TCS Daily

The Golden Years

By Jan Arlid Snoen - November 18, 2003 12:00 AM

In his 28 October TCS article Dominic Standish dismisses the coming pension crisis as a myth (see: "Old and In the Way?"). Cuts in pensions and welfare are unnecessary. Although he makes some valid points, his remedies are inadequate and partly based on wishful thinking.


Let me first briefly restate the problem. Several projections of future expenditure have been made, among them by the European Commission and the OECD. In general they show that public pension expenditure in the EU will increase by some 3-5 percent of GDP from 2000 to 2030. Rather optimistic scenarios developed for the EU's Economic Policy Committee (EPC), taking into consideration a significant increase in female labor participation, show that expenditure will increase by 2-4 percent of GDP in key EU countries such as Germany, France, Spain and Italy.


The main driving force is a rising dependency ratio, i.e. number of pensioners compared to the working age population. This ratio is set to nearly double in the OECD countries over the next 50 years. According to the EPC, this will boost expenditure by more than 6 percent of GDP by 2050, but nearly half of this will be offset by higher labor participation rate and steps already taken to lower benefits, mainly by yearly benefit adjustments below the wage growth rate.


Without pension reform, there are two ways of financing this shortfall: to raise taxes or cut other government spending. Leaving aside ideological objections to higher taxes, it is difficult to raise taxes on such a scale. It would most certainly reduce economic growth and create disincentives for employment, thereby increasing the pressure on other welfare programs. Tax increases are also becoming ever more difficult because of globalization and increasing tax competition between nations. Lastly, large tax increases are unpopular; perhaps even more so than pension reform.


The other option is to cut public expenditure in other sectors. Health spending tends to increase even faster than GDP growth, driven by new technology, aging and constantly rising expectations. Thus without major reforms it is likely that public health and pension expenditure together will lay claims on between 25 and 30 percent of GDP in many European countries by 2030. Substantial cuts in education and R&D are difficult to imagine. This leaves us with infrastructure, law and order, defense and non-pension transfer payments. Leaving aside highly controversial proposals to introduce private financing of hitherto publicly financed services, the deep cuts that would be required in these areas are unlikely to be less damaging or even more politically feasible than major pension reforms.


What about Standish's remedies: growth, more working women and higher birth rates? Let's start with the notion that higher productivity and economic growth will solve the problem. The projections mentioned above take account of economic growth, but even so growth can contribute further in two ways. We might be able to increase the trend growth rate. On the other hand, without pension reform we would be lucky even to achieve the growth rates of the past, because of higher taxes or because public funds might be diverted away from growth-enhancing expenditure, such as R&D and infrastructure. Even a higher growth rate is no assurance that pension expenditure as percentage of GDP will be reduced, as there is huge political pressure to increase pensions in line with wage growth and reverse reforms introduced in several countries in the 1980s and 1990s that provides for smaller increases.


The other solution is to channel a large proportion of the growth to pension purposes, by keeping expenditure growth for other purposes significantly below GDP growth, or by raising taxes. This can be done, and we will still be able to have more money in our pockets in 2030 than today, and to spend more money in absolute terms on other public services and transfers. According to this logic, there are no real public financing problems as long as the economy keeps growing. Then it will always be possible to grab a share of this extra money to solve any specific problem that might pop up. The snag is that expenditure in most sectors tends to increase more or less in tandem with GDP growth, not least because wages are a dominant part of public consumption and productivity growth in public services tend to be low. This leaves little leeway, although the need for tough choices obviously is less acute in a high growth economy. Solutions based on harvesting a large part of economic growth through higher taxes will undermine the very growth taken for granted in this model.


Standish's next remedy is to increase employment rates. Fine, let's do that! More flexible labor markets would certainly help, and should be pursued regardless. However, I'm afraid the impact of various reforms to reduce unemployment can only solve a very small part of the pension funding problem. Higher labor market participation rates for women may contribute more, although these rates have already increased strongly over the last decades. The potential is strongest in southern European countries such as Italy and Spain, where female employment rates are some 25 percent below the male rate, whereas the gap in Germany and France is more like 15 percent. As mentioned above, the EPC projections already include a substantial increase in the participation rate. We must also keep in mind that programs to stimulate women to seek work, such as heavily subsidized child care facilities, are expensive. A large part of the extra tax income generated this way will therefore be offset, and cannot be used to close the pension funding gap.


Standish's last solution, to raise the birth rate, is easy to postulate, but hard to achieve. Falling birth rates are indeed a large part of the problem. It is, however, much more difficult to raise the birth rate by political means than to raise the retirement age, cut pension benefits or stimulate people to save for their own retirement. To have a baby is a choice based on a very complex set of individual preferences, value judgments, cultural trends and economic considerations.


It is true that governments can create incentives such as cash bonuses, generous benefits for parents to stay home with pay during the child's first year, and subsidized childcare. A more flexible labor market would also help. Even so, there are only weak indications that countries with more generous public programs achieve significantly higher fertility rates, with Norway as the most prominent positive exception. It is sobering to point out that the Swedish birth rate declined from around 2.1 in the early 1990s to little more than 1.5 in 1997-2001, despite massive pro-natalist programs. Moreover, all these programs have to be paid for, and some create incentives for mothers to drop out of the work force, at least for a while. Moreover, in the short and medium term, the demographic problem is exacerbated, as higher birth rates lower the proportion of the population in the productive age groups. The total dependency ratio, including children, increases temporarily. Higher birth rates, even if we were able to achieve it, would only yield a net benefit 25-30 years into the future.


Standish also touches on the real solution: "Healthier and longer lives mean more people can and already do work until later in life." He is right on the first part. Older people are much healthier than the same age group used to be a generation ago. They are therefore obviously more capable of working. The problem is that they don't. OECD statistics clearly show that average retirement age fell substantially until the early 1980s and has remained fairly stable since then. This is the heart of the matter. We need pension reforms that give healthy people better incentives to keep on working, instead of spending their last 20 years on the golf course while the young and middle aged are forced to pay higher taxes and work longer hours to pay their green fees.


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