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Portugal: Selected Issues

Author(s):
International Monetary Fund. European Dept.
Published Date:
September 2016
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Policy Options to Mitigate the Impact of Adverse Demographic Developments1

This paper estimates the fiscal impact of demographic changes in Portugal and the euro area over the period 2015-2100, based on the 2015 United Nations (UN) projections for fertility, mortality and migration. By focusing on projections up to 2100, it presents the fiscal implication of demographic trends that will be fully realized only over the longer term. While long-term demographic projections must be taken with caution given large uncertainties, various alternative scenarios point to a significant impact on fiscal sustainability in Portugal.

Under the UN baseline projections, Portugal is among the countries in the euro area that would be most adversely affected by demographic developments. Over the period 2015- 2100, its population is expected to shrink by about 30 percent, while the old-age dependency ratio would more than double, driven mostly by low fertility rates, higher longevity, and—to a much lesser extent—migration outflows.

In light of this outlook, age-related public spending (i.e. on pensions and healthcare) would increase by about 6 percentage points of GDP under the baseline over the period 2015-2050, and the public debt path would become unsustainable in the absence of offsetting policies.2 Pension spending in Portugal would increase until 2035, before declining slightly as reforms adopted over the last ten years would begin to generate savings. However, pension spending would still remain high by European standards. Public healthcare spending would increase sharply, mostly driven by technological change in healthcare which is expected to result in better but costlier services, and to a smaller extent by demographics.

Generating higher potential growth and productivity would be key to mitigate the impact of a shrinking population on fiscal sustainability. Offsetting age-related spending pressures would require either reining in pension and health spending, rationalizing other expenditure or increasing tax revenue, or a combination of these three policy options. While their respective contribution will ultimately depend on social preferences, a comprehensive mitigation strategy will be needed to safeguard social cohesion and ensure fiscal sustainability.

This paper focuses on measures that would help mitigate age-related spending pressure and minimize the impact on tax revenues and non-age-related public expenditure. A multi-pronged approach is proposed with policies that both affect demographics and labor markets, as well as entitlements reforms. Avoiding pension policy reversals and revisiting recent pension reforms to address inequities among generations and across pension schemes, reversing migration outflows, and reducing healthcare cost growth are critical to partially offset the adverse impact of demographics on public finances. The paper is structured as follows: The first section describes demographic developments and projections under the UN baseline scenario. The second section discusses the fiscal impact of projected demographic changes on age related-spending. The final section presents a set of policy options to mitigate the fiscal impact of Portugal’s shrinking population. The conclusion highlights key policy actions needed in the short and medium term.

A. Portugal’s Population is Projected to Shrink over the Medium and Long Run

1. According to the 2015 UN projections, under the baseline the total population in Portugal would shrink more than for the average in the euro area and comparator countries (Figure 1). Notably, the populations of Portugal and five other euro area countries (Estonia, Greece, Latvia, Lithuania, and Spain) have already begun to shrink, while continuing to increase for the euro area as a whole, largely driven by France. Under the UN baseline, the population of the euro area would decline by about 9 percent over 2015-2100, while it would shrink by 29 percent in Portugal.3 Portugal’s unfavorable demographic developments would be more severe than for all comparator countries. However, some other euro area countries would experience an even larger population decline (Croatia, Estonia, Greece, Latvia, Lithuania, and Slovakia).

Figure 1.Demographic Developments

Source: IMF staff calculations using UN 2015.

2. The sharp decline in Portugal’s population would lead to the highest old-age dependency ratio in the euro area (Figure 1). In 2015, Portugal’s old-age dependency ratio of 32 is already above the euro area’s average (of 28) and that of Spain, but in line with France and Germany, and slightly below Italy. Over the projection period, the old-age dependency ratio would increase faster than in comparator countries, and become the highest from 2060 onward. By 2100, Portugal would have the highest dependency ratio (68) among euro area countries.

3. Continued lower fertility rates would have a large negative impact in Portugal (Figure 2). All euro area countries have experienced a demographic transition characterized by a long-term decline in fertility rates which have fallen under the rate needed to maintain a constant population, assuming no immigration (estimated at about 2.1 children per female). Portugal was already estimated to have the lowest fertility rate among euro area countries over the recent period, although there was a slight pickup in 2014 and 2015 (INE, 2016a). Looking ahead, UN forecasts assume a modest and gradual increase in fertility rates on average in the euro area, although still remaining below 2.1. Portugal’s fertility rates would continue declining over the period 2015-2025, before slowly rising to reach its 1995 level by 2045. By the end of the projection period (2100), Portugal would have the second lowest fertility rate among euro area countries, after Germany.

