Modelling the Effect of Population Ageing on Government Social Expenditures

Bryant, John Working Paper Modelling the Effect of Population Ageing on Government Social Expenditures New Zealand Treasury Working Paper, No. 03/15 Provided in Cooperation with: The Treasury, New Zealand Government Suggested Citation: Bryant, John (2003) : Modelling the Effect of Population Ageing on Government Social Expenditures, New Zealand Treasury Working Paper, No. 03/15, New Zealand Government, The Treasury, Wellington This Version is available at: https://hdl.handle.net/10419/205520 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by/4.0/ Modelling the Effect of Population Ageing on Government Social Expenditures John Bryant N EW Z EALAND T REASURY W ORKING P APER 03/15 J UNE 2003 NZ TREASURY WORKING PAPER 03/15 Modelling the Effect of Population Ageing on Government Social Expenditure MONTH / YEAR June 2003 AUTHOR John Bryant Treasury PO Box 3724 Wellington New Zealand Email Telephone Fax [email protected] +64 4 917 7027 +64 4 473 1151 ACKNOWLEDGEMENTS Data for the analysis was generously supplied by Assaf Razin and Phillip Swagel. John Creedy, Dean Hyslop, Assaf Razin, and colleagues in Policy Coordination and Development provided invaluable comments on earlier versions of the paper. NZ TREASURY New Zealand Treasury PO Box 3724 Wellington 6008 NEW ZEALAND Email Telephone Website [email protected] 64-4-472 2733 www.treasury.govt.nz DISCLAIMER The views expressed in this Working Paper are those of the author and do not necessarily reflect the views of the New Zealand Treasury. The paper is presented not as policy, but with a view to inform and stimulate wider debate. WP 03/15 | Modelling the effect of population ageing i Abstract This paper reviews and extends a new framework, developed by Razin, Sadka, and Swagel, for capturing the effect of population ageing on public support for government social expenditures. Razin et al construct up an overlapping generations, median voter model, and investigate the empirical applicability of the model using panel data from 13 OECD countries. Their results suggest that population ageing will put downward pressure on per capita expenditures. These results rest, however, on an assumption that there is only one dependant age group: the old. This paper investigates the consequences of allowing for two such age groups: the young and the old. A replication of Razin et al’s empirical analysis, using two dependent age groups rather than one, suggests that population ageing will instead put upward pressure on per capita expenditures. Although these results are tentative, they illustrate the usefulness of including both youth dependency and old-age dependency in Razin et al’s framework. JEL CLASSIFICATION D72 - Economic Models of Political Processes E62 - Fiscal Policy; Public Expenditures, Investment, and Finance; Taxation J11 - Demographic Trends and Forecasts KEYWORDS Social expenditures; Median voter models; Population Ageing WP 03/15 | Modelling the effect of population ageing ii Table of Contents Abstract...............................................................................................................................i Table of Contents ..............................................................................................................ii List of Tables......................................................................................................................ii 1 Introduction ..............................................................................................................1 2 Razin et al’s theoretical model................................................................................2 3 Razin et al’s empirical results.................................................................................3 4 A reanalysis..............................................................................................................4 5 Conclusion................................................................................................................8 6 References................................................................................................................9 List of Tables Table 1 - Determinants of labour tax rate and benefits per capita in Razin et al’s original specification ..............................................................................................................................4 Table 2 - Correlation matrix for the components of the dependency ratio, for the 13 country sample, 1965-1992 ...................................................................................................................6 Table 3 - Determinants of labour tax rate and benefits per capita......................................................7 WP 03/15 | Modelling the effect of population ageing 1 Modelling the effect of population ageing on government social expenditures 1 Introduction Designing prudent fiscal policy that treats successive generations equitably requires estimates of how population ageing will affect government social expenditures. One way to derive estimates is to start with age-specific expenditure levels and calculate how overall expenditure levels vary in response to changing age structures. Substantial progress has been made in this area (Creedy 2002, Dang, Antolin and Oxley 2001, Foote and Spoor 2001, Woods 2000). A complementary approach is to examine the effect on the policy