Publication: International Advances in Economic Research
Publication Date: 01-AUG-07
Delivery: Immediate Online Access
Author: Hauner, David
Article Excerpt
Abstract Projections of age-related public expenditure growth have raised widespread concerns about fiscal sustainability. This paper examines how total expenditure would develop under four policy rules on public expenditure growth. Some simple arithmetic of expenditure, GDP, and population is reviewed and applied in simulations for 19 OECD countries over 2000-50. A general and a specific conclusion arise from the results. Generally, long-term expenditure projections could benefit from revisiting common assumptions on non-age-related expenditure growth. Specifically, realistic gradual adjustment in non-age-related expenditures could go a long way towards maintaining fiscal sustainability under age-related spending pressures.
Keywords Aging * Fiscal sustainability * OECD countries * Public expenditure
JEL H50 * J11
Introduction
Much has been written on the "fiscal time bomb" of age-related spending, specifically old-age pensions, early retirement programs, health and long-term care, child and family benefits, and education. Given its expected growth, prominent publications on the topic, such as by the Economic Policy Committee of the European Union (2001) and the OECD (2001), project a severe deterioration (in the order of 6-8% of GDP) in primary fiscal balances for most OECD countries over 2000-50.
However, while there is now a large literature on projections of age-related spending, relatively little attention has been paid to non-age-related expenditures, the part of public spending that will have to make room for age-related spending. Long-term fiscal projections, such as those cited above typically assume that non-age-related expenditure will grow with GDP, which is an assumption far from obvious. In fact, European Commission (2004, p. 197) found that for the growth in EU countries' expenditures by function, GDP growth was a significant explanatory variable only for education and health. Tanzi and Schuknccht (2000, p. 23) note that most of the increase in public spending in recent decades was not due to the provision of government services, but cash transfers: "Most of this increase resulted from explicit policy decisions [...]. In other words, there was nothing automatic or inevitable about it that could not have been prevented by determined governments."
This paper contributes to the literature by examining how long-term expenditure projections evolve under alternative assumptions on non-age-related expenditures. The paper lays out the simple arithmetic of four policy rules on public expenditure growth and applies them in sensitivity analyses of the expenditure simulations in OECD (2001), probably the most widely cited source in the field. The findings are then evaluated against expenditure trends over the past decades and cross-country comparisons of expenditure composition.
A general and a specific conclusion arise. Generally, long-term expenditure projections could benefit from revisiting common assumptions on non-age-related expenditure growth. Alternative assumptions on long-term non-age-related expenditure growth lead to vastly different conclusions about fiscal sustainability. Specifically, realistic gradual adjustment in non-age-related expenditures could go a long way towards maintaining fiscal sustainability under age-related spending pressures. According to the simulations here, in most OECD member countries projected GDP growth would suffice to accommodate not only projected increases in age-related spending, but also some real increase in non-age-related spending that is substantial by recent standards, particularly in per capita terms as population growth is slowing. At odds with widespread belief, the simulations suggest that countries with higher population growth might in fact face a bigger, not smaller, fiscal challenge from aging, as they have to finance both aging and expenditure demands from a growing population.
This paper is structured as follows. The rest of the paper first sketches four policy rules on public expenditure in aging societies, then applies them for 19 OECD countries over 2000-2050, and finally draws policy conclusions.
