Global Aging Pressures: Impact of Fiscal Adjustment, Policy Cooperation, and Structural Reforms

Transcription

1 Global Aging Preure: Impac of Fical Adjumen, Policy Cooperaion, and Srucural Reform Denni Boman and Manmohan S. Kumar March 2007 Abrac Thi paper underake a rigorou analyi of he effec of policie ha may be underaken o repond o he looming demographic preure in Europe and elewhere. We examine he effec of fical adjumen by ielf, and when purued in combinaion wih ax, labor and produc marke reform, uing he IMF Global Fical Model (GFM). The model i calibraed o he German economy, a well a o he euro area, and he Unied Sae and ued o imulae he growh effec of alernaive fical adjumen raegie o mainain deb uainabiliy, paricularly in he face of global aging preure. We alo explore he inernaional pill-over effec of demographic preure and aociaed fical adjumen, and he benefi of cooperaive acion. In addiion, we examine he exen o which rucural reform (including ax reform) o boo produciviy growh, labor paricipaion, and produc marke compeiion could ameliorae he advere hor-erm effec of adjumen. The reul ugge (i) ubanial pill-over effec of aging on deb uainabiliy hrough inernaional financial channel; (ii) he preferred adjumen package i broad-baed relying on boh revenue and expendiure meaure; and (iii) here are ubanial benefi from fical cooperaion. Nonehele, even a cooperaive repone ha iniial conracionary effec, and we how ha hee effec can be offe by combining fical adjumen wih expediiou implemenaion of rucural reform in produc and labor marke, a enviaged in he Libon Agenda. JEL Claificaion Number: E62, F4, F42, H30, H55, H62 Keyword: Global aging, fical adjumen, fical cooperaion, Libon Agenda, IMF Global Fical Model Auhor Addre: dboman@imf.org, mkumar@imf.org We are graeful o Terea Ter-Minaian for helpful commen and uggeion. The view expreed in he paper are hoe of he auhor and do no necearily repreen hoe of he IMF or IMF policy.

2 2 I. INTRODUCTION To addre global aging preure, hi paper underake a rigorou analyi of he macroeconomic effec of fical adjumen in Europe purued in combinaion wih ax, labor and produc marke reform uing he IMF Global Fical Model (GFM). We calibrae he model o a large open European economy (Germany), a well o he re of he euro area, Unied Sae, and he re of he world. GFM i a muli-counry dynamic general equilibrium model pecifically deigned o explore fical policy iue, wih rong microfoundaion, a wide menu of axe, and a ylized financial ecor block. A key feaure of he model i ha Ricardian equivalence doe no hold owing o overlapping generaion in he piri of Blanchard-Weil, limied acce of ome conumer o financial marke, and diorionary axaion. Wihin hi framework, he paper explore he following four iue: Fir, European counrie are facing ubanial medium- and long-erm fical preure from populaion aging. Even wih he imporan penion reform and recen improvemen in rucural defici ha have been underaken in a number of counrie, mainaining deb uainabiliy will require ubanial fical adjumen (including furher enilemen reform) and we ae he relaive pro and con of prefunding fuure healh and penion pending. Such fical adjumen could be implemened in a variey of way and we quanify he effec of alernaive revenue and/or expendiure baed conolidaion on oupu, invemen, and employmen. A econd iue recognize ha fical preure from aging are no limied o any one counry or region, bu inead will be occurring in many advanced and emerging marke counrie a broadly he ame ime, albei wih differen magniude and aring fical poiion. We explore wha hi implie for he efficacy of fical adjumen, aking ino accoun he effec on inernaional capial flow. Imporanly, we addre he role policy cooperaion can play in hi environmen. Third, a fical conolidaion are generally conracionary in he hor erm, a key queion arie, from boh an economic and a poliical economy perpecive, a o wheher complimenary policie exi o reduce he advere effec and herefore help he poliical feaibiliy of reform. One area of complimenary meaure, cenral in he renewed Libon Sraegy, i rucural reform, in paricular increaing labor paricipaion (parly hrough ax reform, in paricular moving from direc o indirec axaion), produc marke liberalizaion, and enhancing incenive for innovaion and produciviy growh. We ae o wha exen hee policie can help ameliorae he near-erm conracionary effec of fical conolidaion, for boh oupu and conumpion. Fourh, we analyze he eniiviy of our reul o he behavioral aumpion underlying he repone of firm and conumer o change in fical policy and rucural reform. Specifically, in he non-ricardian eing of GFM, we explore he

3 3 effec of change in hree of he fundamenal deerminan of he effec of fical policy: (i) he planning horizon of conumer; (ii) he fracion of liquidiy-conrained conumer, and (iii) he elaiciy of labor upply. Furhermore, a GFM i rooed in conumer and producer opimizaion, we examine he exen o which he ineremporal elaiciy of ubiuion deermine he impac of fical policy and rucural reform. The re of he paper i organized a follow: Secion II noe he medium and longer-erm fical preure facing he European economie, paricularly reuling from he projeced demographic challenge, and he magniude of hee challenge elewhere; ecion III dicue key feaure of he IMF Global Fical Model, in paricular he exenion of he New Open Economy Macroeconomic framework o incorporae ufficien non-ricardian feaure o allow for an analyi of he effec of fical policy; an annex provide echnical deail of he pecificaion of houehold, firm, governmen and exernal ecor; Secion IV calibrae he model for a large open European economy like Germany, a well a he re of he euro area, and he Unied Sae; Secion V provide an analyi of he impac of a range of ax and expendiure meaure, boh individually and a par of comprehenive raegy in Germany for aaining deb uainabiliy, while he following ecion examine he implicaion of cooperaive fical conolidaion in parner counrie facing imilar aging preure. Secion VII examine he effec of implemening he Libon agenda, and a la ecion provide ummary and concluion. II. DEMOGRAPHIC TRENDS AND FISCAL PRESSURES The budgeary challenge facing he EU counrie ariing from he demographic rend have been analyzed exenively by he European Commiion, counry auhoriie, a well a a wide range of oberver (ee EC 2006a, EC 2006b; Hauner e al 2007). The aemen of he budgeary challenge i baed on he projecion by Euroa ha indicae on average a doubling of he old-age dependency raio (populaion older han 65 relaive o working-age populaion) from 2005 o 2050 in he EU25 counrie. Over hi period, he modal agecohor move from mid-30 o lae 50. Thee change are projeced o exer ignifican upward preure on age-relaed expendiure, primarily relaing o penion and healh care, by he public ecor: for he EU25 a a whole, he average increae (weighed) in age relaed expendiure i projeced a 3.4 percen of GDP; for he EU5, i i 3.7 percen of GDP and for he new EU member ae (EU0) i i 0.2 percen of GDP. However, among he EU0, Poland ha implemened a major penion reform ha implie a marked decline in i penion expendiure amouning o 5.9 percen of GDP. Excluding Poland, he average age relaed expendiure for EU0 are likely o increae by 4½ percen of GDP (ee EC 2006b). If one conider eparaely he age relaed expendiure emanaing from penion, and from healh and long-erm care, he following picure emerge: penion expendiure are projeced o increae by 2.3 percen of GDP on average in EU5 and by 0.3 percen of GDP in EU0 (excluding Poland he increae amoun o 4.8 percen of GDP). Healh and long-erm care