Figure 2.Demographic Trends and Projections

Source: IMF staff calculations using UN 2015.

4. Higher longevity would also contribute to an increase in the old-age dependency ratio, although this improvement is projected to gradually slow down under the baseline (Figure 2). Mortality rates fell significantly across age groups in the euro area, with child mortality reaching 0.3 percent in 2015, and with large improvements in longevity for older ages. Starting from a higher level in 1955, Portugal caught up with the euro area average across most age groups. The UN’s projections anticipate a gradual slowdown in the decline in mortality rates for the elderly over the projection period, in line with recent developments in Japan, where the impact of ageing is already large and longevity improvements have plateaued. By 2100, Portugal’s mortality rates would remain slightly above the euro area average for adults (15-64 years old) and the elderly (65 and over).

5. While Portugal has experienced several episodes of negative migration rates, the baseline assumes a gradual normalization over the projection period (Figure 2). In the past, Portugal has experienced three episodes of negative net migration. The largest episode took place from 1955 through the mid-1970s, followed by a smaller episode in the mid-1980s and early 1990s, and finally a recent episode from 2010. This pattern is similar to Spain—and to a lesser extent Italy, which has recently benefited from a positive migration rate.4 Recent data indicates a slowdown in net migration outflows in Portugal, as the number of permanent emigrants decreased in 2015, while permanent immigrants increased (INE, 2016). During 2010-2015, Greece, Ireland and Spain suffered also negative net migration flows. In Portugal, recent migration patterns have tracked economic developments (IMF, upcoming), with both a decline in migration inflows over the recent period, and an increase in migration outflows, particularly to other European countries following the economic crisis (INE, 2016b). Going forward, the UN assumption is that net migration inflows to developed countries would remain constant over the period 2015-2050, before steadily declining to half of the 2050 level by 2100.5 As a result, net migration rates would remain negative over the short term in Portugal, before becoming positive from 2025 and settling above most comparators (except Spain) from 2040 onward.

B. Adverse Demographic Changes Will Pose Significant Fiscal Challenges

6. Under the baseline, Portugal’s age-related spending would rise significantly above the euro area average and comparator countries (Figure 3). Overall, age-related spending is projected to increase by 6.1 percentage points of GDP by 2050, compared with an average increase of 4.5 percentage points of GDP in the euro area. By 2100, age-related spending would increase by 7.4 percentage points of GDP in both Portugal and for the euro area as a whole. However, with Portugal starting from a higher level of spending, its age-related spending would be higher than the euro average by about 6 percentage points of GDP in 2050, and 5 percentage points in 2100. All comparator countries would have significantly lower age-related spending than Portugal.

Figure 3.Age-Related Public Spending in Portugal and the Euro Area

(In percent of GDP)

Source: IMF staff calculations using UN 2015.

7. Under the baseline, pension spending would increase until 2035 before gradually declining once recent reforms begin to generate significant fiscal savings, but would remain largely above the euro area average and comparator countries (Figure 4). Portugal would experience an increase of 1 percentage point in public pension spending by 2035, larger than the euro area average increase (+0.6 percentage point). In the longer run, pension spending would decrease by about 1.5 percentage point, as recent reforms would largely offset the two-fold increase in the age-dependency ratio (from 32 to 66).7 Over the same period, pension spending in the euro area would increase slightly (+0.5 percentage point of GDP). Portugal’s public-pension-to-GDP ratio surpasses the euro area average by about 4 percentage points of GDP almost over the whole projection period, as well as above all comparators.

Figure 4.Health Spending

(In percent of GDP)

Source: IMF staff calculations using UN 2015.

8. Health spending would drive the sharp increase in age-related spending on the back of higher excess growth cost (Figure 4 and Table 1). Portugal would experience a sharp increase in health spending of 5.7 percentage points of GDP by 2050, and 8 percentage points by 2100, resulting in the highest health spending-to-GDP ratio relative to comparators, and well above the euro area average. By 2100, excess cost growth would explain ¾ of the total increase in health spending in Portugal (Table 1). This significant contribution of health care costs is not attributed to an increase in the coverage ratio of public healthcare, as Portugal completed the transition toward public universal coverage by the end of the 1970s, but instead it would originate from cost-driven factors (see Boxes 1 and 2).

