OECD ECONOMIC SURVEY OF DENMARK 2005 IS THE WELFARE SYSTEM SUSTAINABLE?

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1 ORGANISATION DE COOPÉRATION ET DE DÉVELOPPEMENT ÉCONOMIQUES ORGANISATION FOR ECONOMIC CO-OPERATION AND DEVELOPMENT OECD ECONOMIC SURVEY OF DENMARK 25 IS THE WELFARE SYSTEM SUSTAINABLE? This is an excerpt from Chapter 2 of the OECD Economic Survey of Denmark, 25. Future demographic changes are bound to have substantia effects on pubic finances in a wefare state ike Denmark, where most pubic services and income transfers are provided for free and financed on a pay-as-you-go basis, thus disconnecting the services received from the individua s contributions through taxes and charges paid. It is amost certain that pubic finances wi get worse as a resut of ageing, athough the precise impact is obviousy hard to know. Severa institutions are reguary making projections of the fisca situation over the very ong term (over the next century or so), and a point to a substantia increase in pubic expenditure as a share of GDP. This is argey due to a sharp increase in the od-age dependency ratio, which is projected to move to and stay at a higher eve (Figure 2.1). In other words, the pressure on pubic finances is ikey to be permanent, and not just a temporary baby boomer phenomenon that wi eventuay go away. This has impications for what woud be the optima and the equitabe response to the shift in the popuation structure. Figure 2.1. The od-age dependency ratio moves to a permanenty higher eve Ratio of 65+ year ods to year ods, per cent Wefare Commission Note: The uses the officia popuation projection from DREAM, an independent research group. DREAM aso made the projection used by the Wefare Commission, appying different assumptions on fertiity and mortaity at the request of the Commission. Source: The DREAM group, OECD Economic Surveys: Denmark 1

2 There are at east four sets of ong-term projections produced by Danish institutions, pus some from the OECD, the IMF and the EU. Looking at the Danish modeing, which tends to be more detaied, the s no poicy scenario 1 has an increase in pubic primary expenditure of amost 8 percentage points of GDP between now and 275. Estimates by the Economic Counci and the DREAM Research Group are both in the same bapark as the Ministry, party because they use simiar demographic assumptions. An aternative projection, produced by the government s Wefare Commission, is significanty more pessimistic. In its outook, the increase in primary expenditure is more than a third arger. As discussed in more detai beow, the key differences between these projections concern assumptions about ongevity, the rate of return on net assets and the impact of ageing on heath care costs. In both the Ministry s and the Commission s projections, the majority of the increase in consumption and transfer expenditures happens before 24 (Figure 2.2). Expenditure on heath and edery care and on pubic od-age pensions are the main drivers; in the Ministry s scenario, for exampe, they rise by 1.4, 1.6 and 3.2 percentage points of GDP respectivey. Fortunatey, there is an offsetting factor, as extra government revenue wi come from the arge deferred tax payments on private pension contributions. However, this wi not be enough to prevent a substantia deterioration of primary net ending, and there is expected to be a sustained deficit in the period beyond 215 or so. Aong with the associated interest payments, this wi generate a rapid rise in net debt. Whie cacuations differ on the quantitative impact on the fisca situation, refecting different methodoogy and assumptions, there is a consensus on the overa concusion: pubic finances are unsustainabe in the ight of ageing without further poicy reforms (Box 2.1). Estimates of the fisca gap, i.e. the required improvement of pubic finances to make the wefare system sustainabe as the popuation is greying, range from 1½ per cent of GDP according to the to 3¾ per cent of GDP in the scenario presented by the Wefare Commission (Tabe 2.1). The difference is of more than academic interest. If the Ministry is right, then sustainabiity might just be abe to be brought about through some very tight expenditure restraint combined with an increase in empoyment that, whie very ambitious, is not entirey out of the question. But if the Commission is right, then a more fundamenta rethink wi be needed. The required increase in empoyment or in taxation woud bring them to a eve that is certainy unprecedented and probaby unreaistic given the economic incentives buit in to the current wefare system. Box 2.1. How is fisca sustainabiity defined? Fisca sustainabiity can be viewed in different ways. Ensuring that the eve of debt as a share of GDP does not expode can be one criterion as can various expicit ceiings on the debt ratio. The assessment of fisca sustainabiity in this chapter is based on the government s abiity to satisfy its inter-tempora budget constraint, which states that current net debt shoud not exceed the present vaue of future primary surpuses, using the interest rate on debt as the discounting factor. If it does, a structura improvement of the budget position is required. This method is aso appied in the studies referred to in this chapter. This type of cacuation wi of course depend heaviy on the assumptions regarding the mechanisms shaping the deveopment in expenditure and revenue. The key assumption is that present rues and standards in the wefare system are roughy maintained. Age, gender, and origin-specific participation and empoyment rates are generay kept constant, athough some adjustment is made for the initia cycica position and the ikey as yet unseen effects of past reforms of transfer schemes, active abour market poicies, the tax system, etc. This way, deveopments are argey driven by the demographic changes. Estimates of the future deveopment of pubic finances wi differ to the extent that assumptions vary as to demographic deveopments, effects of past reforms, nomina interest rates, economic growth, infation rates, government investment and coective consumption, terms of trade, etc. Aso, cacuations made using genera equiibrium modes (as the Wefare Commission does) wi incude endogenous behavioura effects, contrary to simper methods (such as those used by the ). OECD Economic Surveys: Denmark 2

