Abstract
This Selected Issues paper on the Czech Republic presents an analysis of various aspects of population aging: its macroeconomic effects; impact on fiscal sustainability; and implications for private savings. The paper simulates the macroeconomic effects of population aging in the Czech Republic using an overlapping-generations model. It finds that aging can significantly weaken the outlook for economic growth and living standards. The paper evaluates the fiscal implications of aging using a generational-accounting framework. It also evaluates the monetary policy implications of capital account volatility—as the relative importance of portfolio flows increases.
II. Macroeconomic Effects of Population Aging in the Czech Republic1
A. Introduction and Summary
6. Population aging is set to affect the Czech Republic earlier and to a greater extent than many other advanced countries and regional peers. Low fertility rates and rising longevity are causing a gradual decline in population growth and a shift in the age structure of the population toward a greater share of the elderly. Although a gradual process, population aging is proceeding faster in the Czech Republic than on average in the EU-15 and Central European countries (Text Figure). By 2050, the elderly will account for a higher share of the population than in the key comparator countries.
Increase in Elderly Dependency Ratios 1/
(In percent)
Citation: IMF Staff Country Reports 2005, 275; 10.5089/9781451810226.002.A002
Increase in Elderly Dependency Ratios 1/
(In percent)
Citation: IMF Staff Country Reports 2005, 275; 10.5089/9781451810226.002.A002
Increase in Elderly Dependency Ratios 1/
(In percent)
Citation: IMF Staff Country Reports 2005, 275; 10.5089/9781451810226.002.A002
Elderly Dependency Ratios 1/2/
(In percent)
Citation: IMF Staff Country Reports 2005, 275; 10.5089/9781451810226.002.A002
Elderly Dependency Ratios 1/2/
(In percent)
Citation: IMF Staff Country Reports 2005, 275; 10.5089/9781451810226.002.A002
Elderly Dependency Ratios 1/2/
(In percent)
Citation: IMF Staff Country Reports 2005, 275; 10.5089/9781451810226.002.A002
7. Population aging is likely to have significant effects on the Czech economy and public finances. A decline in the working-age population, which accompanies population aging, is likely to slow growth in real GDP and improvements in living standards. Although reforms to raise labor force participation and productivity growth can help mitigate these adverse effects, they are unlikely to eliminate the need for structural fiscal reforms. The budget is expected to come gradually under pressure from rising expenditures on pensions and healthcare. Consolidation will be needed to preserve debt sustainability. The earlier it starts, the smaller will be the fiscal adjustment needed to close the fiscal gap.
8. This chapter simulates the macroeconomic effects of population aging in the Czech Republic in an overlapping generations model. The analysis is based on a small-open-economy model, sharing many of the features found in the Fund’s global macroeconomic simulation model, MULTIMOD, but extended to incorporate demographic projections and life-cycle dynamics (Faruqee, 2002).2 The chapter also examines a broad policy response to population aging, identifying trade-offs and synergies between fiscal and structural reforms.
B. Theory and Model
9. The model is a dynamic general equilibrium system with forward-looking behavior and model-consistent expectations. Consumption-saving behavior is based on Blanchard’s (1985) model, where agents are assumed to have finite planning horizons. The production function is of the Cobb-Douglas form with capital and labor. Investment behavior is based on Tobin’s q-theory, whereby the desired rate of investment exceeds the steady-state rate as long as the expected marginal product of capital is greater than its replacement cost. On the external side, import volumes depend on the main components of aggregate demand, and exports reflect the foreign import demand functions. Exchange rates and interest rates are linked by the interest parity condition. The real exchange rate equilibrates the goods markets and ensures consistency between flow relationships and consumers’ desired rates of asset accumulation. International capital markets are assumed to be perfect, allowing the small open economy to borrow freely at the prevailing world interest rate. Government absorption is exogenous, and an endogenous aggregate tax rate ensures that the ratio of government debt to GDP converges to a target level.
