APPENDIX Stochastic Simulations of Long-Term Fiscal Outlook
133. This appendix first describes the structure of the model, then its calibration to the data, and finally the methods used to carry out the stochastic simulations. A key feature of the model is the interaction between developments in the public finances and the real economy.
Barro, Robert J., “Government Spending in a Simple Model of Endogenous Growth,” Journal of Political Economy, 98, 5, Part II, October 1990, pp. S103–S125.
Chand, Sheetal and Albert Jaeger, Aging Populations and Public Pension Schemes, Occasional Paper No. 147, Washington, International Monetary Fund, 1996.
Easterly, William and Sergio Rebelo, “Fiscal Policy and Economic Growth: An Empirical Investigation,” Journal of Monetary Economics, 32, 1993, pp. 417–458.
Fischer, Stanley, “The Role of Macroeconomic Factors in Growth,” Working Paper No. 4565, Cambridge, MA, National Bureau of Economic Research, 1993.
Henry, S.G.B. and Dennis Snower, Economic Policies and Unemployment Dynamics in Europe, Washington, International Monetary Fund, 1996.
Jones, Larry-E., Rodolfo E. Manuelli, and Peter E. Rossi, “On the Optimal Taxation of Capital Income,” Journal-of-Economic-Theory, 73, 1, March 1997, pp. 93–117.
Layard, Richard, Nickell, Steven, and Richard Jackman, The Unemployment Crisis, Oxford and New York, Oxford University Press, 1994.
Levine, Ross and David Renelt, “A Sensitivity Analysis of Cross-Country Growth Regressions,” American Economic Review, 82, 4, September 1992, pp. 942–963.
Livre blanc sur les retraites, Paris, La Documentation Française, 1991.
MaCurdy, Thomas, Work Disincentive Effects of Taxes: A Reexamination of Some Evidence, A merican Economic Review, 82, 2, May 1992, pp. 243–249.
Milesi-Ferretti, Gian Maria and Nouriel Roubini, “Growth Effects of Income and Consumption Taxes: Positive and Normative Analysis,’ Working Paper WP/95/62, Washington, International Monetary Fund, June 1995.
Organisation for Economic Cooperation and Development, “The Macroeconomics of Ageing, Pensions, and Savings: A Survey,” Working Party No. 1 on Macroeconomic and Structural Policy Analysis, ECO/CPE/WP1(97)10, Paris, September 1997.
Organisation for Economic Cooperation and Development, Employment Outlook, Paris, July 1996.
Organisation for Economic Cooperation and Development, New Directions in Health Care Policy, Health Policy Studies No. 7, Paris, 1995.
Sala-i-Martin, Xavier, “Transfers, Social Safety Nets, and Economic Growth,” Working Paper WP/96/40, Washington, International Monetary Fund, April 1996.
Stokey, Nancy and Sergio Rebelo, “Growth Effects of Flat-Rate Taxes,” Journal of Political Economy, 103, 3, June 1995, pp. 519–550.
Prepared by Karl F. Habermeier and Fabrice Lenseigne.
See “Health Expenditure”, Section I of France - Selected Issues (SM/96/249) for a detailed discussion of these issues.
Indeed, it is difficult to explain satisfactorily even past developments in health care spending. While factors such as population aging, greater insurance coverage, and higher real income play a role, there is also a substantial residual (or trend) item, which reflects a variety of technological and institutional factors.
On the other hand, future generations may be healthier and consume relatively fewer health care services at the same age than earlier generations.
Very little work has been done so far on the consequences that population aging and entitlement reform would have on the balance of payments and net foreign asset positions of countries. One important question would be whether in the absence of pension reform, the net foreign asset position of the aging advanced economies should be expected to deteriorate in the course of coming decades.
Other variables have also been shown to have an influence on long-run economic growth, notably public sector deficits, inflation, educational policy, political stability, political and civil liberties, the rule of law, the exchange market regime, and trade protection. Barro and Sala-i-Martin (1996) provide an overview, both of theory and the empirical evidence.
Profit maximization by firms in this model implies that the wage rate is set equal to the after-tax marginal product of capital, and that the rental rate of capital is set equal to the after tax-marginal product of capital.
In general equilibrium theory, a pure lump-sum transfer is defined as a (one-time) redistribution of initial endowments of goods, before markets open.
The work surveyed in OECD (1997), however, suggests that the substitution of private old-age saving for public pensions is not one-for-one, but considerably less.
It is interesting that expenditure tends to be correlated somewhat more strongly and robustly with economic growth; possibly, this reflects the fact that expenditure is the sum of revenue and deficits, and may reflect the negative effects of both better than either variable alone.
Thus, a 1 percentage point increase in the share of government expenditure to GDP would reduce the long-run growth rate by ¼ percentage point.
This result is consistent with the theoretical view, articulated in Barro (1990), that a considerable fraction of government consumption spending is directly unproductive.
Fischer (1993) examines the transmission of a wide variety of macroeconomic policies to growth by way of investment, productivity growth, and labor supply. However, the budget deficit is the only fiscal variable considered in this study.
Another strand of the literature is concerned with the impact of marginal income tax rates on hours of work; for a recent assessment, see MaCurdy (1992). Many of these studies find that higher marginal rates have a fairly small effect. However, as was pointed out more than a decade earlier by Rosen (1980), the effects on the labor market of tax and spending policies are by no means fully captured by relationships between hours of work, income, and after-tax wages. Social security provisions, the overall tax burden, and other variables are likely to be important as well.