4 4 pending i enviaged o increae by 2.3 percen of GDP in EU5 and by ½ percen of GDP in EU0. The bae line cenario aume ha he increae in life-expecancy will lead o ome poponemen of he need for addiional care. The healh care projecion, omewha conervaively, aume an elaiciy of demand higher han uniy (.) in he hor-erm, bu hi i expeced o gradually decline o uniy over he projecion period. There i a coniderable degree of uncerainy relaing o hee projecion, no lea ariing from he impac of echnology and he evoluion of healh care co, a well a demographic. Moreover, he impac of aging on he poenial growh of he economy which would have an imporan bearing on uainabiliy i alo ubjec o wide confidence inerval. Thee uncerainie are amply illuraed for each of he Euro area counrie, and Germany i no excepion. In he cae of Germany, according o EU eimae, he projeced increae in age relaed pending i omewha below he EU average, riing by abou 2 ¾ percen of GDP beween 2004 and Thi i due o an increae in penion expendiure of around.7 which reflec he far-reaching reform ha have been enaced (including Agenda 200 and Harz reform). The increae in healh-care expendiure i projeced o be.2 percen of GDP, lower han he EU average (ee EC 2006b). Nonehele, even hee low eimae, given Germany curren budgeary poiion lead o a uainabiliy gap of 3½ percen o 4 percen of GDP. However, a he dicuion in Secion IV below indicae, here are oher eimae of aging co for Germany ha are ubanially higher. The projeced increae in age relaed pending and he uainabiliy gap in oher major counrie and region are alo riking: in he cae of he Unied Sae, in paricular, he increae in age-relaed pending over i projeced a 5.9 percen of GDP. Given he rucural primary balance of around -.8 percen (2005), he U.S. face a uainabiliy gap of around 7 percen of GDP (OECD, 200; and Hauner, Leigh, and Skaarup, 2007). 2 There are marked aging relaed budgeary preure alo in Japan, where he iniial condiion, boh in erm of he large primary defici and high deb level, alo warran ubanial adjumen (Hauner and oher, op. ci., and Boman, Edion, and N Diaye, 2007). 3 I i worh noing ha he aging iue i of coure no limied o indurial counrie: here are marked preure in many major emerging marke alo. Among he large nine emerging marke, 4 while he populaion in ome i projeced o grow ubanially over he nex four o 2 The eimaed adjumen need i very eniive o he aumpion regarding he inere rae-growh differenial. In he cae of he Unied Sae, a percen inere rae/growh differenial ugge a primary gap of around 7.2 percen, wih he age relaed pending accouning for he bulk of ha. 3 A percen inere rae/growh differenial ugge a primary gap of around 5½ percen, wih aging co accouning for around a hird of hi, and he re due o he high primary defici and deb. 4 Thee include Argenina, Brazil, China, India, Indoneia, Korea, Mexico, Ruia, and Turkey.

5 5 five decade, he 65+ par of he populaion i projeced o increae ignificanly in all counrie (beween 50 and 400 percen), and he old-age dependency raio i expeced o, on average, riple by 2050 (ee Kumar and Skaarup, 2007). (Korea face he eepe increae (almo a five-fold increae, albei from a favorable aring period wih a izable rucural urplu), bu here are alo ignifican preure in China and Ruia). The projeced increae of he old-age dependency raio in hee counrie i alo markedly higher han in he G7 counrie, a are he projeced age-relaed expendiure (Kumar and Skaarup op. ci). III. KEY FEATURES OF THE IMF S GLOBAL FISCAL MODEL The IMF' Global Fical Model (GFM) exend he NOEM framework o incorporae ufficien non-ricardianne o allow for an analyi of he effec of fical policy and of inerdependence. 5 The radiional New Open Economy Model (NOEM) do no depar from he Ricardian equivalence hypohei enough o allow deailed conideraion of fical policy iue. 6 Inead, ince hee model feaure a repreenaive agen framework wih lump-um axaion, he analyi i rericed o he effec of balanced budge fical policie. If he Ricardian equivalence hypohei hold fully, many of he crucial fical policy queion poed in hi paper and in he real world would be virually irrelevan. Generally peaking, complee Ricardian equivalence, on which here i can empirical evidence, will hold in cae conumer are homogenou and have an infinie planning horizon, if axaion i lump um, if acce o financial marke by all agen i complee, and if governmen deb i rikle. In uch a eing, emporary change in policy ha increae governmen deb will affec he compoiion of naional aving, bu no i level. Any increae in he governmen defici will be mached by higher privae aving a agen anicipae higher fuure ax conribuion, wih no effec on inere rae, conumpion, invemen incenive, or oupu. There are hree key reaon why full Ricardian equivalence doe no hold in GFM. Fir, he model feaure overlapping generaion in he piri of Blanchard-Weil. The ue of overlapping generaion allow he aumpion of Ricardian equivalence o be relaxed, implying ha governmen deb i perceived a ne wealh. Eenially, conumer have a hor, and more realiic, planning horizon, which implie ha even emporary change in fical policy affec heir incenive o conume and work a hey dicoun any fuure fical policy reacion. Second, GFM incorporae he aumpion ha ome conumer do no have 5 GFM i decribed in more deail in Boman and oher (2006). 6 See Obfeld and Rogoff (995, 996), Be and Devereux (200), Caelli (200), Corei and Peeni (200) and Ganelli (2003a). In a recen paper, Erceg, Guerrieri, and Gu (2005) add rule-of-humb conumer o a model baed on he repreenaive agen paradigm and hen ue he model o udy he effec of recen U.S. fical defici on he curren accoun defici. No urpriingly, hey find much maller effec han in model ha allow for he poibiliy ha permanen increae in governmen deb can have permanen conequence for he ock of ne foreign liabiliie and he world real inere rae.