Table 1.Health Spending Increase(In percent of GDP, and percent of total increase)
Excess cost growthDemographicsTotalShare of Excess cost growth in total increase
Netherlands9.03.712.770.8
Portugal6.31.78.078.6
Belgium6.24.710.957.0
Greece6.01.77.778.1
United Kingdom4.82.47.266.6
Spain4.42.46.865.2
Austria4.43.07.459.6
Denmark3.63.26.853.3
Finland3.42.05.463.6
France3.12.25.358.3
Germany2.82.55.353.1
Italy2.81.84.661.3
Ireland2.02.74.743.4
Source: IMF staff calculations using UN 2015.
Source: IMF staff calculations using UN 2015.

Box 1.Projection Methodology6

This paper draws on projections of public pension and healthcare spending from the October 2015 IMF SDN on “The Fiscal Consequences of Shrinking Populations”. They are based on the UN 2015 demographic projections for fertility, mortality and migration over the period 2015-2100. By focusing on projections up to 2100, the SDN presents the fiscal implication of demographic trends that will be fully realized only over the longer term. Baseline projections correspond to the main UN demographic scenario. Alternative UN scenarios for lower fertility, and higher longevity are also used given substantial uncertainties in projecting demographic developments.

For pension spending, we use the 2012 OECD data as the base year, and the European Commission (EC) 2015 Ageing report spending profile, to take into account the impact of pension reforms up to 2060. Beyond 2060, pension projection spending is driven purely by demographic factors.

Projections for health care expenditure to GDP are based on the 2012 OECD data. Projections take into account the “excess cost growth”, which is the difference between the growth of health care spending per capita and the real GDP growth per capita, after controlling for the effect of demographic changes. It captures rising health costs related to technology, the Baumol effect, and health policies and institutional settings. For Portugal, excess cost growth is assumed to go from the 1981-2007 mean in 2015 to the mean in the sample of advanced economies (0.7 percent) in 2050, and then converge to zero in 2100.

Box 2.Differences with the European Commission 2015 Ageing Report

First, this paper uses a different base year for spending projections. The EC 2015 Ageing report is based on the 2013 public health and pension spending data provided by EU member countries, whereas this paper uses the 2012 OECD data, which provides a consistent definition and coverage of spending across countries. While using different demographic assumptions from 2060, the IMF pension spending projections replicate the spending profile of the 2015 Ageing report, in order to account for recent spending reforms which are factored in the EC 2015 Ageing report. Using the UN demographic projections without controlling for pension reforms would bring Portugal’s public pension spending about 10 percentage points of GDP above the baseline by 2100. Overall, the IMF staff’s public pension spending projections would be higher by 1.5 percent of GDP in 2060 relative to the 2015 Ageing report baseline scenario.

The health spending projections are based on the UN 2015 demographic forecast, which differs from the EC 2015 Ageing report projections. In addition, the EC 2015 Ageing report baseline scenario only estimates the impact of demographic factors, whereas this paper factors in excess cost growth (see definition in Box 1). When excluding excess cost growth from the baseline, public health spending projections are comparable with the 2015 Ageing report (-0.1 percentage point of GDP in 2060 in the IMF projections). The 2015 Ageing Report presents an alternative projection (“non-demographic determinants scenario”) which calculates the impact of excess cost growth. In this scenario, Portugal would experience the largest increase among EU countries (4.9 percentage points of GDP) in 2060, and significantly above the average increase for the euro area (2.4 percentage points of GDP). IMF staff projections foresee a comparable increase of 5.1 percent of GDP in 2060 due to excess cost growth. The slight difference lies in the use of an average cost sensitivity of 1.4 in the 2015 Ageing report for all EU countries, whereas this paper uses a Portugal-specific excess cost growth of 1.9.

9. Population aging in Portugal, if not offset, could put public debt on an unsustainable path (Table 2, baseline scenario). The present discounted value (PDV) provides a sense of the impact of the increase in age-related spending on public debt burdens.8 In present value terms, the increase in age-related spending in Portugal is equivalent to 106 percent of today’s GDP between 2015 and 2050, and 186 percent of GDP between 2050 and 2100. This would put an already high public debt on an unsustainable trajectory if not offset.9

