Czech Republic: Selected Issues
Author: International Monetary Fund
Publication Date:
08 Aug 2005
eISBN:
9781451810226
Language:
English
Keywords:
ISCR; CR; monetary policy implication; chapter IV; financial asset; implications of capital account volatility; productivity growth; GDP target; growth assumption; early retirement; deficit path; Aging; Labor productivity
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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.

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.

III. Impact of Aging on Fiscal Sustainability in the Czech Republic15

A. Introduction

21. The Czech Republic is projected to age at one of the fastest rates among the OECD countries. This demographic trend is expected to put significant pressure on age-related spending over the coming decades. Furthermore, a decline in productivity growth from its current high rates will adversely impact income taxes and social contributions. As a result, the rising deficits are expected to push debt to unsustainable levels. This fiscal outlook is further dimmed by the generous eligibility conditions for public benefits provided by the existing system, which encourages withdrawal from the labor market and dampens growth prospects.

22. Staff projections show that, in the absence of reforms, the social benefits system will place severe demands on public finances. Under current policies, the relatively low debt position will quickly worsen, and it is estimated that taxes would need to increase by over 10 percent of GDP, in net present value terms, to meet the fiscal solvency constraint. In order to achieve a target debt-to-GDP ratio of 60 percent in 2050—a less stringent requirement, given rising deficits—taxes would need to increase by around 6 percent of GDP.16

23. This chapter seeks to assess the long-run sustainability of current policies and the impact of reform scenarios. In addition, it also aims to examine the generational burden of fiscal policies. The chapter is organized as follows: section B provides a background on the current fiscal policies, including the pension and health care system, and the demographic developments. Section C describes the model for the long run projections, the assumptions used, and the results. Section D discusses conclusions and policy implications.

B. Background

Current fiscal situation

24. The current fiscal position of the Czech Republic is relatively favorable. General government debt at around 25 percent of GDP, in Government Finance Statistics terms, is still low. Near-term fiscal policy is anchored by a medium-term budgetary framework which targets a general government deficit of 3 percent of GDP in 2008, in line with the Maastricht deficit criterion. Current age-related spending, comprising pensions, health care and education, is at around 20 percent of GDP, which is comparable to other European countries.

25. Despite this benign outlook, there are underlying vulnerabilities which could lead to a rapid buildup of debt. A significant share of large outstanding guarantees is considered to be high risk. Privatization revenues, which have been used to finance bank and public enterprise restructuring costs, will soon dry up and the government will need to increasingly rely on market borrowing. With the primary deficit among the highest in the European Union (Figure 1) and a large share of mandatory expenditures, fiscal consolidation and increased budget flexibility is paramount to avoid a rapid increase in debt and create the budgetary room for looming age-related expenditures.

Figure 1.
Figure 1.

Fiscal Indicators

(In percent of GDP, 2004)

Citation: IMF Staff Country Reports 2005, 275; 10.5089/9781451810226.002.A003

Source: IMF, World Economic Outlook.

26. Publicly financed pensions and health care account for the bulk of the age-related expenditures in the Czech Republic. The pension system consists of a mandatory, pay-as-you-go insurance (1st pillar), and voluntary private supplemental insurance (3rd pillar). But private pensions have had limited success, and with assets of only about 3 percent of GDP, they function largely as a state subsidized savings scheme. The health care insurance system provides universal and near comprehensive coverage with no co-payments and a public price-setting mechanism. Private health insurance is virtually nonexistent.

Pensions

27. The public pension system is a mandatory, defined-benefit, social insurance scheme, which has been successful in achieving high coverage and redistribution at a relatively low cost. The pay-as-you-go scheme covers old-age, full and partial disability, and survivors’ benefits, provided through a combination of flat rate and earnings-related benefits. While the level of benefits is not overly generous, the scheme has achieved high coverage and redistribution, as indicated by the relatively low pension wealth and net replacement rates which decline with wage levels (Figure 2). Pension benefits are indexed, at a minimum, to consumer price inflation and a third of real wage rate growth, while the assessment base for new pensions is indexed to wages. In 2000, pension expenditure was around 11 percent of GDP, of which old-age expenditures comprised almost 8 percent of GDP, close to the OECD average. Following reform measures in 2003, the pension system recorded a modest surplus in 2004 (Kraal, 2005; and MLSA, 2004).

