Societal Aging: Implications for Fiscal Policy
Alan J. Auerbach
University of California, Berkeley
April 2012

This paper was prepared for the BOJ-IMES Conference, “Demographic Changes andMacroeconomic Performance,” Tokyo, May 30-31, 2012.

I. Introduction
Japan, the United States, and most leading economies are experiencing significant
population aging, as the result of reduced birth rates and increased longevity. In this paper, I
consider several implications that this aging has for the conduct of fiscal policy, grouping theissues into four areas.
First, and perhaps most important, because the public sector finances a large share of theconsumption of the elderly through unfunded or partially funded transfer programs, population
aging puts significant pressure on government budgets. Increases in life expectancy increase thenumber of beneficiaries of government programs, given that such programs typically provide
benefits for those above a given age, while past reductions in fertility lower the relative numberof taxpayers in the working population upon which these programs largely depend for financial
support.
Second, and related to the first point, changes in the elderly share of the population willaffect the composition of government budgets, with a shift toward programs that benefit theelderly and away from others targeted to younger groups in the population. This shift may
influence the government’s ability to make short-run budget adjustments. Given the long-range
nature of many old-age transfer programs and the potential disruptions that significant immediatechanges to them might induce for those nearing retirement age, changes in old-age entitlement
programs may need to be phased in over time and with advance announcement. Also, these
programs are structured in a way that creates natural coalitions in favor of maintaining them, andthis popular support may reduce the government’s ability to make changes in the programs evenover the longer term.

Third, an aging population has implications for the design of tax policy. An increase in
the average age and elderly share of the population will affect capital-labor and consumptionincome ratios, and hence the relative size of different tax bases (e.g., labor income, capitalincome, and consumption) as well as the relative economic efficiency of different tax systems.
Thus, structural tax changes might be in order, even if the initial tax system were the mostdesirable for a different population age structure.
Finally, there may be some adjustments needed in the conduct of stabilization policy totake account of the changes in population age structure and the associated changes in thecomposition of the government budget and the sources of tax revenues. These changes will be
associated with the extent to which the fiscal system provides automatic stabilizers, the options
available for discretionary fiscal policy, and the effects on the economy of different discretionary
fiscal actions.
Throughout the discussion that follows, I will focus on the effects of societal aging
without typically distinguishing the cause, i.e., increased longevity versus reduced fertility. In
some cases, as for example when the relevant consideration is the share of the population that isvery old, the causes of societal aging matter, but few such issues arise in the analysis presented
below.

II. Societal Aging and Budget Stress
There is nothing inherent in the nature of government budgeting requiring that population
aging must increase budget stress. Just as with the private life-cycle planning of households,
governments can, at least in principle, make arrangements for the rather predictable process ofsocietal aging by saving for future expenditures. This is most apparent in the case of old-age
entitlement programs, where governments could fund future benefits of current workers using2

these workers’ current tax contributions, but the same logic applies to other spending that tends
to rise with the elderly share of the population. On the other hand, the reverse argument would
apply to spending on the young; to the extent that the young receive benefits from thegovernment prior to entering the labor force and becoming taxpayers, logic suggests that a“funding” model of having each cohort finance its own benefits would call for borrowing, rather
than saving for items such as education funding.
Unfortunately, governments generally do not operate in this manner, but rather mostly ona cash-flow basis, balancing (or attempting to balance) revenues and spending in annual terms
and taking inadequate account of the large implicit liabilities associated with future entitlement
commitments. With old-age transfer programs largely financed by current taxes, increases in theold-age dependency ratio lead to an increase in benefits relative to taxes and hence an increased
budget deficit.
A. Assessing the Problem
Figure 1, adapted from Auerbach (2011), helps illustrate the importance of thisphenomenon. For several developed countries, the figure shows the fiscal gap over the 50-year
period 2011-2060, estimated using a variety of data sources. The fiscal gap is defined here as thepermanent annual increase in the primary surplus as a share of GDP, say , that would beneeded to keep a country’s publicly held debt-GDP ratio at the end of the period equal to its
initial debt-GDP ratio; that is,(1)3

