Macroeconomic Effects of Public Pension Reforms

The paper explores the macroeconomic effects of three public pension reforms, namely an increase in retirement age, a reduction in benefits and an increase in contribution rates. Using a five-region version of the IMF‘s Global Integrated Monetary and Fiscal model (GIMF), we find that public pension reforms can have a positive effect on growth in both the short run, propelled by rising consumption, and in the long run, due to lower government debt crowding in higher investment. We also find that a reform action undertaken cooperatively by all regions results in larger output effects, reflecting stronger capital accumulation due to higher world savings. An increase in the retirement age reform yields the strongest impact in the short run, due to the demand effects of higher labor income and in the long run because of supply effects.

Abstract

The paper explores the macroeconomic effects of three public pension reforms, namely an increase in retirement age, a reduction in benefits and an increase in contribution rates. Using a five-region version of the IMF‘s Global Integrated Monetary and Fiscal model (GIMF), we find that public pension reforms can have a positive effect on growth in both the short run, propelled by rising consumption, and in the long run, due to lower government debt crowding in higher investment. We also find that a reform action undertaken cooperatively by all regions results in larger output effects, reflecting stronger capital accumulation due to higher world savings. An increase in the retirement age reform yields the strongest impact in the short run, due to the demand effects of higher labor income and in the long run because of supply effects.

Introduction

The fiscal impact of the global crisis has reinforced the urgency of pension and health entitlement reform.2 Staff projections suggest that age-related outlays (pensions and health spending) will rise by 4 to 5 percent of GDP in the advanced economies over the next 20 years, underscoring the need to take steps to stabilize these outlays in relation to GDP. With the economic recovery not yet fully established, this paper emphasizes their short-run macro impact in order to address concerns that these reforms can undermine short-run growth.3

We examine the preferred set of public pension reforms using the IMF’s Global Integrated Monetary and Fiscal (GIMF) model parameterized on data for five regions as representing the entire world. We consider three policy reform options relating to pay-as-you-go public pension systems that are commonly discussed in the literature. This analytical framework allows us to approximately gauge the effects of these reforms on labor and capital markets and growth in the short and long run.4 (i) Raising the retirement age: this reduces lifetime benefits paid to pensioners. Encouraging longer working lives with higher earned income may lead to a reduction in saving and increase in consumption during working years. In addition, increased fiscal saving will have long-run positive effects on output through lowering the cost of capital and crowding in investment. (ii) Reducing pension benefits: this increases agents’ incentives to raise savings in order to avoid a sharper reduction in income and consumption in retirement. It would reduce consumption in the short to medium run, but would increase investment over the long run. (iii) Increasing contribution rates: this leads to distortionary supply-side effects for labor, which combined with a negative aggregate demand on real disposable income, depresses real activity in both the short and long run.

We assess how the policies compare in attaining the twin goals of strong, sustainable, and balanced growth and fiscal stability (i.e., stabilizing the debt-to-GDP ratio against rising pension entitlements). The key results show that increasing the retirement age has the largest impact on growth compared to reducing benefits, while increasing contribution rates as approximated by an increase in taxes on labor income has the least favorable effect on output. Besides boosting domestic demand in the short run, lengthening working lives of employees reduces the pressure on governments to cut pension benefits significantly or to raise payroll and labor income taxes. Reducing such benefits can lead to an increase in private savings and an unwarranted weakening of a fragile domestic demand in the short run, while raising taxes can distort incentives to supply labor. We also found that if regions cooperate in pursuing fiscal reform, the impact will be greater than if only one or some of the regions in the world undertake reform separately. In all, early and resolute action to reduce future age-related spending or finance the spending could improve fiscal sustainability over the medium run, significantly more if such reforms are enacted in a cooperative fashion.

The paper is organized as follows. Section II provides a background on past and projected age-related pension outlays and discusses the reform options considered to offset them. Section III provides a brief overview of the GIMF model while focusing on the details pertinent to this exercise. Section IV presents the effects of the three different reforms taken by each country at a time, then in all regions simultaneously. The global scenario highlights the compounding effect of the reforms and their impact on external variables through trade and (predominantly) financial spillover channels. Section V assesses in further detail the possible reasons for the size of the macroeconomic impacts based on a sensitivity analysis around the main results. Section VI concludes.

I. Pension Spending Trends, Theory and Existing Studies

Age-related spending has been the main driver of current public spending increases over the past two decades. These trends are expected to continue in the coming years for both advanced and emerging economies pointing to needed entitlement reforms. Old-age dependency ratios, which are already large in the advanced economies, particularly European countries and Japan, are projected to double between 2009 and 2050, putting enormous pressures on pension systems.5 Furthermore, relatively high gross replacement rate of pensions relative to average wages has also contributed to large pension spending and could undermine the viability of pension system over the long run. In terms of contribution rates, taxes on earnings are already high in a number of countries but in others, there is room for raising payroll contribution rates (see IMF, 2010a). In this section, we examine the current and projected pension spending and provide a short review and assessment of public pension reform measures based on theory and existing studies.

A. Current and Projected Public Pension Spending

Within the advanced G-20 countries, pension outlays have risen by 1¼ percentage points of GDP since 1990. Increases have been especially large for pensions in Japan and Korea in the past decade. Strong demographic factors were an important catalyst behind the increase in pension outlays in France, Germany, Italy, and Japan where pension spending has already surpassed 20 percent of total public spending. Looking forward, these trends are expected to continue in all economies. Given the strong demographic pressures on these outlays, reducing this spending would be difficult. A more realistic, if conservative, goal followed in this paper would aim at stabilizing spending-to-GDP ratios—which would still require significant structural reforms (IMF, 2010b).

