Date last revised: May 23, 2012

Macroeconomic implications ofdemographic changes: A global
perspective

Ronald Lee
Departments of Demography and Economics
University of California
2232 Piedmont Ave
Berkeley, CA 94720
E-mail: rlee@demog.berkeley.edu

Key words: population aging, macroeconomic, demographic transition, consequences,human capital, economic growth, support ratio, demand for wealthThis paper was prepared for the 2012 BOJ-IMES Conference: Demographic Changes andMacroeconomic Performance May 30 - 31, 2012. Research for this paper was funded bya grant from the National Institutes on Aging, NIA R37 AG025247. I am grateful toNaohiro Ogawa and Riki Matsukura, and to all the members of National Transfer
Accounts (NTA) country teams for use of their data, and to Gretchen Donehower andAndy Mason. The NTA researchers are identified and more detailed information isavailable on the NTA website: www.ntaccounts.org.

1Introduction
The populations of the World are aging, both in rich countries and in poor ones. This process
will accelerate during the next few decades. The macroeconomic consequences will depend
partly on the particular aging process within each country, and partly on the global process of
aging since markets are increasingly linked. Population aging is viewed as a problem because theelderly consume but largely do not work, so their consumption must be funded in other ways
than through their labor income. Higher fertility and more rapid population growth would reduce
the proportions of elderly and ease the dependency burden on the working age population.
However, more rapid population growth would also require higher savings rates to provide
capital for the more rapidly growing labor force, or else lead to less capital per worker. This
tradeoff between the effects of demographic growth on dependency and on capital intensity is acentral problem in the macroeconomics of population aging, first posed by Paul Samuelson(1975) in an influential article.

In this paper I will focus on this classic theme. However, there are many other issues one might
discuss under this topic, and here are some examples, some followed by brief comments of myown: a) How are aggregate saving rates affected by the demographic transition and during its laststage, population aging? Under life cycle saving behavior, they first rise as fertility declines, and2then fall as the population ages (Lee et al, ***). b) Composition of consumption demand shifts(e.g. toward health care). c) Does productivity decline as the labor force ages? Probably not, inaggregate, since there are fewer less productive younger workers and more possibly lessproductive older workers. d) Will innovation and technological progress slow down? Not much
is known about this, but in any event technological progress originating in other countries will
not be affected by aging in a single reference country. e) How will population aging affectinternational capital flows? The typical case is probably that population aging will raise thecapital intensity and reduce the profit rates in the older richer countries, and consequently that
capital will flow from them to the younger poorer ones, but clearly this is not always the case. f)
Are workers saving adequately to prepare for old age? Adequacy of saving must be assessed in
the context of the public and familial transfer systems of each country. In some countries, old age
consumption is funded virtually entirely through public pensions and publicly provided healthcare. The National Transfer Account studies (to be briefly reviewed later) find that in mostcountries, on average the elderly consume at least as much as younger adults in a given calendar
year. However, much of this consumption is health care. g) Do the elderly exploit the young andfuture generations through public transfer systems that are unsustainable as currently structured,passing on to them enormous implicit debts? This is obviously a contentious and controversial
topic. In my view, it is necessary to take into account the massive public and private transfers to3

children through investments in their human capital via publicly and privately funded education.
When this is done, it is not clear that transfers to the elderly outweigh these benefits received
early in life (Bommier et al, 2010). h) Will population aging lead to a collapse of asset prices?
Most careful studies have concluded that this is highly unlikely, not least because population
aging can be foreseen many decades in advance so that we would expect at most gradual changes
in asset prices (Poterba, 20**).

I will now return to the central theme of this paper, Samuelson’s tradeoff between the two
fundamental consequences of low fertility, slow or negative population growth: risingdependency, on the one hand, and the reduced need for saving and the rising capital intensity ofthe economy, on the other. I will begin by presenting empirical age profiles of consumption andof labor income drawn from the National Transfer Accounts project (NTA). This large
international project is constructing estimates of National Accounts broken down by age andgeneration, including estimates of intergenerational (inter-age) transfers occurring withinfamilies as well as through the public sector. More information is available in Lee and Mason(2011) and at the project url, NTAccounts.org. There are currently 37 countries participating in
the project, each with its own research team. The Japan team is lead by Professor Naohiro
Ogawa.
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The changing economic life cycle: consumption and labor income
In NTA, consumption includes household expenditures. Household expenditures on health andeducation can often be directly assigned to individuals, but other consumption must be imputed
to individual members, which is done in proportion to a set of weights: .5 for children up to age 5,then increasing linearly to 1.0 at 20 and above. Other consumption also includes the imputed
value of services of owned housing and sometimes consumer durables. Consumption also
includes public in-kind transfers, which are primarily public education, publicly funded healthcare, and publicly funded long term care. It does not include public pensions which are income,and need not be consumed. Consumption is given by age, and is an average across males andfemales.

