Sustainability Report 2009

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3 COMMISSION OF THE EUROPEAN COMMUNITIES Brussels, SEC(29) 1354 COMMISSION STAFF WORKING DOCUMENT Susainabiliy Repor 29 accompanying he COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT AND THE COUNCIL Susainabiliy of public finances for a recovering economy {COM(29) 545 final}

4 European Commission Direcorae-General for Economic and Financial Affairs Susainabiliy Repor - 29 EUROPEAN ECONOMY 9/29

5 ABBREVIATIONS AND SYMBOLS USED Member Saes BE Belgium BG Bulgaria CZ Czech Republic DK Denmark DE Germany IE Ireland EE Esonia EL Greece ES Spain FR France IT Ialy CY Cyprus LV Lavia LT Lihuania LU Luxembourg HU Hungary MT Mala NL The Neherlands AT Ausria PL Poland PT Porugal RO Romania SI Slovenia SK Slovak Republic FI Finland SE Sweden UK Unied Kingdom EA European Union Member Saes having adoped he single currency (BE, DE, EL, ES, FR, IE, IT, CY, LU, MT, NL, AU, PT, SI, SK, FI), i.e. counries paricipaing in he economic and moneary union wihou a derogaion EU-27 European Union, 27 Member Saes Oher AR Ageing Repor CAB Cyclically-Adjused Balance CBO Congress Budge Office DR Deb Requiremen in 26 EDP Excessive Defici Procedure iii

6 EMU Economic and Moneary Union EPC Economic Policy Commiee ERM II European Exchange Rae Mechanism, replacing he original ERM in 1999 ESA95 European Sysem of naional Accouns 1995 GDP Gross Domesic Produc IBP Required adjusmen given he iniial budgeary posiion IMF Inernaional Moneary Fund LTC Required adjusmen given he long-erm change in he budgeary posiion MTO Medium-Term Objecive NAIRU Non-Acceleraing Inflaion Rae of Unemploymen PAYG Pay-As-You-Go RPB Required Primary Balance SCP Sabiliy and Convergence Programmes SFA Sock-Flow Adjusmen SGP Sabiliy and Growh Pac iv

7 ACKNOWLEDGEMENTS This repor was prepared in he Direcorae General for Economic and Financial Affairs under he direcion of Marco Bui, Direcor General, and Servaas Deroose, Direcor of he Direcorae for he macroeconomy of he euro area and he EU. The main conribuors were Kamil Dybczak, Chrisine Frayne, Veli Laine and João Nogueira Marins. Tamás Gábor Szin was responsible for saisical and ediorial work. Specific conribuions were provided by Salvador Barrios, Per Eckefeld, Barosz Przywara, Eienne Sail and Zbigniew Truchlewski. The counry secions in Chaper VII benefied from commens from desk officers in he direcoraes Economies of he Member Saes I and II under he responsibiliy of direcors Jürgen Kröger and Elena Flores Gual. Commens and suggesions by colleagues in he Direcorae General for Economic and Financial Affairs as well as by oher services of he Commission are graefully acknowledged. Excellen secrearial suppor was provided by Dominique Prins and Els Verseven. Commens on he repor would be graefully received and should be sen o: Direcorae-General for Economic and Financial Affairs Macroeconomy of he euro area and he EU Uni C4: Fiscal Susainabiliy European Commission B-149 Brussels or by o joao.nogueiramarins@ec.europa.eu v

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9 CONTENTS Ediorial XIII Execuive summary 1 Chaper I: Susainabiliy of public finances 7 Summary 9 1. Defining susainabiliy Wha is mean by he susainabiliy of he public finances Defining he susainabiliy indicaors Inerpreing he susainabiliy indicaors Oher conceps of susainabiliy Deriving he susainabiliy indicaors Required adjusmen given The iniial budgeary posiion The deb requiremen by The required adjusmen given he increase in age-relaed coss Policy implicaions Esimaing he cos of ageing projecing age-relaed expendiure A parial equilibrium analysis Unchanged policy assumpion 17 Chaper II: The economic and budgeary implicaions of ageing 19 Summary The effec of demographic changes Populaion ageing Labour force projecions Labour produciviy and poenial growh Budgeary projecions 28 Chaper III: Quaniaive susainabiliy resuls 31 Summary The susainabiliy resuls The quaniaive indicaors A graphic represenaion of he susainabiliy gap (S2) The long erm budgeary cos of ageing The iniial budgeary posiion Required primary balance Governmen deb projecions Comparison wih he 26 susainabiliy repor The cos of no policy reacion 43 vii

10 Chaper IV: The poenial impac of he curren economic crisis and sensiiviy analysis 45 Summary The effec of he financial crisis The perspecives for economic growh Three medium-erm pos-crisis SCENARIOS The budgeary impac of he pos-crisis scenarios Implicaions on susainabiliy indicaors of he Alernaive POST-CRISIs cenarios The effec of fiscal consolidaion: an MTO scenario Sensiiviy analysis no linked o he financial crisis Life expecancy Labour produciviy Employmen rae Migraion Ineres rae Alernaive healh care scenarios Changes in he long-erm care assumpions 64 Chaper V: Oher facors 67 Summary Deb and asses The level and evoluion of Gross deb Primary balance Governmen Asses Pension projecions Pension expendiure projecions and social and poliical risks Privae funded pension schemes and financial risks Coningen liabiliies Tax raio 79 Chaper VI: Overall classificaion of he long-erm risks o he susainabiliy of public finances 81 Summary Overall assessmen The susainabiliy indicaors Addiional facors Overall assessmen Assessmen of susainabiliy risks for he Member Saes Low long-erm risk counries Medium-risk counries High long-erm risk counries 9 Chaper VII: Susainabiliy assessmen per Member Sae Belgium Overview of he resuls Overall assessmen 92 viii

11 2. Bulgaria Overview of he resuls Overall Assessmen The Czech Republic Overview of he resuls Overall assessmen Denmark Overview of he resuls Overall assessmen Germany Overview of he resuls Overall assessmen 1 6. Esonia Overview of he resuls Overall assessmen Ireland Overview of he resuls Overall assessmen Greece Overview of he resuls Overall assessmen Spain Overview of he resuls Overall assessmen France Overview of Resuls Overall Assessmen Ialy Overview of he resuls Overall assessmen Cyprus Overview of he resuls Overall assessmen Lavia Overview of he resuls Overall assessmen Lihuania Overview of he resuls Overall assessmen Luxembourg Overview of he resuls Overall assessmen Hungary Overview of he resuls Overall assessmen Mala Overview of he resuls Overall assessmen 124 ix

12 18. The Neherlands Overview of he resuls Overall assessmen Ausria Overview of he resuls Overall assessmen Poland Overview of he resuls Overall assessmen Porugal Overview of he resuls Overall assessmen Romania Overview of he resuls Overall assessmen Slovenia Overview of he resuls Overall assessmen Slovakia Overview of he resuls Overall assessmen Finland Overview of he resuls Overall assessmen Sweden Overview of he resuls Overall assessmen Unied Kingdom Overview of resuls Overall assessmen 144 Chaper A.I: Deriving he susainabiliy indicaors Deriving he susainabiliy indicaors 148 Chaper A.II: Revenue projecions Revenue projecions 158 LIST OF TABLES I.2.1. Summarising he indicaors 14 II.1.1. Demographic projecions for he EU counries 23 II.1.2. Increase in age-relaed expendiure, 21-26, % of GDP 29 III.1.1. Resuls of he susainabiliy gap calculaions in he baseline scenario (% of GDP) 35 III.1.2. Governmen srucural balances (% of GDP) 38 III.1.3. Required primary balance (% GDP) 39 III.1.4. Projeced deb developmens 4 III.2.1. LTC componen of he S2 indicaor unil 25 and III.3.1. Cos of delaying he response by 5 years 43 x

