APPENDIX I Decomposition of Pension Spending
37. The evolution of pension spending as a share of GDP depends on the development in the age structure of the population, pension generosity and eligibility, and the productivity of employment. Thus, the pension share to GDP can be written as
38. The ratio of pensioners to employed can be decomposed further into the product of three ratios: (i) the dependency ratio; (ii) the inverse of the employment ratio; and (iii) the eligibility ratio (Dang, Antolin, and Oxley, 2001). This gives
The first three ratios on the right-hand side are the dependency, inverse employment, and eligibility ratios, respectively. This shows that pension spending as a share of GDP increases with the dependency and eligibility ratios and with the generosity of pensions to average productivity, and decreases with the employment ratio.
39. The contribution of each of these four ratios to the change in the overall share of pension spending to GDP can be approximated by the linear decomposition
where pst=0 is current pension spending as a share of GDP and s is the residual from the log linearization. To minimize the significant residuals normally following from a linearization of a non-linear function with large changes over long periods, one can calculate (3) for shorter sub-periods and add the resulting changes up.
40. An approximated decomposition for the projected pension spending under scenario 1 and 2 presented in section IV are presented in figure 4 below.
As can be seen, the largest driver of pension spending in both scenarios is the aging and eligibility effect, which is of the same magnitude in both scenarios. Although the employment effect is negative in both scenarios (largest in absolute terms in scenario 1) due to the assumption of an increase in participation rates among 15-64-year olds, the effect is minimal. On the other hand, the benefit effect helps importantly to counter the rise in pension spending, due to the implicit assumption of relatively high productivity growth, especially in scenario 1. It should, however, be noted that these calculations are only indicative and associated with some uncertainty.
APPENDIX II Ensuring Long-Term Public Finance Sustainability
41. Pension and health care reform is not the only answer to accommodate the projected bulge in age-related spending. Thus, the problem of growing age-related spending in a public pay-as-you-go system based on solidarity among generations should not be thought of as simply an actuarial problem. The sustainability of such a system should be analyzed in the broader context of fiscal sustainability. This section looks at the theoretical concept of fiscal sustainability, its practical application, and presents calculations illustrating a time profile for the primary balance improvement necessary in Cyprus to maintain long-term sustainability under the different scenarios.
Blanchard, Olivier, Jean Claude Chouraqui, Robert P. Hagemann, and Nicola Sartor, 1990, “The Sustainability of Fiscal Policy: New Answers to an Old Question,” Economic Studies, No. 2 (Paris: Organization for Economic Cooperation and Development).
Chalk, Nigel, and Richard Hemming, 2000, “Assessing Fiscal Sustainability in Theory and Practice,” IMF Working Paper 02/18 (Washington: International Monetary Fund).
Dang, Thai Thanh, Pablo Antolin, and Howard Oxley, 2001, “Fiscal Implications of Aging: Projections of Age-Related Spending,” Economics Department Working Paper 31 (Paris: Organization for Economic Cooperation and Development).
Eskesen, Leif Lybecker, 2002, “Population Aging and Long-Term Fiscal Sustainability in Austria,” IMF Working Paper 02/216 (Washington: International Monetary Fund).
Prepared by Leif Lybecker Eskesen.
Civil servants are also eligible for a pension from the social insurance scheme from the age of 63, but this is means-tested and is reduced to take into account their civil service pension.
In all scenarios it is assumed that total public spending and revenues equal IMF projections from 2001-2007 and that non-pension spending and revenues are calculated as residuals during this period. Thereafter, non-pension spending and revenues are assumed to remain constant as a share of GDP at the 2007 level throughout the forecasting horizon.