Figure 1 shows pension spending projected to increase by an average of 1 percentage point of GDP over the next 20 years. Large increases are projected in advanced countries that have not substantially reformed their traditional pay-as-you-go systems, but in other advanced economies, the increase would be less marked due to the projected impact of already legislated reforms (IMF 2010a, Appendices IV and V). Adjustment needs may well be larger, though, as the projections assume that these reforms will not be reversed, even when they involve large cuts in replacement rates such as in Italy and Japan. Among emerging economies, those with relatively high spending in 2010 are projected to experience the steepest increase in outlays over the next 20 years. In other countries with currently low coverage such as China and India, the projected increase is much less severe, but could rise more rapidly if the system expands to cover a larger share of the population. Moreover, beyond 2030, emerging economies are expected to experience a faster pace of aging compared to the advanced economies.

Figure 1.
Figure 1.

Change in Public Pension Expenditures, 2010–30

(In percent of GDP)

Citation: IMF Working Papers 2010, 297; 10.5089/9781455211784.001.A001

Sources: Country authorities; EC (2009); OECD (2009); ILO (2010); and IMF staff estimates.

B. Theory and Existing Studies

A large body of research exists on fiscal consolidation in the face of demographic shifts and the impact of public pension system reforms on growth and public debt dynamics. We focus on three key reforms: (i) raising the retirement age, (ii) reducing benefits, and (iii) increasing contribution rates.

Raising retirement age raises participation in the labor force beyond a certain age and slows down the increase in the pension system dependency ratio. 6 This leads to a reduction in transfer payments to pensioners, an increase in contributions and an increase in tax revenues through increased income and consumption, therefore leading to higher public savings. In the long run, output rises as firms demand more capital inputs to work with higher labor. Before retirement, forward-looking consumers who will be providing more labor services and face a shorter retirement period reduce their saving and increase consumption in anticipation of increased future income. Earning income over a longer working period makes up for this initial drop in savings and has a positive impact on their stock of wealth in the long run.

Reducing benefits has been the policy choice of several countries, with cuts of nearly 20 percent or more set to occur within the next 20 years. Benefits could be reduced by modifying the base used to calculate benefits, modifying indexation rules, or taxing pensions. Rules that link benefits to demographic and economic variables to maintain actuarial balance could also lead to benefit cuts.7 Based on theory, there are strong incentives for working households to increase their savings in the face of announced decline in replacement rates of the pension regime, in order to avoid a sharp reduction in their income and consumption after retirement. A higher saving rate leads to stronger capital accumulation and an improvement in the net asset position of the country, but the effect on short- and medium-run consumption levels can be negative.

Increasing contribution rates needs to be assessed along with potential changes in the tax rate on labor income, since it is their combination that determines the effective marginal and average tax rates that are likely to affect decisions about labor participation and hours worked.8 These incentive effects of social contributions, however, might be less marked if their payment is seen as implying increased benefit entitlement. Overall, offsetting the spending pressures from the pay-as-you-go regime based on an increase in contribution rates usually reduces the potential output of the economy by distorting labor supply. A demand effect through households’ lower disposable income also adds to the negative impact of this option.

Empirical findings on the other hand appear to be inconclusive, reflecting perhaps country- specific and empirical methodology differences. Botman and Kumar (2007) look at age- related reforms, but focused exclusively on the European Union (with Germany as an example). They also analyze the impact of broader structural reforms, such as increasing labor participation, product market liberalization, and higher R&D to help increase productivity and find positive output effects in the short run. Nickel and others (2008) show that timely tax-cut measures can moderate the adverse effect on consumption (and encourage labor supply) of future announcement of cuts in pension benefits, and lower public debt; while increasing retirement age, without cutting pension benefits, fails to lower public debt.9 In contrast, Cournede and Gonand (2006) and Andersen (2008a, b) find that raising retirement age is optimal based on a likely boost in growth and improved public debt dynamics. Real GDP growth is stronger when rebalancing the pension regime by increasing the retirement age (and containing spending) rather than lowering replacement rates and raising taxes. Barrell and others (2009) have also demonstrated an improvement in public debt dynamics following an increase in effective working life (for the United Kingdom and the euro area countries taken together). As workers know that they will work longer, they save less now and increase their consumption ahead of the prospective income increase. Over the long run, labor and capital rise leading to an increase in GDP. Importantly, under constant tax rates and spending, increasing the pension age would result in reduced budget deficits and public indebtedness in European economies, on average.

II. The Methodology For Modeling Public Pension Reforms

This section provides a summary of the methodology followed in addressing the aging-related reforms of public finances, while strictly focusing on the main features of the model’s sectors (households, firms, and government) and parameters which have a direct and relevant impact on our analysis.10 Caveats and areas for future work remain given that the model, like most others cannot reflect all complexities that can influence the effect of the considered reform policies.

A. Overview of the Model’s Key Features

We use GIMF, a dynamic stochastic general equilibrium model widely used inside the Fund, as a framework for analyzing the short- and long-run effects of the planned pension policy actions. Key in analyzing the positive aspects of achieving fiscal sustainability in the face of aging as well as the normative aspects of adjusting public policies to changes in demographics, is GIMF’s underlying overlapping generations’ and finite horizons’ structure. It produces meaningful medium- and long-run crowding-out effects of government debt and captures important life cycle income patterns, including age-dependent labor productivity. Moreover, labor and capital markets are endogenous—the first allowing labor income taxes to have distortionary effects and the latter providing an important channel through which government debt crowds out economic activity. As such, a realistic supply side enables us to consider the impact of public pension reforms on investment decisions.

The multi-country structure of GIMF allows an analysis of global interdependence and spillover effects. The world in this model consists of five regions, the United States (US), the euro area (EU), Japan (JA), emerging Asia (AS),11 and remaining countries (RC). The regions trade with each other at the levels of intermediate and final goods, with a matrix of bilateral trade flows based on recent historical averages. International asset trade is limited to nominally non-contingent bonds denominated in U.S. dollars. Importantly, the link between regions through international financial markets provides the key channel for spillover effect of aging-related spending at a global level while adding realism to the macro outlook and the impact of policy response. The financial spillover effect is likely to dominate the trade channel because of the compounding effects of cooperative public pension reform on real interest rates, which in turn affect the cost of borrowing and overall debt dynamics (Section IV.C).