Some Simple Arithmetic
This section sketches the arithmetic of four simple policy rules of the fiscal impact of aging as a framework for the simulations in the next section. Let there be two periods, t and t+1. Let [[tau].sup.r] be real total government expenditure, [[alpha].sup.r] real age-related expenditure, and [[eta].sup.r] real non-age-related expenditure. Let [[tau].sup.y] be total government expenditure, [[alpha].sup.y] age-related expenditure, and [[eta].sup.y] non age-related expenditure, as a ratio to GDP, respectively. Let [[tau].sup.c] be real total government expenditure, [[alpha].sup.c] real age-related expenditure, and [[eta].sup.c] real non age-related expenditure per capita, respectively. In all three cases, it holds that [tau] [equivalent to] [alpha] + [eta]. Let n, a, g, and p be the growth rates of [[alpha].sup.r], [[eta].sup.r], output (real GDP), and population, respectively. Thus,
[[tau].sub.t+1.sup.y] = [[1 + [a.sub.t+1]]/[1 + [g.sub.t+1]]][[alpha].sub.t.sup.y] + [[1 + [n.sub.t+1]]/[1 + [g.sub.t+1]]][[eta].sub.t.sup.y] (1)
and
[[tau].sub.t+1.sup.c] = [[1 + [a.sub.t+1]]/[1 + [p.sub.t+1]]][[alpha].sub.t.sup.c] + [[1 + [n.sub.t+1]]/[1 + [p.sub.t+1]]][[eta].sub.t.sup.c]. (2)
Note the implicit assumption that the deflators of age-related and non-age-related spending grow at the same rate as the GDP deflator. This implies for, say, age-related spending, that the differential between the GDP deflator and the deflator of age-related spending will be captured in the real growth rate of age-related spending (Levitt and Joyce 1987, p. 21).
Now consider four simple rules for public expenditure growth.
Rule 1 -- Keep non-age-related expenditure constant in percent of GDP. This is the rule usually assumed in the debate. Here, [[eta].sup.r] grows at the same rate as output ([g.sub.t+1]), [[eta].sup.c] grows at the rate (1 + [g.sub.t+1])/(1 + [p.sub.t+1]) - 1, and the path of the ratio of total expenditure to GDP is
[[tau].sub.t+1.sup.y] = [[alpha].sub.t+1.sup.y] + [[eta].sub.t.sup.y] = [[1 + [a.sub.t+1]]/[1 + [g.sub.t+1]]][[alpha].sub.t.sup.y] + [[eta].sub.t.sup.y]. (3)
Under this rule, increases in the ratio of age-related expenditure to GDP fully translate into an increase in the ratio of total expenditure to GDP. Real non-age-related expenditure grows with output. By definition, if population grows less than output, non-age-related expenditure per capita rises.
Rule 2 -- Keep real non-age-related expenditure constant. Here, [[eta].sup.c] grows at the rate 1/(1 + [p.sub.t+1]) - 1, that is, it falls with population growth, and the path of the ratio of total expenditure to GDP is
[[tau].sub.t+1.sup.y] = [[1 + [a.sub.t+1]]/[1 + [g.sub.t+1]]][[alpha].sub.t.sup.y] + [1/[1 + [g.sub.t+1]]][[eta].sub.t.sup.y]. (4)
By rearranging, it can be found that as long as it holds that
[[a.sub.t+1] - [g.sub.t+1]]/[g.sub.t+1] < [[eta].sub.t.sup.y]/[[alpha].sub.t.sup.y], (5)
keeping real non-age-related expenditure constant (that is, [[eta].sub.t+1.sup.r] = [[eta].sub.t.sup.r]) implies a declining ratio of total expenditure to GDP under any realistic set of assumptions on the growth rates (that is, [[tau].sub.t+1.sup.y] < [[tau].sub.t.sup.y]).
Rule 3 -- Keep real per capita non-age-related expenditure constant. Constant non-age-related spending per capita, that is, [[eta].sub.t+1.sup.c] = [[eta].sub.t.sup.c], requires that spending grows with population, that is [n.sub.t+1] = [p.sub.t+1]. Thus, the path for the ratio of total expenditure to GDP is
[[tau].sub.t+1.sup.y] = [[1 + [a.sub.t+1]]/[1 + [g.sub.t+1]]][[alpha].sub.t.sup.y] + [[1 + [p.sub.t+1]]/[1 + [g.sub.t+1]]][[eta].sub.t.sup.y]. (6)
By rearranging, it can be found that as long as it holds that
[[a.sub.t+1] - [g.sub.t+1]]/[[g.sub.t+1] - [p.sub.t+1]] < [[eta].sub.t.sup.y]/[[alpha].sub.t.sup.y], (7)
keeping real per capita non-age-related expenditure constant (that is, [[eta].sub.t+1.sup.c] = [[eta].sub.t.sup.c]) implies a declining ratio of total expenditure to GDP (that is, [[tau].sub.t+1.sup.y] < [[tau].sub.t.sup.y]).
