1. Global Aging Pressures: Impact of Fiscal Adjustment, Policy Cooperation, and Structural Reforms Dennis Botman and Manmohan S. Kumar Fiscal Policy and Surveillance Division Fiscal Affairs Department International Monetary Fund Prepared for the conference “Fiscal Policy Challenges in Europe”, organized by the German Federal Ministry of Finance and the Center for European Economic Research (ZEW), Berlin, March 22 and 23.

2. Debt Sustainability Challenges a.Demographic pressures in Europe b.Current structural deficits, and high initial debt in Europe c.Demographic pressures elsewhere: United States, Japan, and several emerging markets d.Globalization: spillover effects of (fiscal) policies increasingly important e.Other Uncertainties

3. Projected Debt Dynamics in Germany From “Global” Demographic Pressures... (Current Policies Scenario)

4. Projected Debt Dynamics in Germany From Its Own Demographic Pressures... (Current Policies Scenario)

5. Policy Options a.) Fiscal adjustment: revenue/expenditure based— effects on output, consumption, investment, trade and financial markets, and debt; b.) Cooperative action: spillover effects of fiscal adjustment (trade and financial market channels) in light of “global” aging pressures; benefits and costs c.) Lisbon Agenda: complementarities between fiscal adjustment and structural reform—labor participation, R&D spending, and product market competition.

6. Rigorous Modeling Framework: Global Fiscal Model Absence of Ricardian-equivalence:  Short planning horizons; distortionary taxation (consumption- leisure, investment); heterogeneous consumers Rich fiscal structure:  Wide menu of taxes/social security contributions;  Government spending and social security transfers. Interdependence:  Four country blocks/regions: trade and financial market channels. Other features:  Microfoundations;  Market imperfections (imperfect competition);  Labor or capital augmenting productivity growth;  Wage and price flexibility; capital mobility;  Traded/nontraded goods (“home bias”—government spending).

7. GFM: Versatile Framework Fiscal policy analysis: The effects of revenue and non-revenue neutral tax reform; The effects of revenue and non-revenue neutral tax reform; The effects of fiscal adjustment through raising taxes or reducing government expenditure, or a combination of the two; The effects of fiscal adjustment through raising taxes or reducing government expenditure, or a combination of the two; Evaluating social security reforms; Evaluating social security reforms; Addressing long-term fiscal sustainability concerns, including the pace, timing, sequencing, and size of adjustment; Addressing long-term fiscal sustainability concerns, including the pace, timing, sequencing, and size of adjustment; Analyzing the sensitivity of the results to the behavioral and structural assumptions; Analyzing the sensitivity of the results to the behavioral and structural assumptions; International spillover effects of fiscal policy. International spillover effects of fiscal policy. Other policies and applications: Effects of structural reforms; Effects of structural reforms; Debt (domestic and external) debt sustainability; Debt (domestic and external) debt sustainability; Financial market policies (risk-premium, patience); Financial market policies (risk-premium, patience); Effects of productivity convergence; Effects of productivity convergence;

8. Calibration Macroeconomic and fiscal variables calibrated to actual values for: (1) Representative large euro area economy (Germany): - Aging costs (incl. health) by 2050: 4 percent of GDP; - Higher VAT in 2007, tax reform, initial structural deficit; (2) Euro area excluding Germany: - Aging costs (incl. health) by 2050: 4.5 percent of GDP; (3) United States: - Aging costs (incl. health) by 2050: 6.0 percent of GDP; (4) Rest of the World: - Assumes no adjustment.

9. Fiscal Adjustment in Germany: Prefunding 1.)Achieves structural balance by 2011; 2.)Further adjustment: debt below Maastricht limit until 2050. Alternative Adjustment measures: a.) Higher direct taxation: social security contributions workers/employers (default policy response), CIT, PIT—base broadening; b.)Higher indirect taxation: higher VAT—base broadening; c.)Expenditure measures: government spending, entitlement reforms; Authorities’ intention: package of measures, with weight on expenditure measures/entitlement reforms, avoid higher direct taxes. Authorities’ intention: package of measures, with weight on expenditure measures/entitlement reforms, avoid higher direct taxes.

10. Alternative Adjustment Strategies: Prefunding

11. Alternative Fiscal Adjustment Strategies Effects on Real GDP (Germany)

12. Prefunding: Effect on Debt Dynamics

13. Effects of Adjustment Package 1.) Entitlement reform: higher saving by “optimizing consumers” as compensation; lower consumption by “rule-of-thumb” consumers; 2.) Higher saving by the government; reduced consumption of (nontraded) goods; 3.) Base broadening and higher VAT reduce hours worked and consumption (but, inelastic labor supply); As a result, consumption declines more than growth, interest rates decline, investment boom, higher capital-labor ratio, and substantial improvement in current account balance and net foreign asset position.

14. Global Aging: Joint Action? Assumptions: 1.) Germany maintains debt below Maastricht limit until 2050 through package of measures; 2.) Euro area implements its own package to maintain debt below 60 percent of GDP; 3.) U.S. package includes further increasing indirect taxation given starting structural deficit and higher costs from aging; maintains debt somewhat below current level until 2050. Choice between early adjustment or delaying (assume 10 year delay) for each country/region.