13 IV.1.1. The effecs on he level of real GDP per capia of he hree pos-crisis scenarios 5 IV.1.2. Susainabiliy calculaions under alernaive crisis scenarios 53 IV.2.1. Effec of he MTO balance on he S2 indicaor and required primary balance (RPB) 54 IV.3.1. Sensiiviy scenarios, difference in S2 indicaor compared o he baseline scenario 58 IV.3.2. Sensiiviy scenarios, difference in S2 indicaor compared o he baseline scenario 63 IV.3.3. Sensiiviy scenarios, difference in S2 indicaor compared o he baseline scenario 65 V.1.1. General governmen gross deb raio 71 V.1.2. General governmen financial asses as a share of GDP 72 V.1.3. Srucural primary balances as a share of GDP 72 V.2.1. Benefi raio 74 V.3.1. Public inervenions in he banking secor as a share of GDP 78 VI.1.1. Main facors considered in reaching an overall assessmen of he public finance susainabiliy risks 87 VII.1.1. Summary able (Belgium) 93 VII.2.1. Summary able (Bulgaria) 95 VII.3.1. Summary able (The Czech Republic) 97 VII.4.1. Summary able (Denmark) 99 VII.5.1. Summary able (Germany) 11 VII.6.1. Summary able (Esonia) 13 VII.7.1. Summary able (Ireland) 15 VII.8.1. Summary able (Greece) 17 VII.9.1. Summary able (Spain) 19 VII.1.1. Summary able (France) 111 VII Summary able (Ialy) 113 VII Summary able (Cyprus) 115 VII Summary able (Lavia) 117 VII Summary able (Lihuania) 119 VII Summary able (Luxembourg) 121 VII Summary able (Hungary) 123 VII Summary able (Mala) 125 VII Summary able (The Neherlands) 127 VII Summary able (Ausria) 129 VII.2.1. Summary able (Poland) 131 VII Summary able (Porugal) 133 VII Summary able (Romania) 135 VII Summary able (Slovenia) 137 VII Summary able (Slovakia) 139 VII Summary able (Finland) 141 VII Summary able (Sweden) 143 VII Summary able (Unied Kingdom) 145 A.II.1.1. Propery income (% of GDP) 16 LIST OF GRAPHS II.1.1. Life expecancy a birh, 196 o 28, seleced counries (males and females) 22 II.1.2. Feriliy raes, , seleced Member Saes 22 II.1.3. Populaion pyramids (in housands) for EU27 in 28 and II.1.4. Projeced change of main populaion groups (in % change over he period 28-26) 25 xi

14 II.1.5. Populaion of working-age and oal employmen, EU27 27 II.1.6. Decomposiion of GDP growh, EU27, ( annual average growh rae) 27 III.1.1. Decomposiion of he S2 indicaor 36 III.1.2. Gross deb (% of GDP) 4 III.2.1. S2 indicaor in he baseline scenario compared o he resuls of he 26 Susainabiliy Repor 42 IV.1.1. Poenial GDP growh compared: differen crisis scenarios (annual % change) 49 IV.1.2. Poenial impac of he budgeary crisis on pensions 51 IV.1.3. The poenial budgeary impac of he crisis on oal age-relaed expendiure 51 IV.1.4. The dynamics of public pension expendiure (baseline versus los decade scenario, % of GDP) 52 V.2.1. Expendiure of non-public occupaional, privae mandaory and nonmandaory pension (% of GDP) 76 V.4.1. Receips and spending as a share of GDP 79 VI.1.1. Overall risk classificaion and he susainabiliy gaps (S2 and S1 in he baseline scenario) 88 VII.1.1. Deerminans of fiscal susainabiliy (Belgium) 93 VII.2.1. Deerminans of fiscal susainabiliy (Bulgaria) 94 VII.3.1. Deerminans of fiscal susainabiliy (The Czech Republic) 96 VII.4.1. Deerminans of fiscal susainabiliy (Denmark) 98 VII.5.1. Deerminans of fiscal susainabiliy (Germany) 11 VII.6.1. Deerminans of fiscal susainabiliy (Esonia) 12 VII.7.1. Deerminans of fiscal susainabiliy (Ireland) 14 VII.8.1. Deerminans of fiscal susainabiliy (Greece) 16 VII.9.1. Deerminans of fiscal susainabiliy (Spain) 18 VII.1.1. Deerminans of fiscal susainabiliy (France) 11 VII Deerminans of fiscal susainabiliy (Ialy) 112 VII Deerminans of fiscal susainabiliy (Cyprus) 114 VII Deerminans of fiscal susainabiliy (Lavia) 116 VII Deerminans of fiscal susainabiliy (Lihuania) 118 VII Deerminans of fiscal susainabiliy (Luxembourg) 12 VII Deerminans of fiscal susainabiliy (Hungary) 122 VII Deerminans of fiscal susainabiliy (Mala) 124 VII Deerminans of fiscal susainabiliy (The Neherlands) 126 VII Deerminans of fiscal susainabiliy (Ausria) 128 VII.2.1. Deerminans of fiscal susainabiliy (Poland) 13 VII Deerminans of fiscal susainabiliy (Porugal) 132 VII Deerminans of fiscal susainabiliy (Romania) 134 VII Deerminans of fiscal susainabiliy (Slovenia) 136 VII Deerminans of fiscal susainabiliy (Slovakia) 138 VII Deerminans of fiscal susainabiliy (Finland) 14 VII Deerminans of fiscal susainabiliy (Sweden) 142 VII Deerminans of fiscal susainabiliy (Unied Kingdom) 144 LIST OF BOXES IV.1.1. Esimaing he impac on pension spending of changes in macroeconomic variables. 5 IV.2.1. Medium-erm deb projecions under alernaive consolidaion scenarios 55 IV.3.1. Scenario on posponing reiremen 6 xii

15 EDITORIAL The European economy is showing signs of enering a phase of recovery afer a deep crisis. Thanks o effecive and subsanive policy acion since auumn 28, coordinaed in he conex of he European Economic Recovery Plan (EERP), a financial meldown and a generalised loss of confidence has been avoided. However, uncerainy remains high, and here are sill risks of negaive feedback loops beween he financial secor and he real economy. Given he oupu losses in previous quarers, economic aciviy is se o shrink by 4 percen his year, followed by a gradual recovery in 21. Fiscal policymaking has been successfully argeed o he need and urgency of pulling he economy ou of he recession. Discreionary fiscal simulus and unfeered auomaic sabilisers have provided a cushion o economic aciviy and conribued o he recen signs of improvemen, bu have led o a subsanial deerioraion in governmen accouns. From a defici of.8 percen of GDP in 27 he bes resul for hiry years he governmen deficis in he EU are forecas o average 6 percen of GDP in 29 and around 7 percen in 21. In he hree years o 21, he gross deb raio for he EU as a whole is increasing by more han 2 poins. Moreover, very large coningen liabiliies may ranslae ino acual coss over he coming years, alhough some coss in suppor of he banking secor may be recouped. The susainabiliy of public finances in a longer-erm perspecive mus no be ignored. Though he deb and defici increases are by hemselves quie impressive, he projeced impac on public finances of ageing populaions is anicipaed o dwarf he effec of he crisis many imes over. The fiscal coss of he crisis and of projeced demographic developmen compound each oher and make fiscal susainabiliy an acue challenge. The available projecions show ha, in he absence of ambiious effors o implemen srucural reforms and consolidae governmen accouns, here would be large increases in expendiure on deb ineres and public pensions, as well as on healhcare and long-erm care during he coming decades. Rising governmen expendiure and prospecs of an ever-increasing deb would be an obsacle o a susained and recovery and balanced economic growh in he longer run. Successful fiscal expansion o couner recession and longer-erm fiscal susainabiliy are no incompaible. Fiscal measures o increase confidence and suppor demand are only successful if hey are perceived by he markes and public opinion as emporary and consisen wih long-erm susainabiliy. Oherwise, if economic agens expec a durable widening of deb, fiscal suppor will lose is effeciveness and can become counerproducive, in paricular when he crisis climax has been overcome and one eners a phase of recovery. Fiscal exi sraegies aiming a achieving ambiious and realisic medium-erm objecives need o be designed now, and implemened in a coordinaed manner as soon as recovery akes hold, aking ino accoun he specific siuaions of individual counries. To suppor he required reforms and enhance he credibiliy of fiscal adjusmen which ineviably sreches over a number of years Member Saes may also need o develop furher heir own budgeary frameworks. In he Sabiliy and Growh Pac conex, deb susainabiliy should ge a very prominen and explici role in surveillance procedures. Marco Bui Direcor General Economic and Financial Affairs xiii

