Europe’s demographic timebomb

Philip Booth // 16.09.2016

This article is based on a presentation Prof Booth gave at the Autumn University of the Alliance of European Conservatives and Reformists (AECF).

Never before has a developed country with a high level of government spending and an enormous pay-as-you-go social security system faced the kind of demographic decline that we will see over the coming generations in developed countries. Furthermore, many countries already seem to have government spending at levels close to – or even beyond – the taxable capacity of their citizens. I don’t want to exaggerate the scale of the problem, but it seems likely that in many countries in the EU there will be a collapse of public finances followed by civil disorder as the government reneges on promises to the older part of today’s working generation.

So, to begin with, how can we describe the problem conceptually?

Pay-as-you-go pensions systems

The problem is as follows: Following the Second World War, electors voted themselves systems of pensions and health provision whereby, instead of workers putting money aside during their working lives to provide future healthcare and pensions, they simply voted themselves entitlements to pensions and healthcare to be financed by the following generation of workers through their taxes.

Such systems are intrinsically very risky. If life expectancy increases or if there is a decrease in the birth rate, the tax financing burden on the following generation increases. In order to remain solvent, such systems need to have a reasonably high birth rate so that the tax base does not decline relative to the population of elderly people. However, there is no feasible way of ensuring that this happens in practice.

If we take the example of Italy, life expectancy increased from 66 years at birth to 83 years at birth between 1950 and 2011. At the same time, the birth rate in Italy has remained stubbornly low and is now at 1.4 children per family. A falling working population is going to be funding pensions and healthcare to a growing elderly population.

In private systems of social security provision when risks materialise, there is an incentive on individuals to take action by, for example, deferring retirement or increasing saving later in life. In these government pay-as-you-go systems, there is no incentive for anybody to take any action when the birth rate drops or life expectancy increases.

Political obstacles to reform

Not only that, when the system run into trouble, reform is very difficult. As the population ages, cutting benefits becomes more difficult because the older population becomes bigger and bigger in relation to the electorate. So we have seen, for example, the Conservative government in the UK deliberately bias policy away from the interests of young people and towards the interests of older people in order to gain the votes of older people. So, as the electorate ages, it actually becomes more and more difficult to address the problem even though the problem becomes more and more urgent.

This graph, for example, shows how the electorate is ageing in the UK – and the UK is in a relatively good position.

demog

The light blue line is probably the most realistic projection. It shows that, by 2028, 50 per cent of active voters will be over age 55. Politicians are trying to harvest these votes.

How big is the problem?

So, how big is the problem? This table shows the projected population change in four selected EU countries from 2015 to 2080 from EU data.

Country Starting population (m) Fall in population projected 2015-2080 no migration Fall in population projected 015-2080 with projected migration
Germany 80.1 31.0% 19.1%
Greece 11 29.0% 30%
Poland 38.5 25.2% 23.1%
Slovenia 2.1 17% 2.9%

However, this only tells half the story. The population is going to fall despite people living longer. This means that the change in the ratio of the young population working and paying taxes to the older population must be even more dramatic and, indeed, it is.

The second table shows the fertility rate in the four countries (which explains the problem) and the projected dependency ratio change up to 2060 (in other words, roughly over the working life of today’s school leavers) which is a good summary of the impact of population ageing on the next taxpaying generation as it shows the potential population likely to be old enough to receive pensions relative to the working population who are paying taxes.

Country Starting population (m) Fertility rate Dependency ratio 2013 % Projected dependency ratio 2060 %
Germany 80.1 1.4 27.9 41.8
Greece 11 1.3 31.2 60.8
Poland 38.5 1.3 20.5 61.0
Slovenia 2.1 1.6 25.4 52.5

 

The main countries that will not have population falls are the UK, France, Sweden, Ireland and Belgium. However, though they may not experience population falls, they will experience an ageing of the population and a rise in their dependency ratios.

If we take the example of Poland, each worker will be carrying the cost of roughly three times as many pensioners at the end of the period compared with the beginning. We often focus on pensions in these discussions. However, it is important to bear in mind that healthcare is important too. Healthcare is predominantly consumed towards the end of a person’s life. It is something that could be prefunded. If we do not prefund healthcare through savings and insurance schemes then, rather like pensions, society is exposed to an ageing of the population raising healthcare costs.

What makes this all worse is the appallingly low level of labour market participation in many EU countries. For example, in Italy, nearly 60 per cent of people between 55 and 64 do not work. In the EU as a whole, nearly 50 per cent of people between 55 and 64 do not work. The inactivity rate amongst 60-64 year olds is 80 per cent in Italy and France and 70 per cent in the EU as a whole.

The consequences

We can think of the consequences in purely fiscal terms. Inter-generational accounting is often used to try to quantify the impact on taxpayers. I will not go through this in detail, but work on inter-generational accounts in the EU by Jagadeesh Ghokale suggests that, in order to balance the books in the long term, most EU countries should be running big surpluses now which will allow them to run deficits when the population ages. What they essentially need to do is to cut government spending programmes by between 20 and 40 per cent (depending on the country) just to remain solvent and balance the books over the long term. This makes no allowance for trying to reduce the burden of taxation.

What can be done?

So, the last question is, what can be done? I will simply end with a list without much comment.

    • We can reform labour markets to raise labour participation rates. This is low-hanging fruit and the good news is that the fruit hangs lowest in those countries which have the biggest demographic problems (with the possible exception of Germany). Increased participation at older ages both raises the tax base and reduces the spending burden.

 

    • Though cutting benefits and healthcare services is politically difficult, it should be done though there has to be a distinction between formal and informal promises that have been made. The easiest change politically is to raise the age at which state pensions are received. This can be done with less political pushback because it does not affect the already-retired and the young do not tend to be bothered about such changes.

 

    • Welfare systems can be reformed to make them less antagonistic towards family formation. In general, two parent families with at least one parent in work are rarely in need of welfare assistance. Stronger families can also help ensure that the job of caring for elderly people resides where it belongs – with the family rather than with the state.

 

  • The essential reform is to pensions and healthcare systems to promote privatisation, insurance and pre-funding. This cannot really do anything to deal with the promises made to the next generation of old people. However, it can stop the problem getting worse and put social security systems on a sound footing for the future. Of course, it would have been better if this had been done earlier – I have been proposing it publicly since 1996 or thereabouts. Such reforms in the future need to be done in ways that are clever institutionally too. We have seen in Hungary, Argentina and Poland how the government has effectively stolen private pension savings and used them to pay off government debt whilst giving the holders of those funds promises of future state pensions that are off balance sheet. It is important that reforms to pension funds prevent that from happening.

 

Professor Philip Booth is the Academic and Research Director at the Institute of Economic Affairs (IEA).

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