Chapter 12 - Taxation, Pensions, and Demographic Change

https://doi.org/10.1016/bs.hespa.2016.09.005Get rights and content

Abstract

This chapter provides a review of some implications of demographic shift arising from population aging for fiscal policy, taxation policy, and social security settings. The key implications of population aging that have been forthcoming from the many national and international macroeconomic modeling studies are presented. These implications are that population aging will put significant stress on governments’ fiscal situations under current policy settings. Consideration of policy options to accommodate population aging leads to examination of age-dependent taxation, the means testing of social security benefits, general taxation and pension design, and the analysis of taxation policy over time. The chapter concludes with some comments on the nature of the literature reviewed and on possible directions for future research.

Introduction

Much has been said, and written, about the fiscal stress that many nations will face consequent upon demographic shift. But there is little research on the relationship between this change and taxation design, except insofar as analysts have calculated how social security tax rates must change to meet the pension promises made to cohorts approaching retirement. Yet the public finance implications of an aging demographic reach well beyond labor taxation, and the associated revenue requirement involves a wider spectrum of government outlays than just social security payouts.

We therefore begin with a review of some empirical and modeling analyses to identify the quantitative importance of demographic change for the various elements of a tax revenue system, treating social security systems not as separate government entities, but as part of an overall tax–transfer system. Given this backdrop, we turn to the analytic public finance literature to discover what light it sheds on taxation reform and aging, with an emphasis on demographic change. While research focused on taxation and demographic transition has been relatively thin, there are several recent developments in the public finance literature that bear upon this intersection.

Partly guided by our initial review of quantitative studies of the fiscal impacts of demographic change and the related literature, the chapter is framed around several important questions.

  • 1.

    Does age-dependent policy design hold any promise for moderating the fiscal impacts of demographic change? It is often assumed that age-dependent taxation is infeasible. But in the context of retirement policy, in particular, age dependence is often built into policy. If social security payouts are treated as simply transfers (or negative taxes) then this constitutes the most widespread example. While there is an analytical literature built around the idea of age dependence (see Weinzierl, 2011 for a recent example) this literature is typically not linked to social security payouts.

  • 2.

    Is the means testing of pensions a good idea? Resource testing, means testing, or targeting public pensions is a controversial policy reform. It clearly reduces the revenue requirement for older cohorts, but is also frequently criticized for the implied very high marginal tax rates imposed over the entitlement withdrawal range. An important initial question is whether means testing can be designed in a conventional model to improve welfare relative to a demogrant.

    Means or resource testing of public pensions is equivalent to imposing a capital income tax on retirement capital. Recent research has challenged the policy implication of research undertaken in the 1980s and 1990s (for example, Judd, 1985 and Chamley, 1986) that capital should not be taxed. The role of personal capital income taxation in tax design depends upon more complex institutional settings. In a life cycle framework, and where age-varying tax rates are infeasible, Erosa and Gervais (2002) prove that it is optimal for a government to tax or subsidize interest income, as a second-best response to setting optimal taxes as individuals’ optimal consumption-work plans change over the life cycle. It has also been shown (Hubbard and Judd, 1986, Aiyagari, 1995, Imrohoroglu, 1998, Fuster et al., 2007; and Conesa et al., 2009) that if there are incomplete credit and/or insurance markets, i.e., individuals are liquidity constrained and/or face uninsurable idiosyncratic income risk, then the optimal capital tax rate might not be zero. To what extent can means testing a pension be seen as efficiency improving, through its equivalence with a tax on retirement capital?

  • 3.

    To what extent does the changing relative importance of tax bases and the increasing revenue requirement associated with population aging indicate adjustments in tax design? What are the implications for efficiency and for equity, both within and between generations? Would a tax–transfer system, financed by general tax revenue, be more efficient than financing retirement incomes through a social security tax? To what extent do taxation and pension policy settings provide social insurance when individuals face uninsurable earnings, health, and longevity risks?