Table 2.Impact of Demographic Uncertainty on Aging and Age-Related Programs for Portugal, 2015-2100(In percent of GDP, unless otherwise specified)
ChangePDV of spending change
2015205021002015-20502050-21002015-20502050-2100
Baseline
Old-age dependency ratio1326669
Pension spending15.616.015.00.4−1.023−16
Health spending6.812.514.85.72.383203
Pension + health care spending22.428.529.86.11.3106186
UN Low fertility scenario
Old-age dependency ratio1327397
Pension spending15.617.721.32.13.634121
Health spending6.813.819.67.05.996308
Pension + health care spending22.431.541.09.19.5130429
Longevity risk scenario
Old-age dependency ratio1327077
Pension spending15.617.016.81.4−0.13518
Health spending6.812.915.96.23.088223
Pension + health care spending22.429.932.87.52.9123241
1/ Population 65 and older as a share of the population 15 to 65.Source: IMF staff calculations
1/ Population 65 and older as a share of the population 15 to 65.Source: IMF staff calculations

10. While estimating the fiscal impact of demographic changes is subject to large uncertainties, alternative scenarios point to a large increase in age-related spending in Portugal. Alternative UN demographic scenarios estimate an even larger impact of demographics on spending pressure in the medium and long run (Table 2). In particular, a lower fertility scenario would increase dramatically age-related spending in the long run and would catapult public debt ratios over the next 85 years, relative to the baseline. And the increase in both the old-age dependency ratio and in age-related spending would be larger under both alternative scenarios than for the euro area average and comparators (Figure 6).

Figure 5.Impact of Alternative Demographic Scenarios Relative to the Baseline

(in percent of GDP)

Source: IMF staff calculations using UN 2015.

Figure 6.Increase Fertility Rates

(Change from baseline, in percentage points of GDP and old-age dependency ratio)

Source: IMF staff calculations using UN 2015.

C. Policy Options to Mitigate the Fiscal Impact of Portugal’s Shrinking Population

11. Various policy options are considered to mitigate the fiscal impact on ageing (Box 3 and Table 3). In addition to macroeconomic policies and structural reforms to raise productivity, increase potential growth and raise competitiveness (IMF, 2016a), these policy options include: (i) boosting fertility rates; (ii) reversing net migration flows; (iii) increasing labor force participation of women and of the elderly; (iv) revisiting recent pension reforms to promote equity among current pensioners and generations; and (v) lowering health spending excess cost growth. Overall, Portugal needs to implement a multi-pronged approach that would partially address demographic challenges, increase labor force participation, and reform age-related spending programs. This requires defining a policy mix that take into account interactions between those policy options to ensure that they don’t lead to suboptimal outcomes.

Box 3.Decomposition of Age-related Spending - Methodology for Sensitivity Tests

Pension expenditure to GDP (PE/GDP) is the product of four main factors: benefit generosity (average pension to GDP per worker), pension coverage (number of pensioners to the population 65 and older), the inverse of the labor force participation rate (population ages 15–64 to workers), and aging, represented by the old-age dependency ratio (population 65 and older to population 15–64). For sensitivity tests, this framework assumes constant benefit and coverage ratios, as well as labor force participation and GDP per worker, implying that pension spending as a share of GDP only varies with the old-age dependency ratio. It also assumes a no tax policy change scenario, in which tax revenues remain stable as a share of GDP.10 Therefore, the change in the expenditure to GDP ratio depends on factors that change the numerator (a higher number of elderly) and that affect the denominator (a reduction in the working age population), both of which are affected by population dynamics.

Similarly, health care expenditure to GDP (HE/GDP) can be expressed as the product of three factors: the generosity of the health package for the young (average health spending per population 0–64 to GDP per worker), the inverse of the labor force participation rate of the population 0–64, and a function that depends on the ratio of the per capita health spending for the older population to the per capita health spending for the young (α) (3.2 on average for OECD economies) and the old-age dependency ratio. Assuming that the first two factors remain constant, changes in health care spending are a function of the change in the old-age dependency ratio.

Table 3.Impact of Selected Policy Options on Aging and Age-Related Programs in Portugal, 2015-2100(in percent of GDP, unless otherwise specified)
ChangePDV of spending change
2015205021002015-20502050-21002015-20502050-2100
Baseline
Old-age dependency ratio1326669
Pension spending15.616.015.00.4−1.023−16
Health spending6.812.514.85.72.383203
Pension + health care spending22.428.529.86.11.3106186
Increase fertility rates
Old-age dependency ratio1326455
Pension spending15.615.412.1−0.2−3.318−61
Health spending6.811.912.45.10.579163
Pension + health care spending22.427.424.55.0−2.897102
Higher migration risk scenario
Old-age dependency ratio1328089
Pension spending15.619.319.43.70.16598
Health spending6.813.917.47.13.598265
Pension + health care spending22.433.236.810.83.6164363
Increase labor force participation of women
Old-age dependency ratio1326669
Pension spending15.615.314.4−0.3−1.012−35
Health spending6.811.914.15.12.277185
Pension + health care spending22.427.228.54.81.389150
Increase labor force participation of elderly
Old-age dependency ratio1326669
Pension spending15.615.214.3−0.4−0.911−37
Health spending6.811.814.15.12.276183
Pension + health care spending22.427.128.44.71.387146
Lower excess cost growth
Old-age dependency ratio1326669
Pension spending15.616.015.00.4−1.023−16
Health spending6.88.28.51.40.32045
Pension + health care spending22.424.223.51.9−0.74329
1/ Population 65 and older as a share of the population 15 to 65.Source: IMF staff calculations
1/ Population 65 and older as a share of the population 15 to 65.Source: IMF staff calculations

