Policy solutions for demographic change, growing government liabilities and slowing economic growth

Graphic illustrating the idea of people making up various demographics by showing a pie graph made up of many people standing in pie wedge shapes

The summer of 2018 began with disagreement among EU leaders. At the top of the agenda: should EU countries take in more migrants?

The debate over immigration policy seems to have reached a boiling point throughout the United States and many European nations. Building “the wall” to restore control over immigration and protect American jobs and wages has been Donald Trump’s rallying cry since his successful presidential campaign began.

Meanwhile, in Europe, debates over immigration have reached a fever pitch. In 2016 voters in the United Kingdom voted in favor of the Brexit movement, while Marine Le Pen gained support in France, and the Alternative for Germany (AfD) party made its parliamentary debut garnering 13.3 percent of the vote and securing 94 seats. Most recently, Italy announced it would be closing ports to migrant rescue boats this summer.

This wave of anti-immigrant sentiment coincides with a period of declining birth rates in the West. As the population ages and women are bearing fewer and fewer children, many economies are finding themselves short on a key economic resource: people. A slowdown in the growth of the working age population in developed economies can partly explain why economic growth has been slowing. Immigration can help to mitigate our people problem.
A comparison of the current economic expansion (2010-2017) with the 1992-2000 period reveals that economic growth – measured by growth in real gross domestic product (RGDP)- slowed in the United States, Canada, Japan, the United Kingdom and the euro area’s most populous countries – France, Italy, Spain – but not in Germany where growth increased. A slowdown in economic growth has many important implications for living standards and government finances. See figure 1

Figure 1, graph showing average annual growth rate of RGDP
Figure 1

Why long-run economic growth matters

Most developed economies are facing similar demographic challenges: their populations are aging, and in the near future, many countries will be facing population decline as a result of a deficit of births in comparison to deaths.

Demographic change will have important implications for government finances. As populations age, the number of workers per retiree falls, economic growth stagnates and tax revenues fail to keep up with the projected cost of human services, social security, Medicare, pension obligation not to mention large budget deficits.

Given that government outlays are growing in real terms, the higher the growth rate of RGDP, the lower will be the average tax rate on households and businesses that yields the revenue required to finance promised spending. Lower tax rates increase the incentives for market activity, resulting in even higher long-run economic growth. On the other hand, sluggish economic growth means that taxpayers will face higher taxes to cover the growing liabilities.

Only Germany, Italy and the UK experienced increases in the growth rate of the working-age population compared to 20 years ago.

Why economic growth is slowing everywhere but Germany

Analyzing long-run economic growth requires deconstructing the growth in real gross domestic product (RGDP) into its primary contributions: labor inputs and labor productivity. Growth in RGDP can be broken down into growth in labor productivity, measured as growth in GDP per hour worked, and changes in the extent of labor utilization, measured as changes in hours worked per capita.

Following Kliesen (2012)1 in decomposing growth in real gross domestic product (RGDP) during the last three global economic expansions, the following identity links labor inputs with productivity to produce real GDP:

Formula for calculating real GDP

Where Population refers to the working age population (ages 15+).

The data reveals a slowdown in labor productivity growth in every country in our sample. In Italy, productivity growth even turned negative for most of the post Great recession era.

Labor productivity growth has led to gains in compensation for workers and greater profits for firms. High labor productivity growth can reflect greater use of capital, and/or a decrease in the employment of less skilled workers, or general efficiency gains and innovation. Even when labor productivity declines, the growth rate of the economy can increase so long as growth in total hours worked offsets the decline in productivity.

Germany is the only country in our sample to see in an increase in the pace of economic growth despite falling labor productivity growth.

Germany experienced a 8-fold increase in the growth rate of her working-age population and civilian employment growth more than offset the substantial decrease in labor productivity growth.