Labor income includes pre-tax wages and salaries plus fringe benefits. It also includes two thirdsof self-employment income. The other third is treated as asset income. Estimates are population
averages for males, females, those in the labor force and those with zero earnings. For purposesof comparison across countries, both consumption and labor income are standardized by dividing
by average labor income at ages 30 to 49 in each country.

5Figure 1 presents averaged results for the top and bottom income quartiles of countries
represented in Lee and Mason (2011). The top quartile includes Japan, the US, Sweden,
Germany, Austria and Finland. The bottom quartile includes Kenya, Nigeria, India, Philippines,
China and Indonesia. Starting with labor income, we note that labor income is higher inchildhood in the poorer countries, and that in these countries income peaks earlier but drops
more slowly and is much higher in old age. The influence of the incentives built into public andprivate pension plans in the rich countries is apparent in the rapid decline in labor income at 60
or soon after. Consumption also shows interesting differences. In the rich counties there is a
noticeable bump at younger ages representing heavy investment in the human capital. In thepoorer countries, consumption is remarkably flat across adult ages and extending all the way
through old age, as noted earlier. In sharp contrast, consumption rises strongly with age in therich countries. The net effect of these differences is that old age is far more costly in richcountries because older people work far less and consume far more. Consequently the support
cost of each elderly person relative to labor income is far higher in the rich countries than in thepoorer ones, which amplifies the dependency costs of population aging in the richer countries.

Figure 2 shows that Japan in 2004 looks very much like the other rich industrial nations, whichstrongly rising consumption at older ages. It is distinguished by unusually high investment in6human capital, as are other East Asian countries. It is also distinguished by higher labor earnings
at older ages than in most European countries, probably because the public pension system does
not penalize continuing work at older ages (Gruber and Wise, 1998).

One might wonder how these distinctive age patterns of labor income and consumption emergedin the rich countries. It is well known that around 1880 or 1900, the age at “retirement” (whenlabor force participation rates of men first declined to 50%) was far older, in the 70s, in Europe
and the US (Costa, ***). During the 20th century the age at retirement declined steadily, in partdue to the increasing demand for leisure as incomes rose, in part due to the opportunities
presented by public pension programs, and in part to the early retirement incentives built into
these programs. In the US, this declining trend ended in the 1990s and since then the male andfemale age at retirement has risen by a year or two. Changes in the incentive structure of bothpublic and employer provided pensions have clearly played a role.

On the side of consumption, Figure 3 shows the changes that have occurred over the past half
century. In 1960, consumption declined after age 60, and public and private spending on botheducation and health was quite limited. During the 1960s, two new public programs wereintroduced to pay for health care: Medicare, for the elderly and disabled, and Medicaid for the7

poor. By the 1970s public pension benefits had become more generous. The age profiles for1981 reflect these changes. Private consumption did not begin to decline until age 70, likely due
to the increased pension generosity, while total consumption now rose with age, as both public
and private spending on health had expanded remarkably, particularly at older ages. By 2007 theage profile of consumption rose very sharply throughout adulthood beginning in the early 20s
and continuing in the late 80s when spending on long term care (nursing home care for theelderly) grows explosively. Analysis of Swedish historical data shows similar trends and patterns.
It is clear that the growth of the Welfare State, with its massive transfers of income and goods
and services to the elderly, has profoundly affected the age patterns of consumption in ways thatwere probably unexpected and unintended.

Population aging and economic support ratios
We can roughly approximate the effect of changing population age distributions on economic
dependency through the so-called “support ratio”. This takes as given the age profiles discussed
above. Assuming they remain fixed, the support ratio is calculated as the ratio of populationweighted labor income to population-weighted consumption. We will refer to this as the ratio ofeffective producers to effective consumers. In light of the preceding discussion of how thesechange over time, we must recognize the artificiality of assuming them constant. Nonetheless,8we get some useful indications by doing so, and tracing out the implications of changing
population age distributions.

