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Research: Aging, uncertainties argue for more ambitious fiscal policy

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
July 2005
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The challenge of addressing aging-related fiscal pressures looms large on the policy agendas of most industrial country governments. Yet the analysis of long-term expenditure trends has focused mainly on the implications of aging populations for government spending on pensions and health care. Two new IMF Working Papers shed light on a number of policy issues pertaining to long-term expenditure uncertainties that are relatively unexplored. They conclude that governments will have to adopt a more ambitious fiscal policy stance sooner rather than later to allow for gradual fiscal adjustment to aging and create space for potential additional expenditure risks.

Much has been written on the “fiscal time bomb” of age-related spending on pensions and health, including long-term care, in industrial countries. For example, the European Commission suggests the need for a fiscal adjustment— in the form of up-front and sustained tax or expenditure adjustments—of 2-3 percent of GDP until 2050 in most countries to hold current debt ratios constant in the face of pressures related to aging populations. Yet two long-term expenditure uncertainties typically remain relatively unexplored: those associated with the assumptions underlying the projections, and those related to the potential to reduce spending on non-age-related expenditure.

Not set in stone

On average, ratios of government expenditure to GDP in industrial countries have changed significantly in almost all categories.

Citation: 34, 13; 10.5089/9781451938715.023.A007

1Median of 17 industrial countries.

2Including data available for 2000 and onward.

3Includes, among others, corporate and agricultural subsidies, and transportation.

Data: IMF, Government Finance Statistics and authors’ calculations.

Projections highly uncertain

In carrying out long-term budget sustainability projections, technocrats are often constrained in a number of ways. Policymakers may dictate that projections be based solely on legislation currently in force, thus incorporating policies that may, in fact, be unsustainable in the future. Such an approach may not appropriately account for underlying uncertainties and can therefore carry substantial risks. For example, 50 years hence, errors in the assumed fertility rate, the real interest rate, or output growth can make large differences to the projected change in debt ratios.

Long-term fiscal projections also typically assume the absence of other pressures that are likely, but whose timing is hard to predict, such as higher welfare costs, outlays related to geopolitical shocks, incidents of terrorism, or climate change. In many countries, for example, health-care inflation—not aging—has been the most important driver of public health spending. Moreover, the larger share of the elderly in the population may create new demands for government outlays beyond what is implied by current legislation, for example, to bail out poorly performing private pension schemes.

Where is the fiscal space?

A further uncertainty concerns the potential to create fiscal space for age-related expenditures by trimming non-age-related expenditures. After all, even if all education, health care, and social protection spending were to be generously treated as age-related, what is left still amounts to 30 percent of total general government expenditure in the average industrial country.

A constant share of non-age-related expenditure in GDP is typically assumed, but, based on a sample of 17 industrial countries, the ratios to GDP of all expenditure categories except education have indeed changed a great deal over the past decades (see chart). In the 1970s and 1980s, rapid growth of government was driven nearly exclusively by interest payments and social protection. Between 1990 and end-2003, the size of government has remained virtually unchanged, as growth in health-care and social protection costs has been offset by cuts in interest payments, defense, and economic affairs.

Where is the fiscal space? And how much could come from expenditure cuts? Examining expenditure trends since the 1970s, two optimistic and two pessimistic arguments come to mind.

Optimistic Argument 1: There seems to be scope for more expenditure reductions. While classification issues might explain country-specific peculiarities, some functional expenditure categories (mainly in social protection, subsidies, the government wage bill, and capital expenditure) seem high in some countries, yielding potential savings of 5 percent of GDP and more in most continental European countries, but far less for Japan and the Anglo-Saxon countries. Also, given a country’s own historical perspective on a sector, there seems room to retrench. In some countries, there might be scope for cutbacks of 2-5 percent of GDP, with the largest potential being in public services (excluding interest) and economic affairs (such as corporate and agricultural subsidies). However, a number of countries seem to have already hit historic lows in some of the expenditure categories, mostly in defense, but also public order and safety.

Optimistic Argument 2: Rising GDP could help countries “grow out of the problem.” As discussed above, ratios to GDP have historically not been very reliable guideposts for expenditures. Real growth numbers yield more sanguine conclusions: a rule to freeze the ratio of total expenditure to GDP would still allow real non-age-related expenditure growth of about 1 percent per year from 2000 to the peak year of age-related expenditure in the average industrial country, despite age-related expenditure hikes. This is more growth than in the 1990s. Slowing population growth could also have a benign effect in some population-related (as opposed to age-related) areas, such as unemployment benefits. However, any acceleration of health-care inflation—resulting from technology, not aging—would further reduce fiscal space in addition to the impact of specifically age-related expenditures.

Pessimistic Argument 1: Governments have a weak record in implementing their consolidation plans, particularly on the expenditure side. Although some governments managed to reduce their expenditure-to-GDP ratios during the 1990s, most achieved less than they had planned to do.

Pessimistic Argument 2: For two main reasons, the knife could soon reach the bone. First, governments have already cut a lot. The average country has cut 5.1 percent of GDP in non-age-related and 0.7 percent in age-related expenditure categories, mostly in economic affairs, social protection, general public services, and defense. Second, a large share of the past cuts was thanks to the end of the Cold War, a secular decline in interest rates since the 1980s, and the abandonment of subsidies for inefficient industries—factors that are unlikely to be repeated.

What about higher taxes? Revenues are unlikely to provide much consolation to those governments most pressed on the expenditure side. Naturally, countries with the least scope to raise taxes are the ones with the most potential to reduce expenditure (high tax rates and high expenditure levels come together). But while raising taxes has often in the past been politically less painful than cutting spending, tax rates cannot go up much more in many high-tax countries. Thus, governments in high-tax, high-(age-related-)expenditure countries will face the toughest choices. In contrast, countries with low tax and expenditure shares have much more room to finance expenditure pressures through higher taxes.

More ambitious fiscal stance needed

What should policymakers and others take from all this? First, the current approach to setting fiscal policy frameworks tends to understate the downside risks arising from the uncertainty of the policy environment facing governments. Second, only narrow scope remains for most governments to obtain further savings from non-age-related expenditures quickly. Third, if adjustment starts early and is sustained, however, expenditure reduction would, over the long run, be facilitated by GDP growth and stagnating or shrinking populations. Fourth, on the revenue side, only a few countries seem to have room to raise taxes.

Taken together, this means that most governments will have to adopt a more ambitious fiscal policy stance and policy reform framework. With little scope left for tinkering with existing expenditure frameworks, the focus now must be on long-term structural reform programs that achieve a steady and sustainable decline in expenditure commitments arising from aging populations.

Furthermore, the risks stemming from potentially overly optimistic assumptions in current medium-term fiscal projections, including those in the EU Stability Programs, must be addressed more consistently. As a first step, governments of countries facing severe fiscal challenges from aging should be attuned to potential vulnerabilities in making long-term expenditure forecasts of economic and functional expenditure categories. Such vulnerabilities should be reflected in some way in framing annual budgets. Certainly, long-term projections should be informed by scenario analyses. Most important, such scenario analyses can serve to focus the public debate on key long-term policy challenges and provide a continuous reality check of current expenditure trends relative to long-term goals.

Copies of IMF Working Papers No. 05/91, “Characterizing the Expenditure Uncertainty of Industrial Countries in the 21st Century,” and No. 05/71, “Aging: Some Pleasant Fiscal Arithmetic,” are available for $15.00 each from IMF Publication Services. Please see page 216 for ordering details. The full texts are also available on the IMF’s website (www.imf.org).

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