10. The key channel through which population aging affects the economy in this model is the life-cycle profiles of individuals’ earnings (Faruqee, 2002).3 These profiles typically have a hump-shaped pattern: earnings rise, as young individuals enter the labor force and start gaining work experience, peak in middle age, and decline as individuals move into retirement. On the supply side, age-earnings profiles reflect changes in relative productivity and labor supply over an individual’s working life. Changes in the age structure of the population affect aggregate labor supply through differences in relative productivity and individual labor supply. On the demand side, individuals are assumed to adjust their savings and smooth consumption based on their anticipated path of life-cycle income. Young individuals are net borrowers, because their current income is below their permanent income. Mature agents, at the peak of their income potential, save in anticipation of retirement. The elderly also save in this model, given uncertainty about the lifetime.4
C. Calibration and Experiments
11. The age-earnings profiles were estimated using the Czech Statistical Office’s data on wage-based salaries by age cohort for the period 1996–2003. The data on labor earnings were adjusted by the labor force participation rates and normalized relative to per capita earnings of the youngest working cohort.5 The resulting cross-sectional age-earnings profiles were taken to represent the time-series pattern of individuals’ relative earnings over their lifetime and were fitted to the following exponential function:
where ry is relative labor income, s and t are cohort and time indices, respectively; and the difference t – s is the age of a given cohort. This particular exponential form makes the model tractable and ensures a reasonable fit of the data. The first two terms are intended to capture the change in an individual’s labor supply (for example, the number of hours worked) over the lifetime. The last term reflects productivity gains associated with age and experience.6 The fitted values are shown by the solid line in the text figure. Using the nonlinear least squares method, the parameter values in equation (1) were estimated to be: α1=0.09; α2=0.12; and α3=0.10; all significant at the 5 percent level. The model assumes that the relative age-earnings profiles—and hence, these parameters—remain stable over time. However, to the extent that healthier individuals would choose to postpone retirement and remain active in the labor force, the current age-earnings profiles would flatten in the future, mitigating the negative impact of population aging on growth. In this study, the potential overestimation bias is alleviated by the fact that the fitted profiles are flatter for the old-age cohorts than the actual profiles based on the historical data.
Age-Earnings Profiles, 1996-2003
(Relative to the youngest cohort)
Citation: IMF Staff Country Reports 2005, 275; 10.5089/9781451810226.002.A002
Source: Czech Statistical Office and IMF staff estimates.Age-Earnings Profiles, 1996-2003
(Relative to the youngest cohort)
Citation: IMF Staff Country Reports 2005, 275; 10.5089/9781451810226.002.A002
Source: Czech Statistical Office and IMF staff estimates.Age-Earnings Profiles, 1996-2003
(Relative to the youngest cohort)
Citation: IMF Staff Country Reports 2005, 275; 10.5089/9781451810226.002.A002
Source: Czech Statistical Office and IMF staff estimates.12. Demographic projections are based on World Bank data. The main factor underlying population aging trends is the decline in fertility rates over the last half a century: from 2.69 children per woman in 1950–55 to 1.17 in 2000–05. The World Bank’s projections assume that the fertility rate will stabilize around 2015 and then rise gradually to the replacement rate, leading to a stationary population by 2100. Under these projections, the elderly dependency ratio will peak in 2060 and then gradually stabilize by 2090. The assumption that the elderly dependency ratio will stabilize at some point in the future is essential for ensuring the stability of the model. From the policy point of view, however, the choice of the demographic projections is less relevant, since the analysis in this chapter focuses on the period to 2050, and for this period the World Bank projections are broadly similar to those of the authorities and the United Nations.7 The demographic projections assume zero net migration, consistent with the historical data and the baseline assumption that current policies will continue.8 To ensure compatibility of the demographic data with the theoretical structure of the model, we redefine the key demographic rates with respect to the adult population. The declining fertility rates imply that fewer young workers enter the labor force, and the adult population declines. As the share of the working-age people in the adult population falls, the share of the elderly rises (Text Figure).