3 Figure 2.2. Centra and oca government finances are ikey to deteriorate in the ong term in the absence of poicy changes Change from 25, percentage point of GDP 7 6 Pubic consumption Income transfers Wefare Commission Wefare Commission Primary net ending Net debt Leve in per cent of GDP Wefare Commission Wefare Commission Source: (24), Finansredegørese 24, June; Wefare Commission (24), Fremtidens vefaerd kommer ikke af sig sev, Anayserapport, May. OECD Economic Surveys: Denmark 3

4 Tabe 2.1. The size of the fisca gap is significant according to various studies 1 Per cent of GDP, poicy scenario (June 24). ess margina effect from government empoyment objectives in 21 Pan -1. ess margina effect from tight government consumption as stipuated in the 21 Pan -.5, no poicy scenario (June 24) -1.5 The Economic Counci (May 24) -1.9 DREAM (Apri 24) -1.9 Wefare Commission (May 24) The fisca gap indicates to what extent government finances deviates from fisca sustainabiity. A negative number in the tabe means that a permanent improvement of government finances is required. In the s scenarios, the required permanent improvement is measured as from 23, whereas the Economic Counci and DREAM assume that the fisca tightening takes pace from 27. The Wefare Commission assumes that fisca poicy is graduay tightened between 211 and 221. This ater and gradua tightening impies that the required improvement of government finances is.2 percentage point of GDP higher than if it took pace in 27. Source: (24), Finansredegørese 24, June; Wefare Commission (24), Vefærdskommissionens beregningsforudsætninger, June; Det Økonomiske Råd (24), Dansk Økonomi forår 24, May. Long-term projections of pubic finances depend heaviy on basic assumptions The different resuts of these studies iustrate the substantia uncertainty surrounding this type of cacuation. Atering basic assumptions on demographics, abour-market behaviour and interest rates can significanty change estimates of the necessary improvement of pubic finances. One of the key differences between the Ministry and the Wefare Commission is their ongevity assumptions. Danish ifespans fa we short of those in the other Nordic countries, and the debate is therefore argey about how much catch-up there wi be in the future. Whie the two institutions agree on a four-year increase in ongevity for men, the Ministry (aong with the DREAM group and the Economic Counci) is more cautious on the change in average ifetime for women, and assumes an increase of ony 1¾ years unti 25. That wi not even bring ongevity to the eve that other Nordic women enjoy today. The Wefare Commission s assumption of a 4½ year increase seems more reasonabe. For both genders, ongevity in the two projections is beow that of the United Nations projections for Denmark, which assume an increase for both genders of around 5½ years (simiar to that assumed for other EU countries). This suggests that the uncertainty reated to ife expectancy is mosty on the upside (impying that the fisca situation woud be worse), especiay as there has been a remarkabe degree of catch-up over the past decade. But ower ife expectancy is to some extent reated to ess heathy ifestyes, especiay because of cancers due to smoking (Wefare Commission, 24). To the extent that this continues, Denmark coud see ongevity rise by ess than in other EU countries. The second key difference between the Ministry and the Commission concerns the interest rate, and this interacts strongy with the ongevity assumption. If the Wefare Commission s assumptions about ifespans were used in the Ministry s scenario, the estimated fisca gap woud not increase much because ony a itte more debt repayment is required to cover the extra future spending, given the Ministry s assumption of a nomina interest rate of 6.5 per cent (equa to the average interest rate on state bonds in the period ). In contrast, the Commission s interest rate is amost 2 percentage points ower, so more debt repayment and therefore a bigger improvement of primary net ending today is needed for the OECD Economic Surveys: Denmark 4