To emphasize the potential interaction role of fiscal and monetary policies, GIMF combines sufficient non-Ricardian features with a number of nominal and real adjustment costs, such that short-run dynamics of the model would be determined by the interaction of both of these policies while longer-run dynamics are influenced mainly by fiscal policy. This combination is missing from other new-open-economy macroeconomic models and fiscal models, including the IMF’s Global Fiscal Model (GFM).

There are three groups of agents and sectors in the model: households, firms, and the government.

In the households sector, three parameters of interest determine the degree of non-Ricardian behavior of agents: ψ, θ and χ. ψ is the share of liquidity-constrained households (LIQ) in the economy, without access to financial markets, that are limited to consuming their after-tax income in every period. The size of this group, assumed to differ significantly across economic regions, can be crucial to the analysis of the effects of the labor income tax reform measure for instance, as will be seen later. The remainder of the households, are overlapping generations (OLG) households, who are fully optimizing agents. Each of these agents faces a constant probability of death (1 − θ) in each period, which implies an average planning horizon of 1/(1 − θ). In addition to the probability of death, households also experience labor productivity (and hence labor income) that declines at a constant rate χ over their lifetimes. Life cycle income adds another powerful channel through which fiscal policies have non-Ricardian effects, as this along with θ (probability of survival) produce a high degree of myopia. Households of both types are subject to labor income, consumption and lump-sum taxes and the presence of these taxes along with transfers and government spending (see fiscal policy block in Appendix 1) allows us to relate the pension-related tax and expenditure reforms to specific model’s parameters and variables.

In order to represent an increase in retirement age in GIMF, we rely on two parameters in particular: χ (which corresponds to a decline in labor productivity over an average working life—it defines agents’ —income profile”) and N (which is an index of the population size assumed to correspond to population of the work force age, ages 15 to 64).

Firms are managed in accordance with the preferences of their owners, myopic OLG households, and they therefore also have finite-planning horizons.

Government’s intertemporal budget constraint is discussed in Appendix 1. We suffice by highlighting the role of fiscal policy in stabilizing deficits and the business cycle, through a typical fiscal rule. The latter stabilizes the government deficit-to-GDP ratio at a long-run target (structural) level, which rules out default and fiscal dominance (dynamic stability). It also stabilizes the business cycle by letting the deficit fall with the output gap. Finally, monetary policy in the model is based on an inflation-forecast-based interest rate reaction function in which the central bank sets interest rates in order to stabilize inflation at an announced target level.

B. Quantifying Public Pension Reforms

For all public pension reform measures, we use 2014 as the starting point for our benchmark scenario. This is near the end of the current version of the IMF’s World Economic Outlook, when most economies are forecasted to have returned to stable output gaps around zero, and inflation close to their target levels. Starting from such a position, pension reforms are likely to generate short-run increases in output leading to a monetary policy reaction (as will be seen in Figure 15 later). However, we also assess how the results might change if monetary policy remained accommodative for a year or two, as a pre-announced and conscious decision to accommodate a stimulative fiscal policy measure. This is dealt with in the sensitivity analysis Section V. The results below show that delaying a monetary policy action would boost short-run consumption and real GDP (considerably more relative to the benchmark), and public finances improve as government deficits decline faster in light of lower debt service payments. When normal conduct of monetary policy returns, there is the usual dampening effect on demand in the medium run (Section V and Appendix 2).

We consider differentiated retirement age increases which are sufficient to stabilize pension spending as a share of GDP at its 2014 level, over the next three to four decades. Differences in necessary retirement age increases stem from different baseline projections of the pension gap (size determined exogenously based on country-specific demographics and pension parameters) across the five regions, implying different consolidation needs such that the resulting debt trajectory as a share of GDP is stabilized. Based on staff estimates of the projected pension spending in the five regions, the required ‘pension age extension’ is shown in Table 1. The estimates suggest, for instance, that Japan would not require additional reforms.

Table 1.

Required Pension Age Extensions across the Regions

article image
Source: IMF (2010a) and staff estimates.

In line with the change in the lifetime income horizon, we implement a two-year extension of working lives on average, globally, by lengthening agents’ income profile (χ), and assuming an increase in the working-age population (N)12. The income profile is assumed to increase immediately following the start of the reform, with the labor force gradually increasing over the next 15 years. The increase in the income profile is consistent with a decrease of private saving as a percent of GDP, as found in studies focused on European countries.13 Both measures are consistent with a gradual phase in of increases in retirement age as well asevidence which suggests that agents react by delaying retirement (several years ahead of the change itself) thereby leading to an increase in labor supply over their lifetime horizon.

The two other considered reform options, a reduction in pension benefit payments and an increase in contribution rates, are simply modeled as non-distortionary lump-sum transfers to all households and an increase in the labor income tax rate, respectively.

C. Caveats and Qualifications

The fiscal block of the GIMF model does not allow for an explicit breakdown of working- age and retired population,14 nor does it feature an elaborate pay-as-you-go pension regime. In light of this, it is not possible to interpret a rising dependency ratio as due to reduced fertility or increased longevity. Other issues like labor force perception of the pension system as a tax- and-transfer system versus an insurance mechanism, and movement to more actuarially-based public programmes15 may affect individuals’ saving and labor supply behavior differently, influencing in turn the normative assessment of reform—we leave these interesting extensions for future work. But unlike other large simulation models dealing with full-blown demographics and pension systems which may complicate the interpretation of results, GIMF focuses on the dynamics and long-run equilibrium of the main variables in a transparent way, and these dynamics and equilibria can be changed by modifying a few essential parameters. The structure is flexible enough to compensate for missing households who ‘really’ retire by treating an extension of working lives with regard to agents’ income profile coupled with a potential increase in ‘working age’ population.

