employee contributions and there are very limited payroll taxes. Age pension payments to retirees are funded from general tax revenue, which imposes fiscal stress as the population ages.

In Kudrna, Tran and Woodland (2015) we investigate the efficacy of two alternative policy responses – pension cuts and tax hikes – to mitigate fiscal pressure arising from population ageing in Australia. More specifically, we quantify the macroeconomic and distributional welfare effects of these two fiscal adjustments.

We propose a new approach based on a dynamic general equilibrium, overlapping-generations model, which comprises overlapping generations of heterogeneous households, perfectly competitive firms and a government sector incorporating essential fiscal policy settings. Households are considered to be different with respect to ages and skill types. The government sector consists of various public transfer programs and a variety of tax financing instruments such as progressive income, consumption, superannuation and corporate taxes. The government can also issue debt to finance its fiscal deficits. Importantly, the economic decisions made by households and firms (i.e., labour supply, saving and investment decisions) are subject to the distortions induced by the fiscal policy.

Our model differs from the existing computable general equilibrium (CGE) models for policy analysis of the leading private and government agencies, including the Productivity Commission and the Australian Treasury.  Our new approach takes into account inter-temporal decision choices of households over the life cycle, general equilibrium adjustments as well as transition dynamics. Moreover, the rich structure of household heterogeneity and the detailed composition of government fiscal activities are essential to study the effects of fiscal reforms on macroeconomic aggregates and wellbeing of different households over time.

We discipline our benchmark economy to match key Australian macroeconomic aggregates and the demographic structure in 2012 and to approximate the lifecycle behavior of Australian households, including labour supply, labour earnings and pension payments (we consider households as the relevant analysis unit). In addition, our model is able to generate the key Australian macroeconomic aggregates reported by the Australian Bureau of Statistics (ABS), and the government budget deficits and net debt data from the Australian Treasury.  In addition, we use a demographic model to project future changes in the age structure and the size of Australia’s population, based on assumptions regarding future movements in the age profiles for fertility, longevity and immigration. Since rising fiscal costs are due not only to pensions but also to other age-related government spending, our model embodies a rich fiscal structure with age profiles for public expenditures on health care, aged care, the means-tested age pension as well as on education and family benefits. The model is then applied to conduct policy experiments.

Using the demographic projections derived from our demographic model, we quantify the fiscal costs of demographic transition. We maintain initial assumptions about the policy environment to focus on endogenous responses of households, firms and the government to the exogenously projected changes in the demographic structure of the population. The simulation results indicate that the demographic shift in Australia with increasing (decreasing) population shares of the elderly (working cohorts) has significant implications for the future government budget position through changes in both taxation revenues and expenditures. We find (i) significant changes in the tax base, with a shift from labour income to asset income and consumption, and (ii) substantial increases in age-related spending on health care, aged care and the age pension, with a resulting fiscal gap of over 2 percentage points of GDP in 2050, increasing to over 4 percentage points of GDP by 2100 (see Figure 2).

Figure 2: Government expenditures as fraction of GDP

DemographyFig2

Source: Kudrna, Tran and Woodland (2015).

We also examine the macroeconomic and welfare effects of two fiscal reform options to respond to demographic shift. The first policy option is a cut to government spending by reducing pension benefits through an increase in the eligibility age for the pension, a reduction in the maximum pension benefit and an increase in the taper (withdrawal) rate at which the pension benefit reduces as other income increases. The second policy option is an increase in taxation revenues through adjusting either consumption or income tax rates. These two policy options thus address different sides of the government budget constraint. It is found that, while the two fiscal reform options achieve the same goal of reducing the fiscal burden of population ageing, their macroeconomic and welfare outcomes differ greatly. In terms of the welfare effects, we find that young and future generations prefer pension cuts, but currently older and middle-age generations prefer to finance the fiscal burden through tax hikes (see Figures 3 and 4).

Figure 3: Distributional welfare effects of pension cuts

DemographyFig3

Source: Kudrna, Tran and Woodland (2015).

The findings also indicate that high-income households would prefer pension cuts because the age pension is not an important source of retirement income for them, whereas low-income households would prefer tax hikes with increases in progressive income tax rates.

Interestingly, the indirect and regressive consumption tax hikes have opposing effects on macroeconomic aggregates and welfare across skill types compared to those obtained from the income tax hikes. We show that the required increases in the consumption tax rate result in positive effects on per capita labour supply, assets and output, but reduce the welfare of low-income households most. Conversely, the increases in progressive income taxes result in negative effects on output but reduce the welfare of poor households least.

Figure 4: Distributional welfare effects of progressive income tax hike

DemographyFig4

Source: Kudrna, Tran and Woodland (2015).

Final Remark. Both pension cuts and tax hikes can achieve a similar fiscal goal and mitigate Australia’s fiscal challenges. However, the two policy reforms lead to different distributional and welfare effects across income groups and generations. Future generations prefer pension cuts, whereas current generations prefer tax hikes to finance government spending commitments. The opposing welfare outcomes point to limited political support when devising a more sustainable tax-transfer system.

This article is based on George Kudrna, Chung Tran and Alan Woodland. “Facing Demographic Challenges: Pension Cuts or Tax Hikes?”, ANU Working Papers in Economics and Econometrics 2015-626, where you can find more details about our model and analysis.

 References

ARC Center of Excellence in Population Ageing Research (2015): The Back to the Future Fact Sheet: A visual history of demographic projections in Australia 

Kudrna, G., Tran, C., Woodland, A. (2015): Facing Demographic Challenges: Pension Cuts or Tax Hikes?, ANU Working Papers in Economics and Econometrics 2015-16.

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This article has 1 comment

  1. Hi Chung,
    There may be a third alternative to this dilemma and that is creating a national sovereign wealth fund to provide adequate pensions, for those citizens that have inadequate future superannuation savings.
    If we taxed our mineral and natural resources adequately as per Denmark, we might have the revenue to provide decent pensions. Australia has abundant reserves of natural gas and minerals that are exported cheaply. If we taxed these scarce resources properly, this would reduce the burden of personal income taxation on citizens.
    Regards
    Wayne

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