Figure 2.
Figure 2.

Pension System Indicators

Citation: IMF Staff Country Reports 2005, 275; 10.5089/9781451810226.002.A003

Sources: OECD (2004); and OECD (2005).1/ For mandatory pension program, men.2/ Present value of pension entitlement.

28. Despite these achievements, the pension system has drawbacks which will compound the financial pressures arising from population aging. The statutory retirement age (61 currently, 63 for men by 2013) is already low by comparison to most European and OECD nations. Current policy has encouraged an even earlier exit from the workforce by providing generous eligibility criteria for pension benefits, particularly among low-wage earners. Pension benefits combined with other social benefits have resulted in a net replacement rate of around 100 percent among low-wage earners. Among the current cohort of retirees, around 40 percent have chosen early retirement. This phenomenon partly reflected strong incentives provided by generous early retirement schemes, but disability pensions, providing comparable benefits to old-age pensions, were also one of the main pathways to retirement. With longevity expected to increase in the future, disincentives to work among the elderly would have an adverse impact on pension system viability.

Health care

29. The Czech health care system is a largely public-funded network providing generous access to services. Individuals, employers, and the state17 contribute to a mandatory, employment-based insurance system. The public has the choice of the health insurance fund and the provider, which includes a public/private mix of hospitals and physicians. The government supervises, and also has the final authority over the negotiation of contracts between insurance funds and providers, specifying benefits coverage, fee structure and reimbursements. The state also acts as the guarantor of the system (EOHCS, 2000).

30. The system has been facing financial strains. Beneficiaries are not required to make co-payments for most services, and reimbursements are provided for specialist care on a fee-for-service basis. These features have created strong demand for services without adequate incentives for rationalization of service delivery and cost containment, resulting in high utilization rates, as reflected in the higher-than-average in-patient admissions per capita and length of hospital stay (Figure 3). Furthermore, the legacy of a planned economy remains, with excess capacity in hospitals and excess supply of number of specialist care providers. Reimbursements to hospitals by the health insurance companies have been insufficient to cover the costs of these services, and the underfunded health insurance companies have mounting deficits, requiring repeated bailouts by the budget.

Figure 3.
Figure 3.

Health Sector Indicators

Citation: IMF Staff Country Reports 2005, 275; 10.5089/9781451810226.002.A003

Sources: National authorities; OECD; and Chawla (2005).

31. Although health care expenditures are moderate, costs are rising rapidly and health care services need significant reconfiguration to prepare for the demands of elderly care. Health care expenditures on a per capita basis is in line with regional and EU standards. But the demand for pharmaceuticals and technology use has been rising rapidly, consistent with rising incomes. Combined with escalating prices, this has resulted in a sharp increase in expenditures. A high number of hospital beds are devoted to acute care rather than long-term care, and with shifting demographics, resources would need to be diverted towards long-term elderly care.

32. Going forward, the already high social security contribution rate puts the onus of the adjustment burden on entitlement reform. The current social contribution rate for pensions, sickness and employment insurance is 34 percent. With employers paying a large share, the tax wedge is relatively large.18 Further increases would not be desirable as they would discourage labor force participation and dampen growth. Reforms thus need to focus on benefits to restore sustainability.

Demographic and labor market trends

33. The demographic shift in the Czech Republic is set to change the fiscal position significantly. The authorities project the population19 to decline, starting around 2020, and the elderly dependency ratio to increase from around 20 percent in 2003 to over 50 percent in 2050 (Figure 4).20 The resulting increased demand on the pension and long-term care benefits combined with a shrinking contribution base will put significant pressure on the budget. In addition, a decline in the labor force and output growth will lower revenues and adversely affect the fiscal balance.