where Bt-1 is the outstanding debt at the end of year t-1 (the beginning of year t, in this case2011), Dt is the primary deficit in year t, Yt is GDP in year t, T is the terminal year (in this case2060), and r is the relevant interest rate, assumed for simplicity in the formula to be constantover time.1
Note that these fiscal gaps are only imperfectly associated with current fiscal deficits.
While it is no surprise that countries like Greece (EL) are among the “leaders,” other countries
that have faced recent budget problems, such as Ireland (IE) and Spain (ES) are not. The
intuition for this lack of a close connection comes from expression (1). If one assumes that
achievement of a sustainable path means that a country must maintain a constant debt-GDP ratio,
then a portion of debt service is provided by debt growth, since debt is allowed to grow at thesame rate as GDP. Thus, the added fiscal burden of debt service is determined by the difference
between the interest rate and the growth rate, and will not be especially high unless one assumesa large gap between the two rates.
Another way of demonstrating this point is by considering how much of the fiscal gap isdue to debt service, and how much is due to future primary surpluses. The second bar for eachcountry in the figure displays fiscal gaps under the assumption of no initial debt, showing thatprojected future primary deficits based on current policy trajectories, rather than initial debt, aretypically much more important as a determinant of the fiscal gaps. That is, eliminating the1

These estimates are for general government at all levels. To form them, we start with actual 2010 levels of net
publicly held debt and GDP, and then add projections for primary surpluses as a share of GDP through 2016 from
IMF (2011). For years after 2016, it is necessary to make some assumptions as to the further evolution of primary
surpluses. We do this by separating “normal” components from those related to aging and health.
For shares of GDP accounted for by revenues and non-interest spending in areas excluding health care and public
pensions, we set values equal to the average of these shares over the period 2002-2007, an assumption intended toprovide over the longer run a stable estimate of recent, pre-crisis revenue and spending fundamentals. For theremaining components, we incorporate recent projections from the IMF (2010a, b). We assume a real discount rateof 3 percent and a real GDP growth rate of 2 percent.
See Auerbach (2011) for further discussion and alternative calculations.

4

current stock of national debt would, for most countries in the figure, have relatively little impact
on the magnitude on necessary fiscal adjustments; it is changes in future policy that will be
crucial to adjustment.
The last set of calculations in Figure 1 illustrates how important the implicit liabilities arethat are associated with health care spending and pension growth. The third bar for each country
shows what the fiscal gap would be if there were no increase relative to GDP in spending on
health care or pensions after 2016. For all countries, this assumption reduces the estimated fiscal
gaps, and for many (Australia, Belgium, Canada, Denmark, Finland, and New Zealand) it
eliminates the gap entirely. That is, for these countries, more than 100 percent of the estimatedfiscal gap can be attributed to growth in these expenditures. For most other countries, thisadjustment eliminates more than half of the initially estimated fiscal gap, meaning that thesefactors account for a larger share of the fiscal gap than the need to service initial liabilities, theimportance of which we have already considered, or other sources of ongoing primary
imbalances.
Not all of this growth in pensions and health care spending is attributable to population
aging. Particularly for health care spending, other factors may also be playing a role, in this casethe projected growth in health care spending as a share of GDP, even adjusted for changes in
population composition. For example, Figure 2 shows different trajectories for U.S. publichealth care spending through 2035, as estimated by the Congressional Budget Office (2011).
The highest curve corresponds to “excess cost growth” of health care spending at 2.0 percent
faster than GDP (after adjustment for changes demography) – a growth rate consistent with thatof the past several decades, while the lowest corresponds to no excess cost growth at all,presumably all due to population aging (since older individuals not only require more health care5per capita, but, at least in the United States, are more likely to be provided health care by the
public sector). Even this lower, and quite unrealistic projection shows rapid growth in publichealth care spending – 1.2 percent of GDP over the 13-year period 2021-2034. Combined withthe growth in spending on old-age pensions, for which factors unrelated to aging are notimportant, it is clear that population aging is an important factor contributing to increased
government spending.2
Another way to express the size of age-based unfunded liabilities is by capitalizing themand comparing them to outstanding explicit liabilities and trust funds. For the United States, forexample, by one measure the unfunded liability of the Social Security system was $21.6 trillion
at the beginning of 2012 (Social Security Trustees, 2012, Table IV.B7), which was more than
twice the publicly held stock of national debt at that time ($10.4 trillion). This net implicit
liability for the Social Security system is the so-called “closed group” liability measure. It is
calculated as the present value cost of paying benefits to those already retired or in the workforce in excess of the present value of taxes that this same group of individuals will pay into thesystem, and also net of the system’s trust fund balance. An alternative measure of the unfundedSocial Security liability, its “open group” liability to all cohorts over the infinite horizon, isslightly smaller ($20.5 trillion).3
As large as these measures of the Social Security implicit liability are, they pale incomparison to what one would calculate using a similar methodology for the major U.S. publichealth care spending programs, Medicare and Medicaid. Even under the most favorable

2

CBO (2011, p.10) estimates that 64 percent of entitlement spending growth through 2035 and 44 percent through2085 is attributable to aging, rather than excess cost growth, under its “extended baseline scenario,” which issomewhat more optimistic than the cost growth shown by the intermediate curve in Figure 2.
3

This difference reflects the fact that future generations are projected to make net contributions to the system undercurrent rules.