6 6 ufficien acce o financial marke o mooh heir conumpion over ime. Thi i conien wih evidence ha even in he advanced economie up o a hird of he conumer are liquidiy conrained. Liquidiy-conrained agen conume heir enire dipoable income every period and herefore any change in fical policy ha affec hi dipoable income will have real effec. Third, GFM allow labor upply and capial accumulaion o be endogenou and repond o change in incenive relaed o he afer-ax real wage or he afer-ax rae of reurn of capial. Thi in urn allow he model o incorporae he aumpion of diorionary axe, and analyze he conequence of change in hee axe. In addiion, one furher difference beween radiional NOEM model and GFM i he abence of nominal rigidiie in he laer. In he curren eup, i i aumed ha wage and price are fully flexible. Thi aumpion implie ha he cenral bank follow money argeing, which limi he analyi of he ineracion beween moneary and fical policy. Alo, hor-erm muliplier will be maller han i he cae for model wih nominal rigidiie. In hi conex, i hould alo be noed ha capial mobiliy in GFM i perfec implying ha inere rae are e in world marke. A a reul, epecially for mall open economie, he crowding-ou effec of governmen deb via higher inere rae will end o be maller han would be he cae if here were impedimen o capial flow and inernaional rade. Thee feaure nonehele provide a ueful benchmark for he analyi, epecially regarding he medium- and long-erm effec of fical policy. Wih regard o inerdependence, in he verion of GFM ued in hi paper, he world coni of four block (Germany, re of euro area, Unied Sae, and re of he world). Auming ha all conumer in each of he region face idenical urvival probabiliie, he relaive ize of he populaion remain conan and hi eenially fixe he relaive ize of he home economy (Germany). NOEM model have been exended by oher o allow for an analyi of fical policy iue. An overlapping generaion eing ha been brough ino NOEM framework by Ghironi (2003a and 2003b), and by Ganelli (2003a and 2003b). 7 The former doe no conider he effec of governmen deb, bu how ha an overlapping generaion rucure following Blanchard (985) and Weil (989) enure he exience of a well-defined eady ae for ne foreign ae holding (for an early analyi of hi, ee Buier, 98). Ghironi, Ican, and Rebucci (2005) decribe how difference in agen' dicoun rae acro counrie give rie o nonzero ne foreign ae poiion in he long run. 7 See Frenkel and Razin (992) for a diagrammaic expoiion of a wo-counry overlapping-generaion model wihou diorionary axaion.

7 7 Ganelli (2003b) i he fir aemp o analyze alernaive fical policie in a NOEM model wih finie live. Apar from including endogenou labor upply and liquidiy-conrained conumer, GFM exend hi approach in four oher major direcion: The uiliy funcion i le rericive, permiing he analyi of alernaive value for he ineremporal elaiciy of ubiuion. Thi parameer affec he eniiviy of conumer o change in he real inere rae. A hown below, i ha imporan implicaion for an aemen of he impac of fical policy. A he ame ime, he producion rucure i exended o include endogenou capial formaion, which provide an addiional channel hrough which governmen deb can poenially crowd ou economic aciviy and allow for he conideraion of corporae and peronal income axaion. In GFM, invemen i driven by a Tobin Q relaionhip, wih firm reponding luggihly o difference beween he fuure dicouned value of profi and he marke value of he capial ock. In addiion, he upply of labor i made endogenou and conequenly labor income axe will be diorionary. The model feaure boh raded and nonraded good, which allow u o conider he erm of rade effec of change in fical policy and he implicaion of variou degree in home bia in eiher privae and, epecially, governmen conumpion. Compared o oher fical model, GFM feaure a richer menu of axaion. The axe included are ocial ecuriy conribuion paid by worker and employer, a corporae income ax levied on accouning profi of firm, and a peronal income ax levied on labor income, accouning profi, and inere income (on governmen bond and ne foreign ae), and a value added ax. Excep for income axaion, each of hee axe ha a ingle, albei differen, marginal rae, which coincide wih he average ax rae. GFM alo ha a ylized financial ecor block, wih wo kind of ae, namely governmen deb (which can be raded inernaionally) and equiy (which i held domeically). Change in he ouanding ock of deb have direc implicaion for long-erm inere rae, which a a reul of he perfec capial mobiliy aumpion are hared inernaionally. IV. CALIBRATING THE MODEL The model i parameerized o reflec key macroeconomic feaure of Germany, a well a he re of he euro area, he Unied Sae, and re of he world (Table and 2). In paricular, he raio of conumpion, invemen, wage income, and income from capial relaive o GDP are e o heir value in Similarly, key fical variable revenue-o- GDP raio from axaion of corporae and peronal income, from conumpion ax, and from ocial ecuriy conribuion by worker and employer, a well a curren governmen