These questions and issues motivate the contents of this chapter. In Section 2, the issue of taxation, social security, and demographic change is put into context by first asking why population aging is likely to have fiscal implications. Since analyses of the impacts of population aging have been based upon a range of modeling frameworks, the section continues with a brief overview of such models including generational accounting, microsimulation models, and overlapping generations (OLG) models of the economy incorporating life cycle behavior of individuals and intertemporal general equilibrium. With that in hand, various studies of the fiscal and other impacts of population aging are reviewed. There are a large number of such studies, with broadly similar overall conclusions, so only some are reviewed in detail. While many are purely national studies, which focus on national issues, some others are for groups of countries and these focus on international aspects of demographic change, such as through international capital markets. The main message from these studies is that population aging is expected to have major impacts upon many economies, including macroeconomic, household welfare, and government fiscal impacts. This highlights the desirability of policy adjustments on the part of governments to manage and alleviate the impacts of population aging. These policy adjustments are particularly focused on the taxation instruments used to raise government revenue and on the expenditures of this revenue on age-dependent public programs such as health and social security.

Accordingly, Sections 3 and 4 consider, respectively, several different taxation and social security topics that are of policy relevance for population aging. There are two topics that are drawn out of the literature for special and more detailed treatment. The first of these is the concept of age-dependent taxation arising initially out of the Ramsey approach to optimal taxation. Age-dependent taxes seem particularly relevant in the context of population aging, which alters the proportions of people in the various age groups with greater proportions moving to higher age groups, since it is shown to produce efficiency gains if different age groups have different elasticities of response to taxation. This idea is a type of tagging, whereby tax rates are distinguished by a characteristic of those being taxed. The discussion of age-dependent taxation leads to a more general consideration of taxation design and analysis in Sections 3. Here the review covers such topics as the analysis of various tax policy reform proposals, the differential taxation of capital income and labor earnings, other optimal taxation designs, and how fiscal policy might evolve over time due to population aging.

The second topic given special treatment is that of the means testing of pension or social security benefits. The means testing of social security benefits is prevalent in many countries such as the UK, Denmark, and Australia but is being increasingly discussed in other countries such as the USA. Means testing may also be interpreted as a form of tagging, whereby pension recipients are identified as a group to receive specially designed implicit taxation via the pension taper or withdrawal rate applied to income or assets above a threshold. Means tests are often justified on the grounds of limiting government expenditure on publicly provided age pensions, but also raise many issues, including the impacts of the resulting distortions to household labor supply and saving decisions upon welfare and the economy. On the other hand, they may have valuable social insurance roles when households face uninsurable earnings and longevity risks. In addition to discussing means tests, Section 4 also discusses other pension and social security design issues such as privatization of social security and optimal pension structures.

There are, of course, a large number of taxation and pension policy instruments available to governments. In this chapter, focused as it is on taxation, pensions, and population aging, attention will be concentrated on a relatively small subset of such tax instruments.

There are three main taxation instruments that researchers in the area have considered. The first two are income taxation rates applied to the earnings of labor and capital. Typically, models distinguish between the two and there is an extensive literature, some of which is discussed further below, on whether the income from capital should be taxed along with the taxation of labor earnings. It is also common in the literature to simply have linear labor and capital income taxes, meaning that the tax rates are constant with taxation being proportional to income. Extensions of this restrictive assumption to deal with a progressive tax structure, as is common in many countries, do appear in the literature, such progressivity generating another source of potential labor market distortion. The optimal nonlinear income taxation literature initiated by Mirrlees (1971) is one such an example, but nonlinear income tax schedules appear in other literature.

Since most models dealing with population aging and taxation are macroeconomic models, they deal with consumption as a single aggregate rather than a vector of consumption of various commodities. Accordingly, they often incorporate a single tax rate on consumption—a goods and services, consumption, or a value added tax rate. While a consumption tax rate can have differential age-distributional effects on the population, this tax is usually viewed as a source of government revenue rather than a tax rate targeted at population aging per se.