15. The Benefits of Joint Action I (GDP effects)

16. The Benefits of Joint Action II (NPV of GDP effects)

17. Sensitivity Analysis Parameter values based on empirical estimates from micro studies/selected to match the national accounts of a country. However, uncertainty about consumers and firms responses to macro policies remains. The benefits of joint action are robust to alternative parameter estimates. But.they are smaller if consumers are more “Ricardian”:  The planning horizon of consumers is very long;  Labor supply is not sensitive to changes in the after-tax real wage;  If all consumers have access to financial markets; Or if consumption is not sensitive to changes in the real interest rate. Other factors matter as well, such as: a firms’ flexibility to substitute between capital and labor; how costly it is to change the capital stock; degree of monopolistic competition; bias towards domestically produced tradables; bias towards nontradables; or economic size.

18. Effects of Joint Action Early Joint Action relative to delayed action, while entailing some output and consumption losses in the near-term, has significant benefits over the medium and longer run. Financial market effects dominate spillover effects through international trade channels—decline in the world real interest rate more than offsets declining exports following a fiscal consolidation. Nevertheless, output and consumption (especially of “rule-of thumb” consumers) still decline over the next decade: can structural reforms help to offset the contraction?

19. Lisbon Objectives: Germany I: Increase Labor Participation to 70 percent by 2010 (from 65 percent): I: Increase Labor Participation to 70 percent by 2010 (from 65 percent):  Higher labor demand: due to tax reform;  Higher labor supply: reducing incentives for non participation, and reduction of tax distortions. II: Higher R&D spending, raising productivity growth: II: Higher R&D spending, raising productivity growth:  Increase in R&D spending to GDP from 2.5 to 3 percent by 2010; TFP elasticity to R&D spending in the middle of existing estimates. III: Higher product market competition: III: Higher product market competition:  Gradual reduction in markups by 2015 by one quarter. Analyze the contribution of each of these objectives, and as a package, in complimenting fiscal adjustment.

20. Lisbon I: Higher Labor Participation (Germany) Significant increase in output and consumption; rule-of-thumb consumption increases later (as real wage declines)

21. Lisbon II: Higher R&D Spending (Germany) Significant increase in output, smaller increase in consumption (real exchange rate depreciates)

22. Lisbon III: More Competition (Germany) Significant increase in output and consumption, especially of rule-of- thumb consumers (as prices and equity values decline)

23. Implementing the Overall Lisbon Agenda (Germany)

24. Effects of Implementing the Overall Lisbon Agenda  Significant increase in output and consumption, offsets the contractionary effects of fiscal adjustment;  Spillovers of structural reform mainly through international trade channels, and both consumer types (“constituencies”) benefit;  Effects of euro area as a whole achieving the Lisbon objectives even more positive as average starting position weaker, for some of the objectives: (i) labor participation from 62.5 to 70 percent; (i) labor participation from 62.5 to 70 percent; (ii) R&D spending from 2.1 to 3 percent (and further international R&D spillovers); (ii) R&D spending from 2.1 to 3 percent (and further international R&D spillovers);

25. Effects of Delayed and Partial Attainment of the Overall Lisbon Objectives (Germany) Still substantial benefits, but cannot offset short-term adjustment costs of prefunding future aging costs

26. Conclusions: Debt Sustainability  (i) There is little doubt that debt is unsustainable under current policies in the euro area as well as in the United States.  (ii a) Debt in any particular country or region is seen to be even more unsustainable if the trading partners are also aging. The spillover effects of global aging occur through both financial and trade channels, with the former dominating.  (ii b) There is very substantial uncertainty about the costs of aging. But even with low estimates of higher costs of health care and pensions, debt will be on an unsustainable path.  (ii c) Substantial fiscal adjustment inevitable.

27. Conclusions: Fiscal Adjustment  (iii) Fiscal adjustment that combines both revenue and expenditure measures is the only feasible and relatively efficient method to maintain debt sustainability. Such a package should aim for a modest surplus in the primary balance over the next decade, to prefund future aging costs, and maintain intergenerational equity.  (iv a.) The short-term contractionary consequences of Germany implementing such an early fiscal reform by itself can be substantial.  (iv b.) Early Joint Action relative to delayed action has significant benefits over the medium and longer run. Financial market effects dominate spillover effects through international trade channels. If all countries that face aging pressures delay adjustment, the consequences for each and collectively would be highly adverse.

28. Conclusions: Structural Reforms  (v) Achieving the Lisbon objectives in Germany and the euro area is likely to overcome the adverse short-term effects on real GDP and consumption of the fiscal response.  (vi) There are significant benefits for all constituents of pursuing the Lisbon Agenda as a package. Each of the components imply different timing of the benefits, and differential effects across income groups.  (vii) A partial and delayed attainment of the Lisbon objectives has the negative consequence that the short-term output and consumption losses from prefunding of future aging costs cannot be mitigated.  (viii) Regardless of actions by other countries, it is in each country’s own interest to take early resolute measures both in terms of fiscal adjustment and structural reforms.