Figure 4.
Figure 4.

Demographic and Labor Market Indicators

The elderly population, which tends to exit from the labor market early, will rise significantly, leading to a decline in the labor force participation rate.

Citation: IMF Staff Country Reports 2005, 275; 10.5089/9781451810226.002.A003

Sources: Czech authorities; and OECD (2005).1/ Population aged 65 and over divided by the working-age population aged 15-64.2/ Population not employed divided by the total population.

34. Current labor market trends pose additional challenges. Labor force participation ratios have been declining, although this is in line with regional trends. Currently, there is a high inactivity rate among the elderly and women (Figure 4), and this tendency will increase the fiscal burden as more people reach retirement age. Increased labor force participation will require a more flexible work environment, including improvements in part-time employment, which is among the lowest in OECD countries.

35. To meet these challenges, a concerted reform effort is needed to mitigate the fiscal burden while encouraging labor force participation. Important steps have already been taken. Incentives to claim sickness benefits have been revised by lowering the benefit amount and increasing burden sharing with employers. A generous early retirement scheme has been eliminated. Reform proposals under discussion consider a combination of an increase in retirement age, changes in pension benefit indexation, and an introduction of a Notionally Defined Contribution System. Other proposals also consider maintaining a minimum flat rate and opt-out provisions to private pensions.

C. Fiscal Sustainability: Long-Run Projections

36. This section assesses the long-run fiscal outlook under current policies and projected demographic trends, and evaluates the possible impact of some reform scenarios. It provides estimates of the fiscal gap as a measure of the adjustment needed to bring debt to a sustainable path, and the cost of delay in reforms.

Model assumptions

37. The analysis is based on a generational accounting model (see appendix for details on model description). This methodology has been frequently used to assess the long-run fiscal sustainability and the generational burden of policies (Cardarelli, Sefton, and Kotlikoff, 2000; Cardarelli and Sartor, 2000; and UK HM Treasury, 2004). The framework uses age and gender profiles that provide the distribution of taxes and transfers across age cohorts, by gender, for a given year. These profiles, used in conjunction with the population data and aggregate taxes and transfers in that year, provide estimates of the average taxes and transfers paid per person. The average per capita taxes and transfers, aside from pensions and health care, are assumed to grow in line with labor productivity. The long-run evolution of the aggregate taxes and transfers is thus projected based on assumptions of productivity growth and population changes (Box 1).

Baseline scenario

38. In the baseline scenario, age-related expenditures are expected to rise considerably while revenues decline. On the revenue side, income taxes and social security contributions, assumed to grow on a per capita basis at the same rate as productivity growth, decline. Since this reflects the shrinking working-age population, the decline as a share of GDP is marginal. Production taxes, such as the value-added and trade taxes, also assumed to grow in line with productivity growth, increase as a share of GDP, since consumption by the elderly population is expected to stay high.

39. On the expenditure side, pensions and health care expenditures are expected to rise by over 7 percent of GDP (Figure 5). These costs are not offset by the savings from education and social benefits. For existing pensions, the real per capita pension growth is based on the assumption of partial indexation to wages. For new pensions, it is assumed that valorization of the assessment base growth is 55 percent, approximating the net replacement rate for new pensions of an average wage earner. The authorities predict that with current policy—indexation of basic pensions to wage and of pension payments to inflation and one-third of wage growth—total pension expenditure will rise by over 5 percent of GDP by 2050. Health expenditures are expected to grow at a rate slightly above (0.25 percent higher) wage growth, reflecting the high income elasticity of demand and rising costs of pharmaceuticals and advanced medical technologies. This assumption is close to the historical growth rate of health care (around 5 percent in 1999-2003, in real terms, deflated the changes in longevity and morbidity rates would affect health care costs, international experience suggests that per capita health care expenditure rises much faster than assumed in the baseline scenario. Noncontributory social benefits, also expected to grow in line with wages on a per capita basis, decline marginally.

Figure 5.
Figure 5.