Before there is population aging, there is an important earlier stage in the demographic transition,in which fertility declines leading to reduced proportions of dependent children, while the shareof the population in the working ages rises, and the population share of elderly remains low. This
phase can last for many decades, and the rate of increase in the support ratio during this period
gives rise to what is called the “demographic dividend”. Figure 4 presents illustrative trajectoriesof the support ratio for four developing countries, China, India, Costa Rica and Nigeria, based on
NTA age profiles and United Nations estimates and projections (2011). The vertical line marks
2012. The dividend phase occurs from the trough to the peak of the support ratio, and the annual
pace of increase during this period is seen to range from .67% in China and Cost Rica, both ofwhich had rapid fertility declines, and .37% and .27% in India and Nigeria, which had slower
declines. Other things equal, these rates translate into rates of increase in age standardized
consumption, that is consumption per effective consumer – not much different than rates ofgrowth of per capita income. We see that the dividend phase for China is just about over; that
Costa Rica may have another decade or two; India somewhat more than that; and that Nigeria’s
dividend phase is projected to last through 2100. The dividend phase is followed by population
9

aging which causes declining support ratios, and reduces consumption, other things equal.
Calculated from this downturn until 2100, China and Cost Rica will both experience an averageannual decline of around .3%, but this is much more rapid in the few decades following the onsetof aging.

The situation in a few rich countries is shown in Figure 5 for Japan, the US, Germany and Spain.
Japan had the earliest onset of serious population aging, because unlike the other countries
fertility was not raised for so long by a postwar baby boom. Population aging begins slowly inthe 1970s, but accelerates in the 1990s, and the support ratio drops dramatically until around2060. After 1990 the trajectory in Germany is similar to Japan, although muted. Spain is just at
the start of the process, and currently enjoys a high support ratio. The US stands out as
experiencing only mild population aging up to 2050, largely due to its relatively high fertility
which has largely been close to replacement levels for the past three decades. Between 2010 and
2050, both Germany and Japan will experience average annual declines of .7%, while for Spainit will be .8%, and for the US only .3%. Once again, these declines in the support ratio, otherthings equal, would imply equal declines in age-adjusted consumption, and nearly equal declines
in per capita income. These rates can be subtracted from the expected rate of productivity growth10

to find a net effect – assuming that other factors such as saving rates or government borrowing
remain unchanged.

These projected declines in the support ratio in the rich industrial nations are the main cause ofconcern about population aging. Perhaps to some, these calculated impacts of population aging
may seem surprisingly small. These support ratios take into account all kinds of consumption,
not just government transfers. If we were to calculate fiscal support ratios, reflecting only taxes
paid by age and public cash and in-kind benefits received, the consequences of population aging
would appear rather more severe. This is because in all of these countries, the public sector
makes massive transfers to the elderly, far greater than the transfers to children (Miller, 2011). I
will return to this point toward the end of the paper. Suffice it to say for now, however, that I
believe that the general support ratios give a more accurate picture of the fundamental forces atwork than do the fiscal support ratios with their focus on one sector of the larger economy.

This concludes the discussion of the first part of Samuelson’s story, the beneficial effect ofhigher fertility and more rapid population growth on the dependency burden falling on theworking age population. But we must not ignore the second part of his story, the likelihood thathigher fertility and more rapid growth would lead to reduced capital intensity in the economy,
11and lower productivity of labor as a result. I will begin by discussing fertility and investment in
human capital, and then turn to investment in physical capital and financial assets. It is possiblethat even as populations age and support ratios fall, that other changes in the economy will
systematically raise productivity and offset this adverse effect.

Low fertility, population aging, and investment in human capital
The quantity-quality tradeoff theory of fertility and investment in children is well established ineconomics (Becker and Lewis, 1974; Willis, 1972). The basic idea is that parents derive
satisfaction both from the number of children they have, and the average quality of their children.
In its simplest form, parents first decide what share of their income to devote to their own
consumption and what share to spend on their children. They then decide how to allocate theirchild-spending on numbers versus quality, with the product of the two constant, and a hyperbolic
budget constraint. In this story, as various kinds of shocks affect the parents’ choice, we might
expect to observe an empirical elasticity of spending on quality versus quantity (other things
equal) of something like -1, as we move around the budget constraint. This is a story based on
individual behavior, but we might extend it to the public sector, which might operate under asimilar budget constraint. In this case, spending on children’s human capital, say health andeducation, might be a relatively fixed share of the budget or of National Income, while
expenditures per child vary depending on national fertility and proportions of children.
12Figure 6, which plots the log of human capital spending per child (relative to labor income)against fertility in recent years, for 23 NTA countries, shows something of the sort. Human
capital expenditure is measured as the sum of public and private spending on health and on
education on a child at age 0, at age 1, and so on, up to age 17 for health and 25 for education. It
is thus a synthetic cohort estimate of life time spending on a child. It is expressed relative toaverage labor income, and the log of this ratio is on the vertical axis. On the horizontal axis is the
Total Fertility Rate averaged over the five years preceding the NTA base year. Evidently there isquite a tight relationship (descriptive R2=.7) with a slope of -.7. In Nigeria and Kenya, where
fertility was about 5.5 births per woman, about 1.5 years of labor income is invested in a child’s
human capital, on average. In a country with low fertility like Japan, Taiwan, S. Korea, Hungary,
Spain, or Slovenia, around 5 or 6 years of labor income is invested in human capital per child.
The whole relationship is particularly strong across the Asian NTA countries, and holds
separately for both private expenditures and for public expenditures (Lee and Mason, 2011). It
also holds over time, even more strongly, in Taiwan, Japan and the US (Lee and Mason, 2011).

