Germany: Selected Issues

This Selected Issues paper on Germany reviews investment trends and business capital stock in Organization for Economic Co-operation and Development (OECD) countries. Sharp wage increases are found to boost capital formation in the short term as employers substitute capital for labor at a rate that adjusts to the higher relative price for labor. To limit the political economy biases to fiscal policy, the paper explores options to strengthen budgetary institutions, notably more transparency; stronger budgetary rules; and more room for Länder governments to mobilize revenue and tailor spending to local circumstances.

Abstract

This Selected Issues paper on Germany reviews investment trends and business capital stock in Organization for Economic Co-operation and Development (OECD) countries. Sharp wage increases are found to boost capital formation in the short term as employers substitute capital for labor at a rate that adjusts to the higher relative price for labor. To limit the political economy biases to fiscal policy, the paper explores options to strengthen budgetary institutions, notably more transparency; stronger budgetary rules; and more room for Länder governments to mobilize revenue and tailor spending to local circumstances.

III. Pensions and Growth37

A. Introduction

90. Potential output growth in Germany could decline significantly if social security contribution rates continue to rise. Germany’s society is aging, and pension and health care outlays are projected to increase substantially over the next three decades. German law stipulates that the social security accounts maintain balance and, under current rules, the growing expenditures must be met with equivalent social security contributions. While this is helpful in preventing runaway fiscal deficits and a buildup of debt, it does lead to higher payroll taxes. Higher payroll taxes, in turn, negatively affect incentives to work and capital formation, and thereby economic growth. This process can feed upon itself, as slower growth could lead to a shortfall in revenue, triggering further tax increases. To assess these challenges, this chapter uses a general equilibrium model with feedback effects from pensions to growth. It embeds the fiscal dynamics of aging in a model of economic growth that is calibrated to the German data. The chapter highlights the importance of moderating non-wage payroll costs, including by raising the retirement age.38

B. The Model

91. A neoclassical growth model is used to estimate the impact of pension costs on growth. Households allocate their time between work and leisure, with the amount of work financing their consumption. Higher taxes on labor make working less attractive and lead to an decrease in labor supply. Nickell (2003) estimates that for a 10 percentage point increase in payroll taxes, the supply of labor declines by up to 3 percentage points. These parameter values are incorporated into the model. To simplify, the saving rate is stabilized by setting the intertemporal elasticity of substitution to zero, as in the Solow model (empirical estimates yield a small positive value). Firms are assumed to use a Cobb-Douglas production technology with labor and capital inputs. The share of labor is set at two-thirds in accordance with long-run historical data for Germany. The economy is assumed to be closed, and all savings are invested at the rate of 18 percent of GDP, while capital depreciates by 5 percent each year. Total factor productivity increases at 1 percent per year—corresponding to averages for the German economy over the past 20 years. Finally, it is assumed that fiscal policy maintains a constant ratio of debt to GDP at 63 percent. As stipulated by German law, increasing age-related expenditure is financed with higher payroll taxes.

92. The model is used to explore three scenarios of the relationship between aging and growth:

  • Economic effects of aging without reforms,

  • The impact of the entitlement reforms of 2004,

  • The impact from raising the retirement age.

C. Economic Effects of Aging Without Reforms

93. Current demographic projections suggest that Germany’s population could decline by 40 percent during the 21st century. More important for fiscal policy, the ratio between the working age population and dependents (children and elderly) will worsen sharply after 2010, as the process of aging accelerates. The labor force will then decline, even if labor force participation increases. As large cohorts of baby-boomers begin to retire, the demands on the social security system will escalate. This age-related shift is projected to continue to about 2035, when the dependency ratio stabilizes at close to 50 percent, nearly twice the present rate.

94. The decline in the labor force will inevitably reduce trend GDP growth. Capital and labor are the key inputs in the production function. As the supply of labor shrinks, output growth slows. Employment is projected to decline by an average of 0.4 percent a year during the 2010s, and by 1.0 percent a year during the 2020s. In current benchmark scenarios, capital and total factor productivity are assumed to grow at around 2 and 1 percent a year, respectively. With these assumptions, which reflect recent experience, potential GDP growth would be about 0.5 - 1.0 percent per year.

uA03fig01

Population

in millions

Citation: IMF Staff Country Reports 2004, 340; 10.5089/9781451810455.002.A003

uA03fig02

Social Security Contributions

Citation: IMF Staff Country Reports 2004, 340; 10.5089/9781451810455.002.A003

95. However, the burdens of aging may reduce potential GDP growth to around zero if they are financed with ever-higher payroll taxes. Increasing payroll tax rates would reduce net (after-tax) wages, and depress labor supply. This effect would magnify the demographic decline of the labor force mentioned above. As a result, GDP growth will slow further, and in turn reduce investment and capital accumulation. The ensuing shortfall in social security revenue may trigger another round of payroll tax hikes, employment declines and growth reductions. This downward spiral could paralyze potential output. According to the calibrated model, German potential GDP growth could decline to around zero for most of the 2020s.

96. With unchanged policies, the model thus suggests that higher payroll taxes could shave off 1 percentage point of GDP growth per year. As shown in the figure, social security contributions may need to rise by up to 7 percentage points of GDP through about 2035 to cover higher pension and health outlays. This would leave real GDP in 2030 some 20 percent below the level it could attain if contributions had remained unchanged. Similarly, after-tax real wages would also forgo a gain of some 20 percent. This result should also be seen in the context of income distribution. A shrinking working population will transfer more funds to an expanding dependent population. This will lower Germany’s productive efficiency, but also make income distribution more uneven among generations.