Long-Run Projections: Revenue and Expenditure, 2002-50

Citation: IMF Staff Country Reports 2005, 275; 10.5089/9781451810226.002.A003

Source: IMF staff estimates.

Long-Run Fiscal Projections: Underlying Data Assumptions

The demographic projections produced by the Charles University faculty are used. These projections, till 2065, are based on medium-term growth assumptions described in footnote 3. Longer run projections over the period 2065-2150 were obtained from the pension reform committee’s website (www.reformaduchodu.cz).

Labor productivity growth in the Czech Republic has been above 4 percent in recent years. However, this will be difficult to sustain as the economy converges closer to EU levels. Labor productivity growth is assumed to decline to 3 percent by 2010, and in the baseline case, stay at 3 percent over the long run.

Labor force participation is assumed to increase marginally and stabilize at 71.6 percent in the long run. Although much depends on labor market policies, given the downward trend, we use conservative assumptions. The labor force is thus assumed to vary in line with working-age population, which, combined with labor force productivity growth, is used to determine GDP growth rate.

A discount rate of 4 percent is assumed. Historically, the average nominal interest rate on public debt has been around 7 percent. We assume a longer run inflation rate of 3 percent. By current standards, this interest rate assumption is on the high side which provides a downward bias to the estimate of fiscal gap.

The relative age and gender profiles for the income tax revenues and social security taxes were constructed from the data on earnings distribution, labor force participation and population data of the Czech Statistical Office, and average income and social security tax rates. The profiles for expenditures and other revenues were obtained from Dybczak (2004). Although there is uncertainty over the age profiles as behavioral responses of the population could change over time, it is assumed for simplicity that the age profiles remain stable. However, the age profiles are adjusted over time to reflect certain policy changes such as an increase in retirement age.

For aggregate taxes and transfers, consolidated general government fiscal data up to 2003, based on a functional classification, were obtained from the Ministry of Finance and the Czech Statistical Office. Since fiscal projections under this classification were not available, aggregate deficit targets based on the Convergence Program targets are used up to 2007, while growth rates for individual categories of fiscal expenditures were based on historical growth rates adjusted for the GDP deflator. Longer-term projections for fiscal aggregates are based on labor productivity growth assumption, as described in the baseline scenario.

40. These trends imply a widening primary deficit and an unsustainable debt position, which are projected to reach around 11 and 400 percent of GDP, respectively, by 2050. As a share of GDP, expenditures in pensions are expected to increase by around 4 percent and health care by around 3 percent (Figures 5 and 6).

Figure 6.
Figure 6.

Long-Run Projections: Primary Balance and Net Debt, 2002-50

Citation: IMF Staff Country Reports 2005, 275; 10.5089/9781451810226.002.A003

Source: IMF staff estimates.

Fiscal gap

41. The fiscal gap provides a quantitative measure to assess fiscal sustainability. Following the literature, two alternative measures of fiscal gap are used. They are based on the following:

  • Intertemporal budget constraint. This indicates the permanent increase in taxes, as a percent of GDP, needed to meet the intertemporal budget constraint. Based on the deficit path projected in the baseline case and the net general government debt level as the initial condition in 2005, the fiscal gap is estimated at 11.6 percent of GDP in net present value terms.

  • Target debt-to-GDP ratio. An alternative measure is the permanent increase in taxes as a percent of GDP needed to reach a targeted debt-to-GDP ratio. Using a target of 60 percent by 2050, the adjustment needed to close the fiscal gap is 6.1 percent of GDP (Figure 6). Since a primary deficit persists beyond 2050, the intertemporal fiscal gap will be larger than this measure. While this measure aims for the target debt at a certain horizon, it does not suggest a particular debt path till the target date. An alternative adjustment path, which maintains a fiscal balance or a small surplus from early in the next decade would also reach the same debt target.

42. These estimates suggest a more unsustainable fiscal position in the Czech Republic than in many other countries with aging societies. The increase in age-related spending is above average compared with many European countries (Figure 7). When measured in terms of tax revenues and expenditures, fiscal gap estimates are also among the highest relative to some advanced economies (table 1).