6

estimates, for example, Medicare’s infinite horizon unfunded liability at the beginning of 2012
was nearly $43 trillion.4
B. Addressing the Problem
How should governments deal with the large looming unfunded liabilities associated withpopulation aging? In some respects, the answers are the same as those that apply to the standard
question of how governments should deal with previous debt accumulation. The distribution of
the burden of servicing the debt must be allocated across members of current and future
generations according to some pattern, and the instruments for achieving this allocation of theburden, through reductions in spending and increases in taxes, must be determined. In theprocess of determining this optimal policy, distributional fairness and economic efficiency willboth tend to push in the direction of smoothing adjustments over time, even though these are
distinct objectives. Sharply higher tax rates over any short period of time will tend toconcentrate the burden on a small number of generations, and also lead to greater economic
inefficiency than a smoother increase in tax rates.5 Hence, even in cases where intergenerational
distributional considerations are not given as much weight (as, for example, if Ricardianequivalence is viewed as a credible characterization of the behavior of private agents), spreadingof adjustments over time will appear optimal.

4

According to the 2012 Medicare Trustees Report, over the infinite horizon general revenue contributions – funding
from sources over and above the programs’ dedicated revenues – of $23.7 trillion will be needed to cover expenses
for Medicare Part B (supplementary medical insurance; see Table III.C11) and another $14.3 trillion will be needed
to cover Medicare Part D (prescription drug insurance; see Table III.D8). According to these same projections, theremaining component of Medicare, Part A (hospital insurance; see Table III.B11) has an infinite-horizon unfundedliability of $4.8 trillion. Moreover, these large numbers assume the successful enforcement of the reductions inreimbursement rates as called for by the 2010 Affordable Care Act. Alternative projections put the costs ofMedicare higher.
5

For further discussion, see Auerbach (2009).

7

When the liabilities being dealt with are those associated with population aging andunfunded old-age entitlement programs, however, some additional considerations are relevant.
First, to the extent that population aging or other demographic changes are stochastic in nature,
issues arise concerning the use of fiscal policy to spread demographic risks among generations.
For example, to offset stochastic increases in the old-age dependency ratio, increasing taxes on
working generations and reducing benefits for retirees represent two distinct approaches that will
maintain a feasible path for an unfunded old-age pension system, and these two approaches will
spread demographic shocks differently across generations. It appears that some combination of
the two policies may be preferred to either in isolation from the perspective of risk-spreading(Auerbach and Lee, 2011).
Looking forward, this is a potentially important issue in the design of unfunded old-age
pension systems, for building in carefully specified automatic responses to demographic shocks
can make such systems fiscally sustainable while at the same time ensuring that risks are spread
broadly and in a desirable manner. However, while there undoubtedly is uncertainty about themagnitude of the forthcoming increase in the old-age dependency ratio, the very large unfundedliabilities that countries face are already a feature of expected outcomes. That is, even if
unfunded pension systems are reformed on a going-forward basis, such reform does nothing toaddress the unfunded liabilities that already have been accumulated and hence represent current
government liabilities.
Even for dealing with liabilities that already exist, of course, the demographic transition
is relevant for determining how the burden should be distributed. For example, if population
aging is due to increased longevity, it may be optimal to allocate more resources to generations
that live longer, because they may have higher consumption needs than other generations as a8