Another caveat lies in examining the contribution rate hike scenario which we proxy by an increase in the labor income tax rate. This can be seen as a lower bound on this issue, since we have only captured the effect on the labor supply decision and not the direct effects on labor demand from higher contributions by employers. The decline in pension payments to retirees is then captured through lower pension transfers and pension deficits.

D. Calibration

Relevant steady state ratios and parameters of particular importance for this exercise are discussed in Appendix 1, with a brief summary of the important ratios provided in Appendix Table 1. The model is calibrated to reflect key macro features in the five regional blocs (including key expenditure ratios of consumption, government, investment, net exports, and factor incomes) as well as key fiscal variables reflecting the fiscal structure of the regional blocs (revenues and spending, net debt- and deficit-to-GDP ratios). More detailed calibration tables are presented in KLMM (2010). Unless otherwise stated, similar behavioral parameter values apply to all regions and are based on microeconomic evidence. We use an annual version of the model because the critical pension-related fiscal issues stressed are of a medium- to long-run nature.

Calibrated government debt-to-GDP ratios are based on 2014 net debt projections for the five regions from the IMF’s World Economic Outlook Update, February 2010 (IMF, 2010c) but have taken into account the mounting pressure of pension gaps. The real global growth rate is 2.5 percent, the global population growth is 0.5 percent, and the long-run global real interest rate is 4.0 percent.

III. Results: Public Pension Reforms

A. Baseline

The baseline scenario is based on the IMF’s February 2010 World Economic Outlook for public debt in G-20 countries, up to 2014–15, close to what the May 2010 update shows. It is also based on Fiscal Affairs Department staff’s projections of public pension spending and primary fiscal balances over the next four decades, which translate in a very distant future into higher steady state debt-to-GDP ratios and a higher world real interest rate than usually used in GIMF.

B. Region-by-Region Benchmark Public Pension Reform Scenarios

This section discusses the effect of reforms undertaken in each region on its own, beginning in 2014. While similar behavioral parameter values apply to all regions, country-specific variation in the demographics is reflected in the size and pace of the adjustment as described in Table 1 above. Such an individual action is then compared to a cooperative action (albeit still allowing for country differences) in Section IV.C.

Three reform options relating to pay-as-you-go public pension systems are assessed. They are broadly equivalent in terms of their fiscal impact, all of them being broadly sufficient to offset the projected increase in pension spending over the long run, excluding their possible and distinct effect on growth. With the economic recovery still under way, it is important to assess the short- and medium-run impact of such reforms on the pace of activity as well as their budgetary impact. Results show that the type of reform matters: increasing the retirement age has the largest positive impact on real GDP, while increasing contribution rates has the least favorable effect on output.16

Increasing retirement age

To anticipate the results, increases in the retirement age are the most effective tool: on average across regions, raising the retirement age by two years on average17 would raise GDP by almost 1 percent in the short to medium run and 4¼ percent by 2050 above the baseline scenario. It reduces the debt-to-GDP ratio by 30 percentage points over the same period.

Figure 2 illustrates the effect on the United States of an increase in retirement age in the United States alone, while first keeping public pension spending (transfers) constant. As expected, a delay in the retirement age boosts labor supply and labor income. Agents reduce their saving and their demand for assets during working years, while increasing consumption. Future earning incomes over a longer working period are higher and are brought forward through higher consumption by optimizing agents. The private saving rate as a ratio of GDP declines immediately by 0.2 percentage points, while consumption rises above baseline by close to 2 percentage points in the short run, preceding the increase in real GDP.18 In the short run, the increase in real GDP is 0.75 percent above baseline in period 2, and public finances improve slightly (the debt-to-GDP ratio is only 4 percentage points below baseline after 20 periods), a direct result of increased tax revenue collected on income and consumption. Considering Figure 2 alone, despite providing a partial analysis of the overall reform scenario (no implied transfer reductions are modeled thus far), it gives a clear interpretation of the boost in consumption as stemming from an increase in lifetime income horizon (the effect of which is brought forward) and working age population. A cut in benefits as embedded in Figure 3, will dampen this effect.

Figure 2.
Figure 2.

Increase in the Retirement Age in the United States

(Excluding Fiscal Consolidation)

Citation: IMF Working Papers 2010, 297; 10.5089/9781455211784.001.A001

Figure 3.
Figure 3.

Increase in the Retirement Age in the United States

Citation: IMF Working Papers 2010, 297; 10.5089/9781455211784.001.A001

Figure 3 depicts the complete analysis of this reform as the concurrent fiscal consolidation implied by the cuts in public pension spending, as the number of years over which pensions are paid are reduced, is added to Figure 2. The budget deficit improves as a result by close to 3 percentage points of GDP after 30 years and settles around 2.2 percentage points once reached in the long run, given the target we impose in the distant future. Equivalently, the debt-to-GDP ratio declines by roughly 43 percentage points in the long run—more than tenfold the improvement shown in Figure 2. At the same time, a lower government debt which is perceived as a decline in OLG agents’ net wealth along with the decline in transfer payments (with a more pronounced effect on LIQ agents) both work to depress consumption markedly, which now only rises modestly above baseline, compared to Figure 2.

In the short run, there is a tightening of interest rates (by 80 basis points in year 4) in response to inflationary pressure emanating from a short-run increase in domestic demand. As the demand pressures continue from the stimulative increase in labor supply, the monetary authority maintains a tight stance for a long period. This interest rate effect dampens domestic demand in the short run. But in the medium to long run, investment is boosted as real interest rates fall in response to the fiscal consolidation, leading to visible improvement in output. In addition, output rises with the increase in labor supply (and a fall in marginal cost from the falling real wage) which in turn attracts more capital. This rises marginally less than labor supply19 and output continues on an upward trend, reaching over 3.5 percent above baseline in the long run.

