Out of the red and into the grey
The demographics of public finance
Not surprisingly these demographic shifts will have implications for public finance, in terms of pensions, health and long-term care expenditures and other age-related items, as demonstrated in a new report entitled ‘The long-term sustainability of public finance in the EU’ which is published by the Commission’s Economic and Financial Affairs DG. The implications of a greying population will not bite straight away, particularly while the EU labour force continues to grow. However, rising employment rates can only provide a temporary cushion, and eventually the weight of demographic change will prevail (see chart 1). “The budgetary impact of ageing populations is a concern for all EU Member States, although the degree of risk for public finances is different across Member States,” said Elena Flores, head of the public finances unit at DG ECFIN. “Ageing populations will pose major economic, budgetary and social challenges.”
Chart 1: Labour force projections (% change of persons aged 15-64 between 2003 and 2050)
|Source: EPC and European Commission (2006)|
Through a number of sustainability indicators (see box), the report projects the long-term feasibility of current public financing for the EU as a whole, in the euro area and on a country-by-country basis. It also identifies the size of the sustainability gaps. Of course, the projections reflect the underlying assumptions and hypotheses used to construct them. “The results of the indicators are sensitive to the different hypotheses used in the calculations and as such the exact level of the sustainability gap is not known.” In addition, it is important to note that these projections do not take into account the impact of policy measures that might be taken in the future.
At both ends of the age pyramid, there are certain age-related expenses borne by government. The report categorises these expenses into five groups.
- Public pensions: The largest and most obvious expense item in Europe related to ageing is the pensions paid out to people who have retired from the workforce.
- Healthcare: Even if older Europeans are leading healthier lives, they still tend to require more healthcare – such as routine checkups and constant monitoring for age-related diseases – than their younger compatriots. In addition, older people carry more of the disease burden. This will undoubtedly push up public health budgets.
- Long-term care: Although many older Europeans are leading largely independent lives, there are many whose health challenges compel them to require the care of others. This has public finance implications, particularly in northern Europe where long-term care is more institutionalised than in the more family-based model favoured in the south.
- Education: Despite the recent focus on lifelong learning, most state-funded education occurs early in life. Therefore, as the European populations gets older, education budgets are bound to fall.
- Unemployment benefits: Given that the labour force will shrink and employment will rise, the amount spent on unemployment benefit looks likely to fall. However, the drop in education and unemployment expenditure is unlikely to offset the growth in other age-related expenses.
The sustainability indicators also provide information on the extent to which the risks to public finance sustainability can be attributed to the current budgetary position and/or to the long-term impact of ageing. The report divides EU Member States into three groups according to the long-term budgetary impact of ageing. This is mainly due to the characteristics of their pension systems and their reforms. There are nine countries in the most-affected group, including Spain, Belgium and Slovenia. The least-affected group contains eight countries, including Sweden, Italy and Lithuania.
In order to ensure the long-term sustainability of public finances amid an ageing population, a certain balance between public finance revenues and projected public finance expenditures needs to be struck. Sustainability gap indicators can help indicate how much of a permanent budgetary adjustment is required to maintain the sustainability of public finances.
This report uses two sustainability indicators, S1 and S2. S1 indicates the adjustment needed to meet the so-called Maastricht government debt target of 60% of GDP by 2050. S2 indicates that needed to fulfil the inter-temporal budget constraint over an infinite period.
Over the coming decades, the share of age-related public expenditures in GDP (see box) will grow by 3.4% by 2050. This is mainly due to the rise in pensions spending which is set to occur across most of the EU, with the exception of some new Member States, such as Poland. The Union currently ploughs just over 10% of its combined gross domestic product into pensions. By 2050, this will have risen by an additional 2.2%. Healthcare, which currently accounts for 6.4% of GDP will rise by an additional 1.6%. Education is the only major area set to shrink, but by a relatively modest 0.6% by 2050.
Chart 2: Sustainability gap and required primary balance
|Source: Commission services|
In addition to these direct impacts, a number of supplementary complicating factors could inhibit Europe’s ability to age gracefully. One is the large debt burden carried by many European governments. “The level of outstanding government debt is arguably the most important additional factor,” the report notes. This is because countries with high public debt levels are more vulnerable to fluctuations in the economic cycle and interest rates.“
The debt/GDP ratio is projected to remain above 60% of GDP over the coming decades for the EU as a whole and towards 2020, it is projected to start rising considerably, revealing that the public finances are on an unsustainable path,” the report observes. This unsustainable path arises mainly from future pension and health commitments – both related to ageing.
How much the population is currently taxed also plays an important role. “A high current tax ratio leaves limited room [for] manoeuvre for using tax increases to finance additional public expenditure,” the document explains.
An exercise such as this does not, and cannot, actually forecast what will happen in the future – it is not meant to. The value of this report is to project the policy consequences of a particular set of alternatives for the future. The document demonstrates what would happen if public finance continues with a ‘business as usual’ mentality in the face of these changing conditions, and considers how much of an adjustment would have to be made to keep public finances afloat. “Budgetary projections over the long-term are based on a set of assumptions which can potentially have a very large impact on the results,” the report explains. However, such common assumptions are fully part of any long-term projections exercise. “In a multilateral context, having a common setting for the projections for the purposes of analysing and assessing the long-term sustainability of public finances is therefore essential to ensure comparability of results and equal treatment.”
The report divides EU Member States into three risk groups, according to the sustainability of their public financing in the face of these expected demographic shifts. The high-risk group contains six countries; ten countries are judged medium-risk, and nine low-risk. The document then goes on to analyse the situation in each country and draw policy conclusions for it.
Chart 3: Gross debt in the EU on current projections
|Source: Commission services|
For the EU as a whole the report conforms to a three-pronged strategy. Firstly Member States need to quickly achieve sound budgetary positions as defined by the Stability and Growth Pact – this alone would halve the EU-wide sustainability gap by 2010. Secondly, employment rates must be raised, particularly among women and older workers – thus raising total pension contributions and the level of pensions. Third, individual Member States must consider the appropriate reforms of pension and welfare systems they need to ensure they are viable while remaining adequate and accessible.
In order to meet these public finance challenges, many national governments will need to undertake difficult structural reforms or continue their ongoing reform efforts. “EU Member States need to put in place the appropriate combination of reforms and ambitious fiscal policy,” concluded Flores.