D. The Reform of 2004

97. The recent pension reform dampens somewhat the growth in benefits. Following the recommendations of the Rürup commission, a series of measures was implemented in February 2004 to limit the increase in benefits. The annual raise in pensions was suspended for 2004, and more importantly, a “sustainability factor” was added to the pension adjustment formula. This factor slows benefit growth if the population ages and the dependency ratio increases. Simplifying for exposition, the pension formula now reads:

Δbenefits=Δgrosswages×(1αDt1Dt2),

where D is the old-age dependency ratio and the sustainability factor a is equal to 0.25 according to the law. The indexation of benefits to gross wages thus becomes less than unity as the dependency ratio increases. A higher value of a would slow benefit growth further. Until now, a was zero, and there was only a weak link to demographics.

uA03fig03

GDP Growth

Citation: IMF Staff Country Reports 2004, 340; 10.5089/9781451810455.002.A003

98. This reform is estimated to raise GDP growth by 0.1 percent per year compared to the no-reform scenario. Slower benefit increases translate into smaller increases in payroll taxes, and a somewhat smaller decline in the labor supply. Nevertheless, with social security contributions still increasing by 5 percentage points of GDP, the active generation continues to bear a large transfer burden. The figure below shows the effects of the recent pension reform on income distribution. The horizontal axis shows that with no reform (α=0), the average real pension over the coming 20 years would be around 16 percent higher than today. The vertical axis shows that average real net wages would decline by about 3 percent (2004 levels are set at 100). The recent reform (α=0.25) slows down somewhat the growth in real pensions (still an increase of 14 percent), and preserves average real net wages at their current level. At the same time, labor supply and GDP would be slightly higher, as shown by the thin downward-sloping lines of constant GDP (moving away from the origin indicates higher levels of real output). While not part of current government plans, an α above 0.25 would dampen transfers further, raise labor utilization and lift GDP from Y(0) toward Y(1).

99. Many current projections do not take into account the feedback effects from payroll increases to labor supply—they hence may underestimate the challenge from aging and overestimate future growth. Notwithstanding the recent reform, employment and output growth in the next few decades may thus be lower than generally expected. For instance, the officially projected increase in contribution rates is only about 2 percentage points of GDP compared to 5 percentage points in our model. Therefore, additional measures will be required to ensure that payroll burdens do not rise to a crippling level.

E. Raising the Effective Retirement Age

100. While life expectancy has increased by eight years since the early 1970s, the effective retirement age has declined by two years, to around 60. A recent study by the OECD39 finds that there are strong disincentives to work beyond the age of 60 in Germany. Generous benefit payments have raised the replacement rate for early retirement, in particular after a pension reform in 1972. In addition to pension benefits, early retirees are often eligible for unemployment benefits, too. At the same time, the costs of this generous system have increased payroll tax rates from 25 to 42 percent of gross wages, one of the highest in the world. Taken together, recent OECD estimates suggest that high replacement rates and payroll taxes create a net income loss of 20 percent for those who opt to work beyond age 60, instead of retiring.

101. Raising the effective retirement age in line with life expectancy would help support growth and sustain the welfare system. This measure directly reduces the dependency ratio, and slows the increase in benefits more markedly than a change in the adjustment formula. In addition, raising the retirement age boosts labor supply twofold: (1) it directly increases the participation rate and (2) it keeps the rise of payroll taxes in check, which improves work incentives. Simulations suggest that payroll taxes would need to increase by less than half the amount under the current system if the effective retirement age were gradually raised to 65. Consequently, potential GDP growth would be about 1 percentage point a year higher than in the no-reform scenario.

uA03fig05

Life Expectancy and Retirement

Citation: IMF Staff Country Reports 2004, 340; 10.5089/9781451810455.002.A003

uA03fig06

Employment Rate

Citation: IMF Staff Country Reports 2004, 340; 10.5089/9781451810455.002.A003

uA03fig07

Capital Accumulation

Citation: IMF Staff Country Reports 2004, 340; 10.5089/9781451810455.002.A003

102. Higher growth and lower payroll taxes would increase both real wages and real pensions. With higher levels of output, there are more resources to distribute, and the budget constraint for the whole economy expands. A higher supply of labor would temporarily lower gross real wages, but the moderation in payroll taxes more than offsets the effect on net real wages. This allows workers to participate in the benefits of higher growth. Model simulations show that a gradual increase of the effective retirement age to 65 would increase average real net wages by 9 percent over the next 20 years, and average real pensions by 15 percent.

103. Distributive equity could improve as the financial burden of aging is spread more evenly. Under present rules, the tax base for Germany’s pay-as-you-go system will narrow as the number of workers declines. An increase in the retirement age would effectively widen this tax base, allowing payroll tax rates to increase less, and providing higher real net wages for workers. Figure 6 compares the distribution of real wages and real pensions for a retirement age of 60, 61 and 65 and values of a ranging from 0 to 1. Each increase in the retirement age shifts the trade-off line between higher wages or pensions away from the origin by improving productive efficiency. Furthermore, the trade-off line edges closer to the diagonal of equal growth for wages and pensions as the system becomes more equitable.

104. In sum, the financial burden of aging is likely to reduce labor supply and GDP growth by more than currently expected. This is mostly due to increasing in payroll taxes to finance growing entitlements. The recent reforms were a step in the right direction, as they reduce the transfers from the active to the retired population. However, the growth slowdown will still be dramatic. A change in incentives to increase the effective retirement age will thus be necessary. This would allow much more significant gains in growth and distributional equity between generations.

37

Prepared by Benedikt Braumann.

38

Chapter 2 discusses labor market reforms that could boost employment. These reforms are an important complement in financing the burden of aging.

39

OECD working paper ECO/WKP(2003)25

Germany: Selected Issues
Author: International Monetary Fund