Policies that Affect Demographics

Boosting Fertility Rates

12. Increasing fertility rates would generate large fiscal savings (Figure 6), but widespread policies to raise fertility in Europe seem to have had a limited impact. A higher fertility rate would reduce the old-age dependency ratio more in Portugal than in comparator countries and the euro area.11 In the medium run, the impact on age-related spending would be limited, as the continued increase in fertility rates would be gradual, and as the impact on the working-age population would take time to materialize. In the long run, the reduction would be more sizable, particularly in Portugal, where the old-age dependency ratio would be significantly lower than under the baseline.

13. Portugal has made progress in providing childcare services to allow high maternal employment, but suffers from a low number of children per family. Participation rates of young children in childcare (45 percent in 2013) and pre-primary education (89 percent in 2012) has risen steadily and is slightly above the euro area average. By reducing opportunity costs of childbearing for families, this has led to a high maternal employment rate relative to the euro area (73 percent of women with children aged 0-14). However, around half of all Portuguese families have only one child, significantly above most euro area countries, possibly indicating difficulties for families to offset childbearing costs.

14. Portugal has contained public spending on children through high means-testing, but it appears insufficiently geared toward early childhood (Figures 7 and 8). More than half of all European countries are implementing policies to raise the rate of population growth (IMF, 2015a). Portugal spends significantly less on family and children benefits, services and tax measures (1.4 percent of GDP in 2011) than the euro area average (2.6 percent of GDP), and most comparators. Portugal has introduced means testing for family benefits, and compares favorably with other countries. However, family cash benefits are insufficiently targeted, as the eligibility threshold (€8,803) is above the minimum wage. In addition, the share of social spending for 0-5 year-old children (including family benefits and education spending) is the smallest in Europe, pointing to the need to reallocate benefits toward families with young children, by increasing the efficiency of public education spending.

Figure 7.Family Benefits

Source: OECD

Notes: 1/ Excluding Cyprus, Lithuania, Latvia, and Malta.

2/ Includes family benefits and education spending.

Figure 8.Share of Means-Tested Family and Child Benefits 2012

(In percent of GDP, and percent)

Source: IMF staff calculations using UN 2015.

Note: Dash line represent EU median.

15. Rather than increasing cash benefits which have limited impact in improving fertility, Portugal could further improve childcare services. In 2016, Portugal increased the progressivity of family support, through a progressive increase in family allowances, a personal income tax reform to replace the family quotient by a lump-sum deduction, and a reversal to the 2012 scale of the guaranteed minimum income benefit to better take into account children, to offset the impact of recent measures on poverty (OECD, 2015). 12 While these measures are geared toward reducing inequality and poverty for families, they may have a limited impact on fertility, as evidenced by empirical studies on family cash benefits (IMF, 2013a). Financial measures that attempt to encourage parents to have more children have individually little or no impact, and may only induce parents that were in any case going to have a child to have a child earlier. Therefore, if Portugal wants to engage in policies to raise fertility, it would need to look at measures other than cash benefits to families, particularly childcare services for low income families. Key bottlenecks are capacity constraints in subsidized childcare, and insufficient access for low income families to affordable childcare services, as evidenced by the highest enrollment gap (around 40 percent) between high- and low-income families among OECD countries (OECD, 2011).

Reversing Net Migration Outflows

16. Portugal would be adversely impacted by a continuation of migration outflows under an alternative risk scenario (Figure 9). A continuation of recent outflows would have a large impact on Portugal’s age-related spending. This would translate into a sharp increase in the old-age dependency ratio, as the working-age population would further decline, leading to a spike in both public pension and health spending over the medium and long term. Based on evidence by large emigration from Central, Eastern and Southeastern Europe, a sustained period of large migration outflows could also lower growth potential in Portugal, by reducing the size of the labor force and productivity, and would also worsen competitiveness (IMF, upcoming).