process of increases in the population share of older people. The conventional view is that an increase in the number of older voters will create strong pressures for increased social spending. Razin, Sakda, and Swagel (2002) cast doubt on this view. Razin et al present a model of how changes in dependency rates affect social expenditures via their effect on the interests of the median voter. They show that, under some parameter settings, an increase in dependency rates can lead to a decline in per capita social expenditures. They also present results from a regression analysis, based on panel data for the United States and 12 European countries, suggesting that per capita social expenditures are indeed negatively correlated with dependency levels. This paper argues, however, that Razin et al’s approach needs to be extended to allow slightly more demographic detail. Neither Razin et al’s model nor their empirics distinguish between old-age dependency and youth dependency. As with many overlapping generations models, the model contains only two age groups: young workers and old dependants. Razin et al’s empirical analysis carries over the use of one working and one dependent group, with the dependent group including both young and old. Using data supplied by Razin et al, I have repeated their empirical analysis, but with dependency disaggregated into youth and old-age components. The revised analysis suggests that taxes and transfers are negatively correlated with youth dependency but positively correlated with old-age dependency. This finding can be reconciled with an extended version of Razin et al’s theoretical model. The first two sections of this paper describe Razin et al’s theoretical model and empirical results. The third section describes a new analysis. The final section discusses the implications. WP 03/15 | Modelling the effect of population ageing 2 2 Razin et al’s theoretical model Razin et al construct a median voter model with overlapping generations. This section sketches out features of the model that are relevant to the extension and reanalysis described below. There are two generations: young workers and old dependants. The young are assumed to outnumber the old. The only tax is a labour tax, which is proportional to labour income.1 The budget is balanced in every period, and the entire tax revenue is spent on benefit payments. Everyone, young or old, receives the same payment. People care only about their own income. Young people face the decision of whether or not to acquire an education. Workers with an education have higher productivity and earn a higher wage than workers without an education. However, acquiring an education takes time, and has an opportunity cost in forgone wages. Young workers vary in their innate ability. The greater a person’s innate ability, the more quickly the person can complete an education, and the lower the education’s opportunity cost. All those whose ability is greater than a certain level acquire an education, while none of those whose ability is lower than this level acquire an education. The location of the cut-off point depends on taxes, wages, the pecuniary cost of education, and the extent to which education improves productivity. The lifetime incomes of the educated vary, depending on their innate ability and hence the time spent in the workforce. The lifetime incomes of the uneducated are identical. As with standard median voter models, taxes and benefits are at their equilibrium level when the income that the median voter would gain through an increase in benefits exactly equals the income that he or she would lose through the corresponding increases in taxes. No other combination of taxes and benefits is politically sustainable. Suppose, for instance, that the median voter would gain more from a small increase in benefits than he or she would loose through the corresponding increase in taxes. The median voter would join a pro-benefits coalition, which would then have a majority, and the new regime of benefits and taxes could be voted in. Old people pay no taxes, and are therefore always in favour of raising taxes and benefits. Young people are divided into pro-benefit and anti-benefit groups. Young people who do not acquire an education are either all pro-benefit or all anti-benefit, since they all receive the same income. Young people who do acquire an education are, in general, divided into pro-benefit and anti-benefit groups. The greater the educated young person’s ability, and hence the higher their income, the more anti-benefit they are. The fact that young people can be ranked from most anti-benefit to most pro-benefit according to their innate ability keeps the analysis of coalition formation relatively simple. The identity of the median voter, and hence the equilibrium level of taxes and benefits, depends ultimately on the ratio of old to young, and on the distribution of innate ability among the young. An increase in the ratio of old to young has opposing effects on the level of taxes and benefits. All the extra old people favour increasing tax and benefit levels. The rise in the number of dependants per taxpayer means, however, that a smaller proportion of any taxes paid are returned to taxpayers in the form of benefits; Razin et al describe this as an increase in ‘fiscal leakage’. Increased taxes also lower pre-tax incomes by discouraging some young people from undertaking productivity-enhancing education. The first effect makes it more likely that the median voter will favour higher taxes and benefits, while the 1 Razin, Sadka, and Swagel (2001b) use a different model with a tax on capital. WP 03/15 | Modelling the effect of population ageing 3 second and third effects makes it less likely. The balance between these effects, and hence the new level of taxes and benefits, depends on the ratio of old to young, and on the distribution of innate ability among the young. 