Figure 7.
Figure 7.

Age-Related Spending for 2008 and 2050

(In percent of GDP)

Citation: IMF Staff Country Reports 2005, 275; 10.5089/9781451810226.002.A003

Sources: UK HM Treasury (2004); and IMF staff estimates.
Table 1.

Intertemporal Fiscal Gap: An International Comparison

article image
Sources: Cardarelli and Sartor (2000); and IMF staff estimates.

43. The magnitude of the gap also indicates that a delay in reforms to restore a sustainable fiscal position would be costly. It is estimated that each year of delay increases the size of adjustment needed to close the intertemporal budget gap by 0.15–0.2 percent of GDP (table 2). If labor productivity growth is assumed to be lower (2.5 percent), the delay in adjustment costs 0.3 percent of GDP every year, which is in line with the authorities’ estimates.

Table 2.

Indicators of the Fiscal Gap

(In percent of GDP)

article image
Source: IMF staff estimates.

Immediate change in taxes needed to meet the intertemporal budget constraint.

Immediate and permanent change in primary deficit needed to maintain a target debt-to-GDP ratio at a target time horizon.

44. Inevitably, there is uncertainty surrounding these projections; nevertheless, a sensitivity analysis points to a sizable fiscal gap. The gap is not closed even under a higher discount rate and adjustment is needed to maintain a debt to GDP ratio of 60 percent in 2020 (table 2). In addition, an increase in the productivity growth rate also does not eliminate the gap, partly because growth in per capita expenditures track labor productivity growth. Below, we simulate the impact of alternative assumptions on per capita revenue and expenditure growth, reflecting alternative reform scenarios and their impact on the fiscal gap.

Alternative reform scenarios

45. Restoring fiscal sustainability will require significant reforms encompassing fiscal adjustment as well as labor market reforms. Possible reforms, including parametric changes to the pension system, are quantified below (Figures 8 to 11):

  • With age-related spending set to escalate, reform needs to focus on increasing labor force participation among the elderly. An increase in the statutory retirement age—by 2 years (to 65), phased in over the next 16 years—is considered, given the increasing longevity trends and the need to reduce the number of pensioners. Under this scenario, pension expenditure will moderate but pick up again from around 2020, reaching almost 11 ½ percent of GDP in 2050. This will also increase the number of contributors to the pension system, which, together with the increase in the income taxes, will reduce the fiscal gap to 9.8 percent of GDP.

  • Another option to ease the age-related fiscal burden is to reduce pension benefits by lowering the rate of valorization. Pension expenditures are assumed to grow at 40 percent of wage growth. This is used as an approximation of an indexation rule that keeps a constant net replacement ratio at 40 percent for new pensions and maintains existing pension benefit growth at 40 percent of wage growth. This has a significant impact on pension expenditure, reducing the intertemporal fiscal gap to 8.8 percent of GDP.

  • Tighter health care spending, where per capita health expenditure is assumed to grow in line with productivity growth (compared with 0.25 percentage point higher than productivity growth in the baseline case), will also have a large impact in improving fiscal sustainability. Health expenditure is lowered by 1 percent of GDP by 2050, leading to an intertemporal fiscal gap of 8.9 percent.

  • A lower growth rate on non-age-related spending—of half the productivity growth rate compared to the baseline case—shows that the fiscal gap is narrowed sizably to 2.3 percent, but is still not closed. Indeed, to close the fiscal gap, real spending per capita growth in this category would need to be lowered to 0.5 percent. Since the average real growth rate, over 1999-2003, has been around 5 percent, this implies an adjustment that would likely be infeasible.