Figure 9.Higher Migration Risk Scenario

(Change from baseline, in percentage points of GDP and old-age dependency ratio)

Source: IMF staff calculations using UN 2015.

17. Portugal has implemented policies to attract highly-skilled professionals, EU retirees and non-EU foreign investors. First, a golden visa scheme was put in place from 2012 for non-EU private investors, which however has generated only limited inflows thus far, with about 2,788 residency permits granted by end-2015 (SEF, 2014). A specific tax regime for non-habitual resident was also established for highly-skilled foreigners (such as doctors, senior managers, and auditors), and foreign pensioners that would settle in Portugal. While attracting more retirees from the rest of EU will not improve demographic prospects of the country, it may however have a positive indirect impact on the economy. About 5,600 foreigners had benefited from this tax regime at end-2014.

18. First and foremost, increasing potential growth and employment prospects would help reversing migration outflows. Two recent studies suggest that intra-EU migration in response to different degrees of labor market slack across member countries has increased (Goodhart and Lee (2013), and Beyer and Smets (2014)). Portugal still suffers from significant labor slack, with a sharp increase in the share of workers that are neither employed, fully employed nor fully disinclined to work, particularly among lower skilled workers. Migrant workers abroad, and particularly those intending to migrate out only temporarily, form a pool of workers that is connected to the domestic labor market by a two-way safety valve. To reverse past trends, it would be critical to reduce the labor slack through structural reforms to boost competitiveness, a prudent minimum wage policy to absorb lower-skilled workers, and a more inclusive and transparent social dialogue (IMF, 2016a).

19. In addition, more could be done to increase migration inflows of Portuguese workers and other migrants to improve demographic and growth prospects. Policy responses should first incentivize workers to stay, primarily by fostering a more favorable macroeconomic environment to boost employment. Engaging with the Portuguese diaspora abroad and removing barriers to reintegration in the workforce would facilitate return migration (IMF, upcoming). In addition, Portugal may try to attract more working-age migrants to increase the size of its labor force. While increasing migration inflows would be beneficial for Portugal’s demographic developments, the medium-term impact of a larger inflows on output would depend on its capacity to successfully integrate them into the labor force (IMF, 2016a). This would require implementing policies that facilitate labor market integration of migrants, such as introductory programs to support migrants in getting jobs, preventing a further increase in the minimum wage to reduce barriers for low-skilled workers, or active labor market policies to support private sector employers in the hiring migrants (IMF, 2016b).

Policies that Affect Labor Markets

20. Improving labor force participation of women and the elderly would contribute more modestly to offsetting age-related spending pressures (Figures 10 and 11). Increasing labor force participation would increase GDP by raising the number of workers, assuming that productivity remains constant. Higher labor force participation of women and the elderly would however generate limited savings in the long run, relative to an increase in fertility, or an improvement in net migration. For ages 25-64, female labor force participation is high (75.5 percent in 2015) relative to the euro area average (71.1 percent), and above most comparators. In addition, the gap between men and women in labor force participation in Portugal is lower in Portugal. Cutting this gap by half over 2015-2050 would generate a saving of about 1 percentage point of GDP by 2050 and 2100. For the elderly (aged 55-64), the labor force participation rate is comparable to the euro area average, but the gap with individuals 25-64 is larger. Cutting this gap by half would reduce age-related spending by about 1.5 percentage point of GDP.

Figure 10.Increase Labor Force Participation of Women

(Change from baseline, in percentage points of GDP)

Source: IMF staff calculations using UN 2015.

Figure 11.Increase Labor Force Participation of Elderly

(Change from baseline, in percentage points of GDP)

Source: IMF staff calculations using UN 2015.

21. Recent tax and pension reforms should contribute to increasing the labor force participation of both women and the elderly. Portugal has recently adopted reforms aiming at raising the labor force participation of women and the elderly. They include allowing individual income taxation to reduce the secondary earner tax wedge, to which labor supply is more responsive (IMF, 2013b). For the elderly, the legal retirement age has been increased to 66 years old, and is adjusted in line with the evolution of life expectancy at age 65.

22. Reinforcing work incentives for older workers could increase their labor participation. Older workers (aged 40 and above) have longer unemployment benefits than young workers, as they are eligible to additional social unemployment after the end of their unemployment insurance benefits (IMF, 2013a; OECD, 2015). Gradually aligning the benefit duration of older workers on young workers as employment conditions improve could usefully increase work incentives for the elderly.