Fiscal policy instruments that play important roles in some macroeconomic models are, of course, the size of the government budget deficit and the level of government debt. These are inherently dynamic in nature and allow intertemporal substitution in fiscal policy and the smoothing of taxation policies. Models used in this area vary significantly in their assumptions with some models based upon the assumption that governments balance their budgets in every period and others allowing budget deficits and surpluses over transition paths but requiring a long-term intertemporal government budget constraint to hold.

The literature dealt with in this chapter provides a strong link between the taxation policy instruments indicated above and the nature and structure of the social security system. Indeed, it is the intersection of these two areas that is especially important in the analysis of population aging. Accordingly, taxation policy can quite reasonably be interpreted as including the tax and structural aspects of the social security system. Many countries have a publicly provided old age pension scheme that is funded by some form of contributions and taxation. For example, a percentage of labor earnings may be mandated to be paid into a pension fund. There may be concessionary tax rates applied to these contributions. The earnings within pension funds may be taxed at concessionary rates, as may the pension withdrawals from these funds upon retirement. The pension payments that retirees receive might be means tested, a topic dealt with in some detail further below, so that those with higher other income or assets receive lower pensions. All these tax rates, means tests, and other pension rules constitute policy instruments available to governments and with fiscal implications. Additionally, governments may provide tax incentives for individuals to save in special retirement funds outside the public pension program and these also may have concessionary taxes on fund earnings and payouts. All these taxes and schemes therefore constitute policy instruments of relevance for the literature examined in this chapter.

The chapter finishes in Section 5 with some concluding remarks and observations. Provided first are some views on the main features of the literature covered in this review, followed by some comments on what the different tax and social security ideas covered may imply for population aging responses. The chapter concludes with a brief discussion of potential developments in research on taxation and demographic change.

Section snippets

The Issue

The demographic change currently being experienced by many countries is due to substantial increases in the longevity of people arising largely from better health care and reductions in fertility. These two factors have manifested themselves in a significant change in the age distributions of populations, with relatively fewer young people and relatively more older people than was previously the case. The result is that the old age dependency ratio, defined as the number of people aged 65 years

Conclusions

In this chapter, the issue of the role of taxation and pensions in a country's response to demographic change arising from population aging has been reviewed and addressed. This review has identified some pertinent features and aspects of the literature surveyed.

The first main feature of the literature is that it is set fairly firmly within the life cycle and OLG theoretical and modeling framework. The fact that it makes extensive use of the life cycle model of individual and household behavior

Acknowledgments

I wish to thank John Piggott for discussions on this chapter and for providing initial suggestions and references. The chapter has benefited significantly from the insightful and constructive comments of the two referees and of George Kudrna and Chung Tran, to whom I am especially indebted. I am grateful to Rafal Chomik for providing Fig. 1 and comments and to Tuong Van Pham for proofreading. This research was supported by the Australian Research Council Centre of Excellence in Population

References (171)

  • A. Erosa et al.

    Optimal taxation in life-cycle economies

    J. Econ. Theory

    (2002)
  • H. Faruqee et al.

    Population aging in Japan: demographic shock and fiscal sustainability

    Jpn. World Econ.

    (2003)
  • H. Fehr

    CGE modeling social security reforms

    J. Policy Model

    (2016)
  • H. Fehr et al.

    Welfare effects of life annuities: some clarifications

    Econ. Lett.

    (2008)
  • H. Fehr et al.

    Social security with rational and hyperbolic consumers

    Rev. Econ. Dyn.

    (2008)
  • H. Fehr et al.

    Fertility, mortality and the developed world's demographic transition

    J. Policy Model.

    (2008)
  • H. Fehr et al.

    Taxing capital along the transition? Not a bad idea after all?

    J. Econ. Dyn. Control.

    (2015)
  • H. Fehr et al.

    Means-testing and economic efficiency in pension design

    Econ. Model.

    (2014)
  • M. Fougere et al.

    Population ageing and economic growth in seven OECD countries

    Econ. Model.