3 Razin et al’s empirical results Razin et al’s empirical analysis is designed to test which effects dominate in practice. The data come from 12 European countries2 and the United States, over the period 19651992. They carry out an Ordinary Least Squares regression, with country-specific fixed effects. Because data are not available for all countries in all years, the panel is unbalanced. Two different dependent variable are used. The first is the ‘labour tax rate’, which uses ‘revenue statistics to calculate an average tax rate on labor income’ (Razin et al 2002: 912), and was assembled by Razin et al based on a method set out in Mendoza, Razin, and Tesar (1994). The second dependent variable is (the log of) benefits per capita. These are also calculated by Razin et al from OECD data, and include unemployment and disability benefits, though they are dominated by payments to the aged. The independent variable of interest is the ‘dependency ratio’, which Razin et al define as one minus the proportion of the population in the labour force.3 Razin et al include a number of control variables, based on previous studies of the size of the welfare state. These variables are shown in Table 1. Trade openness is measured by imports and exports as a percentage of GDP. Income inequality is measured by the share of total income received by the top quintile divided by the share received by the middle quintile. The other variables are self-explanatory. All data come from the OECD analytical database, apart from the data on income shares, which come from the World Bank’s inequality database. Summary statistics for the variables are presented in Razin, Sadka and Swagel (2001a: Table 1). As can be seen from the estimated coefficients on the dependency ratio in Table 1, Razin et al find that increased dependency rates are associated with reduced taxation and benefits. Within the framework of their model, this suggests that the fiscal leakage and education-reducing effects have outweighed the voting power effect. 2 The 12 countries are Austria, Belgium, Denmark, Finland, France, Germany, Italy, the Netherlands, Norway, Spain, Sweden, the United Kingdom. 3 Razin et al’s definition is somewhat different from the usual definition in the literature on population ageing, though perhaps more economically meaningful. The usual definition is the number of people outside the working ages divided by the number in the working ages. WP 03/15 | Modelling the effect of population ageing 4 Table 1 - Determinants of labour tax rate and benefits per capita in Razin et al’s original specification Labour tax rate (Log of) benefits per capita (1) (2) (3) (4) Dependency rate -0.382 (-4.02) -0.383 (-4.40) -7.493 (-8.81) -7.492 (-8.80) Government jobs / employment 0.915 (12.17) 0.729 (10.01) 4.467 (6.64) 4.611 (6.47) Trade openness 0.198 (8.09) 0.131 (5.45) 0.740 (3.73) 0.792 (3.37) Per capita GDP growth -0.187 (-2.83) -0.127 (-2.09) -2.716 (-4.59) -2.762 (-4.63) Rich / middle income share -0.055 (-2.77) -0.049 (-2.66) 0.276 (1.55) 0.271 (1.52) Unemployment rate 0.480 (7.82) -0.370 (-0.62) Period* 19651992 19651992 19651992 19651992 N 330 330 330 330 R2 0.753 0.793 0.617 0.618 Note – All specifications include fixed effects (coefficients not shown.) The value for R2 does not include the contribution of the fixed effects. The numbers in brackets are t-statistics. Source – Razin et al (2002: Table 1) 4 A reanalysis Razin et al’s model makes some obviously unrealistic assumptions, such as the assumption that benefit payments are the same for everyone. Razin et al (p911) also caution that their empirical results should be seen merely as ‘suggestive’ and ‘broadly consistent with the main implications of the theory’. They note (p915) that further statistical analysis is needed, such as the use of instrumental variables to deal with the possibility of reverse causation. Both the unrealistic assumptions and the limited statistical testing are readily defensible. Razin et al’s work is an early exploration of a difficult topic. Moreover, much of the heuristic value of Razin et al’s model is due to its simplicity, which inevitably requires the sacrifice of some realism. Little is therefore gained from merely pointing out counterexamples to the assumptions or potential limitations in the statistical analysis. What is useful, however, is the identification of areas where substantively important extensions can be added to model without unduly complicating it. That is the aim of this section. Razin et al’s theoretical model and statistical analysis both recognize only one sort of dependant. A straightforward extension of Razin et al’s framework suggests, however, that the effect on equilibrium taxes and benefits of increasing the number of young dependants may well be different from the effect of increasing the number of old dependants. The exact effects depend on whether benefit payments to children are treated as if they were payments to the children’s parents.