This substitution of quality of child for quantity of children carries over to the labor force when
the children mature. The smaller number or workers is offset, at least partially, by their greater
13

productivity deriving from their greater human capital. For a more formal development of thisidea, see Lee and Mason (2010). We now turn to assets and capital.

Population aging, provision for old age consumption, and asset accumulation
Consumption in old age is paid for in different ways in different countries. One way, of course, isfor older people to continue to work as they age. As we saw in Figure 1, this is more common inpoorer countries, but there are great variations in rich countries as well (Lee and Ogawa, 2011).
Another approach is to accumulate assets during the working years, and then consume theseassets and the income they generate, in old age. But in some societies, familial transfers may be
more important. Older people may live with the family of an adult child, and share in thehousehold’s consumption, receiving in-kind intra-household transfers. Or children who havemigrated to the city or to another country may send back cash remittances to help cover the costsof old age consumption. Yet another possibility is that the public sector taxes workers andtransfers resources to the elderly in the form of public pension payments or in-kind transfers ofhealth care or long term care.

Our NTA project finds that when elders rely mainly on public or private transfers for theirconsumption, they tend to work very little and have very little labor income. When they rely
more heavily on asset income to fund their consumption, then they tend also to work more. For
14

simplicity, we will now look at that portion of old age consumption that is not funded by work in
old age, which we can call net consumption. Figure 7 shows how net consumption of people age
sixty five and over is paid for. It plots the proportional share of net consumption funded by assets,
by public sector transfers, and by private transfers. The figure is a triangle graph, which ispossible since the three sources of support must add up to 1.0. At the vertex labeled “assets”, net
consumption is paid for 100% out of asset income, and similarly at the vertices labeled “public
transfers” and “private transfers”. A point at the center of the triangle would indicate a country inwhich the elderly derive consumption support equally (33%) from each of the three sources. In a
country situated on one of the edges the elderly derive support only from the two vertices at theends of the edge. Countries outside the triangle to the right are those in which the elderly aremaking net transfers to their children rather than receiving support from them.

With that background, we see that Hungary, Austria, Sweden, Slovenia and Brazil derive 100%or more of their consumption expenses from public transfers. We also see that some Asian
countries derive substantial old age support from family transfers: China, Taiwan, Korea, andThailand. But it is striking that this is not the case in Japan (net familial transfers of zero), India,
or the Philippines. In ten of the countries, the elderly make net transfers to their children, as inIndia, the Philippines, Indonesia, some Latin American countries, some European countries, and15

the US. If we look more closely by age within the 65+ group (not shown here), we see that often,
the younger elderly are making substantial transfers to their children, as in Japan, while the older
elderly (say above age 75) are receiving substantial transfers, and these two may cancel out inthe aggregate. Finally, there is a group of countries where asset income plays an important role,
including the US (more so than any other rich country), India, Philippines, Thailand and Mexico.

The point of this long discussion of the sources of old age support is that the institutional andpolicy context matter a great deal when it comes to population aging and capital accumulation.
When working age people anticipate support from transfer systems, particularly public systems,
they have less incentive to save for retirement. In this case, population aging may simply
increase the dependency load on the working ages and not generate any increase in productive
assets. I suspect, although I have not evidence, that this is less so with the family support system,
since workers may wish to ease the burden of support on their own children, but not feel this way
in relation to government transfer programs. But when people do not expect to receive much in
the way of transfer support in old age, as is the case when public pensions are absent or relatively
small (the US case), then working age people will save and accumulate assets.