    (1999)
  • M. Fougere et al.

    A sectoral and occupational analysis of population ageing in Canada using a dynamic CGE overlapping generations model

    Econ. Model.

    (2007)
  • M. Fougere et al.

    Population ageing, time allocation and human capital: a general equilibrium analysis for Canada

    Econ. Model.

    (2009)
  • V. Galasso

    Postponing retirement: the political effect of aging

    J. Public Econ.

    (2008)
  • M. Gervais

    On the optimality of age-dependent taxes and the progressive U.S. tax system

    J. Econ. Dyn. Control.

    (2012)
  • M. Golosov et al.

    Preference heterogeneity and optimal capital income taxation

    J. Public Econ.

    (2013)
  • A. Gorry et al.

    Optimal taxation over the life cycle

    Rev. Econ. Dyn.

    (2012)
  • R. Guest

    Innovations in the macroeconomic modelling of population ageing

    Econ. Model.

    (2007)
  • B. Heer et al.

    Population, pensions, and endogenous economic growth

    J. Econ. Dyn. Control.

    (2014)
  • E. Hernaes et al.

    Pension reform and labor supply

    J. Public Econ.

    (2016)
  • S. Imrohoroglu et al.

    Labor supply elasticity and social security reform

    J. Public Econ.

    (2009)
  • K. Jeske et al.

    U.S. tax policy and health insurance demand: can a regressive policy improve welfare?

    J. Monet. Econ.

    (2009)
  • L.E. Jones et al.

    On the optimal taxation of capital income

    J. Econ. Theory

    (1997)
  • K.L. Judd

    Redistributive taxation in a simple perfect foresight model

    J. Public Econ.

    (1985)
  • J. Jung et al.

    Market inefficiency, insurance mandate and welfare: U.S. health care reform 2010

    Rev. Econ. Dyn.

    (2016)
  • R. Aaberge et al.

    Population ageing and fiscal sustainability: an integrated micro- macro analysis of required tax changes

    (2004)
  • S. Adam et al.

    Dimensions of Tax Design

    (2010)
  • M. Aglietta et al.

    Scenarios for global ageing: an investigation with the INGENUE 2 world model

    (2005)
  • R.S. Aiyagari

    Uninsured idiosyncratic risk and aggregate saving

    Q. J. Econ.

    (1994)
  • R.S. Aiyagari

    Optimal capital income taxation with incomplete markets, borrowing constraints, and constant discounting

    J. Polit. Econ.

    (1995)
  • G.A. Akerlof

    The economics of “tagging” as applied to the optimal income tax, welfare programs, and manpower planning

    Am. Econ. Rev.

    (1978)
  • D. Altig et al.

    Simulating fundamental tax reform in the United States

    Am. Econ. Rev.

    (2001)
  • Y. Alvarez et al.

    Optimal taxation in a life-cycle model

    Can. J. Econ.

    (1992)
  • J.A. Auerbach et al.

    Dynamic Fiscal Policy

    (1987)
  • A.J. Auerbach et al.

    The efficiency gains from dynamic tax reform

    Int. Econ. Rev.

    (1983)
  • A.J. Auerbach et al.

    The economic dynamics of an ageing population: the case of four OECD countries

    OECD Econ. Stud.

    (1989)
  • A.J. Auerbach et al.

    Generational accounting: a meaningful way to evaluate fiscal policy

    J. Econ. Perspect.

    (1994)
  • Intergenerational Report: Australia in 2055

    (2015)
  • S. Bastani et al.

    The welfare gains of age-related optimal income taxation

    Int. Econ. Rev.

    (2013)
  • H. Benitez-Silva et al.

    The social security earnings test and work incentives

    J. Policy Anal. Manage.

    (2007)
  • M. Bielecki et al.

    In the search for the optimal path to establish a funded pension system

    (2015)
  • A.S. Blinder et al.

    Notches

    Am. Econ. Rev.

    (1985)
  • Cited by (0)

    View full text