Discussing next the external variables, if we only focus on the effect of the increase in the retirement age without the fiscal adjustment (Figure 2), the United States experiences an appreciation of the real exchange rate, and, therefore, a deterioration in the trade balance and the current account. Here, the saving-investment perspective predominates, as real wages decline (as more labor is supplied), the higher return on capital attracts capital inflows and leads to a current account deficit which needs to be closed through a depreciation in the exchange rate. However, the effect on external variables is dominated by the fiscal consolidation that is occurring simultaneously (Figure 3). Now, lower real interest rates from increased world saving crowds in investment in external assets, leading to an accumulation of net foreign assets. In the very long run, with declining interest payments to foreigners, current balances are above baseline which means that the real effective exchange rate begins appreciating again. However, relative to the baseline, the real effective exchange rate has depreciated, albeit much less in 50 years into the future, relative to only 30.

Figures 4 to 6 show the same ‘package’ of reforms (akin to Figure 3) being undertaken by each of the three other regions facing notable challenges to their pension systems—the euro area, emerging Asia, and remaining countries (recall, in the case of Japan, no pension age extension was needed). Although the quantitative results are different, the story behind each scenario is intrinsically the same as that of the United States, with some qualification.

Figure 4.
Figure 4.

Increase in the Retirement Age in the Euro Area

Citation: IMF Working Papers 2010, 297; 10.5089/9781455211784.001.A001

Figure 5.
Figure 5.

Increase in the Retirement Age in Emerging Asia

Citation: IMF Working Papers 2010, 297; 10.5089/9781455211784.001.A001

Figure 6.
Figure 6.

Increase in the Retirement Age in the Remaining Countries Block

Citation: IMF Working Papers 2010, 297; 10.5089/9781455211784.001.A001

For the euro area (Figure 4), results are qualitatively similar to the United States, but there is a smaller required pension-age increase to attain given budgetary saving (this is primarily due to the fact that in the euro area a pensioner receives on average larger benefits), more rigid prices and a more aggressive monetary rule, leading to a weaker consumption profile relative to the United States, in the short run.20 Over the long run, consumption improves by more as pension transfers are cut more aggressively in the later periods, bringing with them a larger drop in interest rates, and therefore lower debt level (close to 47 percentage points below baseline). Driven by higher domestic demand, real GDP rises 5.8 percent above baseline.

An exception is emerging Asia, because it pursues a fixed nominal exchange rate vis-à-vis the United States, instead of inflation targeting. In this case (Figure 5), there is a depreciation of the real exchange rate, as occurs in the cases of other regions such as the United States (Figure 3) or the euro area (Figure 4). But emerging Asia’s nominal exchange rate peg constrains them to importing their short-run interest rate profile from the United States (as uncovered interest rate parity holds in GIMF). In order that the real effective exchange rate in emerging Asia depreciates in the long run, there will be downward pressure on domestic prices, resulting in sustained disinflation, relative to the baseline scenario. Here, GIMF may overstate the actual inflation and interest rate dynamics in emerging Asia, as there is no role for capital or credit controls, which may play some role in the actual conduct of exchange rate policy.

This story related to the conduct of monetary policy in emerging Asia will also hold in the other two public pension reform options discussed below. A policy aiming at greater exchange rate flexibility in emerging Asia over the medium run, whether through a nominal appreciation or through higher inflation is not assessed here.

Reducing benefits21

This reform generates rewards over time following the transitory short-run initial costs of fiscal tightening on aggregate demand. Consider if the decline in benefit payments (and the consequent decline in government debt) occurs only in the United States. Figure 7 shows the simulated effects of reduced government debt-to-GDP ratio brought about by decreases in pension benefit payments (that behave in GIMF as non-distortionary lump-sum transfers) to reverse past promises of enlarged public pension spending. Although consumption drops by about 1 percent below baseline in the short run, this is largely outweighed by the persistent benefits of lower real interest rates and higher real GDP—over time, real GDP rises and settles at a higher level in the long run, almost 0.5 percent above the baseline scenario.

Figure 7.
Figure 7.

Reducing Pension Benefits in the United States

Citation: IMF Working Papers 2010, 297; 10.5089/9781455211784.001.A001

World real interest rates decline, moderately, beginning in period 10, before they hit a trough close to -0.4 percentage points below the baseline after 40 years.22 Such an effect is transmitted to the global economy with all countries experiencing a boom in investment, varying between 0.5 and 2 percent in the euro area and emerging Asia, respectively, and a permanent expansion in real GDP, varying between 0.3 to 0.5 percent. In sum, the U.S. policy scenario generates a positive and large effect in other regions as long-run real interest rates are equalized internationally to a lower level and capital investment is boosted.

So, following a reduction in pension benefit payments, U.S. domestic demand (consumption and investment) decreases for a rather prolonged period of time, while real GDP experiences an uptick for a brief period,23 buoyed by improved external balances, but decreases moderately thereafter before increasing and settling at higher levels in the long run. Consumption declines in light of the non-Ricardian nature of the model whereby a fiscal consolidation reduces the net wealth of OLG agents (as the value of taxes for which they are now expected to be responsible has increased, if taxes were to be used as an instrument). For a given marginal propensity to consume, these reductions in (human) wealth lead to a reduction in consumption, accompanied by a decline in real interest rates. During the initial phase, real interest rates are predominantly driven by the monetary policy response to excess supply in the economy and deviation of inflation from target. Externally, reduced import demand (part of the consumption demand decline is absorbed by trading partners) leads to improvement in trade balances and a real depreciation.