8 8 pending and governmen have been calibraed o he fical rucure of Germany, and ha of he oher region. Table. Key Macroeconomic and Fical Variable in he Iniial Seady Sae / (percen of GDP) Germany Euro Area (excl. Germany) Unied Sae Re of he World Size (percen of world GDP) Expendiure Raio Privae conumpion Governmen expendiure 2/ Invemen Expor Facor Income Capial Labor Governmen Deb Trade Flow Marix Toal expor o: Germany Euro Area (excl. Germany) Unied Sae Re of he World / Naional expendiure accoun a marke price 2/ Ne of governmen ranfer Table 2. Germany: Fical Variable and Key Parameer Value Rule-of-Thumb Veru Forward-Looking Conumer (percen hare of variable) Type of conumer Rule of humb 40 Inere Rae Forward looking 60 Nominal hor erm 5. Conumpion Real hor erm 3.0 Rule of humb 5.6 Forward looking 84.4 Price markup over marginal co (in percen) Tradable 4.3 Ineremporal Elaiciy of Subiuion 0.33 Nonradable 26.7 Elaiciy of labor upply 0.92 Probabiliy of urvival 0.90 Elaiciy of ubiuion beween capial and labor 0.75 Home bia in governmen expendiure (excl. ranfer) ye Nominal rigidiie no Effecive Tax Rae, Governmen Revenue, and Tranfer Social ecuriy conribuion worker Peronal income ax.0 Rae 27.2 Rae 8.9 Revenue (o GDP) 8.7 Revenue (o GDP) Social ecuriy conribuion employer Conumpion 0. Rae 22.8 Rae 6.2 Revenue (o GDP) 8.7 Revenue (o GDP) Corporae income ax Tranfer Rae 29.0 A a percen of GDP 9.7 Revenue (o GDP) 8. The key behavioral parameer are baed on microeconomic evidence. Thee include parameer characerizing real rigidiie in invemen, markup for firm and worker, he elaiciy of labor upply o afer-ax wage, he elaiciy of ubiuion beween labor and

9 9 capial, he elaiciy of ineremporal ubiuion, and he rae of ime preference. Simulaion examine he impac of changing he value of he following key parameer: 8 The wedge beween he rae of ime preference and he yield on governmen bond. Thi parameer, which deermine conumer degree of impaience, ha no been ubjec o exenive microeconomic analyi. We e he baeline value of he wedge o 0 percen (correponding o a planning horizon of 0 year), wih an alernaive imulaion uing percen (correponding o a planning horizon of 00 year). The fracion of liquidiy-conrained conumer. The baeline aume ha 40 percen of conumer experience liquidiy conrain. Thee conumer have no wealh and conume one-fourh of aggregae conumpion. An alernaive imulaion aume ha 0 percen of individual are liquidiy conrained. The eniiviy of labor upply o he real afer-ax wage (Frich elaiciy). The baeline value (-8) i a he low end of hoe found by microeconomic udie given ha he pecific German microevidence poin o a more inelaic relaionhip (Ever, de Mooij, and van Vuuren, 2005). Alernaive imulaion aume almo compleely inelaic labor upply (-). The elaiciy of ineremporal ubiuion. The baeline value for hi parameer, which decribe he eniiviy of conumpion o change in he real inere rae, i The parameer value in he alernaive imulaion (-0.29) i conien wih he lower end of microeconomic eimae. V. DEBT DYNAMICS AND FISCAL ADJUSTMENT IN GERMANY A. Deb Dynamic: Populaion Aging in Germany and in Trading Parner To evaluae he deb dynamic in Germany we aume aging-relaed expendiure preure of 4 percen of GDP by 2050 in our baeline (Figure ). We alo facor in he hree-percenage poin increae in he andard VAT rae from 6 percen o 9 percen in 2007 eimaed o generae addiional revenue of percen of GDP. To ake ino accoun VAT exempion, we have mapped hi ino a correponding effecive VAT rae of 0. percen of oal conumpion in 2006, which increae by.9 percenage poin from 2007 onward. In addiion, we incorporae he payroll-ax relief equivalen of 0.4 percen of GDP, effecive January 2007 and a reducion in he CIT rae a a revenue lo of ¼ percen of GDP from 2008 onward. The propoed reform would reduce he marginal CIT rae from an average of 39 percen o le han 30 percen, parly financed hrough bae-broadening meaure. Since he governmen plan wih regard o he CIT reform i ill evolving, he imulaion poi an equivalen ax relief hrough a CIT rae reducion only, yielding a revenue lo of ¼ percen 8 Oher rucural parameer have been calibraed uing evidence from Laxon and Peeni (2003) and Baini, N Diaye, and Rebucci (2005).

10 0 of GDP wihou offeing bae broadening (ee Boman and Danninger (2007) for a more deailed decripion and aemen of hee ax reform propoal and i impac on deb dynamic, oupu, and conumpion) % Figure. Germany: Primary Expendiure (In percen of GDP) 48.0% 47.0% 46.0% 4% 44.0% 43.0% 42.0% 4.0% Primary expendiure 4% Overall, however, he reform are likely o achieve a more efficien ax yem by hifing from direc o indirec axaion. Over he long run, hifing revenue from direc axaion o le diorionary indirec axe increae growh hrough higher employmen and invemen growh. Thi i relevan in an aging ociey where he direc ax bae could conrac, while he indirec ax bae i more able (ee Boman and Danninger, 2007, for a deailed evaluaion of hee ax policy change).

11 Figure 2. Effec on German Deb Dynamic of Populaion Aging in Germany / Source: GFM imulaion. / Include he eimaed revenue from higher VAT rae in 2007 and revenue lo from lower ocial ecuriy conribuion by worker and employer in 2007 and lower corporae income axaion in 2008; aging-relaed expendiure co are 4 percen of GDP by In GFM, repone of he economy o hee pending preure and change in ax policy are deermined endogenouly. The rucurally adjued defici a end-2006, eimaed a 2.4 percen of GDP i included, a well a he effec of inflaion and growh on deb dynamic. Figure 2 repor he reuling deb dynamic in Germany, holding aging-relaed expendiure in he re of he euro area or he Unied Sae conan. Alhough deb decline moderaely in he hor-erm, following lower aging co and he higher VAT in 2007, i i clearly unuainable in he long erm, and never decline below he Maarich limi. The deb dynamic depend crucially on projecion relaed o aging co. The analyi in Figure 2 aume ha, even afer far-reaching reform (Agenda 200 and Harz reform), aging-relaed expendiure are projeced o increae by ome 4 percen of GDP by Thi fical-aging co profile i aken from a long-erm fical cenario developed in Braumann and oher (2006), and i in beween a more opimiic cenario by he auhoriie (Federal Miniry of Finance, 2005; and Werding and Kalchüz, 2005) and he EU Aging Working Group (2¾ percen), and a more peimiic view expreed by he IFO iniue (7¾ percen). Figure 3 illurae he eniiviy of he deb dynamic in Germany o hee alernaive eimae. Depie he eniiviy of he deb dynamic o he uncerainy of aging co, deb i unuainable under curren policie even if we ignore he effec of populaion aging in oher counrie and he reuling preure on real inere rae in Germany.

