Aging, the World Economy and the Coming Generational Storm

Studies | Economy

No. 273
Friday, February 04, 2005
by Laurence Kotlikoff, Hans Fehr, and Sabine Jokisch


Executive Summary

The United States is about to experience the greatest demographic change in its history. Most of this change will occur over the next 30 years, as 77 million baby boomers cease to work and pay payroll taxes and instead start to retire and collect benefits. Even more dramatic population aging will occur in the European Union and Japan, where the burden of paying state pension and health care benefits for the elderly presents an even greater challenge.

Over the next 30 years, the number of elderly in these regions will more than double. At the same time, the number of workers available to pay the elderly their government-promised benefits will rise by less than 10 percent. In this paper, we use a new dynamic life-cycle computer simulation model to analyze the economic impact of these developments. The results are alarming: The shift to a much older population will severely damage the macro economies of the developed world.

According to our simulations, paying the elderly their promised benefits will require large tax increases, including sharply higher payroll taxes. For example:

  • In order to finance elderly benefits in the United States, the payroll tax will have to climb from 14 percent (the current pure pay-as-you-go rate) to 23 percent over the next 30 years, while the average income tax on wages will rise from 10 to 14 percent.
  • Thus the total tax on wages will rise from 24 percent to 38 percent by 2030 and to 40 percent by mid-century.

Higher taxes mean lower after-tax income for workers. But they also have another, highly damaging effect. Less disposable income means less saving; less saving means less capital formation; less capital formation means lower labor productivity; and lower productivity means lower real wages.

Ordinarily, one would expect an economy that is short of capital to turn to international capital markets. However, because the capital shortage in Europe and Japan will be even more severe than that in the United States, the other two regions will bid capital away from our country. Over the course of this century, the international capital shortage will raise real interest rates by 4.4 percentage points (440 basis points).

The emerging capital shortage will significantly reduce real wages per unit of human capital (labor productivity absent technological change). Specifically:

  • Real wages of U.S. workers will be 10 percent lower than otherwise by 2030 and 15 percent lower by the middle of this century.
  • By 2030, projected tax hikes combined with the decline in pre-tax wages will cause workers’ take-home pay to be about one quarter less than otherwise.
  • By mid-century, the American worker’s after tax income will be almost one-third lower than otherwise.

As bad as these results are, the future for Europe — where fertility rates are much lower and prospective aging much more severe — is substantially worse.

  • In Europe, where the total tax on wages is already above 40 percent, the tax burden will rise to 60 percent by 2030 and approach a staggering 70 percent by mid-century.
  • Combining these tax rates with an 8 percent simulated fall in real wages, the expected reduction in take-home pay of European workers will be one quarter by 2030.
  • By mid-century, the relative fall in after tax wages will exceed 40 percent relative to what it would have been without the growing burden of elderly entitlements.

Like Europe, Japan already has taxes on wages in excess of 40 percent, and its aging society will cause a doubling of the payroll tax over the next 50 years. As in Europe, the results will be devastating:

  • By 2030, the total tax on labor in Japan will approach 60 percent, and Japanese workers will face a one-fourth reduction in their take-home pay.
  • By the middle of this century, the effects of elderly entitlements will push the Japanese tax on labor to 70 percent and the after tax wages of Japanese workers will be more than 40 percent lower than they otherwise would have been.

In making these estimates, we assume that the fall in fertility rates will reverse over time and that women will eventually have enough children to replace the current population — the exact opposite of recent trends. We also assume that the growth of health care costs per beneficiary will match the rate of growth of per capita real wages — even though they have grown many times faster in recent years. As a result of these very conservative modeling assumptions, the results reported here err on the side of optimism. Reality is likely to be far worse.

What can be done to avoid a very unpleasant future? Increased immigration is an often recommended solution, yet our simulations indicate it will offer little help. Although additional workers would increase payroll tax revenues, more immigrants would also mean more spending on education, infrastructure and a host of other public goods. Moreover, immigrants would become entitled to benefits in their own right; and since they are disproportionately low-wage earners, they would receive more benefits per dollar of tax payments than do typical native workers.

Another reform idea is Social Security privatization. Any reform proposal that relies on increased saving instead of pay-as-you-go financing helps ease the future problem. The reform we simulated pays retirees all the benefits they have accrued under the current system. At the same time, it allows workers to deposit their share of payroll taxes (6.2 percent) into private retirement accounts. The transitional costs are financed by a new consumption tax, such as a sales tax or value-added tax.

The consumption tax will lead to an increase in saving and capital formation. The long-run consequences of this reform for the U.S. economy are stunning:

  • Whereas without reform, the relative real wages of U.S. workers will decline by 15 percent by mid-century, the drop is only 4 percent with reform;
  • Whereas the combined tax on U.S. labor income will approach 40 percent without reform, labor taxes with this reform will be less than half as high.

The effects on European economies will be even more dramatic:

  • Instead of a 13 percent drop in relative real wages by 2050, European workers will see a drop of only 2 percent.
  • Whereas without reform, European workers can expect to pay more than two-thirds of the future wages they earn in taxes, with reform they will pay about one-fourth.

Results are similar in Japan, where there will be no decrease in real wages by mid-century and tax reductions will be even greater.

Among younger workers (especially workers yet to be born), the long run benefits of a reformed system are very large and very progressive.

  • In the United States, low-income workers born in 2030 will experience a one-third increase in their standard of living; middle-income workers will enjoy a 22 percent increase; and high-income workers will gain a mere 6 percent.
  • In Europe the gains are even more dramatic: An almost doubling of living standards (90 percent) for the low-income group, a two-thirds increase for those in the middle and a 15 percent gain for those at the top.
  • In Japan, the gains for the three earnings groups are 84 percent, 61 percent and 10 percent, respectively.

Thanks to the consumption tax, older workers and retirees will bear a net cost as a result of this reform. However, these are the very people who have disproportionately gained from the current system. Note also that many consumption tax proposals are combined with measures to give relief to low-income taxpayers and such features could be added to this reform as well.

In summary: The generational storm approaching the shores of the developed world is much more threatening than is commonly believed. Yet, there are policies, albeit painful ones, that can materially improve our long-term prospects.


Read Article as PDF