Over the longer run, real GDP increases relative to the baseline. Higher fiscal saving leads to an increase in both in U.S. and world savings, given the size of the U.S. economy. Real interest rates decline by close to 40 basis points in order to re-equilibrate world saving and investment. The non-Ricardian OLG structure of the model and the endogenous capital formation provide the channels through which government debt crowds in investment in U.S. physical capital, so that real output increases. Moreover, agents’ decreased investment in government debt instruments frees up resources to other forms of investment, including foreign assets. This implies that current balances improve subsequently necessitating a real appreciation in the exchange rate, which only comes gradually.

In other regions (euro area, emerging Asia, and the remaining countries block) which undertake similar reforms, the effects are similar (Figures 8 to 10). However, the spillover effects are different as they are driven by their responsiveness to movements in the world real interest rate. For instance, the spillover effects of reforms initiated by a large economic region (i.e., the United States or the euro area) on other regions’ real GDP is four times the spillover effect if a smaller region (i.e., emerging Asia constitutes is calibrated in GIMF to be 13 percent of world nominal GDP, versus 27 percent for the United States) undertakes reforms, since a smaller region will have less of a long-run impact on world interest rates, and by extension on investment and output on those regions which do not undergo reform.

Figure 8.
Figure 8.

Reducing Pension Benefits in the Euro Area

Citation: IMF Working Papers 2010, 297; 10.5089/9781455211784.001.A001

Figure 9.
Figure 9.

Reducing Pension Benefits in Emerging Asia

Citation: IMF Working Papers 2010, 297; 10.5089/9781455211784.001.A001

Figure 10.
Figure 10.

Reducing Pension Benefits in the Remaining Countries Block

Citation: IMF Working Papers 2010, 297; 10.5089/9781455211784.001.A001

Raising contribution rates 24

We proxy the increase in contribution rates in GIMF, by considering an increase in the labor income tax rate, in this case, the United States only (Figure 11). Consequently, there is a decline in the supply of labor with negative effects on actual and potential output. Besides this supply-side effect, this policy measure affects the demand side of the economy indirectly through a decline in households’ real disposable income—this income and wealth effect is an important channel given the myopic nature of both LIQ and OLG agents (in light of the θ planning horizon parameter and χ finite remaining working life of 20 years on average). Given that the LIQ households consume at most their after-tax current income, the size of this group, which is assumed to be significantly different across economic regions, is critical for the analysis of this labor income tax measure. Moreover, a decline in potential output is likely to exert upward pressure on inflation. In all, the effect on U.S. real GDP is notably worse than in the benefit-reduction scenario in the short run, and even in the long run. This should not be surprising, since GIMF, like most models in the literature, find that the multiplier effect of a change in the labor income tax rate is higher than an equivalent shift in a lump-sum transfer, such as a pension benefit cut (Coenen and others, 2010).

Figure 11.
Figure 11.

Raising Contribution Rates in the United States

Citation: IMF Working Papers 2010, 297; 10.5089/9781455211784.001.A001

Therefore, the results of this form of public pension reform are similar to those found under a cut in pension benefits, but the distortionary nature of this reform means the short-run losses are more significant—real GDP declines by about 0.7 percent below baseline by period 10. The negative effect of distortionary taxes on potential output also means significant losses in the long run. Also, the consequent decrease in the real world interest rate does not play as effective a role in raising real GDP in the long run as in scenario 2 above—real GDP remains close to 0.4 percent below baseline versus an increase of 0.4 percent when cuts in pension benefits are the fiscal measure of choice.

Once again, these results also hold in the other three regions, the euro area, emerging Asia, and the remaining countries block (Figures 1214).

Figure 12.
Figure 12.

Raising Contribution Rates in the Euro Area

Citation: IMF Working Papers 2010, 297; 10.5089/9781455211784.001.A001

Figure 13.
Figure 13.

Raising Contribution Rates in Emerging Asia

Citation: IMF Working Papers 2010, 297; 10.5089/9781455211784.001.A001

Figure 14.
Figure 14.

Raising Contribution Rates in the Remaining Countries Block

Citation: IMF Working Papers 2010, 297; 10.5089/9781455211784.001.A001

C. Benchmark Global Scenario—Simultaneous Reforms in all Regions

A cooperative strategy to pursuing fiscal reform has a larger impact on output and fiscal sustainability than if regions undertake reform alone. The cooperative benefit is greater than the sum of individual country/region benefits. The magnification effect of global reforms on key variables is driven by the significantly stronger decline in the world real interest rate corresponding to larger compounding effect on word savings under the cooperative strategy.

Thus far, we have only considered reforms in each region of the world in isolation. While it is in each country’s interest to pursue reforms regardless of what other countries or regions do, there can be a clear advantage from promoting global policy cooperation. In the cases of individual action, the effects of the policy measure will often leak abroad, which, while benefitting other regions, reduces the potential impact domestically. Countries can simply delay reforms and free ride on adjustments undertaken elsewhere.25 Faced with a common and an unavoidable demographic shift and a future of possibly muted growth and high unemployment, cooperative action for public pension reform among all regions can be key. Cooperation can buttress the twin goals of growth and fiscal stability by stabilizing the debt-to-GDP ratio against rising pension entitlements. It is expected that the world real interest rate will over time change by more than when an individual region engages in reform alone, which leads to a larger effect on capital accumulation and potential and actual output levels in the long run.

Figure 15 clearly shows those benefits by looking at the effects on the United States when it undertakes an increase in retirement age pension reform alone (the right column), versus a cooperative global effort (the left column), both beginning in 2014. Under the cooperative case, real GDP is 50 percent higher in the long run. A cooperative action results in an interest rate decline that is about five times that under an individual action. As a result, a permanent expansion in real GDP worldwide (average over the five regions) in the order of 7.2 percent above baseline follows (Table 2)—this table also shows that this is about 40 percent larger than the sum of benefits from individual country reforms.

Figure 15.
Figure 15.

Cooperative Versus Regional Public Pension Reform—Increase in Retirement Age

Global (LEFT Column) versus US (RIGHT Column)

Citation: IMF Working Papers 2010, 297; 10.5089/9781455211784.001.A001

Table 2.