12 2 Figure 3: The Effec of Alernaive Aging Co Projecion on Deb Dynamic in Germany / Baeline: 4 percen of GDP aging co by 2050 Maarich deb limi High aging co (7.75 percen of GDP by 2050) Low aging co (2.75 percen by 2050) Source: GFM imulaion / Include he eimaed revenue from higher VAT rae in 2007 and revenue lo from lower ocial ecuriy conribuion by worker and employer in 2007 and lower corporae income axaion in Taking ino accoun aging preure in he re of he euro area and he deb oulook for he Unied Sae, add a dramaic flavor o he deb dynamic of Germany own aging iue. Figure 4 illurae he effec of global aging, in addiion o fical preure from populaion aging in Germany, on deb dynamic in Germany. A he euro area and he U.S. face ignifican pending preure from weak aring fical poiion, fical and curren accoun defici in he counrie emerge and real inere rae will increae. Germany i an open economy implying ha hee higher rae will increae borrowing co for he governmen on newly iued deb and make he deb oulook coniderably more unuainable. Thi linkage beween counrie hrough inernaional financial marke i he key pillover effec of global aging and ignoring hee inerdependencie beween counrie will lead o a mileading judgmen abou he macroeconomic oulook of a counry.

13 3 Figure 4: Effec on German Deb Dynamic of Global Populaion Aging / Aging in Germany alone Maarich deb limi Aging in Germany, euro area, and U.S Source: GFM imulaion and IMF long-erm public finance projecion for Germany / Include he eimaed revenue from higher VAT rae in 2007 and revenue lo from lower ocial ecuriy conribuion by worker and employer in 2007 and lower corporae income axaion in 2008; aging-relaed expendiure co are 4 percen of GDP by Increae in real inere rae conien wih evidence in Ford and Laxon (999) who find ha a 2.5 percen increae in deb in he OECD increaed real inere rae by 00 bai poin (on new deb) during he 980. Aume aging co of 4.5 percen of GDP by 2050 in he euro area and 6.0 percen in he Unied Sae, wih deb increaing by 7.5 percen by B. Fical Adjumen in Germany A deb i unuainable, we explore alernaive adjumen raegie o achieve deb uainabiliy defined here a a governmen-deb-o-gdp raio of below 60 percen by Achieving fical uainabiliy require addiional effor beyond hoe in he coaliion ax reform package. A e ou in i Sabiliy Program, he governmen aim o move oward rucural balance over he medium-erm. In pracical erm, hi would require abou a ½ percenage poin of GDP reducion in he defici per year during (ome 2 percen of GDP in oal). However, addiional adjumen he ize of which depend on he ype of adjumen meaure i required o mainain deb below he Maarich limi for he enire period unil We characerize he ize of he adjumen needed, if adjumen i fron loaded, beyond achieving rucural balance by 20 for each meaure in Table 3. Srucural fical adjumen could be aained hrough variou combinaion of expendiure and revenue meaure (Table 3). GFM can be ued o analyze he effec of differen conolidaion mehod: (i) lower governmen conumpion; (ii) lower governmen ranfer; (iii) higher worker ocial ecuriy conribuion; (iv) higher employer ocial ecuriy conribuion; (v) higher peronal income ax rae; (vi) a higher VAT; (vii) raiing ocial ecuriy conribuion of worker in combinaion wih income ax bae broadening meaure;

14 4 (viii) higher corporae income ax rae, or (ix) a combinaion of hee meaure labeled a package. Table 3. Germany: Alernaive Fical Adjumen Sraegie: / (In percen unle oherwie indicaed) VAT Sauory rae Effecive ax rae Revenue (in percen of GDP) Labor income ax worker Effecive ax rae Revenue (in percen of GDP) Bae broadening and higher labor income ax worker Bae broadening 2/ Reducing effecive exempion rae (in percen of GDP) Labor income ax Effecive ax rae Overall revenue effec (in percen of GDP) Labor income ax employer Effecive ax rae Revenue (in percen of GDP) Peronal income ax Effecive ax rae Revenue (in percen of GDP) Corporae income ax Effecive ax rae Revenue (in percen of GDP) Social ecuriy ranfer In he abence of fical adjumen (aging effec) 3/ Spending (in percen of GDP) Wih fical adjumen Spending (in percen of GDP) Governmen conumpion Spending (in percen of GDP) Percenage reducion (relaive o 2007) Package of meaure (in percen of GDP) Spending Social ecuriy ranfer Revenue from reducing effecive exempion rae VAT (in percen) Effecive rae Sauory rae Source: IMF aff eimae. / Adjumen of /2 percen of GDP during in addiion o he coaliion agreemen. All adjumen cenario achieve rucural balance by 20 wih ubequen adjumen o mainain governmen deb wihin he Maarich limi unil / Reducion in he fracion of average labor income ha i ax exemp. 3/ Aging co are projeced o decline in Germany during a a reul of recen reform (ee Figure ).

15 5 Figure 5. Macroeconomic Effec of Alernaive Fical Adjumen Sraegie / Revenue meaure Expendiure meaure 4 3 Adjumen package Indirec axaion Direc axaion Real GDP (percenage poin) 4 3 Adjumen package Spending Tranfer Real GDP (percenage poin) Conumpion (percen) 4 Conumpion (percen) Conumpion poor (rule-of-humb) minu wealhy (opimizing) (percenage poin) 5 Conumpion poor (rule-of-humb) minu wealhy (opimizing) (percenage poin) Source: GFM imulaion. / All adjumen raegie achieve rucural balance by 20 wih ubequen adjumen o mainain governmen deb below he Maarich deb limi. See Table 3 for deail on each adjumen raegy. Indirec axaion relie on higher VAT rae; direc axaion relie on higher corporae income axaion.