Reforms to Age-Related Spending Programs

Revisiting Recent Pension Reforms to Promote Equity among Current Pensioners and Future Generations of Pensioners

23. The sustainability factor will gradually raise the retirement age and generate a large reduction in pension spending over the long run. The sustainability factor links the legal retirement age to life expectancy at the time of retirement, and reduces pension benefits for early retirement in line with improvements in life expectancy.13 It will increase the legal retirement age by more than two years by 2050, according to the authorities’ projections.14 As a consequence, the pension coverage ratio is expected to decline by more than 20 percentage points by 2035. The authorities should therefore avoid reversing this adjustment mechanism that is expected to contribute to reining in pension spending.

24. Additional pension reform measures will be needed to bring down spending in the more medium term (Figure 12). Reforms need to focus on restoring fiscal sustainability, increasing equity (between the workforce, pensioners and across generations), minimizing the incentives for informality and inactivity, and retaining the ground gained on protecting the most vulnerable (IMF, 2013a). Pursuant to the Constitutional Court ruling on pension reforms, a comprehensive structural reform of the pension system is required to balance the sustainability of the public pension system and equity among generations and across pension schemes (EC, 2014). This reform would require a clearly articulated social consensus that would involve all stakeholders. As part of a broader policy package, the authorities should in particular review recent reforms, given rising pension spending in the short and medium terms due to extensive grandfathering, and falling benefit generosity in the long run. Portugal has both a larger increase in pension spending over 2013-2035 than the euro area and most comparators (excluding Germany) and a larger reduction in pension spending over 2035-2100 (excluding Italy). Partly due to legal considerations, recent reforms have protected current retirees while placing a substantial adjustment burden on the future generation of retirees (IMF, 2012). Benefits would be largely unchanged over the short and medium term, as only about 15 percent of the adjustment will be borne by those who receive pensions over the next 20 years, compared to a median of about 46 percent of the adjustment burden in the EU. In addition, the relatively rapid increase in the legal retirement age will lead to an adjustment of about 80 percent in the benefit eligibility within the next two decades for new pensioners, somewhat closer to the European median. Therefore, a comprehensive reform should address both inequities among generations including current pensioners whom were largely preserved from recent pension reforms, and across pension schemes in Portugal, as benefit generosity for current pensioners varies significantly.

Figure 12.Projected Reductions in Benefit Ratios and Pension Eligibility (2013-2060) and Projected Reductions Achieved During 2013-2035

(In percent)

Source: IMF staff calculations, EC 2015 Ageing Report.

Lowering Health Excess Cost Growth

25. In the health sector, there is limited room to reduce public spending by increasing private participation (Figures 13 and 14). While public spending on health in Portugal is below the euro area average, total health spending is in fact higher (+0.3 percent of GDP in 2013). This is due to the share of private spending which is higher than in most countries, except in Greece. In this context, there might be limited room to transfer the financing of health spending to households, as the coverage by private health insurance is low in Portugal (21.1 percent, compared to 46.3 percent on average in the euro area), leaving a large amount of health spending outside the coverage of public and private health insurance. Over the recent period, out-of-pocket spending for households has already increased more in Portugal, but large social exemptions have made copayments progressive and have not adversely impacted access (OECD, 2015).

Figure 13.Lower Excess Cost Growth

(Change from baseline, in percentage points of GDP)

Source: IMF staff calculations using UN 2015.

Figure 14.Health Spending

(In percent of GDP)

26. Policies to reduce healthcare costs should be expanded and pursued forcefully (Figure 14). Health spending efficiency could be improved. In this area, Spain and Italy have outperformed Portugal, with higher Health Adjusted Life Expectancy (HALE) and lower total spending. The composition of health spending shows areas where more spending containment could contribute to reduce costs. Recent efforts have focused on reducing public spending on pharmaceuticals (0.4 percent of GDP in 2014) which are now significantly lower than in the euro area (1.2 percent of GDP), and as a share of total public health spending (Figure 21). But Portugal’s public wage bill in the health sector is still largely above EU average. Efficiency gains could be achieved in the following areas: (i) increasing performance financial incentives in both hospitals and primary care; (ii) further increasing the share of generics; (ii) making the production mix less cost intensive, by reducing the length of stay in hospitals, and expanding nursing role to reduce the number of physicians without diminishing the quality of service (OECD, 2015).