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As the proportion of older people in the population rises with population aging, there is anincrease in assets per capita and in assets per worker. Figure 8 shows the age distribution of new
worth in the US, illustrating this point. Population aging between 2012 and 2050 would raise theratio of net worth to the working age population in the US if the age profile shown in Figure 8
remained constant. In fact, we would expect asset accumulation to increase in response to longer
life. If those assets are invested domestically, they will raise the productivity of labor andstimulate economic growth. If they are invested internationally, then they will not raise domestic
wages, but they will generate flows of asset income. Similarly, in a closed economy the rising
capital intensity will lead reduce the rate of return to capital, but in an open economy the return
will be unaffected. Either way, the increase in assets per capita will lead to an increase in assets
per capita, offsetting the declining support ratio, and reducing the need of the elderly to dependon transfers from the working age population.

Fertility, declining support ratios, and capital
In work in progress with Andy Mason, we ask what level of fertility would maximize the support
ratio; what level would maximize the fiscal support ratio; what level would maximize
consumption while maintaining a capital/income ratio of 3.0; and what level would maximize
consumption when we can also vary the capital intensity (golden rule). The results are shown in
Table 1, for different regions of the world and for Japan.
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The first column reports the unweighted current average TFR for the NTA countries in eachregion. The second column shows the level of fertility that would maximize the fiscal support
ratio. These levels are rather high in the rich industrial nations (3.1), and indeed they are highwherever there are generous public transfer programs for the elderly and not much for children –as in Latin America, where the outcome is a TFR of 3.9! But where there are low public transfers
to the elderly, as in South and Southeast Asia, the outcome fertility is very low, at 1.2 births per
woman. Nations would be ill-advised to strive for these levels of fertility. When we look at thegeneral support ratio, all these fertility levels move toward replacement level. In the West, inJapan, and in East Asia, support ratios are slightly above replacement, while in Africa andSouth/Southeast Asia they are a bit below, and in Latin America right at replacement.

When we take the costs of saving to invest in a more rapidly growing labor force, or the
possibilities of raising productivity by deepening the capital stock, rather lower fertility looks
desirable, and every region does best with below-replacement fertility, some with fertility far
below replacement.

18

I do not want to make much of these results. They are based on very simple calculations, theyignore the transition to steady state, and they don’t consider policies aimed at altering economic
behavior over the life cycle, such as raising the retirement age. Furthermore, nothing in here
takes account of individual fertility preferences. Still, these calculations do bring us back to
Samuelson’s original analysis. We need to look at both sides of the matter, and when we do, lowfertility, even below replacement, may not be such a bad thing. In fact, we find that small
variations in fertility in the neighborhood of replacement or just below make rather little
difference in the rich industrial nations.

Conclusions
Let me briefly reiterate the main points. We saw that on average, the elderly consume at least as
much as younger adults, and in rich countries substantially more. However, much of this old age
consumption, at least in the rich countries, is health care. It appears that over time, and with thedevelopment of a European style welfare state, very large transfers to the elderly raise therelative level of consumption by the elderly. At the same time, at least partly due to the growth inpublic pension programs, labor supply at older ages is reduced. The net result is that an older
person becomes substantially more costly, as labor supply is reduced and consumption increased.
These changes in the economic life cycle make the whole process of population aging a more
expensive proposition for society. As populations age, the support ratio drops, reducing the19growth rate of consumption per capita by between .3% and .8% per year over a number of
decades, below what it would otherwise be.

However, the same processes that lead to population aging also may lead to increased investment
in both human capital and assets. Investment in human capital per child rises strongly as fertility
declines, and as these children mature into adult workers, their increased productivity will at
least partially offset their smaller numbers. Turning to assets, to the extent that workers expect torely on asset income in old age and save accordingly during their working years, population
aging will tend to raise assets per capita and per worker, also boosting labor productivity andwages, or at least generating increased asset income per capita in a globalized economy. The
increased productivity of labor arising from both more human capital and more physical capitalshould to some degree offset the declining support ratio, and increased asset income will further
offset these declines. However, the extent to which these offsetting processes unfold depends on
the institutional structures and public policies that are in place.

Some simple calculations suggest that low levels of fertility are not seriously disadvantageous in
the long run because even without taking into account the human capital effects, we find (in a20

simple Solow growth model) that the capital-intensifying benefits of slower growth, oralternatively the benefit of lower saving rates, largely balance the declining support ratios.

While population aging will place severe strains on particular public programs, overall, theeconomic challenges of population aging need not be overwhelming, and need not pose a major
threat to our economic well-being.

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Willis, R. J. (1973). "A New Approcah to the Economic Theory of Fertility Behavior." Journal of
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Table 1.

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Figure 1

26

Figure 2

27

Figure 3

28

Figure 429

Figure 530

Figure 6

31

Figure 7

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Figure 833