Demographic Projections, 1950-2050
(In percent, in terms of the adult population)
Citation: IMF Staff Country Reports 2005, 275; 10.5089/9781451810226.002.A002
Source: World Bank, United Nations, and IMF staff estimates.1/ Year-on-year percent change in population aged 20 and above.2/ Year-on-year percent change in population aged 20-24 years.3/ The ratio of population aged 65 to the population aged 20-64.Demographic Projections, 1950-2050
(In percent, in terms of the adult population)
Citation: IMF Staff Country Reports 2005, 275; 10.5089/9781451810226.002.A002
Source: World Bank, United Nations, and IMF staff estimates.1/ Year-on-year percent change in population aged 20 and above.2/ Year-on-year percent change in population aged 20-24 years.3/ The ratio of population aged 65 to the population aged 20-64.Demographic Projections, 1950-2050
(In percent, in terms of the adult population)
Citation: IMF Staff Country Reports 2005, 275; 10.5089/9781451810226.002.A002
Source: World Bank, United Nations, and IMF staff estimates.1/ Year-on-year percent change in population aged 20 and above.2/ Year-on-year percent change in population aged 20-24 years.3/ The ratio of population aged 65 to the population aged 20-64.13. The baseline was calibrated to reflect the key relevant features of the Czech economy in a long-run steady state. Real GDP growth in the Czech Republic is assumed to converge to that in the EU-15, taken to be about 2 percent per year.9 The population is assumed to remain stationary in the baseline, and hence the long-run per capita GDP growth also equals roughly 2 percent. Consumption is assumed to be inelastic with respect to the interest rate, i.e., the intertemporal elasticity of substitution is small (0.4), while the rate of time preference is taken to be 2½ percent. As regards investment, a fixed equity risk premium is added to yield a reasonable capital-output ratio equal to 3. The long-run real world interest rate is assumed to be 4 percent. The initial level of public debt is about 25 percent. Note that since the model simulates the effects of population aging in relative terms—as percent deviations from the baseline—the simulation results are fairly robust to the baseline assumptions.
14. Simulations focus on the macroeconomic effects of a population aging shock relative to the baseline of a stationary population. We first consider population aging under current policies, and then assuming that fiscal and structural policies are adjusted to offset the adverse effects of population aging:
Demographic shock. We assume that the elderly dependency ratio rises relative to the baseline of stationary population in line with demographic projections. By 2050, the elderly dependency ratio increases by about 12½ percent compared to the baseline of a stationary population. This increase reflects a gradual decline in the fertility rate and a rise in longevity (a decline in the mortality rate).
Fiscal consolidation. First we assume that consolidation is delayed by about 10 years, from 2020 to 2030; during this time, the government finances rising age-related expenditures through borrowing. Next we consider a scenario where the government does not take any special consolidation measures and finances the increase in age-related expenditures exclusively through borrowing.
Labor market reforms and technological change. Factors related to labor market reforms and technological change are assumed to augment growth in the effective labor supply (i.e., in productivity-adjusted terms) by an average rate of ⅓ percent per year during the next 50 years (thereafter, the effective labor supply is assumed to gradually return to the baseline level). This boost to growth can come from several sources: (i) ⅓ percent growth in the number of workers owing to an increase in the labor force participation rates,10 (ii) a labor-augmenting technological change raising labor productivity growth by ⅓ percent per year; (iii) ⅓ percent annual growth in the number of hours worked; or a combination of these sources amounting to ⅓ percent increase in annual growth in the effective labor supply during 2005–55. The needed increases in labor productivity and labor supply are significant (amounting to a cumulative increase of 17½ percent in the effective labor supply by 2055), and would require designing comprehensive and consistently effective reform strategies.11
D. Simulations
15. Population aging is estimated to reduce GDP growth in the long run compared to the baseline scenario of a stationary population. By 2050, the level of real GDP is projected to decline by about 30 percent (relative to the baseline without demographic change); this amounts to an average reduction of more than ½ percentage point per year in trend growth (Figure 1). With the composition of the labor force shifting toward a larger share of the elderly, the productivity-adjusted labor supply falls by more than the number of workers. As a result, real GDP per capita also declines in the long run relative to the baseline, albeit to a lesser extent (i.e., by 15 percent relative to the baseline by 2050 or about ⅓ percent per year on average). Under these estimates, growth of total and per capita GDP will remain positive in absolute terms. Additional age-related expenditures are assumed to be covered through borrowing and increases in direct taxes. Public debt approaches 60 percent of GDP by 2050, and a permanent tax revenue increase of about 6 percent of GDP would be needed to maintain the debt ratio on a sustainable path. The current account deficit start to widen after 2050.
