Population ageing and future tax burdens An integrated micro-macro analysis of possible taxation policy changes

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1 Population ageing and future tax burdens An integrated micro-macro analysis of possible taxation policy changes R Aaberge, U Colombino, E Holmøy, B Strøm, T Wennemo Research Department, Statistics Norway University of Turin DIW-Workshop "Applying microsimulation for fiscal policy analysis, February, 2008.

2 Background Norway will experience one of the sharpest increases in public expenses as a share of GDP in OECD if the present welfare schemes are maintained. The ratio of the number of individuals 65+ years relative to the working force is expected to increase from 28 percent in 2008 to about 48 percent in Over the same period the number of elderly 80+ will increase from 4.5 to 8.8 percent of the total population. This has motivated the Norwegian Parliament to introduce a more actuarial pension reform

3 Purpose of this study How will aging affect fiscal sustainability in the next decades in Norway accounting for incentive effects on labour supply from changes in taxes, wages and non-labour income ignored in conventional Norwegian studies Integrate a detailed microeconometric model of labour supply and a large scale CGE model

4 Basic question How large tax increases are required in order to Maintain the current welfare arrangements, given that the current fiscal policy rule for using petroleum wealth is kept fixed

5 The microeconometric model allows large heterogeneity in labour supply behaviour Simultaneous labour supply decisions of household members Both couples and singles Flexible representation of preferences (depending on age, number of children 0-2, 3-6, 7-14) Exact representation of complex budget sets induced by tax-transfer rules Constraints on hours-of-work opportunities

6 Basic assumptions U(C, h, j) = v(c, h) ε(h,w,j) =v(f(wh,i), h) ε(h,w,j) v(f(wh,i), h) is the systematic component ε(h,w,j) is the stochastic component Prob(ε < u) = exp(-1/u)

7 Choice probability The probability (density) that a single individual chooses a job (h,w) is given by: ϕ( hw, ) Pr U( f( whi, ), h) = max U( f( xyi, ), y) = ( xy, ) B vhwphw (, ) (, ) v( x, y) p( x, y) dxdy Aaberge, Colombino and Strøm, J. of Applied Econometrics, 1999

8 Structural part of the utility functions for couples: ( ) log v h, h, w, w, s, s M F M F M F α f w h w h I α1 (,, ) 1 F F M M = 2 α1 2 ( α4 α5 log AF α6 ( log AF) α7sf α8c1 α9c2 α10c3 α11sc F 1 α12sc F 2 α13sc F 3 ) α14 LF α14 2 ( α15 α16 log AM α17 ( log AM ) α18sm α19c1 α20c2 α21c3 α22smc1 α23smc2 α24smc3 ) α3 α14 L 1 L 1 α. M F + 25 α3 α14 α3 LM 1 α3

9 Labour supply elasticity If, for example, we look at the overall labour supply elasticity in Norway 1994, we read a modest and then we would answer: NO, this is not relevant, forget about behavioural modelling! But if we look BEHIND the aggregate figure the picture changes quite a lot

10 Labour supply elasticities w.r.t. wage Married couples, Norway 1994 Household income decile Female Male Own Cross Own Cross I II III-VIII IX X All

11 Simulating tax reforms Given a new tax function t( ) and using the estimated U( ) and B the simulation consists of solving for each household max U(C, h, j) s.t. C=t(wh, I) (h, w, j) B to get new values of h and C

12 Flat tax in 1995 under the constraint of fixed tax revenue Flat tax rate = 22.6 per cent

13 Observed and predicted relative distributions of disposable income in 2001 Couples Single males Single females Deciles Observed Simulated Observed Simulated Simulated Simulated

14 Wage Cash transfers Capital income MSG Integration of the Micro- and the CGEmodel Micromodel Labour supply

15 Results from the simulation exercise Equilibrium tax rates Tax system Current (instrument: pay-roll tax rate) Flat Tax (instrument: flat tax rate) Exog Labour Supply Endog

16 Summary The average flat tax rate - ceteris paribus - in 1995 is 24.0% Fiscal sustainability in 2050 would require to increase the tax rate to 32.0% if labour supply is kept exogenous If we threat labour supply as endogenous, then fiscal sustainability would require only a 22.9% flat rate However, if we account for endogenous labour supply also in 1995, then the new equilibrium in 1995 would imply a 18.3% flat tax rate

17 Conclusions Endogenous labour supply contributes to a much less worrying picture of future fiscal sustainability In particular, the problem appears to be reduced to manageable dimensions when the tax system is reformed in order to improve labour supply incentives Possible undesirable implications of FT