  • On the other hand, a higher growth in labor productivity while maintaining a tighter growth rate for non-age-related spending produces a more favorable result. Increasing labor productivity growth from 3 percent to 3.5 percent, while keeping health care spending growth as in the baseline reduces the gap to 5.6 percent. An increase in productivity growth does not reduce the gap more drastically because an increase in the labor productivity growth also affects the overall expenditures. Indeed, if health care is also assumed to grow in line with productivity growth, at 3.5 percent, the fiscal gap remains high at 8.7 percent. But if growth of non-age-related spending per capita is also lowered to around 3 percent, the intertemporal fiscal gap turns into a surplus. The impact of the non-age-related spending, assumed to grow slower than productivity growth, dominates the age-related spending after 2060, which helps to reduce the level of primary deficit over time and ultimately close the fiscal gap. This underscores the importance of combining fiscal adjustment with labor productivity enhancing measures to restore fiscal sustainability.

Figure 8.
Figure 8.

Alternative Scenarios: Health Care Spending, 2002-50

Citation: IMF Staff Country Reports 2005, 275; 10.5089/9781451810226.002.A003

Figure 9.
Figure 9.

Alternative Scenarios: Pension Expenditure (2002-50)

Citation: IMF Staff Country Reports 2005, 275; 10.5089/9781451810226.002.A003

Source: IMF staff estimates.
Figure 10.
Figure 10.

Alternative Scenarios: Net Debt, 2002-50

(In percent of GDP)

Citation: IMF Staff Country Reports 2005, 275; 10.5089/9781451810226.002.A003

Source: IMF staff estimates.
Figure 11:
Figure 11:

Alternative Scenarios: Primary Balances, 2002-50

(In percent of GDP)

Citation: IMF Staff Country Reports 2005, 275; 10.5089/9781451810226.002.A003

Source: IMF staff estimates.

46. These results also suggest that, although the fiscal outlook will be considerably more benign following the implementation of reform, the fiscal gap will not be eliminated under any one single measure. Parametric changes in the pension system, such as extending the retirement age and lowering the degree of indexation, buys some time but does not address the longer-run sustainability of the system. Indeed, under the model assumptions, fiscal solvency is not achieved even in the absence of demographic pressures. The high level of the primary deficit implies a fiscal gap of 2 percent of GDP, under the constant population scenario. This calls for a fiscal objective of a balance or a small surplus over the medium term. Thus, achieving fiscal sustainability would require an integrated approach that combines reforms in both age-related and non-age-related expenditures, as well as labor market reforms.

Intergenerational equity

47. An important consideration for fiscal reform is the generational burden. This is evaluated using the concept of generational accounts, which defines the discounted average remaining lifetime net taxes paid by an individual (see appendix for a technical discussion). The baseline simulation above shows that the intergenerational balance gap is lower than the intertemporal budget gap (table 3). This implies that the net taxes paid by the future generations is lower than that paid by the current generation. A decomposition of the net taxes shows that this can be largely attributed to the higher growth in the health benefits per beneficiary over the longer run. Indeed, under an alternative scenario with tighter health care spending, the net tax burdens of future and current generations are similar, suggesting that the generational burden is more fairly distributed.

Table 3.

Intertemporal Fiscal Gap and Generational Balance Gap: Alternative Policy Scenarios

article image
Source: IMF staff estimates.

48. Early implementation of reform measures to restore fiscal sustainability is needed to ensure generational fairness. In the alternative reform scenarios, the generational burden is more fairly distributed than in the baseline case, as shown by the more even net taxes paid by the different generations. However, with reforms that substantially reduce the fiscal gap, such as the scenario with a tighter non-age-related spending where the fiscal gap is lowered to 2.3 percent, much of this adjustment burden falls on future generations. Indeed, as the intergenerational balance gap measure indicates, if future generations pay the same lower net taxes as the current generation, the fiscal gap increases to 3.7 percent. Fiscal adjustment thus needs to be implemented early to ensure that a fairer generational balance can be achieved while restoring fiscal sustainability.