5 reduction in net interest payments to cover the extra spending arising from the arger increase in ongevity in its scenario. 2 The effect on pubic finances arising from onger ives aso depends on the extent to which this refects heathier ives, as extensive use of edery and heath care services may just be shifted to ater ages. The Wefare Commission has chosen to maintain a fixed distribution of pubic services for the individua across ages throughout its projection. It argues that the increase in expected remaining ifetime for 65 year-ods does not seem to change the age at which pubic services are demanded, pointing to the experience in Sweden where the distribution of pubic services for the individua across ages is quite simiar to that in Denmark, even though ifespans there are significanty higher. The, on the other hand, assumes that haf of the age-reated expenditures depend on remaining ifetime rather than on actua age, thereby reducing the fisca gap by ¼ percentage point of GDP in its scenario. Whie the impact may not seem arge, it depends cruciay on the other key assumptions. Using the Commission s ongevity and interest rate assumptions, the assumption of better heath in od age reduces the fisca gap by 1 percentage point of GDP (according to estimates). It is thus the combined effect of divergences in these three centra assumptions that generates a substantia part of the difference in the estimated fisca gap. Continuation of past trends in service improvements wi worsen the situation A factor not taken into account in any of the projections described so far is the ikeihood that medica advances ead to greater quaity and new and possiby more expensive treatment methods. The usua assumption in these fisca projections is that nomina heath spending per person in each age group foows wage increases, impying that rea spending per user wi increase ony minimay (to the extent that the price of government purchases rises ess than wages). Uness extra heath spending can be financed via ower expenditure growth in other areas, additiona increases in heath services wi therefore mosty have to come from efficiency improvements. Such productivity gains are unikey to be sufficient to meet the trend increase in service standards that has been seen in the past, especiay in the areas of edery and heath care. If rea service standards instead grew ½ per cent per year faster than in the Ministry of Finance s no poicy scenario, which woud be more in ine with historica experience, tota heath expenditure woud be raised by 1¾ percentage points of GDP in 25, eading to an acceeration of net debt we above the stabe debt ratio that the 21 Pan is designed to deiver (Figure 2.3); this scenario adds 1¼ per cent to the fisca gap. The same assumption appied to edery care (an extra ½ per cent per year) woud boost spending as we, but by a esser amount overa. Higher immigration wi not improve pubic finances Since the pressure on pubic finances arises because a diminishing share of the popuation wi finance the wefare state through its tax payments, it has from time to time been suggested that Denmark shoud admit more immigrants. However, more immigration wi not hep to aeviate the pressures on pubic finances uness a higher proportion of immigrants come from more deveoped countries (MDCs), as these tend to have higher empoyment rates, or uness new immigrants from ess deveoped countries (LDCs) have the same economic behaviour as immigrants from MDCs (see previous Survey). Higher fertiity woud not hep either, because pubic finances are unsustainabe at the outset; in fact, higher fertiity wi make the situation worse because on current parameters the average newborn Dane wi make a negative net contribution (in present vaue terms) to pubic finances over his/her ifetime. OECD Economic Surveys: Denmark 5