consequence of having to spread resources over more years. This will be less of an issue themore that demographic changes are permanent, since there will be little heterogeneity to takeadvantage of in shifting the burden across generations.6
Finally, the unfunded liabilities of age-based entitlement programs differ from official
national debt in two important respects. First, they do not have the same legal status as official
government liabilities; governments can adjust them through changes in law without having toundergo the process of default. This makes benefit cuts or tax increases on those holding theimplicit liabilities easier to undertake than adjustments in national debt, although national debt
can be eroded through inflation without explicit default, and in cases (like Japan) where most of
the national debt is domestically held the distinction lessens further, since debt holders are
subject to domestic taxation anyway.
Perhaps a more important difference between explicit and implicit liabilities, given thepolitics of debt and fiscal adjustment, is that implicit liabilities are just that – they are not listed
as liabilities in official government accounts, even where, as in the United States, they are atleast partially acknowledged and computed and reported annually in official government
documents. As a consequence, policies to deal with implicit liabilities may be difficult to
enforce.
For example, if one made the type of fiscal adjustment called for by the calculations
based on expression (1) and Figure 1 to achieve a sustainable path, this permanent increase in the
primary surplus would generate large official primary surpluses in the short run, as aconsequence of the need to set aside resources to fund implicit liabilities that are projected to
grow faster than GDP. Indeed, calculations in Auerbach (2009) suggested that to make U.S.

6

See Auerbach and Hassett (2001) for further discussion of optimal fiscal responses to demographic changes.

9policy permanently sustainable (that is, over the infinite horizon, not simply through some fixed
terminal year) at that time, using such a permanent adjustment in primary surpluses, it would
have been necessary for the government initially to run large primary surpluses, so that in themedium run the government would eliminate all explicit national debt and actually begin theaccumulation of net financial assets.
Although such a policy response is based on apparently reasonable assumptions andprojections, it calls for a path for explicit debt and deficits that ranges far from historical values,
and one must ask how sustainable, politically, a policy of debt retirement followed by asset
accumulation would be?7 The presumption here is that the underlying fiscal policy path isoptimal, in which case the path of deficits and spending would be, as well. But with policy
traditionally using the annual deficit and debt-GDP ratio as a signal of performance, substantial
learning on the part of political actors and voters might be required to accept large tax increases
to pay for future benefits.
Indeed, past U.S. policies aimed at dealing with unfunded liabilities have not proved
viable. In 2001, as a decline in explicit (but not implicit) liabilities loomed in official forecasts,
the United States adopted a large tax cut shortly after the election of George W. Bush. One of
the stated objectives of proponents of the tax cut was to reduce the budget surplus. The logic
was that the government would be returning money to taxpayers that it did not need, as
evidenced in their view by the existence of the budget surplus.
More generally, some evidence empirical suggests that accumulations of the Social
Security trust fund (around $2.7 trillion at the beginning of 2012 and still small in relation to the7This leaves aside the interesting question, contemplated briefly in the United States in 2001, of what assets thefederal government and the Federal Reserve would have held if the explicit stock of national debt were retired andthe government continued to run budget surpluses. Fortunately or not, this question no longer appears to be ofimminent policy relevance.

10unfunded Social Security liabilities discussed above) are at least fully offset elsewhere in thebudget; that is, the annual surpluses that arise in the trust fund simply lead to larger deficits of atleast equal magnitude elsewhere in the government’s budget (Smetters, 2004). It is possible thatchanges in government accounting practices might alter this bleak situation, for example, if
certain government programs were accounted for on an accrual basis, thereby converting implicit
liabilities to implicit ones. Such changes have evolved over time in accounting for the long-term
commitments made by private companies, as for unfunded retirement benefits and executive
stock options. But governments have generally resisted such accounting provisions and they are
not a common feature of government accounts.8
In summary, dealing with implicit liabilities that arise from the combination of societal
aging and unfunded old-age entitlement programs is in some respects similar to dealing with any
past accumulation of national debt, since both represent obligations that already have been
incurred. But both real and perceived differences in circumstances make dealing with implicit
liabilities more challenging. Perhaps the biggest challenge is that they are not included among
implicit liabilities, and so are treated by the political process as “future” problems thatgovernments will confront. With political horizons in democracies already made short by thenature of the electoral process, an opportunity to put off dealing with significant fiscal problems
is likely to be readily accepted.

8

An important real effect of the lack of explicit accounting for long-term government liabilities comes from the U.S.
state and local government sector. Although such governments typically can accumulate debt only for capitalprojects, they currently have enormous unfunded liabilities for the pension and health benefits of current and retired
government workers (Novy-Marx and Rauh, 2011).