D. Conclusions

27. The projected decline in Portugal’s population poses a serious threat to its public finances. Under the baseline, age-related public spending would increase by more than 7 percentage points of GDP, and public debt would become unsustainable. This would be driven by health spending, as population ageing and technological improvements are projected to increase faster than economic growth. Pension spending will also further rise in the short term, as recent reforms have protected current retirees, while postponing the sharp adjustment on future generations of pensioners.

28. Addressing this massive fiscal challenge will require policies to raise growth potential, improve demographics and labor markets, and reform entitlements. While their respective contribution will ultimately depend on social preferences, a comprehensive mitigation strategy will be needed to safeguard social cohesion and ensure fiscal sustainability. First and foremost, macroeconomic policies should aim at generating sustainable growth and improving competitiveness. Offsetting rising fiscal costs will also require either reining in pension and health spending, rationalizing other expenditure or increasing tax revenue, or a combination of these three policy options.

29. Policy action is needed in the short term as Portugal already experiences adverse demographic changes. Portugal is one of the few advanced countries which has already experienced a decline in population over the recent period. As a consequence, the pace of entitlement reform should be faster in Portugal and policy reversals should be avoided to circumvent disruptive adjustments in the future. In particular, there is a great urgency to revisit recent pension reforms to frontload the adjustment effort. This would both contain spending pressure in the short run, while ensuring more equity between current pensioners and future generations of pensioners. Finally, reforms to reduce health care cost should be pursued forcefully to ensure that health costs are fiscally sustainable.

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Prepared by Maximilien Queyranne (FAD). The author would like to thank Kamil Dybczak and Mauricio Soto (FAD) for their support and advice, and the Portuguese authorities and the Fiscal Council for their useful comments. This paper uses the spending projections and analytical framework created by Benedicts Clements, Kamil Dybczak, Victor Gaspar, Sanjeev Gupta and Mauricio Soto in the IMF Staff Discussion Note (SDN) “The Fiscal Consequences of Shrinking Populations,” October 2015.

The impact of ageing on long-term care spending, education spending and unemployment benefits is not estimated in this paper. The European Commission 2015 Ageing report projects an increase of 0.5 percentage point of GDP in long-term care spending from 2015-2060 in its baseline scenario, but alternative scenarios point to larger increase up to 2.5 percentage points of GDP. The OECD (2013) estimates the increase in long-term care spending between 0.8 and 1.3 percentage points of GDP from 2010-2060 under various scenarios.

Past UN projections have been subject to large errors, as they underestimated the decline in both fertility and mortality rates, given that demographic transition happened at a much faster than anticipated. Alternative demographic scenarios are presented in Table 2 to estimate the fiscal impact of faster transition to declining population.

Baltic countries and Croatia have experienced more sustained negative net migration rates over the last 20 years.

The UN projections were established before the recent refugee crisis in Europe and the Middle East.

According to the EC 2015 Ageing report, the public pension expenditure change over 2013-2060 (-0.7 percentage point of GDP) would be driven by the increase in old-age dependency ratio (+11.7 percent of GDP), which would be more than offset by pension reforms, and labor market developments to a smaller extent. As regard pension reforms, lower coverage (about -25 percent over 2013-2060) would result in a reduction of 3.1 percent of GDP, while reduced pension generosity (about -20 percentage points) would lower spending by 5.9 percent of GDP. The magnitude of these offsetting factors is significantly above the euro area average (-2.4 percentage points of GDP for the coverage ratio contribution, and -3.1 percentage points of GDP for the benefit ratio contribution). Labor market changes would contribute to a total reduction in spending of -2.6 percent of GDP, mainly through higher employment rate.

The PDV is estimated assuming an interest rate-growth differential that converges to 1 percent by 2025 from their current level of -0.8 for advanced countries, based on the medians from the World Economic Outlook (IMF, 2015a).

This paper does not estimate the impact of demographic changes on economic growth, as well as the impact of lower growth on fiscal sustainability. For a discussion on these issues, see IMF, 2015a (annexes 1 and 2), and Bank of Portugal, 2015.

The EC 2015 Ageing report projects social contributions to the public pension system in Portugal to decline from 10.5% of GDP to 9.6% between 2013 and 2060 (the second larger decline in the EU).

The higher fertility rate alternative scenario assumes an annual increase in fertility of about 0.7 percent starting from 2015, equivalent to the average increase observed in Europe in the past two decades.

Family benefits were increased by 2 to 3.5 percent based on income brackets, and bonus for single-parent households were increased by 20 to 35 percent.

In 2016, early retirement was suspended for new pensioners.

From 66 years and 2 months in 2016 to 68 years and 4 months.

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