Cooperative Versus Regional Public Pension Reform—Increase in Retirement Age

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The magnified effects of simultaneous public pension reforms by all regions, relative to reform by each region alone, are further illustrated in Table 2 (the increase in retirement age case). It highlights the effect of reform on real GDP, consumption, the real interest rate, and the government debt-to-GDP ratio in the five regions, which are clearly larger in every case under a cooperative policy action (the first set of rows) versus the individual action (the second through fifth set of rows). While all regions benefit relatively more from a cooperative action, the euro area, a large and relatively less open region benefits relatively less than a smaller and more open emerging Asia (40 percent and 110 percent improvement, respectively).

Figures 16 and 17 make a similar point for the other two policy options. In the case of an increase in labor income taxes to finance the pension gap, real GDP no longer falls relative to the baseline scenario in the long run. However, real GDP in the United States in this case increases by only 0.5 percent, while rising above baseline by more than three times that amount in the long run (1.6 percent) if the fiscal measure was a decrease in pension benefits. Tables 3 and 4 summarize the results of these corresponding reforms if carried out individually (along with their spillover effects into other regions) or globally.

Figure 16.
Figure 16.

Cooperative Versus Regional Public Pension Reform—Reducing Pension Benefits

Global (LEFT Column) versus US (RIGHT Column)

Citation: IMF Working Papers 2010, 297; 10.5089/9781455211784.001.A001

Figure 17.
Figure 17.

Cooperative Versus Regional Public Pension Reform—Raising Contribution Rates

Global (LEFT Column) versus US (RIGHT Column)

Citation: IMF Working Papers 2010, 297; 10.5089/9781455211784.001.A001

Table 3.

Cooperative Versus Regional Public Pension Reform—Reducing Spending on Pension Benefits

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Table 4.

Cooperative Versus Regional Public Pension Reform—Raising Contribution Rates

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To sum up, promoting a global cooperative increase in retirement age appears to yield the largest impact on activity—the relative improvement in real GDP worldwide is four and over 10 times larger than under reform options 2 and 3.

In terms of external balances, the global cooperative scenario yields a weaker external balance in each country, and corresponding less accumulation of net foreign assets. The current account improves by less under a cooperative action than when a policy is taken by each country or region on its own. Under a global scenario where only one country does not reform, improvements in the current account balances of the reforming countries would be reflected in a deteriorating balance of the non-reformer—private saving declines or consumption rises due to an appreciating real exchange rate and an investment rises due to lower interest rates.

As for improving public finances, stabilizing the GDP share of age-related (pension) expenditures leads to a sizable decline in the debt-to-GDP ratio. Early and resolute action to reduce future age-related spending could significantly improve fiscal sustainability in several countries over the medium run and more so if such reforms are again enacted in a cooperative fashion; for instance, debt-to-GDP ratios decline by 40 to 50 percentage points (depending on the undertaken reform) below baseline on average across the regions, an improvement of approximately 30 percent relative to a non-cooperative strategy (Tables 24). This is due to the magnified effect of fiscal consolidation efforts on world savings and world real interest rates with larger attendant crowd-in effect on investment.

Sensitivity Analysis

The benchmark reform scenarios depend on many assumptions, ranging from agents’ degree of impatience and myopia, to the timing of fiscal consolidation. As such, we test the sensitivity of those benchmark results to changes in selected key parameter values and investigate the potential shifts in the impact of the public pension reform on the economy. We focus on the results of the benchmark cooperative global reform scenarios26 and apply the tests to the benefit cut scenario except for two tests, the sensitivity of hours worked to a raise in retirement age and the role of monetary policy accommodation in the short run. To keep the paper concise, we report the qualitative results of the main tests and refer the reader to Appendix 2 for a quantitative assessment accompanied by Figures 18 to 24. The sensitivity tests are the following:

Figure 18.
Figure 18.

Sensitivity Analysis Around the Benchmark Coordinated Global Reform Scenario—Labor Supply Response

Citation: IMF Working Papers 2010, 297; 10.5089/9781455211784.001.A001

Figure 19.
Figure 19.

Sensitivity Analysis Around the Benchmark Coordinated Global Reform Scenario—Role of the Planning Horizon (Degree of Myopia)

Citation: IMF Working Papers 2010, 297; 10.5089/9781455211784.001.A001

Figure 20.
Figure 20.

Sensitivity Analysis Around the Benchmark Coordinated Global Reform Scenario—Share of LIQ Households at 50 Percent Worldwide

Citation: IMF Working Papers 2010, 297; 10.5089/9781455211784.001.A001

Figure 21.
Figure 21.

Sensitivity Analysis Around the Benchmark Coordinated Global Reduction in Public Pension Spending—Rapid Implementation

Citation: IMF Working Papers 2010, 297; 10.5089/9781455211784.001.A001

Figure 22.
Figure 22.

Sensitivity Analysis Around the Benchmark Coordinated Global Reduction in Public Pension Spending—U.S. Reduction Levels Applied Globally

Citation: IMF Working Papers 2010, 297; 10.5089/9781455211784.001.A001

Figure 23.
Figure 23.

Sensitivity Analysis Around the Benchmark Coordinated Global Reform Scenario—Monetary Policy Accommodation

Citation: IMF Working Papers 2010, 297; 10.5089/9781455211784.001.A001

Figure 24.
Figure 24.

Sensitivity Analysis Around the Benchmark Reduction in Public Pension Spending by the United States Only—Different Inflation Behaviors

Citation: IMF Working Papers 2010, 297; 10.5089/9781455211784.001.A001

  • A smaller increase in labor supplied in response to an increase in retirement age reduces real activity. The benchmark case assumes no change in hours worked and effort.