11

III. Changing Budget Composition
Spending on old-age entitlement programs will pose a serious challenge to national
budgets as societal ageing occurs, as just discussed. But the changing composition of
government budgets is likely to have additional short-run and long-run effects on the conduct offiscal policy.
To help motivate the discussion of these issues, Figure 3 shows the historical andprojected shares of federal spending (excluding debt service) for the U.S. federal government,
comparing spending on the three large age-based entitlement programs – Social Security,
Medicare, and Medicaid – and all (defense and non-defense) discretionary spending. Together,
these two categories of spending account for around 86 percent of federal spending,9 a total sharethat is relatively constant over the period. However, the breakdown into these two categories
changes over the period, starting with discretionary spending at 60 percent and old-age
entitlements at 24 percent, and ending with the values roughly switched, at 28 percent and 61
percent.
Assuming that this shift in spending can be accommodated along a feasible fiscal
trajectory, it still has other implications for the conduct of fiscal policy. First, there is likely tobe less flexibility with respect to high-frequency (i.e., annual) budget adjustments, because for
old-age entitlement programs long-range planning is involved on the part of beneficiaries, andthis translates into the need for long-range planning for changes on the part of government. As
an illustration of this point, Auerbach (2006, Table 3) estimated simple linear decision rules forannual changes in U.S. federal spending relative to full-employment GDP, with two explanatory
variables, the lagged values of the budget surplus and the GDP gap, meant to represent budget
9

The remaining categories of spending are primarily other entitlement programs, such as unemployment
compensation, plus retirement programs for government workers.

12and macroeconomic policy determinants. In looking separately at discretionary spending andspending on Social Security, Medicare, and Medicaid, the results were that while discretionary
spending responded to both determinants with the expected sign (and with the level ofsignificance depending on sample period), spending on the three major entitlement programs
bore essentially no relationship to these same determinants.
Thus, as the composition of government spending changes over time, the ability of
governments to make high-frequency policy adjustments is likely to be diminished. From awelfare perspective, this inflexibility is probably a good thing, as it may be substantially morecostly to affected individuals for the government to make sudden changes in old-age entitlement
benefits than, say, for the government to accelerate or slow down spending on public
infrastructure programs or military hardware development. But from the perspective of agovernment that may need to make overall budget adjustments or may wish to use spending
adjustments for purposes of macroeconomic stabilization, this reduction in flexibility will present
a challenge. There may be a very small component of the government budget that is relatively
easy to adjust.
A second potential impact on budget policy of the growth in old-age entitlement spending
is more of a long-term, lower frequency concern. This concern relates to the “natural
constituency” that such programs have, as a consequence of their universality. As has been
explored in the literature (see, e.g., Tabellini, 2000), universal unfunded systems can create anatural constituency of support among the elderly and those nearing retirement. Even those whoover an entire lifetime may have contributed far more to a public pension system or old-age
health care system than they receive as retirees will benefit when old from the system’s
continuation. These individuals, along with those who are younger but for other reasons may

13

still benefit from the system’s continuation (perhaps because they have low incomes and so will
be net beneficiaries of the system’s redistributive provisions), can form a coalition against
reducing benefits, even if such a coalition would not exist if everyone were voting at the
beginning of their respective lives.
In the context of societal aging, the presence of a large cohort of beneficiaries simply
strengthens the coalition in favor of maintaining the current system. This impact may besomewhat mitigated to the extent that maintaining an increasingly expensive transfer program
might have very negative effects on the economy, for example through the need for much higher
marginal tax rates and hence a reduction in the level of economic activity. In such a case, evenself-interested voters might favor some modifications in entitlement programs, but presumably
they would still prefer alternative budget cuts to reductions in their own benefits. While thelarge postwar baby-boom cohort might, when young, have weakened the coalition in favor of
old-age entitlement programs (see, e.g. Cooley and Soares, 1996), the aging of this cohort has
likely reversed the effect.
How resistant the voting population will be to reform depends critically on the proposed
alternatives, for a coalition that favors the current system over one simply reduced in size won’t
necessarily favor the current system over a more sophisticated alternative that, for example,
alters the structure of benefits, hurting some beneficiaries more than others. Nevertheless, thefact that democracies must undertake changes to programs with a large and growing natural
constituency of voters presents a significant challenge to government budget adjustments overthe longer term.