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17 EXECUTIVE SUMMARY Alongside households and firms, governmens oo have o mee heir financial obligaions over ime. The concep of he susainabiliy of he public finances concerns he abiliy of a governmen o finance is curren deb and expeced expendiure. There is no one clear-cu definiion of a susainable fiscal posiion; insead here are alernaive heoreical and pracical approaches o assessing he susainabiliy of public finances. In general, i can be saed ha, a firs insance, a susainable posiion involves a deb level ha does no enail ineres paymens so large ha hey canno be paid. Thus, he susainabiliy of he public finances considers he abiliy of a governmen o service he coss of is deb hrough fuure revenues. Susainabiliy of public finances is herefore a long-erm concep and differs from solvency which is concerned wih he immediae (shor run) abiliy of a counry o finance is expendiure. This repor akes ino accoun he crisis conex and is impac on public finances a he momen when he firs signs of sabilisaion become apparen. As long as he recovery is no susained and he discreionary measures deployed by governmens are no wihdrawn, he effec of he crisis on public finances canno be fully deermined. However, given he large impac of he crisis on public deb, i provides a imely inpu a a sage where fiscal policies mus progressively be reoriened owards susainabiliy and exi sraegies need o be designed now and implemened in a coordinaed manner as soon as he recovery akes hold, aking ino accoun he specific siuaion of individual counries. The fiscal coss of he crisis and of projeced demographic developmens compound each oher and make fiscal susainabiliy an acue challenge. The available projecions show ha, in he absence of ambiious effors o implemen srucural reforms and consolidae governmen accouns, here would be very large increases in expendiure on deb ineres and public pensions, as well as on healhcare and long-erm care during he coming decades. The assessmen of he long-erm susainabiliy of fiscal policy is now a well esablished par of budgeary surveillance in he EU. However, in a conex of crisis and recovery, he susainabiliy assessmen is underaken under larger han usual uncerainy. On he one hand, i is difficul o correcly judge he iniial srucural fiscal posiion. This is relaed o he uncerainy on he poenial oupu and he oupu gap, bu also on he way ha ax revenue has been affeced by he crisis, as well as on he durable or emporary naure of he suppor measures adoped by governmens. On he oher hand, he crisis may consiue a srucural break in our economies and have a proraced impac on he way hese economies will grow over he nex decades. Populaion ageing is a phenomenon ha he Member Saes are already familiar wih, bu whose consequences are ye o be fel in full force. Already, he European Union has experienced an ageing of is populaion hrough an increase in life expecancy and a fall in feriliy raes. Over he nex 5 years he EU populaion is expeced o age furher his will have consequences for he public finances and heir susainabiliy. The economic and budgeary consequences of he expeced change in populaion srucure sem mainly from a reducion in he working age populaion and an increase 1

18 European Commission Susainabiliy Repor - 29 in he number of elderly people requiring suppor. A lower number of economically acive people leads o lower economic growh and lower axes, while a higher number of reired people enails addiional public provision of age-relaed ransfers and services. On he basis of curren policies, age-relaed public expendiure is projeced o increase on average by 4.3 percenage poins of GDP by 26 in he EU. The increase is mainly due o pension, healhcare and long-erm care spending. As here are significan differences in boh he srucure of ageing and he social securiy sysems ha provide suppor for he elderly across he Member Saes, he projeced increase in public expendiure also varies by counry. In order o asses he susainabiliy of fiscal policy in each Member Sae, a number of indicaors have been developed. In general, hese indicaors assume a coninuaion of curren revenue and expendiure policies over a finie or infinie imescale, usually aking he expeced developmen of populaion size and srucure ino accoun. More specifically, hese indicaors reflec he projeced developmen of main ax revenues (usually direc and indirec axes and social conribuions) and expendiure (i.e. pensions, healh care, long-erm care ec.) under curren policy over a very long horizon. The susainabiliy indicaors quanify he gap ha mus be closed o ensure he public obligaions can be financed in he fuure. In his repor in line wih previous assessmens wo main susainabiliy gap indicaors are derived: he S1 and S2 indicaors. Boh S1 and S2 show he size of he permanen budge adjusmen required o ensure ha he public budge consrains are me. The S1 indicaor shows he adjusmen o he curren primary balance required o reach a arge governmen gross deb of 6% of GDP in 26, including paying for any addiional expendiure arising from an ageing populaion. The S2 indicaor shows he adjusmen o he curren primary balance required o fulfil he infinie horizon ineremporal budge consrain, including paying for any addiional expendiure arising from an ageing populaion. Thus, he difference beween S1 and S2 is he lengh of he ime horizon aken ino accoun when assessing he susainabiliy of he public finances. In boh cases, non-age relaed and nonineres spending is assumed o remain consan as a share of GDP in he relevan ime period. In addiion o hose wo indicaors, he required primary balance (RPB) is also used o illusrae he susainabiliy siuaion. The RPB indicaes he saring budgeary posiion which, if aained, ensures he susainabiliy of he public finances under no policy change assumpions. The RPB can hen be used o compare he acual or planned budgeary sraegy wih he srucural primary balance required for fulfilling he iner-emporal budge consrain. The major inpus ino S1, S2 and RPB indicaors are he curren levels of gross governmen deb, he srucural primary balance (i.e. public budge balance excluding ineres paymens on public deb, cyclical facors and one-off ransacions) and he expeced addiional coss arising from populaion ageing. A posiive value of he gap indicaors like S1 and S2 signifies he permanen adjusmen o he fiscal policy ha is necessary o ensure susainabiliy. The analysis is underaken on he basis of curren policy coninuing in he fuure; his does no imply ha i is realisic o assume ha hese policies will coninue, bu serves o quanify he necessary magniude of he change in 2

19 Execuive summary policy in order o inform he debae. Indeed, he greaer he value of he indicaor he greaer adjusmen ha is required o resore he susainabiliy of public budges. On he conrary, a negaive value indicaes ha fiscal policy is susainable. The value of S1 and S2 can be furher decomposed ino pars characerising he required adjusmen given he iniial budgeary posiion (IBP), required adjusmen given he long-erm change in expendiure (LTC) and, in case of S1, he effec of he saring level of deb relaive o he 6% arge for 26 (DR) o allow consideraion and comparison of he conribuion hese componens make o susainabiliy. Sill, he indicaors do no in hemselves provide any guide as o how he adjusmen should ake place as he necessary adjusmens could occur as resul of an increase in governmen receips or a reducion in is spending, or srucural reforms. The value of he S2 indicaor shows a susainabiliy gap of 6.5% of GDP for he whole EU and of 5.8% of GDP for he euro area, albei wih wide variaion beween counries. The S1 indicaor shows a susainabiliy gap for he EU counries and for he euro area, of 5.4% and 4.8% of GDP respecively. The decomposiion resuls show ha for he EU-27 counries, he IBP is responsible for 3.3 poins of he S2 gap and 3.1 poins for he S1 gap. This means ha even wihou aking he cos of ageing ino accoun, ha is assuming ha age-relaed expendiure in governmen accouns remained consan as a share of GDP, European counries should ighen heir fiscal sance (in erms of he srucural primary balance) by an average of 3.3% of GDP, or adop srucural reforms, for heir public finances o reurn o a susainable pah. The long erm cos of ageing (LTC) conribues 3.2 poins o he S2 gap and 2 poins o he S1 gap, wih he figures being 3.5 and 2.4 poins respecively for he euro area. This shows ha he LTC has a significan fiscal impac on average. For he S1 gap, he requiremen o reach a deb level of 6% of GDP by 26 (DR) adds an adjusmen of.2 poins for he EU-27 and.3 poins for he euro area. Overall, he baseline resuls in his repor differ significanly from hose presened hree years ago in he 26 Susainabiliy Repor. While he EU-25 average susainabiliy gap was esimaed a 3.4% of GDP on S2, he curren esimaes are for 6.5% of GDP. On average, he susainabiliy gap has increased by 3.1% of GDP for he 25 counries ha were members of he EU in 26. While four Member Saes (Hungary, Porugal, Ialy and Germany) show a lower susainabiliy gap han in he 26 exercise, he remaining Member Saes show deerioraion. Of hese, in all cases expec Greece, Luxembourg and Mala, he deerioraion is essenially due o he crisisrelaed weakening of he iniial budgeary posiion raher han o an increase in he age-relaed coss and he delay in he required adjusmen ha leads o a higher LTC. For Spain, Greece, Ireland, Lavia and he UK he weakened iniial budgeary posiion is responsible for an increase of he esimaed susainabiliy gap of over 5% of GDP. The financial and economic crisis has added o counries' susainabiliy difficulies, hrough he significanly worse han expeced macro-economic and fiscal developmens in 28 and 29 i has led o. In addiion, here is marked uncerainy regarding economic growh in he medium and long-erm perspecive. As a consequence, a number of alernaive macroeconomic scenarios were produced o look a he impac of he crisis. In a los decade scenario, pension expendiure is.9% of GDP higher in 26 relaive o he 3