During the 1990s and into the 2000s, Germany’s economic outlook was bleak, sporting a double-digit unemployment rate. However, Germany’s economy relative to her peers has been improving since 1995 when union coverage began to decline, perhaps in part due to a more relaxed wage setting structure that allowed employers to deviate from union contracts. The nation began to turn around even further in 2003 when the nation enacted labor market and welfare reforms which included reducing and capping unemployment benefits.2

Germany has run a budget surplus each of the last four years and has experienced continued success while taking in over 1 million refugees since 2015.

Why is labor productivity growth declining?

Now that we’ve looked at some specific details for various nations, let’s zoom out and look at the big picture.

A decline in productivity growth for the countries in our sample indicates that: either 1) the capital stock is not increasing fast enough to accommodate new workers, 2) there have been no substantial recent improvements in technology or, 3) labor quality has declined because new workers (the young) are less productive than old workers (those entering retirement).

New businesses require less investment than in the past

Economists refer to a situation where the capital per worker is increasing as “capital deepening.” Capital deepening means that more equipment, machines and tools are available to workers, thus making them more productive. A decline in labor productivity can partly be explained by a falling capital per worker ratio.

Economist Robert J. Gordon3 of Northwestern University highlights that despite a tidal wave of new internet services, new inventions pale in comparison to old ones. Professor Gordon points out that since 1750, most of U.S. economic growth was caused by three industrial revolutions. The first featured the creation of steam engines and railroads. The second featured electricity that led to air conditioning, home appliances, running water, indoor plumbing and the interstate highway system. The most recent one was the computer and the internet revolution. Since this latest revolution, innovations in the past 15 years have been smaller and smarter devices that require little investment and thus causing little growth in capital per worker.

Rising monopoly power hinders growth

Business dynamism and competition raises economic growth. Higher monopoly power, and thus higher pure profits tend to decrease GDP through a lower capital stock and labor supply.

The rise in monopoly power is well documented (Karabarbounis and Neiman4, 2014, Elsby, Hobijn and Sahin, 20135, Dorn et al, 20176 , Grullon, Larkin and Michaely, 20177).

Eggertsson, Robbins and Wold (2018)8 show that imperfect competition, barriers to entry that are consistent with a rise in firm market power can explain 1) increasing financial wealth-to-output despite a stagnant capital-to-output ratio, 2) an increase in the market value of corporations relative to the replacement cost of their capital, 3) the decrease in the labor share and capital share and 4) a decline in the investment-to-output ratio, despite historically low borrowing costs. This decline in investment is consistent with the slowdown in labor productivity growth.

Demographic change contributes to lower investment

The reason societies invest is in significant part to provide capital for new workers and to provide housing for new families. If the growth rate of new workers and new families slows or even declines, one should expect the share of gross domestic product (GDP) dedicated to investment to decline. A decline in investment makes capital scarce.

A slowdown in the accumulation of productive capital will cause output per worker – a measure of labor productivity – to decline, thus having a negative impact on economic growth and on living standards.

Demographic change reduced labor quality

Human capital increases labor quality, thus raising labor productivity. Workers accumulate human capital over their lifecycle. The accumulation of human capital comes from schooling, and experience.

Vandenbroucke (2017)9 shows that baby boomers retirement has played a role in the productivity slowdown. As the share of younger less experienced workers is expected to increase, labor productivity growth is expected to slowdown.

How to boost growth: The role of government policy

The sobering analysis in the previous section underscores the need for government policies that reward productive behaviors such as work, saving, investment, and entrepreneurship. Fortunately, there are some answers.

Tax policy

Incentives matter. Much of the persistent productivity differences across economies can be explained by differences in fiscal policies (see Prescott, 2002, 2004, Ragan, 2006) and labor policies that affect work incentives. That means that countries can raise productivity by removing barriers that hold back R&D and market activity and by improving the design of their tax system. Policy can help by pushing out the production frontier.

Using data from the United States, Canada, Australia, Belgium, Finland, Germany, Norway and the United Kingdom, Cassou and Lansing (1999)10 show that declining stocks of public infrastructure capital alone are not enough to explain a slowdown in productivity that began after 1973. Rising average tax rates also played a large role in explaining the productivity slowdown.