D. Concluding Remarks

49. This chapter analyzed the long-run impact of population aging on the general government fiscal balance and illustrated some reform scenarios under alternative policy assumptions. The main conclusions are as follows:

  • Despite the relatively favorable current fiscal position, longer-run fiscal viability is at risk. Debt is expected to increase to over 400 percent of GDP by 2050, and restoring solvency would require taxes to increase by over 10 percent of GDP in net present value terms. Every two-year delay would raise this adjustment cost by 0.3 percent of GDP. Although projections are subject to considerable uncertainty, alternative reform scenarios suggest that, even under more benign assumptions, the fiscal gap would remain considerable.

  • Meeting these challenges would require an immediate focus on reform measures. A broad approach to reform is needed, concentrating on enhancing labor productivity, and restructuring fiscal benefits and other non-age-related spending. A fiscal target aiming for balance or a small surplus over the medium-term would also be needed.

  • Given the size of the fiscal gap, restoring sustainability would place a large burden on future generations. Since current policies favor future generations, reform measures would help to restore generational balance, but delays in implementing reforms risk placing an even larger fiscal burden on future generations. Hence, early implementation of reform is needed for intergenerational fairness.

APPENDIX 1: Note on Generational Accounting Model

Projection methodology

Let Xt denote the aggregate transfer of health care benefits in the base year. This can be expressed as the sum of transfers to different age groups, i, as

Xt=∑1100Xi,t,

where Xi,t is the transfer to the age cohort i at time t. This can be calculated using the relative age profile, Ri,t, which attributes the share of the total transfers to the different age groups.

Xi,t = Ri,tXt

To project forward the age specific transfers, the per capita transfers are calculated:

Ai,t=Xi,tPi,t,

where Ai,t denotes the per capita transfer to an individual of age i at time t, Pi,t is the number of individuals in this age cohort. In other words, the aggregate transfers can also be calculated as

Xt=∑1100Ai,tPi,t.

The projection for each of the transfers would thus depend upon the growth of the per capita transfers, g, and the population growth within each cohort:

Xt+1=∑1100Ai,t+1Pi,t+1Xt+1=∑1100Ai,t(1+g)Pi,t+1.

The growth of the per capita transfers, is typically linked to per capita productivity growth to reflect the indexation to wages. If the transfers are only indexed to inflation, however, per capita growth would equal zero. It is also assumed that the relative profile remains constant:

Ri,t = Ri.

Thus, transfers are projected as

Xt+1=∑1100RiXtPi,t+1Pi,t(1+g).

Under some of the alternative scenarios, such as extension of retirement age, the relative age profile is allowed to vary for specific variables, such as income taxes, social security contributions, and pensions.

Generational accounts

The generational account of an individual measures the present value at time t of the average remaining lifetime net tax payment. This is defined as

Nt,k=∑s=max⁡(t,k)k+100Ts,kPs,kPt,k(1+r)−(s−t).

Here, Ts,k is the projected average net tax payment to the government in the year s by a member of the generation born in the year k, which essentially represents the sum of the per capita transfer (or tax) Ak,s of an individual born in the year k across all the government taxes and transfers at time s. The term Ps,kPt,k is the proportion of members of cohort k alive at time t who will also be alive at time s. The net tax payments are discounted using the real discount factor, r. Thus, the generational account captures the average present value over all net tax and transfer payments as well as probability of survival.

Intertemporal fiscal gap

The intertemporal fiscal gap, based on a dynamic analysis of fiscal policy, is defined as the imbalance in the intertemporal budget constraint. This constraint simply states that in present value terms, the future net tax payments of current and future generations should cover the government’s future purchases of goods and services and the initial net debt. Formally, the intertemporal budget constraint, is expressed as

∑s=0∞Gt+s(1+r)t−s+Dt=∑s=0100Nt,t−sPt,t−s+∑s=1∞Nt,t+sPt,t+s(1+r)t−s,

Where G is the government purchase of goods and services, D, the initial net debt, Nt,k, the generational account in year t of an individual born in year k. The first term on the right hand side thus represents the net tax payments over the remaining lifetime of currently living generation while the second term is the present value of the net tax payments of future, yet unborn, generations. The intertemporal fiscal gap is calculated as the immediate and permanent adjustment in taxes or expenditures needed to ensure that the above constraint holds:

IBG=[∑s=0∞Gt+s(1+r)t−s+Dt−∑s=0100Nt,t−sPt,t−s−∑s=1∞Nt,t+sPt,t+s(1+r)t−s]/GDP.