20 European Commission Susainabiliy Repor - 29 baseline, while oal age relaed expendiure is 1.4% of GDP higher, wih he mos of he increases occurring beween 27 and 22. Alhough he crisis has added o he susainabiliy problems, he recovery is no likely o solve all he difficulies on is own. For some Member Saes he curren deficis may reurn o surplus when he recovery comes, bu where his is no he case budgeary consolidaion will be necessary and should be underaken as soon as he ime is righ in order o reduce long-erm risks o public finance susainabiliy. Projecions based on a scenario of growh reurning o he long-erm pah of before he crisis show ha wihou consolidaion, he gross deb-o-gdp raio for he EU as a whole could reach 1 percen as early as 214, and keep on increasing. A consolidaion effor of.5 percen of GDP per year unil he Member Saes MTOs are reached will only sabilise he deb raio a around 1 percen of GDP if growh akes ime o reurn o he pre-crisis rend. Thus, alhough fiscal suppor mus be mainained unil recovery is secured, fiscal policies mus progressively be reoriened owards susainabiliy. Exi sraegies need o be designed now and implemened in a coordinaed manner as soon as recovery akes hold, aking ino accoun he specific siuaions of individual counries. Of course, he esimaes presened in he repor are parly deermined by he underlying assumpions made. To assess he robusness of he susainabiliy indicaors and o beer undersand he long-erm susainabiliy risks in each counry, he Susainabiliy Repor quanifies he impac of changes in main assumpions on he susainabiliy indicaors. In paricular, alernaive assumpions are presened for life expecancy, labour produciviy, paricipaion of older workers in he labour marke, oal employmen, migraion and he ineres rae. For all hese elemens here is considerable uncerainy when predicing ino he fuure, so considering he response of susainabiliy resuls o he underlying assumpions is imporan. Again, he final change of S2 as a response o a change in some of he menioned parameers may differ counry-by counry as eligibiliy and indexaion rules for age relaed expendiure are counry specific. On he basis of he susainabiliy indicaors, as well as a number of oher facors (including deb and asses, average pensions and ax burden), he EU Member Saes are classified in hree caegories depending on he degrees of long-erm risk hey face. Overall, only five counries are classified as lowrisk counries, nine counries are classified as facing medium long-erm risk, while hireen counries are exposed o higher long-erm risks. Bulgaria, Denmark, Esonia, Finland and Sweden have relaively sronger budgeary posiions and have underaken comprehensive pension reforms in recen years. Though he crisis is leading o a deerioraion in governmen balances and a subsanial increase in governmen deb raios of each of hese counries, heir srucural fiscal posiions remain sounder han in mos oher EU counries, and presen herefore a low long-erm risk. In Bulgaria, Denmark, Esonia and Sweden, he increase in age-relaed expendiure over he nex decades is projeced o be well below he EU average. Noe, however, ha he projecions for Bulgaria and Esonia do no include any srenghening of social proecion in he coming decades ha may be necessary for heir sysems o converge wih oher EU counries. In Finland, he projeced increase in expendiure is subsanial and he fiscal cos of he 4

21 Execuive summary crisis has been large. However, he large sock of financial asses in he social securiy porfolio provides a cushion o absorb a deerioraion in governmen accouns. Belgium, Germany, France, Ialy, Hungary, Luxembourg, Ausria, Poland and Porugal are counries wih very differen characerisics in relaion o heir iniial budgeary posiion and age-relaed expendiure. Belgium, Germany and Ausria are projeced o bear coss of ageing close o, or above, he EU average, bu heir iniial budgeary posiions are relaively sound, provided ha he crisis-relaed deerioraion in governmen accouns does no become srucural. Though medium-erm consolidaion will improve he susainabiliy indicaors, reforms o address rising age-relaed coss will be indispensable. For Belgium, he deb raio which is reurning o above 1 percen of GDP consiues a burden and a specific risk. The projeced increase in he age-relaed expendiure in Luxembourg is he highes of he whole EU; however, his risk is cushioned by he currenly low deb and large governmen-owned financial asses. In general, for his group of counries, he long-erm susainabiliy risk is medium. For France, Ialy, Hungary, Poland and Porugal, he long-erm coss of ageing are no projeced o be paricularly high. However, heir iniial budgeary posiions imply ha fiscal policy is unsusainable even wihou considering any increase in age-relaed expendiure. In all hese counries, he crisis and he suppor o recovery are leading o a very fas increase in deb raios, quickly offseing he consolidaion gains achieved in recen years. For Poland, projecions indicae a fall in age-relaed expendiure over he long erm because of he shif of pension provision o funded schemes; however, he projeced reducion in expendiure is also relaed o a large cu in benefi raios. This may raise issues of social susainabiliy by increasing old-age povery. For France, ambiious fiscal consolidaion, once he recovery is firmer, is indispensable and will consiue a major sep o improve susainabiliy. In Porugal, a recen pension reform have done much o improve susainabiliy; however, he srucural budgeary posiion remains largely unbalanced. In he case of Ialy, fas fiscal consolidaion once he recovery akes hold is indispensable o ensure a seady reducion in he very high deb raio. The low susainabiliy gap of Hungary resuls from pension reform and recen fiscal consolidaion; however, he correcion in srucural imbalances in recen years needs o be pursued furher in order o reduce deb. The Czech Republic, Cyprus, Ireland, Greece, Spain, Lavia, Lihuania, Mala, he Neherlands, Romania, Slovenia, Slovakia and he Unied Kingdom have susainabiliy gaps above 6 percen of GDP; over double ha level in Ireland, Greece, Spain, Slovenia and he Unied Kingdom. In nearly all of hese counries, he susainabiliy gaps are he resul of a very large projeced increase in age-relaed expendiure, compounded in mos cases by large iniial imbalances, and hence hey are exposed o higher long-erm risks. This indicaes ha closing heir gaps will require boh ambiious consolidaion programmes ha reduce debs and deficis in he coming years, and profound reforms of social proecion. This is paricularly he case for Greece, which faces he second highes increase in age-relaed expendiure of he enire EU, while is very high deb raio adds o he concerns on susainabiliy. The possible coninuing effecs of he crisis on he budgeary posiion and on medium-erm growh are a serious concern for mos of he counries exposed o high long-erm susainabiliy risks in paricular, 5

22 European Commission Susainabiliy Repor - 29 Ireland, Greece, Lavia, Spain and Unied Kingdom for whom avoiding exponenially increasing debs is a policy challenge already in a mediumerm perspecive. The repor is srucured as follows. Chaper I inroduces he concep of susainabiliy and discusses how i will be measured. I inroduces he addiional difficulies ha demographic changes and he fiscal coss of he crisis poses o susainabiliy. Chaper II presens daa on projeced demographics in he EU for he years unil 26, and he projeced increases in a number of age-relaed expendiure caegories. Chaper III presens he resuls of he susainabiliy analysis in he form of he S1 and S2 indicaors and breaks he resuls down in heir consiuen pars. I compares he resuls wih hose presened in he 26 Susainabiliy Repor and considers he cos of delaying acion. Chaper IV considers he effec ha he economic crisis migh have on susainabiliy and by presening he effec ha alernaive poscrisis macroeconomic scenarios migh have. I considers he impac ha consolidaion in line wih he exising medium erm budgeary objecives would have, if underaken once he economies are firmly in he recovery phase. Finally i presens a sensiiviy analysis which considers how differen underlying assumpions would affec he value of he S2 indicaor. Chaper V discusses oher facors ha affec susainabiliy bu which do no direcly ener he calculaion of he indicaors. These are he addiional risk of deb and he value of governmen asses, he level of pensions and he social and poliical risks ha hese may enail, he role of coningen liabiliies and he implicaions ha differen levels of exising ax raios have for governmens' policy choices. Chaper VI presens an overall classificaion of counries according o he long-erm susainabiliy risks ha hey face, while deailed daa, and discussion of he resuls, for each Member Sae is se ou in Chaper VII. 6