Macroeconomic Effects of Population Aging
(Deviations from stationary-population baseline levels)
Citation: IMF Staff Country Reports 2005, 275; 10.5089/9781451810226.002.A002
Macroeconomic Effects of Population Aging
(Deviations from stationary-population baseline levels)
Citation: IMF Staff Country Reports 2005, 275; 10.5089/9781451810226.002.A002
Macroeconomic Effects of Population Aging
(Deviations from stationary-population baseline levels)
Citation: IMF Staff Country Reports 2005, 275; 10.5089/9781451810226.002.A002
16. The transmission dynamics of a population aging shock are characterized by a two-stage process. The stages reflect the relative strength of the two factors driving population aging: rising longevity and declining fertility rates (Figure 1):
Initially, until 2015, the effect of rising longevity outweighs that of lower fertility rates, and the adult population and the effective labor supply increase. Output increases by about 3 percent relative to the baseline, as investment and capital-labor ratios increase. Savings rise in line with output and for precautionary reasons, because individuals anticipate continued population aging. The ratio of the current account to GDP narrows by about 2 percent by 2015. Social security expenditures initially rise at a moderate rate; relative to GDP, they are less than 1 percent higher in 2015 than in 2005 relative to the baseline without the demographic change. This increase is fully financed through borrowing. The rate of growth in public debt is moderate until the late 2010s, with debt rising by about 5 percent relative to GDP.
As the population aging shock continues to unfold, the effect of lower fertility rates starts to dominate. From around 2015, the effective labor supply starts to decline. Interest rates rise, as savings and investment decline with output. In the early 2020s, total and per capita GDP start decline. Growth of social security expenditures and public debt accelerates, requiring the government to start raising taxes around 2020 to close the financing gap and preserve debt sustainability. The current account deficit continues to narrow until about 2030, as investment falls. Thereafter, this trend reverses as the decline in savings starts to outpace the decline in investment.
17. A delay in fiscal consolidation accelerates the accumulation of public debt and raises the cost of adjustment. If the government delays consolidation by 10 years, to 2030, the fiscal gap would need to be closed through government borrowing. Public debt reaches the targeted level earlier, by 2030 instead of 2050 (Figure 2). The magnitude of the fiscal adjustment needed to close the gap is larger in this case, reflecting higher debt-servicing costs. If consolidation does not take place at all, the debt ratio reaches 60 percent by 2030, and the fiscal position becomes unsustainable in the long run (Figure 3).
Delayed Fiscal Consolidation
(Deviations from stationary-population baseline levels)
Citation: IMF Staff Country Reports 2005, 275; 10.5089/9781451810226.002.A002
Delayed Fiscal Consolidation
(Deviations from stationary-population baseline levels)
Citation: IMF Staff Country Reports 2005, 275; 10.5089/9781451810226.002.A002
Delayed Fiscal Consolidation
(Deviations from stationary-population baseline levels)
Citation: IMF Staff Country Reports 2005, 275; 10.5089/9781451810226.002.A002
No Consolidation Scenario
(Deviations from stationary-population baseline levels)
Citation: IMF Staff Country Reports 2005, 275; 10.5089/9781451810226.002.A002
No Consolidation Scenario
(Deviations from stationary-population baseline levels)
Citation: IMF Staff Country Reports 2005, 275; 10.5089/9781451810226.002.A002
No Consolidation Scenario
(Deviations from stationary-population baseline levels)
Citation: IMF Staff Country Reports 2005, 275; 10.5089/9781451810226.002.A002
18. Labor market reforms or boosts to labor-augmenting technological change can help offset the adverse impact of population aging on growth and welfare (Figure 4). An increase in the effective labor supply by about 17½ percent by 2050 would largely neutralize the welfare implications—as measured by GDP and consumption in the per capita terms—of the increase in the elderly dependency ratio. Labor market reforms and/or a labor-augmenting technological change would also reduce the need for the fiscal adjustment relative to GDP by about 2 percent. Yet, the needed fiscal adjustment would remain significant—about 4 percent of GDP in 2050.