16 6 Figure 6. Deb Dynamic in Germany Wih Fical Adjumen Governmen deb (percen of GDP) Deb dynamic wih adjumen Maarich deb limi Deb dynamic wihou adjumen Source: GFM imulaion. Calibraion reul from GFM ugge ha he hor-run growh lowdown of achieving rucural balance varie wih he ype of conolidaion meaure (Figure 5). The impac on hor run growh varie beween -0.2 percen and -0.3 percen each year beween , depending on he pecific meaure, heir diorionary effec, and he impac on domeic demand: Revenue increae. The negaive growh impac of he differen ax meaure range from -0. percen o -0.3 percen. The VAT i le diorionary han payroll axe, becaue i alo axe accumulaed aving (i.e., reache a broader bae, including reiree) in addiion o affecing he labor-leiure choice. Increaing payroll axe on worker i more diorionary han reducing ax exempion (bae broadening) owing o marginal ax rae on worker exceeding he average rae. Raiing corporae or peronal income axe i roughly equally diorionary in erm of oupu lo. Tha payroll axe are le diorionary han axaion of capial i a reul found in oher udie a well (Baylor, 2005), and reflec generally inelaic labor upply in paricular among male in mo indurial counrie, including in Germany. Expendiure cu. Lowering ocial ecuriy ranfer ha he malle growh impac per year. Thi relaively mode growh effec occur when he benefi ha are

17 7 reduced are diribued in a lump um manner reducing ranfer ha caue economic diorion (uch a unemploymen benefi) would imply growh loe imilar o hoe oberved for higher payroll axe. Par of he decline in conumpion demand i aborbed by rading parner via reduced impor demand. In conra, reducion in oher governmen conumpion would lead o a larger lowing in growh, which reflec he fac ha curren governmen pending in mo counrie i heavily biaed oward domeic good, or nonradable ( home bia ). Figure 7: Macroeconomic Effec on Germany of Adjumen Package / 4.0 Real GDP Conumpion 3.0 GDP Conumpion Opimizing conumer Rule-of-humb conumer Facor of producion Relaive price Real wage Real exchange rae Real inere rae (righ axi) Invemen Capial ock Labor effor (righ axi) Overall defici and curren accoun balance 80 Governmen deb and ne foreign ae Overall governmen defici -3.0 Curren accoun balance -4.0 Governmen deb 70 Ne foreign ae Source: GFM imulaion / See Table 3 for deail on he adjumen package.

18 8 If no pecific raegy i propoed, riing aging-relaed expendiure preure would likely reul in higher direc axaion. German law ipulae ha he ocial ecuriy accoun have o mainain balance and a a reul, under curren rule, growing expendiure mu be me wih equivalen ocial ecuriy conribuion. While hi preven runaway fical defici and a buildup of deb, i implie higher payroll axe a he defaul policy repone. Expendiure cu and enilemen reform, in combinaion wih bae broadening and raiing indirec axe, compare favorably o raiing direc axe. Achieving he 2 percen of GDP adjumen beween 2008 by relying excluively on ju one of he eigh adjumen meaure appear difficul, and he governmen likely will need o chooe a combinaion of meaure. For inance, reducing governmen pending wheher on good and ervice or ocial ecuriy ranfer by 2 percenage poin of GDP by 20 implie unrealiically large cu in dicreionary pending. Similarly, furher increae in he VAT revenue are alo limied (including hrough EU regulaion), alhough furher bae broadening would be poible by placing fewer iem under he lower (7 percen) VAT rae. Raiing direc axaion i diorionary and run couner o he governmen inenion o increae incenive for labor paricipaion and invemen. The macroeconomic effec of a mixed policy package i alo oulined in Figure 5 compriing lower governmen pending, lower ocial ecuriy ranfer, reducion in income ax exempion (bae broadening), and a mall furher increae in he effecive VAT, o a auory rae of 20 percen. Eliminaing he rucural defici by 20 hrough uch a package lower medium-run growh by abou 0.2 percen per year (Figure 5). The effec on conumpion are more izable, paricularly for hoe conumer ha rely relaively more on labor income a lower ocial ecuriy ranfer in paricular lower heir conumpion opporuniie. Neverhele, uch a package i no necearily wore for hee rule-of-humb conumer compared o he longerm effec of raiing corporae income axaion. The laer ax affec conumpion by he opimizing conumer more in he hor erm a hee conumer hold he equiy in he firm, bu in he long erm he ax incidence hif o worker a well hrough lower real wage. Thee adjumen raegie achieve a coniderable improvemen in deb dynamic (Figure 6). Eliminaing he rucural defici by 20, wih furher adjumen hrough 207, implie a ubanial improvemen in he overall balance of he governmen. In a ene, hi adjumen package prefund (parially) fuure aging co: a ignifican reducion in governmen deb over he medium erm, reduce he inere burden of he governmen o he exen ha riing aging co can be accommodaed wih limied increae in deb up unil Alhough he package preven deb from riing above he Maarich deb limi, however, Figure 6 alo ugge ha, oward he end of he period, furher adjumen will be required. Prefunding fuure aging co reul in a reducion in real inere rae, by abou 40 bai poin in he medium erm, alhough he effec i reerved a Germany i a relaively mall

19 9 open economy in he ene ha Germany naional aving rae ha only a mode effec on he global aving and invemen balance (Figure 7). A higher VAT and bae broadening of income axaion imply reduced incenive for labor hour, a indicaed by he decline in hour worked and he increae in he real wage. Invemen repond poiively hrough crowding-in afer deb ar o decline. Oupu gradually increae a a reul, alhough i ake a long ime before GDP ha reurned o he level oberved before he fical adjumen wa iniiaed. A conumpion decline, he real exchange rae depreciae, and he rade balance will record ronger urplue. Higher naional aving reul in increaing claim on he re of he world hrough accumulaion of ne foreign ae. VI. GLOBAL AGING AND FISCAL ADJUSTMENT: INTERNATIONAL COOPERATION? Since deb i een o be unuainable in Germany, he re of euro area, and he Unied Sae, we analyze he implicaion of each counry/region implemening an adjumen package imilar o he package implemened in Germany, alhough he ize and compoiion will depend on aring fical poiion and fuure aging co. The focu i on he impac of uch an adjumen package on oher counrie and region, were he pillover effec maerialize hrough financial and rade channel. The equencing of hee fical conolidaion in differen counrie i paricularly inereing. To analyze he poenial co and benefi of fical cooperaion, we underake imulaion baed on wo alernaive conellaion: (i) ha he adjumen package i implemened immediaely; or (ii) i will be implemened afer 0 year. Thee cenario capure he relaive co and benefi of fical cooperaion veru he incenive o poenially free ride on fical adjumen in oher par of he world. The deail of he package in he euro area and he Unied Sae are differen from he one in Germany, given he difference in he rucural characeriic and aring poin (ee Table 4 for deail on he package in he euro area and he U.S.). We aume, a wa done for Germany, ha he package of adjumen meaure in he euro area mainain governmen deb below he Maarich limi unil 2050 and avoid increae in direc axaion if implemened wihou delay. Alhough, he iniial fical balance and he magniude of aging co are differen in he re of he euro area compared o Germany. Nonehele, he adjumen will reduce he real inere rae more in he euro area a a whole ince i i a larger region (compared o Germany). Thi eenially allow he ize and compoiion of he package (o abilize deb a abou 55 percen) o be imilar a in Germany. For he U.S., he package i deigned uch ha deb remain omewha below i curren level unil However, depie he US being a larger economy compared o Germany, given he ubanially higher aging co including Medicare and Medicaid co in he U.S.