23 Chaper I Susainabiliy of public finances

24

25 SUMMARY The crisis-relaed fiscal expansions and he ageing of European Union's populaion raise quesions abou he susainabiliy of he Member Saes' public finances. As he share of working age people in he populaion falls and he share of he old increases, economies are faced wih lower economic growh and higher coss associaed wih providing services for he ageing populaion. This resuls in pressure on he public finances; bold measures will be necessary o ensure ha hey reurn o a susainable fooing before he full effec of ageing is fel. Susainabiliy relaes o he abiliy of a governmen o assume he financial burden of is deb currenly and in he fuure. While here is no one clear-cu definiion of a susainable fiscal posiion, his chaper defines wo susainabiliy gap indicaors which are mos widely used in he EU o measure he susainabiliy challenges ha Member Saes face. These are: The S1 indicaor shows he durable adjusmen o he curren primary balance required o reach a arge deb of 6% of GDP in 26, including paying for any addiional expendiure arising from an ageing populaion. The S2 indicaor shows he durable adjusmen of he curren primary balance required o fulfil he infinie horizon ineremporal budge consrains, including paying for any addiional expendiure arising from an ageing populaion. srong. The susainabiliy indicaors also provide informaion on he cos ha would resul from a delay in addressing he long-erm susainabiliy issues. The analysis in his repor uses he projeced changes in age-relaed expendiure from he Commission and EPC s 29 Ageing Repor. I considers he addiional expendiure on pensions, healhcare and long-erm care ha populaion forecass enail, as well as he poenially offseing effec of changes o educaion expendiure and unemploymen benefis. The differen social proecion srucures and demographic rends of he Member Saes mean ha such expendiure is expeced o evolve in very differen ways across counries. The analysis underaken in his repor akes he 29 fiscal posiion as a basis and projecs he rajecory of he public finances on a parial equilibrium basis. All projecions are done on a no policy change assumpion, whereby i is assumed ha already approved legislaion coninues o apply, bu ha mos ax receips and spending say consan as a share of GDP over he long erm. This assumpion of unchanged polices over he whole projecion period is no adoped for reasons of realism, bu because i is he assumpion ha allows a robus assessmen of he required remedial acion o avoid ha he EU public finances ener in an exponenially increasing deb spiral. The susainabiliy indicaors quanify he required permanen budgeary adjusmen (e.g. a durable reducion of non age-relaed public expendiure as a share of GDP or a consan increase in public revenue as a share of GDP) o ensure he susainabiliy of he public finances. The susainabiliy indicaors provide a firm basis o idenify he size and he main source of risks o public finance susainabiliy in he EU Member Saes in a long-erm perspecive. They can be decomposed ino a par ha relaes o he saring fiscal posiion and a par ha relaes o he addiional coss of an ageing populaion. Decomposing hem in his way gives addiional informaion abou he naure of he policy response ha is appropriae. In paricular, where he coss of ageing are a significan risk facor o he susainabiliy of he public finances, he case for reforming he social proecion sysems becomes 9

26 1. DEFINING SUSTAINABILITY 1.1. WHAT IS MEANT BY THE SUSTAINABILITY OF THE PUBLIC FINANCES The concep of he susainabiliy of he public finances relaes o he abiliy of a governmen o assume he financial burden of is deb currenly and going forward. There is no clear-cu definiion of a susainable fiscal posiion, hough he concep is raher inuiive. A a firs insance i involves a deb level ha does no enail eiher now or in he foreseeable fuure ineres paymens so large ha hey canno be paid. A firs way of wriing down he wides definiion of susainabiliy is o look a he solvency condiion for he general governmen hrough he governmen s iner-emporal budge consrain. ( 1 ) This considers he abiliy of he governmen o mee he coss of is deb hrough fuure revenues. The ineremporal budge consrain is saisfied if he projeced ouflows of he governmen (curren public deb and he discouned value of all fuure expendiure, including he projeced increase in age-relaed expendiure) are covered by he discouned value of all fuure governmen revenue. This is equivalen o saying ha he governmen mus run sufficienly large primary surpluses (receips minus spending excluding ineres paymens) going forward o cover he cos of servicing is deb. The ineremporal budge consrain is mos ofen considered over an infinie horizon wih no implicaions abou when he primary surpluses should be larger or smaller, nor wha balance of expendiure and receips hey should be driven by. Nor does i imply ha ha he deb should sand a a paricular finie value a any given poin in ime. As such i could, heoreically, be saisfied by very high levels of deb and, herefore, very high ineres paymens, in he shor erm or a any ime horizon, as long as here is reason o believe ha sufficienly large primary surpluses will be achieved aferwards. While he infinie horizon gives a comprehensive picure of he susainabiliy of he public finances, i can prove weak from a policy poin of view due o is lack of immediacy and raises issues of ime consisency. Alernaively, a finie version of he budge consrain can be defined, by seing a arge dae and a arge deb level and considering wheher and how his can be achieved. The choice of arge dae reflecs he aim of he exercise in erms of how i is expeced o guide policy. By picking a shor imescale, he requiremens placed on he governmen are sronger as here is lile possibiliy of adjusing he fiscal posiion in he fuure o ensure ha his budge consrain is me, hough some challenges (such as he demographic developmens and poenial growh afer he arge dae) are disregarded. Conversely, he furher away he arge dae, he more absrac he exercise becomes as a guide o policymakers, and he more relevan ime consisency issues become. By choosing oo high a arge deb level, here is he possibiliy ha susainabiliy is compromised in he period beyond he arge dae, while choosing oo low a deb level can implicily impose an undue burden on curren axpayers versus hose in he more disan fuure. In his repor, he arge dae is 26 en years more han 25, he arge dae in he Commission s previous Susainabiliy Repor. ( 2 ) The arge level of deb is 6 % of GDP, which is he hreshold for he general governmen gross deb in he EC Treay. The analysis presened in his repor aims o provide an esimae of wheher he curren budgeary posiion in he Member Saes presens a susainabiliy gap going forward, once he effecs of an ageing populaion are aken ino accoun. The analysis aims o aid he undersanding of he choices he governmens of he Member Saes face over he long erm and o inform he debae abou he magniude of changes ha need o be considered. ( 1 ) D PB = = + 1 (1 + r) where D is gross deb as a share of GDP in he year before he long-erm projecions, PB is he srucural primary balance (receips minus spending excluding deb ineres paymens) a ime and r is he differenial beween he nominal ineres rae and he nominal GDP growh rae. ( 2 ) Long-Term Susainabiliy of Public Finances in he EU, European Economy, 4/26 and respecive Commission communicaion, COM (26) 574 final, 12 Ocober 26. 1

27 Chaper I Susainabiliy of public finances 1.2. DEFINING THE SUSTAINABILITY INDICATORS In his repor susainabiliy is assessed using curren levels of gross governmen deb, he primary balance in srucural erms (i. e. he cyclically-adjused primary balance and removing one-off ransacions) and expeced addiional coss arising from ageing o see wheher an infinie and a finie version of he ineremporal budge consrain are me. The greaer he expeced coss of ageing, he harder i is for he ineremporal consrains o be me, oher hings being equal, as he curren primary balance will need o be sufficienly large o accoun for hese addiional fuure coss. Corresponding o each version of he budge consrain over an finie or infinie horizon wo susainabiliy gap indicaors are derived, showing he size of he permanen budge adjusmen required o ensure ha he consrains are me. The S1 indicaor shows he durable adjusmen o he srucural primary balance required o reach a arge deb of 6% of GDP in 26, including paying for any addiional expendiure from now o he arge dae, arising from an ageing populaion. The choice of he deb arge for he S1 indicaor is in line wih he deb hreshold in he Treay. The imescale has been chosen o be long enough o allow he impac of ageing o be analysed in a meaningful way, while sill remaining wihin he sighs of curren axpayers and policy makers. The S2 indicaor shows he adjusmen o he srucural primary balance required o fulfil he infinie horizon ineremporal budge consrain, including paying for any addiional expendiure arising from an ageing populaion INTERPRETING THE SUSTAINABILITY INDICATORS The susainabiliy indicaors quanify he gap ha mus be closed o ensure he susainabiliy of he public finances. The larger he value of he gap indicaors, he greaer is he necessary adjusmen o he srucural primary balance o ensure susainabiliy. A negaive value indicaes ha he ineremporal budge consrain is me; even deerioraion in he primary balance could allow he consrain o be me. The indicaors do no provide any guide as o how he adjusmen should ake place. Alhough he susainabiliy indicaors are someimes referred o as ax gaps, he necessary adjusmens could occur as resul of an increase in governmen receips (usually hrough higher direc or indirec axes), a reducion in non age relaed spending, or hrough policy responses aimed a reducing he cos of ageing. The choice of measure, or combinaion of measures, may iself have an impac on he economy or on fiscal susainabiliy. For example, a large increase in he ax burden o fill he susainabiliy gap may iself lead o deerioraion in he economy s growh prospecs, wih consequences for susainabiliy. The susainabiliy gap indicaors are one way of presening he resuls of he susainabiliy analysis. An alernaive would be o look a he fuure level of deb assuming no policy acion in response o he susainabiliy imbalances. This exercise is also presened laer in he repor, showing a more cumulaive or sock assessmen of he challenge faced by each Member Sae. The required primary balance (RPB) is anoher indicaor used o presen he susainabiliy siuaion. The RPB indicaes he saring budgeary posiion which, if aained, ensures he susainabiliy of he public finances under no policy change assumpions. Unlike he S2 indicaor, i is a level for he budgeary posiion, raher han a gap. I is imporan o noe ha he RPB is no a saic indicaor. For a counry ha has reached is RPB (so wih a S2 gap which is zero and which is projeced o remain zero), he acual and required primary balance will progressively deeriorae given he increase in ageing-relaed expendiure, hough susainabiliy is ensured. Where he acual (or planned for he medium erm) budgeary balance is equal or more posiive han he RPB, he public finances are susainable. The opposie is rue where he acual or planned budgeary balance is smaller or more negaive han he RPB. In pracice, he RPB is ofen calculaed as he projeced average srucural primary balance over several years. In his repor i is given for he firs five years afer he Commission Spring 29 forecas horizon (211 15). Like he susainabiliy 11