Intergenerational balance gap

The intergenerational balance gap is a hypothetical calculation of the intertemporal budget gap based on the assumption that net tax payments of the future generation is the same as that of the newborn in the currently living generation, adjusted for growth:

∑s=1∞Nt,t+sPt,t+s(1+r)t−s=∑s=1∞Nt,t(1+g)Pt,t+s(1+r)t−s.GBG=[∑s=0∞Gt+s(1+r)t−s+Dt−∑s=0100Nt,t−sPt,t−s−∑s=1∞Nt,t(1+g)Pt,t+s(1+r)t−s]/GDP

Thus, IBG will be greater than GBG if Nt,t+s is lower than Nt,t(1 + g). In other words, if the current policy is favorable to future generations such that the net taxes owed by a member of the future generation is lower than that of a currently newborn, the intertemporal budget gap will be higher than the intergenerational balance gap. For further details on these concepts, see Cardarelli, Sefton, and Kotlikoff (2000).

References

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  • United Kingdom, HM Treasury, 2004, Long Term Public Finance Report: An Analysis of Fiscal Sustainability (London: HM Treasury).

15

Prepared by Anita Tuladhar. The author would like to thank Roberto Cardarelli, Lawrence Kotlikoff, James Sefton, and Natalia Tamirisa for their kind assistance with the program, and seminar participants at the Czech National Bank and European Department for useful suggestions.

16

As part of the Convergence Program (Ministry of Finance, 2004), fiscal reform measures have been identified and partially implemented. The authorities estimate that if these reform measures are fully implemented, in order to achieve the target debt of 60 percent by 2050, an additional adjustment of 5 percent of GDP will be needed. Under a more pessimistic scenario, if the reforms are not implemented, a 10 percent adjustment will be required.

17

The budget covers for the “state insured” comprising unemployed, pensioners, dependents up to the age of 26, students, women on maternity leave, military, prisoners and people on social welfare. They constitute almost 53 percent of the population.

18

Income tax plus employee and employer contributions in the Czech Republic was 43.8 percent of labor costs in 2003, compared to the OECD average of 36.5 percent.

19

Demographic projections by Charles University, which are used by the Pension Reform Committee, are based on the assumption of life expectancy increasing from 72.8 years to 82 for men and 79.2 years to 86.7 for women, fertility rates increasing from 1.23 births to 1.64, and net migration rate increasing from 22.8 persons (per thousand) to 25.4, between 2005 and 2050.

20

See Chapter II for a more detailed description of aging trends and cross-country comparisons.

Same Series

Other IMF Content

Other Publishers

Cover IMF Staff Country Reports
Czech Republic: Selected Issues
Author: International Monetary Fund
Volume/Issue:
Volume 2005: Issue 275
Publisher:
International Monetary Fund
ISBN:
9781451810226
ISSN:
1934-7685
Pages:
66
DOI:
https://doi.org/10.5089/9781451810226.002

Fiscal Indicators

(In percent of GDP, 2004)

Pension System Indicators

Health Sector Indicators

Demographic and Labor Market Indicators

The elderly population, which tends to exit from the labor market early, will rise significantly, leading to a decline in the labor force participation rate.

Long-Run Projections: Revenue and Expenditure, 2002-50

Long-Run Projections: Primary Balance and Net Debt, 2002-50

Age-Related Spending for 2008 and 2050

(In percent of GDP)

Alternative Scenarios: Health Care Spending, 2002-50

Alternative Scenarios: Pension Expenditure (2002-50)

Alternative Scenarios: Net Debt, 2002-50

(In percent of GDP)

Alternative Scenarios: Primary Balances, 2002-50

(In percent of GDP)