Using industry-level data from a set of OECD countries, Vartia, L. (2008)11 examines how industries are affected differently by taxation. Investment responds negatively to an increase in the corporate tax rate and a decrease in capital depreciation allowances. The paper finds evidence that corporate and top personal income taxes have a negative effect on productivity. In contrast, tax incentives for research and development (R&D) are found to have a positive effect on productivity. These effects are stronger in those industries that are more R&D intensive.

Misallocation of resources can arise when government policies favor one type of market activity over others. Examples include tax incentives that depend on firm size or type of investment, tariffs applied to particular goods and market regulations that limit market access. Preferential tax treatment and tax disparities across market activities steer economic agents towards tax-favored assets. Tax incentives for large businesses give them an unfair advantage that leads to rising market power.

Immigration policy

Bove and Elia (2017)12 found that mass migration that increases diversity boosts economic growth. Their empirical findings suggest that cultural heterogeneity, measured by either fractionalization or polarization, has a discernible positive impact on the growth rate of GDP over long time periods. For, example, from 1960 to 2010, when the growth rate of fractionalization increased by 10 percentage points, the growth rate of per capita GDP increased by about 2.1 percentage points. (This is the average effect across all countries in the world).

Diversity leads to specialization. A number of studies have found that immigration increases the level of specialization in the economy and hence productivity (Barone and Moretti, 201113, Foged and Peri, 201614). Jaumotte et al. (2016)15 find that a 1 percent increase in the migrant share of the adult population results in an increase in GDP per capita and productivity of approximately 2 percent. Using evidence from the United States, Peri (2012)16 finds that a 1 percent increase in immigration raised total factor productivity by 0.5 percent.

Immigration can also boost labor quality. Migrants tend to be younger, more skilled and more likely to be in the labor force than non-migrants. A decline in the migrant share of the population can also have contributed to declining labor quality in the U.S. (Gordon, 2018).17 From 1990 to 2000, the college-educated immigrant population increased by 89 percent and a further 78 percent between 2000 and 2014 compared to only 32 percent and 39 percent respectively for the native-born population.18 College-educated immigrants are also more likely to have advanced degrees than their U.S.-born counterparts.

U.S. university departments that have more foreign graduate students produce more academic publications and have their work cited more frequently (Stuen, Maskus, and Mobarak 2010).19 Once they graduate, U.S.-educated foreign workers patent at a significantly higher rate than U.S.-born workers (Hunt 2009).20 U.S. cities that attract these workers produce larger numbers of patents in electronics, machinery, pharmaceuticals, industrial chemicals, and other technology-intensive products (Kerr and Lincoln 2010).21 Simply put, high-skilled immigration promotes innovation and improves labor quality (Hanson, 2012).22

While U.S. universities still attract the best and brightest, many highly skilled immigrants are working in low skilled jobs or return to their country of origin because of visa limitations.

Immigration restrictions and non-recognition of foreign academic and professional credentials limit access to the labor market leading to a brain waste.23 Transitional temporary-to-permanent visas that allow employers and workers to “test the waters” would reduce the underutilization of highly skilled foreign-born workers.

Even low skilled immigration is good for the economy. When immigrants complement natives and they accept lower paying jobs that means lower business costs that make small businesses more sustainable and viable.

An increase in surviving establishments leads to higher market competition, higher wages for workers and lower prices for consumer households (Ottaviano and Peri 200824; Ottaviano and Peri 201025; Cortes 200826). Empirical evidence further suggests that immigration does not negatively affect employment or wages for natives; further eroding the narrative that immigrants pose a threat to the employment and wages of the native born population.27

Concluding remarks

Immigration can raise the growth rate of RGDP by doing two things: 1) immigration can boost the growth rate of employment by increasing the size of the labor force and by reducing labor costs, and 2) immigration can boost labor productivity growth by improving labor quality.

In light of the empirical evidence on the effects of immigration, it seems that the economic concerns over immigration that has swept throughout the West may be unjustified.


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