Generational aspects of fiscal policy under changing demographic forecasts - PowerPoint Presentation

Slide1

Generational aspects of fiscal policy under changing demographic forecasts

Jukka

Lassila

(ETLA)

MoPAct

workshop

Helsinki,

June

2016

Slide2

Motivation and aim

In

an economy

with ageing population,

we

analyze

long-run fiscal

strategies, with a novel method.

(fiscal strategy

–

a set

of

rules and practices

describing how policy parameters

change)

What does this method tell us about intergenerational fairness?

The

ultimate aim is to find strategies that could be described as both fiscally sustainable and

intergenerationally

fair.

Slide3

Intergenerational equity

between

contemporary

generationsin public transfers between generationsin private transfers between generationsbetween contemporary and future generations, as yet unborn

Piachaud

,

Macnicol

and

Lewis

(

2009)

Slide4

Intergenerational equity in

public

transfers

and

servicesPAYG pensions are a good reference becauseyoung people pay, old receive, and cohort sizes vary with aging population pension policy changes always(?) hit some

cohorts

more

than

others

.

Many

similarities

in

other

public

sector

areas

,

but

also

differences

issues

unrelated

to

age

(

administration

,

defence

)

age-neutral

instruments

(VAT,

municipal

taxes

)

stabilization

issues

Slide5

Previous studies

Jensen

,

Nødgaard

and Pedersen (2002): Tax smoothing v. debt smoothingMiles and Iben (2000): Winners and losers from pension reform, bequestsAuerbach and Lee (2009): generational uncertainty and risk sharing in pension systems, in context of economic and demographic uncertainty, with the goal of finding properties that do not result from some particular demographic circumstances. Elder (1999): Individuals do not know the duration of a tax

cut

with

certainty

.

Revised

expectations

and

optimization

.

Focus

on capital

formation

(

closed

economy

).

Slide6

Auerbach and Hassett (2001)

”…

how

and

when

to deal with long-term fiscal imbalances that are at once very significant and very uncertain,…””…stylized models in search of more general conclusions regarding the nature of optimal policy responses.” (OLG with 2-period

lives

)

Here:

Finnish

public

institutions

, OLG with 16-period

lives

Starting

point

: Lassila

– Valkonen – Alho,

Int

. J. of

Forecasting

2014

Slide7

Slide8

Slide9

Alho: Forecasting

demographic

forecasts

Int. J. of Forecasting 2014 “We assume that an approximation to the predictive distribution of the future population is available in terms of simulated population counts. The required conditional expectations are then obtained by averaging the future evolution of a set of sample paths that come from the neighborhood of a target path.This is formally equivalent to n-nearest neighbor kernel regression.”

Slide10

The economic

model

Open-economy

Auerbach

– Kotlikoff type general equilibrium modelOverlapping generations, life-cycle optimization Forward-looking firms, maximizing share value Perfect foresight, except for demographics where forecasts

are

believed

in

A

revised

demographic

forecast

every

5-year

period

.

Households

and

firms

re-optimize

.

Re-optimization

leads

to (

perceived

)

changes

in

welfare

Slide11

Demography-related features

in the

model

Earnings-related

pensions (DB, with longevity adjustment)and their funding (partial)National pensions, means-tested on earnings-related pensionsHealth and LTC costs, depending both on age and proximity to deathPublic education costs

and

some

transfers

Aggregation

: How

many

people

in

what

age

doing

what

(

working

or

not

,

consuming

,

saving

,

paying

taxes

,

getting

transfers

etc.)

Slide12

Slide13

Slide14

Slide15

Slide16

Welfare changes

under

which

strategies?Base strategy (”current policy”)Base strategy with conditional VAT changesRaise VAT by 2% if forecasted debt/GDP exceeds 60 % within 20 yearsTax smoothing policiesBased on forecasts,

periodically

revised

With

varying

smoothing

horizons

Slide17

Base strategy

Mandatory

pension contributions adapt to pension

expenditure

Health

and long-term care costs are financed partly by municipal taxes, which adapt. Part of health and LTC is financed by state aid to municipalities. State tax rates are held constant, so changes in expenditure and tax bases go into public debt.Consolidation after 55 years (smoothing taxes from 2068-72 to 2143-47)

Slide18

Tax smoothing

policies

Government

sets

a constant VAT rate so that the state’s debt/GDP gets back to initial level after, say, 50 years – if the population forecast comes true. VAT rate updated when new

forecast

arrives

.

Municipalities

:

constant

income

tax

rate

,

debt/GDP

back

to

initial

level

after

50

years

–

if

forecast

is

good

.

Updated

every

period

.

Earnings-related

pensions

:

constant

contribution

rate

,

funds

back

to

normal

level

after

50

years

,

updates

Consolidation

after 50 years (smoothing taxes from 2063-67 to 2143-47)

Slide19

Welfare

changes

under

base strategy, 50 % predictive limits CV, % of consumption

40-44

80-84

from

revisions

-

1.01

-

+1.08

-4.17

-

+3.62

Slide20

Welfare

changes

under

base strategy, 50 % predictive limits CV, % of consumption

40-44

80-84

from

revisions

-

1.01

-

+1.08

-4.17

-

+3.62

from

consolidation

-4.82 - -2.93

-

5.49 - -3.24

Slide21

Welfare

changes

under

base strategy and tax smoothing, 50 % predictive limits CV, % of consumptionfrom

revisions

40-44

80-84

Base

-

1.01

-

+1.08

-4.17

-

+3.62

50 yrs

-1.49 - +0.97

-4.79 - +3.50

from

consolidation

Base

-4.82 - -2.93

-

5.49 - -3.24

50 yrs

-2.16 -

+0.69

-2.37 - +0.56

Slide22

Welfare changes

under

tax

smoothing50 % predictive limits Smoothing horizonCV, % of consumption

from

revisions

40-44

80-84

20

yrs

-

1.55

-

+1.08

-4.85

-

+3.70

50 yrs

-

1.49

-

+0.97

-4.79

-

+3.50

from

consolidation

20 yrs

-4.55 -

+1.68

-

4.88 -

+1.52

50 yrs

-2.16 -

+0.69

-

2.37 -

+0.56

Slide23

Slide24

Which intergenerational

aspects

does

our method addressbetween contemporary generations- revision effects by age, consolidation effects by agein public transfers between generations -

yes

,

next

slide

in

private

transfers

between

generations

-

not

dealt

with

between

contemporary

and

future

generations

-

comparing

revision

effects

to

consolidation

effects

Slide25

Slide26

Should

strategies

include

client fees?

Slide27

Should

strategies

include

client fees?Pre-announced client fees?

Slide28

Should

strategies

include

client fees?Pre-announced client fees?Prefunding?

Slide29

Some observations

on

smoothing

Forecast-based

tax smoothing is imperfect, sometimes grossly so.Still it probably improves intergenerational fairness.With smoothing, public debt is well in control. However, the EU’s debt rule and

other

fiscal

rules

may

be

violated

.

In

practice

only

few

speak about or do

smoothing, let alone 50 year debt targets.

Canadian pension system (CPP) uses forecasts explicitly, and goes to great length to reduce doubts concerning forecast manipulation.

Swedish

NDC system ignores forecasts completely

.

Finnish

earnings-related pension system (

TyEL

)

aims at smoothing

Municipalities

in Finland cannot take debt to any significant amount.

They

could (but don’t) prefund for future health and LTC expenditure.

With aging populations, tax smoothing

strategies cause tax

increases.