20 20 he package need o include furher meaure, aumed here o coni of furher increae in indirec axaion. Table 4. Adjumen Sraegie in he euro area and he U.S.: (In percen of GDP unle oherwie indicaed) Euro area aumpion Aging co by Governmen deb by 2022 wihou adjumen 87.5 Adjumen package abilize deb by 2050 a: 53.0 US aumpion Aging co by Governmen deb by 2022 wihou adjumen 57.5 Adjumen package abilize deb by 2050 a: Package of meaure in EU Spending Social ecuriy ranfer in he abence of adjumen wih adjumen Bae broadening VAT Effecive rae (percen) Package of meaure in he U.S. Spending Social ecuriy ranfer in he abence of adjumen wih adjumen Bae broadening Indirec axaion Effecive rae (percen) Source: IMF aff eimae. To ae he benefi of cooperaive acion, we analyzed a number of varian for he early adjumen and he lae adjumen cenario: we fir conidered all hree counrie/region underaking early join acion, and hen each one delaying by 0 year, while he oher wo implemened early adjumen. We alo explored pair-wie delay (e.g., U.S. and re of euro area delay by 0 year, while Germany coninue wih adjumen), and hen all hree delaying. A key reul i ha Germany benefi ubanially from early fical adjumen in he re of he euro area, and in he U.S. (Figure 8). Alhough expor decline following lower conumpion in he wo region and herefore lower demand for impor from Germany, hi i more han offe by he decline in real inere rae hrough financial linkage beween Germany and he euro area and he U.S. The reul i an invemen rebound and higher domeic demand in Germany.

21 2 Delaying adjumen in Germany ha hor-erm benefi, bu ubanial medium-erm co in erm of foregone oupu, a he adjumen will need o be more izeable (Figure 8). Germany would alo uffer from delay in adjumen in he euro area or in he U.S. a he iniial fical poiion and he one of higher aging co pu upward preure on real inere rae. Alo in he hor erm, pillover hrough hi financial channel more han offe he inerdependence of counrie hrough rade channel, wih delayed adjumen benefiing Germany by mainaining exiing expor poenial. Similarly, while he euro area and he U.S. benefi in he hor-run only from delaying heir repecive adjumen and free riding on conolidaion elewhere, if all counrie op o popone addreing hi iue, each one loe. Effecively, he global economy loe hrough higher inere rae and increaed adjumen in he fuure. We alo examined he broader macroeconomic effec on Germany (apar from he effec on GDP) of inernaional cooperaion in fical adjumen o addre riing aging co. The reul are illuraed in Figure 9, and ugge appreciable benefi compared o he reul of Germany acing alone, hown in Figure 7 above. For inance, invemen i now ignificanly higher (hrough he inere rae channel), which iniially alo crowd in higher labor effor; conumpion i alo higher, and alhough here i now a weaker exernal balance, and correponding le accumulaion of ne foreign ae, a he above analyi indicaed, here i a ubanial benefi in erm of higher real oupu. Table 5. Ne Preen Value of GDP of Fical Cooperaion / Germany EU US Early cooperaed adjumen Germany delay 0 year EU delay 0 year US delay 0 year Germany and EU delay 0 year Germany and US delay 0 year EU and US delay 0 year year delay Germany, EU, and US 40 0 Source: GFM imulaion. / See Table 2 for baeline parameer value. Ne preen value equal o he um of dicouned oupu effec, wih dicoun rae equal o marke real inere rae implied by he imulaion.

22 22 A quaniaive aemen of he early veru delayed raegy, and he poenial for he prioner dilemma o maerialize in pracice, depend alo o a coniderable exen on how much weigh policymaker aach o he preen veru he fuure. One way of quanifying he radeoff beween hor-erm gain veru medium-erm loe i hrough a ne preen value calculaion. Thee calculaion depend crucially on he dicoun rae, bu acro a range of i plauible value, i i clear ha he benefi of early and cooperaive acion exceed ubanially hoe of delayed acion (ee Table 5). Thee eimae ugge ha real GDP, in dicouned erm, i on average 4 percen higher unil 2050 from an early cooperaive repone. In addiion, delaying adjumen will compromie inergeneraional equiy, a fuure generaion will pay a diproporionae porion of aging co. The above eimae are alo eniive o how much governmen deb crowd ou privae invemen, and he value of a number of oher parameer. Seniiviy analyi wa underaken for he effec of longer planning horizon, lower elaiciy of labor upply, le liquidiy-conrained conumer, and a lower ineremporal elaiciy of ubiuion (ee Table 6). A longer planning horizon implie ha conumer anicipae ha prefunding of fuure aging co will lead o lower inere rae in he fuure and reduce labor effor and conumpion by a maller amoun (i.e., he more Ricardian he conumer, he maller he effec). Thi caue a maller iniial decline in oupu, bu alo maller increae in conumpion and oupu in he medium erm. Nonehele, albei maller, he relaive benefi of cooperaive acion raher han free riding ill remain. Similarly, bu o a much maller exen, reducing he eniiviy of worker o change in he afer-ax real wage rae and reducing he hare of liquidiyconrained conumer in he economy, make he framework more Ricardian, wih imilar (bu quaniaively much maller) conequence. Wih regard o a lower eniiviy of conumpion o change in he real inere rae, he effec i o increae he gain from early adjumen and fical cooperaion. The reaon i ha prefunding generae win urplue, ha i boh he curren accoun and he governmen balance move ino urplu. Conien wih exernal deb uainabiliy, he rade balance will gradually move ino defici, which occur hrough change in relaive price including he real inere rae a he price of conuming oday veru laer. A he real inere rae decline, conumpion will increae generaing rade balance defici over ime. If, however, conumpion i le eniive o change in he real inere rae, he real inere rae will decline by more, benefiing invemen and real GDP in he medium erm.