28 European Commission Susainabiliy Repor - 29 gaps (S1 and S2), he RPB does no provide firm guidance on which policy measures (such as ax increases, spending cus or reforms in social proecion) are required o reurn o susainable public finances. However, when he RPB is so large ha i is no realisic, medium-erm fiscal consolidaion via ax or spending measures will no be enough and reform of he demographicdriven spending caegories (noably public pensions and healhcare) appear indispensable OTHER CONCEPTS OF SUSTAINABILITY Depending on he public policy ineres, oher conceps of susainabiliy exis. For example, conceps of poliical or social susainabiliy or of iner-generaional equiy would be assessed using a differen approach o ha pursued in his repor. Deb involves he deferral of paymens o fuure axpayers and resrics choice abou how o spend he producs of heir labour and invesmen. Quesions abou iner-generaional equiy, herefore, also need o be considered by policy makers. I migh, for example, be informaive o look a he marginal benefi o fuure axpayers of he expendiure financed hrough deb whose repaymen may fall on hem. For small economies ouside he moneary union, he currency denominaion of deb and wheher deb is held inernally or exernally may also be imporan. Moreover, while a given level of deb may no be unbearable, he budgeary pressures caused by he deb burden can creae poliical incenives for governmens o defaul on heir deb, eiher explicily or hrough inflaion. The EU, and in paricular, he euro area counries, is well equipped o resis pressures o inflae away governmen debs. 12

29 2. DERIVING THE SUSTAINABILITY INDICATORS The susainabiliy indicaors, S1 and S2, show he gap beween he curren budgeary posiion expressed in erms of he srucural balance and ha required o ensure susainabiliy. Table II.2.1 breaks he indicaors down ino he hree facors ha he gap depends on, and he hree corresponding componens of he indicaors. I shows ha he iniial budgeary posiion and he long erm coss of ageing affec boh indicaors direcly, while he S1 indicaor is also direcly affeced by he saring level of deb relaive o he 6% arge for 26. In he resuls shown in laer secions of his repor, he conribuion of hese hree componens is considered in deail REQUIRED ADJUSTMENT GIVEN THE INITIAL BUDGETARY POSITION Irrespecive of he increase in governmen expendiure due o projeced demographic developmens, he public finances of a given counry may be unsusainable if he iniial srucural primary balance, he projeced ineres paymens and economic growh imply an ever increasing deb raio. Thus, he firs componen of he S1 and S2 indicaors corresponds o he gap beween he iniial srucural primary balance and he deb-sabilising primary surplus. This componen is referred o as he required adjusmen given he iniial budgeary posiion, or simply IBP. ( 3 ) In order o correcly accoun for he conribuion of he budge balance a he saring year, i is imporan o consider he underlying fiscal posiion, raher han he acual value of he governmen surplus or defici published by he saisicians. This means adjusing he saring balance for he effec of he business cycle and emporary measures, such as one-off expendiure and revenues, o derive he srucural balance. This repor usually uses he forecass for 29, as published in he European Commission 29 spring Forecass, for he saring posiion of he boh he srucural balance and deb level. Correcly esimaing he srucural balance requires an esimaion of he posiion of he economic aciviy relaive o is poenial, he so-called oupu gap, and an esimaion of he effec of he economic cycles on governmen revenues and spending. ( 4 ) Cyclical adjusmen always enails a cerain level of imprecision. However, under he curren circumsances, wih he European economy in he early phases of recovery afer a deep financial and economic crisis, he inheren difficulies are unusually large. Firs, i is difficul o correcly judge he posiion of he oupu gap. In he ligh of possible srucural changes, he poenial oupu of oday, as well as is rajecory in he fuure conains a subsanial elemen of uncerainy. These facors ac o compound he fac ha ax elasiciies end o vary over he economic cycle and ha hey are implicily affeced by asse price changes which are difficul o model or predic. The naure of he crisis has been such ha he elemen of uncerainy linked o judging he iniial budgeary posiion and is conribuion o susainabiliy over ime is of paricular significance. The forecas rajecory of economic growh over he medium- and long-erm is a crucial facor in deermining he impac of he iniial budgeary posiion and deb on susainabiliy, and he required adjusmen given he iniial budgeary posiion. As his rajecory is paricularly uncerain given he economic and financial crisis, Chaper IV derives alernaive esimaes for he susainabiliy indicaors under alernaive scenario. ( 3 ) As he size of his componen depends on expeced growh and ineres raes, i is no necessarily he case ha i will have he same magniude in he S1 and S2 indicaors, as expeced growh and ineres raes migh vary over ime. However, in pracice IBP (S1) an IBP (S2) are quie close o each oher. Moreover, also because of he expeced movemens in growh and ineres raes, including hose of a cyclical naure, he concep of deb sabilisaion should be undersood in a long-erm perspecive and no year by year. ( 4 ) Cycles in asses prices may also be relevan in esimaing he srucural balance, hough hey are usually no considered explicily in mos srucural adjusmen mehods. 13

30 European Commission Susainabiliy Repor - 29 Table I.2.1: Summarising he indicaors Required adjusmen given he iniial budgeary posiion (IBP) S1= Gap o he deb-sabilising primary balance Required adjusmen o reach deb o GDP raio of 6% in 26 (DR) + Addiional adjusmen required o reach a deb arge of 6% of GDP in 26 Required adjusmen due o long-erm changes in he primary balance (LTC) + Addiional adjusmen required o finance he increase in public expendiure due o ageing up o 26 S2= Gap o he deb-sabilising primary balance + + Addiional adjusmen required o finance he increase in public expendiure due o ageing over an infinie horizon Source: Commission services 2.2. THE DEBT REQUIREMENT BY 26 The saring level of deb eners he definiion of boh indicaors hrough he iniial budgeary posiion, as i deermines he size of ineres paymens on governmen deb ha mus be covered. In he case of he S1 indicaor only, he size of adjusmen required also direcly depends on he deb requiremen se a end of he ime period (6% of GDP in 26). For counries wih saring governmen gross deb above 6% of GDP he required adjusmen o reach he arge deb by 26 (DR) erm will increase he size of he indicaor as he effor of deb reducion by 26 needs o be considered. For counries wih curren deb of below 6%, he DR componen will be negaive and reduce he S1 indicaor. The curren financial and economic crisis, adds an elemen of uncerainy o he DR esimae oo. The esimaes presened laer in he repor use deb from 29 as he base. Ye wih he hisorically large defici raios being recorded in several European counries, in some cases up o 1% of GDP, he increase in deb likely o be seen over he nex couple of years could lead o very differen esimaes of he conribuion of he deb componen o he S1 indicaor. Moreover, he accumulaion of financial asses such as shares, oher equiy or loans, as par of he bail ou of banks and oher eniies heavily hi by he crisis by governmens also implies ha he governmen gross debs of several counries are increasing much faser han implici by he defici ( 5 ) THE REQUIRED ADJUSTMENT GIVEN THE INCREASE IN AGE-RELATED COSTS Finally, boh S1 and S2 include a componen which corresponds o he required adjusmen due o he long-erm changes in governmen expendiure (or simply, LTC). The hird componen of boh indicaors is he addiional adjusmen required as a resul of hese expenses eiher o 26 or over an infinie horizon. The magniude of he LTC componen depends on boh he demographic oulook for counries and heir social proecion arrangemens. The LTC componen represens eiher he change required o pay for he addiional expenses or he size of a srucural reform ( 6 ) o social proecion schemes o avoid he increase ha would oherwise ensue. The size of his componen is likely o vary beween he S1 and S2 indicaors. The larger he par of he expeced ageing of he populaion ha is o occur in he shor- raher han medium-erm ( 5 ) See European Commission (29), Public Finances in EMU-29, chaper II-1, European Economy, 5, for more deails on how governmen ransacions o bail ou banks and oher eniies hi by he crisis are recorded in governmen accouns in paricular wih respec o he governmen defici and deb. See also Eurosa News Release 13/29 of 15 July 29: The saisical recording of public inervenions o suppor financial insiuions and financial markes during he financial crisis. ( 6 ) The size of a srucural reform o social proecion schemes (such as public pensions and healhcare) means here he discouned sum of he spending savings implied by ha reform. 14