  • A shorter planning horizon with more myopic agents leads to a larger drop in consumption initially but higher real GDP in the medium run driven by a boost in investment resulting from an increased labor supply. Under a much longer planning horizon, agents become far more Ricardian in their behavior. The demand effect is far weaker with consumption behavior barely changing in response to reform in both the short and long run. The supply and the capital intensity of production respond a lot less which in turn reduces the effect of fiscal reform on real interest rates—the latter does not respond in the long run to the global reform which lowers debt permanently.

  • Increasing the share of liquidity-constrained agents in the population to 50 percent in all regions leads to a reduction in consumption in the United States and the euro area (regions where this share has doubled), contrary to the benchmark results. Over the medium run, interest rates fall relative to benchmark, boosting investment and the long run level of real GDP. Emerging Asia and the block of remaining countries (regions for which this share does not change) benefit from lower world interest rates, which actually leads to a small improvement in consumption starting in the first year.

  • As for the timing of fiscal consolidation, having the public pension spending adjust immediately to its lower long-run level depresses consumption in the short run for most regions. The difference is larger in the remaining countries block due to a larger share of LIQ households. The increase in government savings crowds out the need for private savings much quicker, but investment picks up faster, which means that the recovery in real GDP happens much earlier than in the benchmark reform scenario.

  • Monetary policy accommodation for one or two years boosts consumption and real GDP at the expense of added inflation volatility. Short-run demand pressure results in movements in inflation away from its target and a further decline in real interest rates, prolonging the initial positive impact of the public pension reforms. Over the short run, real GDP and consumption rise considerably more relative to the benchmark scenario, and public finances improve as government deficits decline faster in light of lower debt service payments. When normal conduct of monetary policy returns, there is the usual dampening effect in the medium run. In the long run, the economy follows the same path as in the benchmark scenario.

  • The formulation of inflation behavior can have an effect on real variables. In the case where the United States alone carries out public pension reform, there is a short-run decline in consumption, because of inflationary pressures that lead to an increase in interest rates by the monetary authority. However, by either cutting the degree of inflation persistence, or altering how inflation persistence is determined, consumption will be positive. Such a change to the calibration of the model would be at the expense of other properties such as the volatility of exchange rates, and the possibility for effective monetary accommodation.27

IV. Conclusion

We considered reforms to the pension system that can help ensure the long-run viability of public finances, while mindful of their short-run effect on economic activity in the midst of a global financial crisis. This is carried out within a dynamic general equilibrium model (GIMF) that captures the important economic interrelationships at a national and international level. We emphasized measures to contain and fund the rising costs of age-related spending in the medium to long run. We find that reforms which lead to short-run adverse effects on real GDP (i.e., benefit reductions) are largely outweighed by the benefits of declining real interest rates and the positive effect on future potential productive capacity. The reform which has the most positive effects in the long run is lengthening the working lives of employees, effectively raising the size of the active labor force relative to the retiree population. It helps boost domestic demand in the short run but also eases off the pressure on governments to cut pension benefits alone—which can lead to additional private savings and cause fragile domestic demand to fall in the short run—or to raise payroll and labor income taxes—which can distort incentives to supply labor. We also found that the impact on real GDP of a cooperative approach to age-related fiscal reforms is greater compared to a case where one but not all regions undertake reform.

In terms of public finances, our results generally show that stabilizing the GDP share of age- related expenditures leads to a sizable decline in the debt-to-GDP ratio. Early efforts and resolute action to reduce future age-related spending or finance the spending through additional tax increases and other measures (preferably through an increase in retirement age) could significantly improve fiscal sustainability in several countries over the medium run, and more so if such reforms are enacted in a cooperative fashion.

Macroeconomic Effects of Public Pension Reforms
Author: Ms. Joana Pereira, Mr. Philippe D Karam, Mr. Dirk V Muir, and Ms. Anita Tuladhar
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    Change in Public Pension Expenditures, 2010–30

    (In percent of GDP)

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    Increase in the Retirement Age in the United States

    (Excluding Fiscal Consolidation)

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    Increase in the Retirement Age in the United States

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    Increase in the Retirement Age in the Euro Area

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    Increase in the Retirement Age in Emerging Asia

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    Increase in the Retirement Age in the Remaining Countries Block

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    Reducing Pension Benefits in the United States

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    Reducing Pension Benefits in the Euro Area

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    Reducing Pension Benefits in Emerging Asia

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    Reducing Pension Benefits in the Remaining Countries Block

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    Raising Contribution Rates in the United States

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    Raising Contribution Rates in the Euro Area

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    Raising Contribution Rates in Emerging Asia

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    Raising Contribution Rates in the Remaining Countries Block

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    Cooperative Versus Regional Public Pension Reform—Increase in Retirement Age

    Global (LEFT Column) versus US (RIGHT Column)

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    Cooperative Versus Regional Public Pension Reform—Reducing Pension Benefits

    Global (LEFT Column) versus US (RIGHT Column)

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    Cooperative Versus Regional Public Pension Reform—Raising Contribution Rates

    Global (LEFT Column) versus US (RIGHT Column)

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    Sensitivity Analysis Around the Benchmark Coordinated Global Reform Scenario—Labor Supply Response

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    Sensitivity Analysis Around the Benchmark Coordinated Global Reform Scenario—Role of the Planning Horizon (Degree of Myopia)

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    Sensitivity Analysis Around the Benchmark Coordinated Global Reform Scenario—Share of LIQ Households at 50 Percent Worldwide

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    Sensitivity Analysis Around the Benchmark Coordinated Global Reduction in Public Pension Spending—Rapid Implementation

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    Sensitivity Analysis Around the Benchmark Coordinated Global Reduction in Public Pension Spending—U.S. Reduction Levels Applied Globally

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    Sensitivity Analysis Around the Benchmark Coordinated Global Reform Scenario—Monetary Policy Accommodation

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    Sensitivity Analysis Around the Benchmark Reduction in Public Pension Spending by the United States Only—Different Inflation Behaviors