The employment rate is defined as the ratio of employment to population aged 15 to 64. The non-employment rate, defined as 1 less the employment rate, takes account of both measured unemployment and non-participation in the labor force.
A11 public finance variables are expressed in current price terms to facilitate inflation accounting and ensure continuity with historical series.
This type of accounting is particularly important in representing changes in the effective retirement age, discussed in the following section. With a standard retirement age of 60, there is a distribution of ages at which individuals retire, ranging from 55 to 65. An increase in the retirement age gradually shifts this distribution upwards.
It should be noted that even though the results are similar, the model used in this paper endogenously generates the rate of economic growth over time, rather than assuming it to be exogenous as is done in accounting-type studies.
The average annual growth rate of real non-pension, non-health primary expenditure amounts to about ¾ percent. This reflects the operation of the expenditure adjustment mechanism described in the Appendix.
A11 random variables were assumed to be normally distributed with means and standard deviations derived from regressions on historical data. For the sake of simplicity and tractability, it was assumed that the various sources of uncertainty are statistically independent of one another. However, this assumption also motivated the decision to limit, to just a few key variables, the sources of uncertainty in the model.
Compared with Chand and Jaeger (1996), the unfunded pension liability is considerably higher, at 250 percent of GDP.
Compared with about one-quarter in the basic scenario.
One could also assume that the deficit target gradually drifts upward.
A system in which a pensioner would experience an erosion, in real terms, of his initial pension by 2 percent per year for, on average, 20 or 25 years may lack credibility. Questions have also been raised about sustained indexing to retail prices only, because of the very wide income differentials that develop among different cohorts of pensioners. In this context, it should be noted that the shift from gross wage to price indexation introduced in 1992 in the regime general must be re-examined in 1999.
The various early and pre-retirement schemes, including DRE provisions in unemployment benefits and arrangements for an early pension in the regimes speciaux, pose a serious moral hazard problem, as they allow firms to eliminate older workers at virtually no cost to themselves (or to the workers).
Among the young, the high non-employment rate has been caused mainly by a minimum wage that is in excess of the productivity of many inexperienced workers.
An interesting calculation is to adjust the retirement age so that the old-age dependency ratio remains constant at its 1995 level (for this purpose, one calculates the ratio of people from 20 to retirement age to people above retirement age). The results are the following:
Year 2000: retirement age stabilizing the “dependency” ratio= 61
Year 2010: retirement age stabilizing the “dependency” ratio= 62
Year 2020: retirement age stabilizing the “dependency” ratio= 65
Year 2030: retirement age stabilizing the “dependency” ratio= 68
Year 2040: retirement age stabilizing the “dependency” ratio= 69
Year 2050: retirement age stabilizing the “dependency” ratio= 70
A fixed retirement age may also reduce the employability of older workers by signaling to employers that investments in on-the-job training and experience may not be worthwhile, raising the risk of a vicious circle: dropping older workers creates pressures to institutionalize a lower effective retirement age, which in turn leads employers to drop workers even earlier.
Life expectancy at the time of retirement is still increasing and entry into the labor market is being further and further delayed by schooling (taking into account unemployment and participation by age, the duration of work over the life cycle for an average wage-earner in France ranks ninth out of 14 among the principal OECD countries, largely owing to low participation rates for both young and old persons).
Even so, many older people may not be able to work productively at a full-time job, or at the most demanding jobs. Allowing older people to draw a partial pension while continuing to work part-time (and continuing to contribute to the pension system) could be a remedy. It will also be important to reform labour market institutions to facilitate part-time work by older persons, for example by providing fiscal incentives for training of older persons (possibly financed by the elimination of pre-retirement schemes), and stronger laws against age discrimination in employment.
The last objective could presumably be achieved by implementing some or all of the following measures: (1) closing underutilized hospitals; (2) creating regional medical centers to improve capacity utilization for expensive equipment and improve health outcomes by allowing staff to gain greater experience in difficult procedures; (3) making more use of generic medicines (this presupposes strict quality standards to maintain confidence); (4) periodically reinforcing the controls imposed by the 1996 health care reform on the practices of individual physicians; (5) limiting the number of university places and licenses for new physicians; and (6) subjecting new medical technology to a strict cost-benefit analysis, with public financing being made available only for the adoption and use of technology that meets this test. See “Health Expenditure”, Section I of France - Selected Issues (SM/96/249) for a detailed discussion of these issues.
The Annex provides some background on the microfoundations of this equation.
In this model, unemployment is not modeled explicitly. However, the non-employment rate, which is a composite of labor force non-participation and unemployment, is.
The two may differ because of taxes and other elements of the cost of capital.
A11 public finance variables are expressed in current price terms to facilitate inflation accounting and continuity with historical series.
The calculation of the mixed-age survival tables is technical and not described here in full detail.
The social production elasticity in this model falls significantly short of unity, indicating that it would not generate permanent self-sustaining growth (though the transition to the steady state would take quite a long time). The model was re-estimated with a trend term to allow for the possibility that there might be an autonomous element to the growth of TFP; the trend term turned out to be insignificant (p=0.59), and the other parameters were virtually unchanged.
Differences in the share of women in the overall labor force are seen as primarily reflecting exogenous differences across countries in social attitudes toward and legal institutions affecting female participation in the labor market. The share of women in the labor force is highest in the Nordic and Anglo-Saxon countries, and lowest in Southern Europe and Japan. Of course, differences in economic conditions (such as relation between the market wage available to women, and the shadow wage of household work) may also play a role in explaining differences in female labor force shares.
The wage dispersion measure is intended to capture the effect of minimum wage laws and other policies (including toward competitive bargaining) that affect the wage structure.