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


Introduction

The developed world is about to experience an unprecedented demographic change. In virtually all developed countries, people are getting older — a lot older. And everywhere the reason is the same — a dramatic baby boom followed by an equally dramatic baby bust, all accompanied by a remarkable increase in life expectancy. Over the next 30 years, the number of elderly in the United States, Europe and Japan will more than double. At the same time, the number of workers available to pay the elderly’s government-guaranteed pension and health care benefits will rise by less than 10 percent. The fiscal implications of these two demographic trends are alarming. With no change in policy, paying the elderly their promised benefits will require large tax increases, including a doubling of the payroll tax in some cases.

The alternative to such massive tax hikes is, of course, major benefit cuts. And whatever fiscal adjustments are eventually made, the longer they are delayed, the more painful they will be.

“Over the next 30 years the number of elderly people will more than double.”

In this paper, we assume that governments collect the needed taxes to pay all entitlement benefits. We use a new dynamic simulation model to analyze the general equilibrium economic impact on the world’s three major industrialized regions: the United States, Europe and Japan. Our simulation results show that population aging will greatly damage all three regional economies.

An important conclusion of the analysis is that a relative capital shortage will emerge throughout the developed world.1 The reason for this reduction in capital is the crowding out of saving associated with the rise over time in taxes, particularly payroll taxes. Over the course of the century, the capital shortages will lower real wages per unit of human capital (relative to what they would have been) by 17 percent in the United States, 22 percent in the European Union and 19 percent in Japan.2 When this decline in real wages is combined with higher payroll and income tax rates, the reduction in take home pay implies that the standard of living of future workers will be one-third lower than it otherwise would have been in the United States and 40 percent lower in Europe and Japan — due to the growth of elderly entitlement programs.


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