31 Chaper I Susainabiliy of public finances fuure, he larger he impac on he S1 indicaor relaive o he S2 indicaor. Conversely, if he coss of an ageing populaion are mainly borne closer o 26 han now, he larger he relaive impac of ageing on he S2 indicaor. The economic crisis has an impac on LTC in so far as he crisis leads o a durable fall in poenial growh, and indirecly on several governmen oulay ha somehow depend on growh. Moreover, he shock o asse prices and asse reurns also impac on he ne coss of providing pension for he pension schemes ha conrol large asses POLICY IMPLICATIONS The decomposiion of he indicaors allows an analysis of he driving forces behind he resuls summarised by he indicaors. The same overall susainabiliy gap may be he resul of eiher he curren fiscal posiion (see IBP), he level of deb (see DR) or he expeced increase in ageing-relaed expendiure (see LTC). In relaion o he laer, comparing LTC componens in S1 and S2 (i.e. he finie- and infinie-horizon versions of he susainabiliy indicaors) also allows idenificaion of he urgency in addressing he demographicrelaed susainabiliy issues. An opimal policy response requires an undersanding of hese issues. For example, a susainabiliy gap arising primarily from an imbalanced iniial budgeary posiion being insufficien or one ha is insufficien o sabilise deb migh be easier o recify poliically hrough ax increases or spending cus, han one due primarily o he coss of ageing. In he laer case, coss on governmen budges migh only become direcly visible in he fuure and anicipaory remedial acion may be more difficul o implemen. The overall efficiency of fiscal consolidaion approach (increasing axes or cuing expendiure) or of approaches based on srucural reforms of social proecion also depends on he source (IBP, DR or LTC) of he susainabiliy imbalances. 15

32 3. ESTIMATING THE COST OF AGEING 3.1. PROJECTING AGE-RELATED EXPENDITURE An ageing populaion pus pressure on a counry s finances primarily hrough is effecs on he labour marke and hence economic growh and agerelaed expendiure. Wih fewer people being of working age, he poenial growh rae of he economy is reduced. These changes affec each of he componens of he S1 and S2 indicaors, hrough changes in he esimaed rae of economic growh. The direc coss of ageing involve increases in agerelaed expendiure. This repor uses he esimaes of he fiscal impac of hese changes as presened in he 29 Ageing Repor. ( 7 ) As he aim is o provide an esimae of he long-erm effec on susainabiliy of ageing, he analysis akes he figures for age-relaed coss saring in 21. The projecions are made on a basis of no-policy change assumpion where i is assumed ha curren ax and spending arrangemens coninue in he fuure. The Ageing Repor considers he public cos of ageing using five expendiure caegories. This repor uses he projeced changes o hese caegories o quanify he impac of ageing on he susainabiliy of he public finances. Public pensions' expendiure increases wih an older populaion. This caegory consiss of old age pensions and survivors' pensions, early reiremen funding, various disabiliy benefis and oher iems of public expendiure ha provide suppor for hose unable o work. The exen o which such expendiure increases depends on boh he degree of ageing he number of reirees and he average lengh in reiremen, which is direcly linked wih longeviy bu also very significanly on he reiremen age and he srucure of he pension and suppor sysems in place. Such sysems ypically consiue a significan porion of he public budge, bu heir srucures vary widely, in erms of ( 7 ) 29 Ageing Repor join repor of he European Commission and he EPC, European Economy, 2, and Commission Communicaion Dealing wih he Impac of an Ageing Populaion in he EU, COM (29) 18 final, 21 April 29. heir curren generosiy and of heir dynamic properies. Healhcare expendiure is also affeced by he age srucure of he populaion and he way oal healh-relaed coss are spli beween he governmen, paiens or privae insurance bodies. However, he link beween age and he cos of healhcare is much less linear han for pensions. Alhough here is evidence ha he consumpion of healhcare services by he elderly is subsanially larger han ha by prime-age aduls, an increase in life expecancy is ypically also accompanied by an increase in he average number of healhy years and so healhcare coss need no increase in a linear fashion. The reference scenario from he Ageing Repor which is used in he baseline resuls in his repor assumes ha half he increase in life expecancy is spen in good healh. Long-erm care expendiure relaes o he coss associaed wih helping people carry ou daily living aciviies. This is also expeced o increase wih an ageing populaion. The increase depends, as wih he healhcare expendiure, on he qualiy of he ageing, bu also crucially on he governmen suppor available for individuals less able o look afer hemselves. There is large variaion beween Member Saes in erms of heir reliance on informal care (usually provided by family members) which migh be difficul o mainain going forward. Educaion expendiure as a share of GDP ends o fall as he populaion ages, as young people make up a smaller share of he populaion. In order o esimae he size of his change, he Ageing Repor considers he impac of he change in he number of children and young people on oal saff compensaion, oher coss (such as educaional infrasrucure) and he cos of direc and indirec ransfers o sudens and heir households. Unemploymen benefis and oher benefis for hose ouside he labour marke are also expeced o pu relaively less pressure on governmen balances, as he higher dependency raio is likely o resul in lower levels of unemploymen amongs labour marke paricipans and greaer incenives o paricipae in he labour marke for working age individuals. 16

33 Chaper I Susainabiliy of public finances The social proecion sysems in place deermine how a change in he populaion ranslaes ino coss for governmen accouns. The projecions used for he analysis are presened in Chaper II. Sensiiviy scenarios in Chaper IV show he uncerainy involved in projecions for hese variables and he implicaions on he differen measures of susainabiliy gaps. Neiher he Ageing Repor nor his repor make any normaive judgemen abou he efficiency or desirabiliy of Member Saes' social proecion sysems i merely assesses heir expeced coss. Nor are he second-order effecs of hese policies on he economy aken ino accoun. For example, inadequae healhcare may reduce he labour marke paricipaion of individuals who migh oherwise be able and willing o work o an older age. Higher educaion sandards may require higher expendiure bu increase he efficiency of labour force and poenial oupu in he medium o long erm. Inadequae provision of formal longerm care may adversely effec he labour marke paricipaion of women, which in urn would have a knock-on effec on economic growh A PARTIAL EQUILIBRIUM ANALYSIS The susainabiliy indicaors presened in his repor are derived on he basis of a parial equilibrium analysis. A number of assumpions are herefore necessary for esimaion o be possible. On he real side of he economy, he growh pah uses he demographic profile o esimae fuure labour inpu by making assumpions abou he oal populaion, employmen rae, he share of he working age populaion and he average hours worked. This is combined wih assumpions abou oal facor produciviy (TFP) and capial deepening o reach a forecas of poenial GDP, using a producion funcion approach. This depends on demographic developmens (i.e. on working age populaion) bu is exogenous relaive o public finance and herefore fiscal policy developmens. The growh projecion does no, herefore, consider he impac ha unsusainable fiscal policies or he increase in ax burden o close susainabiliy gaps may have on economic aciviy. In he same manner, he real ineres raes are se in an exogenous manner a 3% for all Member Saes, irrespecive of he governmen deb developmens in he EU, he euro area and globally UNCHANGED POLICY ASSUMPTION The projecions assume ha social proecion arrangemens remain unchanged going forward, and ha nearly all governmen revenues and nonage relaed expendiure says consan as a share of GDP. This no-policy change assumpion is a purely echnical assumpion. I does no mean ha such a scenario is realisic. However i is a necessary assumpion, given ha he purpose of he exercise is o idenify unsusainable fiscal policies and o measure he size of he required remedial acion. Two componens of governmen revenue form an excepion o he consan share assumpion. Projecions for revenues from pension axaion and propery income are modelled separaely. In he former case i is because revenues from pension axaion as hemselves a consequence of ageing. I is modelled using elasiciies of personal income ax revenues wih respec o he ax base. This is a echnical improvemen as compared o he 26 Susainabiliy Repor where such modelling was no underaken. Moreover, in he 26 Susainabiliy Repor propery income was assumed o remain consan as a share of GDP. In addiion no accumulaion of financial asses (or oher componens of he sockflows adjusmen (SFA)) were incorporaed in he long-run so ha he evoluion of nominal deb was only driven by he acual governmen defici/surplus. These wo assumpions are, however, no muually consisen. A consan raioo-gdp of propery income would have required a regular accumulaion of financial asses, wih implicaions for gross deb developmens. Therefore he assumpion of consancy of propery income as raio o GDP in he Susainabiliy Repor of 26 was, herefore, abandoned. The assumpion of no accumulaion of financial asses and, herefore, no SFA assumpion is kep in his repor. I implies ha he nominal value of governmen-owned financial asses remains consan and so here is a decrease of he share of hose asses in GDP. Under he assumpion ha nominal reurns on asses are consan over ime, 17

