Japan’s Prime Minister Shinzo Abe opted to raise the sales tax in order to shore up government finances in addition to taking steps to increase immigration in light of the country’s shrinking tax base.
For the past decade, Japan’s population has been declining. This decline has been driven by decades of extremely low fertility rates and a recent uptick in the number of deaths among the oldest population in the world.
Japan’s young (under 15 years of age) and working-age (15-64 years old) population growth rates have turned negative. With a declining workforce, and a 65-and-over population that is growing at an average rate of 2.5 percent per year, the pressure on government finances – due to rising entitlement spending coupled with a shrinking number of taxpayers – has prompted authorities to enact a number of programs to make having children more appealing for young adults.
An aging population and the decline in Japan’s workforce have had serious consequences for economic growth and government finances. The rapid aging of Japan’s population has raised the cost of medical care services; resulted in a serious shortage of a young workforce; and led to a decline in demand as evidenced by houses that become and stay vacant, and in the growing number of municipalities that face “local extinction.”
But Japan is not alone. Many of the world’s most advanced economies will soon face a similar fate.
According to data from the World Bank’s World Development Indicators, the world’s population is aging fast. Population aging raises the number of elderly people relative to the number of working-age people, when we hold the age boundary constant at some level such as age 65. In this sense, population aging occurs partly because individuals live longer, and partly because birth rates are lower, so that younger generations are smaller than older generations.
Since the late 1980’s the world’s older population (mostly retired individuals, 65 years old and over) has grown at a faster rate than the world’s potential workforce. During the past decade, the world’s working-age population has grown at an average yearly rate of 1.1 percent. The population entering retirement age has grown at nearly three times that rate during that same period. See figures 1, 2, and 3
Lower growth of the population’s youngest cohorts means that the median age is increasing and that the world is aging fast. This structural change in the age of the population has been even more pronounced for some of the world’s most advanced economies, notably the U.S., Canada and the Euro-area.
An aging population has serious implications for economic growth since economic growth crucially depends on the quantity and quality of workers. As people age and leave the labor force, economic growth is expected to slow.
How demographic factors affect economic growth and tax revenues
Income and spending patterns change over the lifecycle and the impact of these changes on economic growth and tax revenue can be substantial. Earnings increase during a worker’s career and then fall in old age. Similarly, consumer spending tends to increase as people move from early life to middle age, and then spending declines after retirement. The effects of these changes in income and spending have significant implications for economic growth and tax revenue since most governments rely heavily on income and sales taxes.
The experts agree: recent demographic trends explain much of the decline in economic growth and in the labor share of income. A decrease in population growth leads to fewer new investments, and fewer new firms being created such that large firms now account for a greater share of economic activity. This concentration of employment in large firms can explain the decline in the labor share of income.
A number of economists argued that expected structural economic changes – including adverse demographic developments – have led to a persistent decrease in the propensity to invest coupled with the oversupply of savings. In this context, excess savings act as a drag on growth and inflation resulting in economic stagnation and lower real interest rates.
Traditionally societies invest to provide new equipment for young workers and to provide new housing for young families. Unfortunately as the number of new workers and new families falls, the demand for new business capital and housing capital also falls. Despite falling investment demand, middle-aged workers tend to increase their savings due to longer life expectancy. Declining fertility rates combined with longer life expectancy work together to depress investment while pushing up savings. The result has been lower economic growth and declining real interest rates.
The demographic shift may have already caused a decline in real GDP growth and in the equilibrium real rate by 1 to 1.5 percentage points.
Lower economic growth is associated with lower tax revenues and more severely underfunded pension systems
Economic growth is a major driver of the level of tax revenues. If the economy is growing slower, tax revenues will also increase a slower pace. This means that the likelihood of a budget deficit increases and that pension systems funding ratios could also decrease. This is because a shrinking workforce, combined with a growing old-age dependency ratio, is expected to negatively affect tax revenues while raising public healthcare and pension costs. Lower growth coupled with prolonged periods of low interest rates have contributed to disappointing returns for pension funds.