While Rules 2 and 3 could be dismissed as unrealistic on the basis of well-known real-world budget dynamics (for example, the "Baumol effect" (Baumol 1967)), they do serve the cause of questioning the assumption of non-age-related expenditure growing with GDP that underlies Rule 1; Rule 2 does, after all, permit to buy as many kilometers of road and pay as many civil servants (if wages grow only with the GDP deflator) in t+1 as in t. Rule 3, in turn, permits to continue to spend as much as before per capita on all those things.
Rule 4 -- Keep total expenditure constant in percent of GDP. For this (that is, [[tau].sub.t+1.sup.y] = [[tau].sub.t.sup.y]), it must hold that
[[alpha].sub.t.sup.y] + [[eta].sub.t.sup.y] = [[1 + [a.sub.t+1]]/[1 + [g.sub.t+1]]][[alpha].sub.t.sup.y] + [[1 + [n.sub.t+1]]/[1 + [g.sub.t+1]]][[eta].sub.t.sup.y]. (8)
Rearranging yields the "permissible" real growth rate of non-age-related expenditure,
[n.sub.t+1] = [[g.sub.t+1][[tau].sub.t.sup.y] - [a.sub.t+1][[alpha].sub.t.sup.y]]/[[eta].sub.t.sup.y]. (9)
Freezing the ratio of total expenditure to GDP will permit real non-age-related expenditure to grow at a positive rate [n.sub.t+1] if it holds that
[a.sub.t+1][[alpha].sub.t.sup.y] < [g.sub.t+1][[tau].sub.t.sup.y], (10)
that is, if given the expenditure ratios in period t, output grows sufficiently to finance some real non-age-related expenditure growth on top of age-related expenditure growth.
Simulating Expenditure Under the Four Rules
Based on the four rules, this section presents expenditure simulations for 19 OECD member countries (1) from 2000 to the peak of age-related spending. The variables underlying the simulations, that is, population, GDP, and age-related expenditure are from OECD (2001, 2002). (2) Age-related spending includes old-age pensions, early retirement programs, health and long-term care, child and family benefits, and education.
Table 1 shows the simulations of expenditure under the four rules. The uppermost panel shows total expenditure and age-related expenditure in percent of GDP in 2000 and estimated average annual real non-age-related expenditure growth over 1990-2003, (3) which will be used below to gauge the realism of the four rules by comparing past and potential future growth rates of non-age-related expenditure. The second panel shows the projections of the underlying variables (population, GDP, and age-related expenditure) from 2000 to the peak year of the age-related-expenditure-to-GDP ratio from OECD (2001). The remaining four panels show the expenditure simulations under the four rules. (4)
Rule 1 -- Keep non-age-related expenditure constant in percent of GDP. While widely assumed, this rule would imply unrealistically high non-age-related expenditure growth for many countries. In fact, 10 of the 19 countries could loosen the belt and have higher non-age-related expenditure growth than in the recent past (comparing...
NOTE: All illustrations and photos have been removed from this article.
More articles from
International Advances in Economic Research
Which elasticity? Estimating the responsiveness of taxpayer reporting decisions, 01-AUG-07
Socio-economic gaps within the EU: a comparison, 01-AUG-07
Dividend-driven trading strategies: evidence from the Warsaw Stock Exchange, 01-AUG-07
Looking for additional articles?
Click here to search our database of over 3 million articles.
Looking for more in-depth information on this industry?
Click here to search our complete database of Industry & Market reports by text, subject, publication name or publication date.
About Goliath
Whether you're looking for sales prospects, competitive information, company analysis or best practices in managing your organization, Goliath can help you meet your business needs.
Our extensive business information databases empower business professionals with both the breadth and depth of credible, authoritative information they need to support their business goals. Whether it be strategic planning, sales prospecting, company research or defining management best practices - Goliath is your leading source for accurate information. |