34 European Commission Susainabiliy Repor - 29 propery income from hose asses also decreases as a share of GDP. This is clearly he case for ineres-bearing asses (bonds) bu also applies o shares and oher equiy. ( 8 ) The increases in age-relaed expendiure due o demographic change are added o a consan level of oher public spending as a share of GDP. For he years beyond 26 he horizon of he available demographic projecions furher assumpions are also necessary in relaion o he infinie-horizon budgeary consrain and he S2 indicaor. Beyond ha year i is assumed ha governmen revenue and primary expendiure, including age-relaed expendiure, remain consan as a share of GDP, while ineres paymens evolve in line wih deb developmens. In so far as he EU populaion keeps ageing beyond 26, his assumpion implies underesimaing he susainabiliy gap (S2), hough he size of such a projecion error is minimised by he discouning of all fuure flows. ( 8 ) Reurns on asses ha are currenly owned by governmen are recorded as propery income, and herefore included in governmen revenue reducing he general governmen defici. This is why he change in he primary balances implied by he propery income projecions is included in he required adjusmen given he iniial budgeary posiion (IBP) erm of he susainabiliy indicaors. More deails on propery income projecions and revenue projecions from pension axaion are included in an appendix. 18

35 Chaper II The economic and budgeary implicaions of ageing

36

37 SUMMARY An increase in life expecancy, alongside a fall in feriliy raes is leading o an acceleraed ageing of he populaion in he EU and oher pars of he world. Over he years o 26, he ime period covered by his repor, he EU populaion is se o age furher. Aside from he social consequences, populaion ageing has significan economic consequences due o a reducion in he working age populaion and an increase in governmen expendiure relaed o ageing. Populaion ageing is no a new phenomenon in he European Union. Already, increased life expecancy and falling feriliy raes have led o a change in he demographic srucure. Over he nex 5 years, he phenomenon of an ageing populaion is projeced o inensify wih life expecancy increasing by 7 years for women and 8 ½ years for men, on average. Alongside his, feriliy raes are projeced o pick up somewha from heir curren level of 1.5 children per woman, o 1.6. They will herefore remain well below he sable populaion level of 2.1, hus conribuing o a falling populaion. A coninuaion of ne migraion ino he European Union should alleviae some of he effecs of increased longeviy and low birh raes, bu his oo is projeced o slow, albei wih grea uncerainy underpinning he projecions. These changes in he populaion srucure have significan economic consequences, semming mainly from a reducion in he working age populaion and an increase in he number of elderly people requiring suppor. Overall, he old age dependency raio defined as he populaion aged 65 or over as a percenage of he populaion aged 15 o 64, is projeced o increase from 25% in 27 o 54% in 26. In parallel, he number of individuals aged 15 o 64 is se o fall from 332 million in 27 o 283 million by 26. fiscal impac of ageing is herefore projeced o be subsanial in almos all Member Saes; hese coss will accelerae significanly over he course of he nex decade. An elderly populaion requires suppor in he form of pensions, healhcare and long-erm care. Of hese, old-age pension provision is currenly he mos significan budge iem, alhough is share of GDP varies widely, ranging from 5% in Lavia o 14% in Ialy. By 26, he Member Saes' public finances would face spending increases of 2.3 percenage poins of GDP, on average, on he basis of curren pension srucures. The size of he increase differs significanly across Member Saes and pension reforms enaced in a number of counries are bringing posiive resuls in erms of expendiure conainmen and susainabiliy of public finances. Almos all Member Saes have ighened he eligibiliy requiremens for receiving a public pension, mainly by raising he reiremen age and resricing access o early reiremen schemes. Once projeced spending on healhcare and longerm care has been added, and he decreases in unemploymen benefi and educaion expendiure have been need ou, age-relaed expendiure over he EU is forecas o rise by 4½ percenage poins of GDP by 26, from a base of 23¼% of GDP (projeced for 21). However, while Poland is expecing a reducion in age-relaed expendiure, Greece and Luxembourg are forecas o have increases of over 15 percenage poins of GDP, wih all oher counries lying beween hese wo exremes. A decrease in he number of people of working age reduces he poenial economic growh rae of a counry. For he EU before considering any durable impac on medium- o long-erm growh of crisis which is discussed in chaper IV poenial growh is forecas o fall from 2.4% per annum over 27 2 o 1.3% over Aside from he effec on economic growh, an ageing populaion also enails addiional governmen expendiure in erms of public provision of age-relaed ransfers and services. The 21

38 1. THE EFFECT OF DEMOGRAPHIC CHANGES An increase in life expecancy, alongside a fall in feriliy raes is leading o an acceleraed ageing of he populaion in he EU and oher pars of he world. Over he years o 26, he ime period covered by his repor, he EU populaion is se o age furher. Aside from several social consequences, populaion ageing has significan economic consequences due o a reducion in he working age populaion and an increase in governmen expendiure. This chaper looks a populaion projecions ha underpin his repor and considers he way in which hey are likely o affec he economies of he Member Saes of he European Union. underpinning he analysis in his repor are he Eurosa populaion projecions EUROPOP 28. ( 9 ) Life expecancy is projeced o coninue changing over he nex 5 years (see Table II.1.1), coninuing he rend of increases in life expecancy in all Member Saes for several decades. Life expecancy a birh for women is projeced o increase from 82.1 years in 28 o 89. years by 26, while for men i is se o increase from 76. years o Overall, i is in counries ha currenly have lower life expecancy ha he increase is projeced o be greaes as he projecions assume a caching up in life expecancy POPULATION AGEING Graph II.1.2: Feriliy raes, , seleced Member Saes Populaion ageing is a phenomenon ha he Member Saes are already familiar wih, bu whose consequences are ye o be fel in full force. Already, he European Union has experienced an ageing of is populaion hrough an increase in life expecancy and a fall in feriliy raes. This can be seen in graphs II.1.1 and II Graph II.1.1: Life expecancy a birh, 196 o 28, seleced counries (males and females) BE BG CZ GR HU PT SK FR 75 Source: Eurosa Source: Eurosa. BE BG CZ GR HU PT SK FR Feriliy in he EU has declined sharply in pas decades. The oal feriliy rae, defined as he average number of birhs per woman, has fallen from a baby boom level of 2.5 in he lae 196s o 1.5 in 28, on average for he EU as a whole. Graph II.1.2 shows he evoluion of feriliy rae in eigh seleced EU Member Saes over he years 1961 o 28; he decline over he years is eviden o see. Graph II.1.1 shows life expecancy a birh for eigh seleced EU Member Saes from 1961 o 28. Alhough here is variaion beween counries he overall rend is clear. The overall effec is se o inensify over he years o 26, he years covered by his repor. The figures ( 9 ) See Giannakouris, K. (28), Ageing characerises he demographic perspecives of he European socieies, Eurosa Saisics in Focus, 78/

39 Chaper II The economic and budgeary implicaions of ageing Table II.1.1: Demographic projecions for he EU counries Feriliy rae (brihs per woman) Females Life expecancy a birh Males Ne annual migraion flow (as % of populaion) BE BG CZ DK DE EE IE EL ES FR IT CY LV LT LU HU MT NL AT PL PT RO SI SK FI SE UK EU EA Source: Eurosa, EUROPOP 28. Graph II.1.3: Populaion pyramids (in housands) for EU27 in 28 and 26 Source: Eurosa, EUROPOP 28 23