It is a spending problem, not a revenue problem
Demographic trends suggest that the global economy and that tax revenues are not likely to grow very fast in the future. However, in the United States, even the most robust growth in historical terms is not sufficient to keep up with the growth in entitlement spending.
In the United States, social security, Medicare and institutional Medicaid and for the time being, “Obamacare” already make up more than 70 percent of the federal budget according to the Congressional Budget Office. As more individuals leave the workforce and life expectancy continues to increase, entitlement spending is expected to grow even faster.
According to Harvard University economist Jeffrey Miron, the U.S. fiscal imbalance – the excess of what we expect to spend, including repayment of our debt, over what government expects to receive in revenue – stood at $117.9 trillion as of 2014, with few signs of future improvement even if GDP growth accelerates or tax revenues increase relative to historic norms. Thus the only viable way to restore fiscal balance is to scale back mandatory spending policies, particularly on large health care programs such as Medicare, Medicaid and the Affordable Care Act (ACA).
Unfortunately, political expediency means that taxes have been raised instead of reforming unsustainable entitlement programs (state and local governments also face future crises, though this is mostly because of underfunded public employee pensions).
But, higher tax burdens will not fix the problem. In fact, higher tax burdens relative to historic norms will exacerbate the problem.
Unfortunately, politicians prefer tax hikes to spending reform. Raising taxes seem like a simple (a bit naïve) solution since tax rate changes have important consequences for economic growth.
While demographic forces have contributed to a decline in investment resulting in lower economic growth, a large body of empirical research suggests that tax hikes have also deterred investment and resulted in large declines in output. That means that any increase in the tax burden would only exacerbate the problem.
Individuals adjust their investment and consumption patterns in response to changes in the tax burden. An increase in the tax burden is likely to cause individuals and businesses alike to alter their financial portfolios, to alter their charitable donations and investment decisions, to reduce their labor supply or simply to leave a tax jurisdiction altogether to avoid increased tax burdens. Those who are most likely to alter their behavior in response to higher taxes are high-income individuals. That means that populist appeals to “tax the rich” would ultimately end up even more devastating for economic growth.
The high responsiveness of investment to changes in the tax burden indicate that new taxes could not provide a long-term solution to the coming fiscal challenges since economic growth would be even more sluggish, and returns on retirement savings would remain low.
The real solutions remain entitlement reform and binding spending rules
Given the reality that economic growth is likely to remain low relative to historic norms, there are only two serious ways to deal with the coming fiscal crisis: 1) to reform entitlements and 2) to enact rigid fiscal rules such as a spending cap.
While some countries are preparing for the coming population bust, others are refusing to enact the necessary reforms to deal with the coming crisis. More and more countries have introduced automatic adjustment mechanisms to rebalance pension systems in line with recent demographic and economic developments. A large part of the solution is to freeze the level of future benefits and to re-align them with what current and future taxpayers can afford. There is also a growing move by many governments to promote and even at times, subsidize private retirement savings.
But, none of these changes will be enough without spending restraints.
The fear of a looming debt crisis has a negative effect on investment depressing economic growth further, leaving retirees with less than adequate retirement income. Policies that stimulate economic growth must be part of the solution.
Using data from 29 countries, research by the International Monetary Fund (IMF) reveals that fiscal rules have led to stricter prioritization and greater efficiency in spending. When expenditure rules are written into law and not just a mere political commitment that can easily be broken, they are associated with spending control and improved fiscal discipline.
The benefits of strict expenditure rules are two-fold: 1) they reduce the volatility of expenditure, thus imparting a degree of predictability to fiscal policy and making it less destabilizing and 2) expenditure rules are associated with higher public investment efficiency.
While recent demographic forces have acted to depress the propensity to invest, higher public sector efficiency would free up resources for more high quality public investments that raise aggregate demand and raise labor productivity.
A spending cap would raise public sector efficiency, an essential part of the solution to offset the negative effect that recent demographic trends are having on economic growth and living standards.
Orphe Pierre Divounguy is the Chief Economist at the Illinois Policy Institute, a libertarian think-tank based in Chicago, Illinois. He is also the founder of the Quantitative Policy Group based in England.