23 23 Figure 8. Effec on Real GDP in Germany of Fical Cooperaion / The Effec of Fical Cooperaion on Germany 0 Early cooperaed adjumen Germany delay EU delay US delay Early cooperaed adjumen Germany and EU delay Germany and US delay EU and US delay Early cooperaed adjumen 0 year delay Germany, EU, and US Source: GFM imulaion. / See Table 3 and 4 for deail on he adjumen package in Germany, he euro area, and he Unied Sae. Delaying adjumen by en year i aumed o be compenaed hrough higher ocial ecuriy conribuion by worker.

24 24 Figure 8. con. Effec on Real GDP in he euro area of Fical Cooperaion The Effec of Fical Cooperaion on he Euro Area 0 Early cooperaed adjumen Germany delay EU delay US delay Early cooperaed adjumen Germany and EU delay Germany and US delay EU and US delay Early cooperaed adjumen 0 year delay Germany, EU, and US 6 2-2

25 25 Figure 8. con. Effec on Real GDP in he Unied Sae of Fical Cooperaion The Effec of Fical Cooperaion on he US 0 Early cooperaed adjumen Germany delay EU delay US delay Early cooperaed adjumen Germany and EU delay Germany and US delay EU and US delay Early cooperaed adjumen 0 year delay Germany, EU, and US 6 2-2

26 f Table 6. Seniiviy Analyi of Ne Preen Value of GDP of Fical Cooperaion / Baeline Long planning horizon 2/ Lower elaiciy of labor upply 3/ Germany EU US Germany EU US Germany EU US Early cooperaed adjumen Germany delay 0 year EU delay 0 year US delay 0 year Germany and EU delay 0 year Germany and US delay 0 year EU and US delay 0 year year delay Germany, EU, and US Baeline Le liquidiy-conrained conumer 4/ Lower ineremporal ela. of ubiuion 5/ Germany EU US Germany EU US Germany EU US 26 Early cooperaed adjumen Germany delay 0 year EU delay 0 year US delay 0 year Germany and EU delay 0 year Germany and US delay 0 year EU and US delay 0 year year delay Germany, EU, and US Source: GFM imulaion. / See Table 2 for baeline parameer value. Ne preen value equal o he um of dicouned oupu effec, wih dicoun rae equal o marke real inere rae implied by he imulaion. 2/ Longer planning horizon of conumer (horizon equal o 00 year). 3/ Le elaic labor upply making worker le eniive o change in he afer-ax real wage (abolue elaiciy equal o 0.99). 4/ Fewer liquidiy-conrained conumer (fracion equal o 0 percen of conumer). 5/ Lower ineremporal elaiciy of ubiuion making conumer le eniive o change in he real inere rae (elaiciy equal o 0.29).

27 27 Figure 9: Macroeconomic Effec of Fical Cooperaion on Germany / (Deviaion from iniial eady ae in percenage poin unle oherwie noed) Real GDP 2 Conumpion (percen) Conumpion Opimizing conumer Rule-of-humb conumer Facor of producion Relaive price Real wage (percen) Real exchange rae (percen) Real inere rae (righ axi) Invemen - Capial ock (percen) Labor effor (righ axi; percen) Overall defici and curren accoun balance 20 Ne foreign ae Overall governmen defici -4.0 Curren accoun balance - 0 Ne foreign ae -5 Source: GFM imulaion / See Table 3 and 4 for deail on he adjumen package in Germany, he euro area, and he U.S. VII. ACHIEVING THE LISBON AGENDA: ARE FISCAL ADJUSTMENT AND STRUCTURAL REFORM COMPLEMENTARY? The Libon raegy adoped in 2000, enailed a wide ranging program of economic, ocial and environmenal reform, deigned o enhance EU growh and employmen and allow i o compee more effecively in he global economy. The backdrop of he raegy wa he expoure of EU counrie o growing inernaional compeiion, he need of he knowledge

28 28 baed economy, and demographic challenge. The raegy wa reinforced in 2005 wih a harper focu on rucural reform o improve compeiivene, dynamim, and employmen. A. Increaing Labor Paricipaion We fir conider he impac of higher labor paricipaion. Thi i o be achieved by lower direc axaion of labor and capial, and amoun o one-half percen of GDP per year during he period The reform i deigned o be revenue neural hi i achieved by increaing he effecive VAT rae, for example hrough bae broadening and VAT rae harmonizaion raher han increaing he highe auory ax rae (which in our imulaion already reache he maximum allowed under inernal EU rule a par of he adjumen package). The baic premie i ha hi ype of ax reform imulae incenive o ave, work, and inve and herefore increae he demand for labor. Labor upply increae a a reul of a gradual reducion in he elaiciy of labor upply over he period Thu, hi policy implie a reducion in he bargaining power of worker in he ene ha he markup of he real wage above he level of wage oberved if labor upply i compleely inelaic. Thi reduce he uiliy of leiure, and miigae he effec of payroll axaion on labor upply. The ronger incenive for labor demand and labor upply ogeher imply an increae in labor paricipaion equal o 5 percen of he labor force over he five year period. A illuraed in Figure 0, increaing labor paricipaion by hi amoun ha large poiive effec on conumpion and real GDP, offeing mo of he hor-erm co from fical adjumen. Conumpion of rule-of-humb conumer increae in paricular, a labor income expand depie he reducion in he real wage ha accompanie uch a large increae in paricipaion. However, becaue of he reducion in real wage, overall conumpion increae by a maller amoun han oupu.