Labor Market Reforms and Labor-Augmenting Technological Change
(Deviations from stationary-population baseline levels)
Citation: IMF Staff Country Reports 2005, 275; 10.5089/9781451810226.002.A002
Labor Market Reforms and Labor-Augmenting Technological Change
(Deviations from stationary-population baseline levels)
Citation: IMF Staff Country Reports 2005, 275; 10.5089/9781451810226.002.A002
Labor Market Reforms and Labor-Augmenting Technological Change
(Deviations from stationary-population baseline levels)
Citation: IMF Staff Country Reports 2005, 275; 10.5089/9781451810226.002.A002
19. The qualitative conclusions are robust to demographic projections and alternative assumptions on consolidation policies. The results are quantitatively sensitive to alternative demographic projections, with growth and fiscal effects being proportional to the increase in the elderly dependency ratio. However, for a reasonable range of demographic projections, such as the United Nation’s high and low variants, for example, the simulated effects of aging on growth and public finances remain broadly similar.12 In addition, the results are somewhat sensitive to the assumption on how the fiscal gap is closed. Our simulations assume that the fiscal gap is closed through an increase in direct taxes. This is the most conservative assumption, as the distortionary effects of a direct tax increase on saving and labor supply are likely to be higher than those for indirect taxation and cuts in social security benefits. Under such alternative assumptions, the estimated impact of population aging on growth would be smaller than in the simulations presented in the paper, but, for reasonable values, remain significant.
E. Conclusion
20. Aging weakens the outlook for economic growth and living standards and puts pressure on public finances. It is comforting that the adverse impact on growth can be largely mitigated through what appears to be an achievable increase in labor force participation rates and a labor-augmenting technological change. Yet, even with extensive structural reforms, significant fiscal consolidation will be needed to ensure long-term debt sustainability.13 The earlier consolidation starts and the deeper are the accompanying structural reforms, the smaller the needed fiscal adjustment will be. To mitigate the macroeconomic effects of population aging, private savings need to adjust in preparation for aging. Such an endogenous response is assumed in the model, but in practice it will be conditional on good foresight on the part of individuals and well-functioning financial markets for long-term savings.14
References
Blanchard, O., 1985, “Debt, Deficits, and Finite Horizons,” Journal of Political Economy, 93, pp. 223–247.
Czech Statistical Office, “Statistical Yearbook of the Czech Republic,” various years.
European Commission, 2004, “The EU Economy: 2004 Review.”
Faruqee, H., 2002, “Population Aging and Its Macroeconomic Implications: A Framework for Analysis,” Working Paper 02/16 (Washington: International Monetary Fund).
Faruqee, H., and M. Mühleisen, 2003, “Population Aging in Japan: Demographic Shock and Fiscal Sustainability,” Japan and the World Economy, 15, pp. 185–210.
International Monetary Fund, 2004, “How Will Demographic Change Affect the Global Economy,” World Economic Outlook, September (Washington: International Monetary Fund).
Laxton, D., and others, 1998, “MULTIMOD Mark III: The Core Dynamic and Steady-State Models,” Occasional Paper 164 (Washington: International Monetary Fund).
United Nations, 2004, “World Population Prospects: The 2004 Revision Population Database,” available at www.esa.un.org.
Prepared by Natalia Tamirisa and Hamid Faruqee.
For more details on MULTIMOD, see Laxton and others (1998).
For an application of the model to the analysis of population aging in other countries, see Faruqee (2002) and Faruqee and Mühleisen (2003).
This feature of the model is consistent with household survey data, which typically find positive savings rates for the old-age cohorts.
We take the 20–24 year-olds to be the youngest working cohort. The labor force participation rates for the preceding, 15–19 year-old cohort are significantly below those for other working-age cohorts.
There are restrictions on the coefficients in equation (1), for example, a1 + a2 + a3 = 1. These restrictions are intended to generate non-negative hump-shaped profiles, which are normalized to unity for the youngest cohort (for which s = t). For more details, see Faruqee (2002).
The authorities’ analysis of long-term fiscal sustainability is based on the demographic projections prepared at the Charles University (available at www.reformaduchodu.cz).
Net migration flows are relatively small in the Czech Republic: less than ⅛ percent of the population during 2000–04. See the data provided by the Czech Statistical Office at www.czso.cz.
In the model, the increase in the effective labor supply can also result from immigration, provided immigrants are of the working age and are at least as productive as the resident population.
See Czech Republic—Selected Issues (IMF Country Report No. 04/265) for a discussion of labor market reforms.
See Chapter III for a detailed analysis of fiscal policy responses to population aging.
Chapter IV examines the extent of adjustment households need to make in their balance sheets to prepare for population aging.