6 Figure 2.3. Centra and oca government net debt in various scenarios Per cent of GDP "No poicy" scenario (Deviation from fisca sustainabiity: - 1 1/2 per cent of GDP) Higher heath service standards ( - 1 1/4 per cent of GDP) Higher edery care service standards ( - 3/4 per cent of GDP) Average age of retirement increases by 1/2 year ( + 1/4 per cent of GDP) Eigibiity age adjusted to ife expectancy ( + 3/4 per cent of GDP) 21 poicy pan carried through ( + 1 1/2 per cent of GDP) Note: Numbers in brackets show the effect on fisca sustainabiity. A positive contribution means that the required improvement of primary net ending to make pubic finance sustainabe is reduced. Source: cacuations. whie measures to make the wefare state more robust coud deiver significant contributions Adjusting basic parameters in the wefare system may on the other hand be powerfu measures. For instance, if the eigibiity age for vountary eary retirement pension (VERP) and the pubic od-age pension were indexed to ongevity, the required improvement in primary net ending woud be haved in the Ministry s scenario. The current fixed eigibiity ages in pubic retirement systems impy that wefare generosity is automaticay expanded when average ifetimes increase. If the statutory age for receiving od-age pensions remains at 65 years (reduced from 67 years in 24) and the VERP is maintained, future generations wi be abe to enjoy more years receiving pubic retirement income than those currenty aive. Whie indexing to ongevity woud seem an obvious way of avoiding this impicit expansion of wefare provisions, it is, however, not without significant practica obstaces. but the government is focusing mainy on improving empoyment rates for the current popuation Recognising these ong-term prospects, successive governments have pursued a strategy of saving before the pressures from the demographic changes begin to emerge and reducing the fisca pressures up front by boosting empoyment. In the government s medium-term fisca framework (the 21 Pan), fisca sustainabiity is supposed to be achieved by keeping growth in rea government consumption at a historicay ow rate (½ per cent per year in the remainder of the period unti 21) and by a structura increase in empoyment rates that wi shift amost 1 peope (2¾ per cent of the working-age popuation) from income transfers to sef-support between 23 and 21, of which 4 is expected to come from previous reforms. This woud deiver an average structura budget surpus within the targeted range of 1½ 2½ per cent of GDP in the period unti 21, with the improvement in empoyment rates offsetting the negative effect from the underying demographic changes. Maintaining surpuses within the target range woud provide a substantia reduction in government debt and net interest payments. In fact, in this scenario the government woud become a net asset hoder by 22, aowing it to finance projected subsequent primary deficits with net interest earnings. Thus, under the assumption that the 21 objectives are achieved, there woud be no need for further tightening of fisca poicy in order to OECD Economic Surveys: Denmark 6

7 achieve fisca sustainabiity, i.e. there is no fisca gap (the fisca gap is zero in the s poicy scenario in Tabe 2.1). Without neither new abour market reforms nor restrained rea pubic consumption, the structura surpus woud graduay deteriorate, moving further beow its target range in the period unti 21. Such a no poicy scenario woud be consistent with fisca sustainabiity ony if the actua surpus in 23 had been around 2¾ per cent of GDP instead of the recorded 1¼ per cent. In other words, an improvement of pubic finances of 1½ per cent of GDP woud be needed, if the assumed reforms and tight spending restraint in the 21 Pan were not carried out (the fisca gap is -1.5 per cent of GDP in the Ministry of Finance s no poicy scenario in Tabe 2.1). NOTES 1. No poicy means no additiona abour market or wefare reforms beyond what has aready been impemented, and pubic consumption growing in ine with demographic deveopments (i.e., without the expenditure constraint buit in to the 21 Pan). 2. One of the most important differences between the cacuations made by the and the Wefare Commission is the assumed interest rate on government assets. Because assumptions on nomina GDP growth are practicay the same, this makes for a simiar difference in the growth-corrected rea interest rate, which is the reevant discounting factor in the government s inter-tempora budget constraint. Despite a arger deterioration of primary net ending, net debt rises ess in the Wefare Commission s scenario, because it uses a ower interest rate than the. The interest burden is therefore smaer, for a given debt eve, and that more than offsets a reativey worse deveopment in centra and oca government primary net ending. Nevertheess, the required improvement of primary net ending is arger than in the s scenario. This may seem counter-intuitive, given the ower debt trajectory. However, for a given tightening of pubic finances the resuting improvement of the net debt position makes for a smaer reduction of net interest payments in the Wefare Commission s scenario because of the ower interest rate. OECD Economic Surveys: Denmark 7