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IV. Impacts on Tax Policy
Governments in developed economies raise revenue using four primary taxes: individual
income taxes, corporate income taxes, payroll taxes, and consumption taxes (primarily value
added taxes). Other taxes, such as excise taxes and estate/inheritance/wealth taxes, are present as
well, but typically account for a small share of revenues. The arguments in favor of the different
approaches to taxation have been well worked out in the literature on taxation, with the main
factors of economic efficiency, distributional equity and simplicity and ease of administration
being used in evaluating the approaches.
While distributional concerns are often represented in a static, cross-section context, inwhich tax burdens are expressed by income class, the distribution of taxes across generations is
also relevant, for different tax bases are concentrated among different generations. Distributional
concerns across generations may seem of little consequence, since age is not an exogenous
characteristic and each individual passes through the different stages of life. But, a transition
from one tax system to another at a given point in time hits different generations at different
stages of life, which can lead to different generational burdens and important efficiency effects
as well.
Two important examples of such combined distributional and efficiency effects comefrom the analysis of a shift from income taxes to one of two alternative tax bases that eliminate
intertemporal saving distortions, consumption taxes and labor income taxes. As discussed in
Auerbach and Kotlikoff (1987), a transition from an income tax to a consumption tax, by shiftingtax burdens to the elderly, not only hurts older generations and helps younger generations as of
the time of the tax reform, and hence can have large distributional effects; it also can improve theefficiency of the tax system, beyond the efficiency gain delivered by eliminating the15intertemporal distortion, by effectively imposing a capital levy on existing wealth. The capital
levy occurs because the consumption that previously accumulated assets will finance in the
future will now be subject to a tax, and this efficient tax provides revenue that allows a reductionof future distortionary taxes.
On the other hand, a switch from an income tax to a labor income tax, by shifting burdens
to the young, not only hurts younger generations and helps older generations at the time of the
tax reform, but also can reduce efficiency, in spite of the fact that the intertemporal distortion has
been eliminated. By reducing the future taxes that asset-owners have to pay, a reduction incapital income taxes will not only reduce intertemporal distortions, but in the short run will also
effectively provide a windfall to owners of existing wealth, many of whom may have shortplanning horizons and therefore mostly will simply experience an income effect. These
windfalls must be paid for by raising distortionary taxes on labor income, and the efficiency loss
from the need to pay for windfalls with distortionary taxes can more than fully offset theefficiency gains from eliminating the intertemporal distortion.
Societal aging affects the relative merits of different tax bases. First, as a simple matterof revenue, the relative sizes of the different bases will change and hence so will their revenue
generating capacity for given tax rates. For example, standard life-cycle analysis as well as
empirical evidence suggests the existence of a hump-shaped saving pattern, and in particularincreasing consumption-income ratios as the population ages and a larger share of the population
is using principal as well as income from assets to finance consumption. Thus, increases in theold-age dependency ratio would be expected to increase the consumption-income ratio, making
consumption taxes, in principle, a stronger potential revenue source.10
10This conclusion is tempered to the extent that consumption items concentrated among the elderly, such as healthcare, are either exempt from taxation or government-provided.

16

Likewise, an increase in the elderly share of the population would be expected to increase
the economy’s ratio of capital to labor, reflecting the prior wealth accumulation of older
individuals. In a closed economy, this would have an uncertain impact on the relative shares ofcapital income and labor income, with the production elasticity of substitution determining theoutcome; but in an open economy, with factor prices less sensitive to changes in the ratio ofdomestically-owned capital to labor, one would expect an increase in the capital share of income.
Thus, the capital income component would become more significant as a share of income andhence also as a potential tax base. On the other hand, labor income taxes would fall on a smaller
tax base, relative to overall income.
Of course, the relative sizes of the different tax bases don’t provide all the necessary
information about the relative attractiveness of different taxes. However, analysis of efficiency
effects does yield similar results. For example, an increase in the dependence on consumption
taxes will result in a higher capital levy with an older population, assuming that a larger elderly
cohort is associated with increased asset-holding; hence, there will be a bigger efficiency gainfrom such a tax shift. On the other hand, a reduction in capital income taxes accomplished via atransition to labor income taxation will produce larger windfalls to asset-holders and therefore
make such a tax shift even less attractive. Thus, the efficiency differences between consumption
taxes and labor income taxes will be magnified by societal aging, because the different effects ofthe two taxes on existing wealth will be magnified.11
To illustrate this last point, Table 1 presents results from simulations based on the
Auerbach-Kotlikoff (1987) dynamic overlapping generations model, using the model’s baseline

11

A corollary of this conclusion is that taxes on intergenerational wealth transfers, such as estate and inheritancetaxes, will be more efficient with an older population at the time of their enactment or increase, because of thehigher concentration of wealth among those of advanced age.

17

assumptions regarding tastes and technology.12 The table shows both the long-run welfare gains(which result from changes in both the distribution of the tax burden and in economic efficiency)
and pure efficiency gains (which exclude the effects of intergenerational transfers) that result
from immediate transitions from a 30 percent proportional income tax to either a proportional
consumption tax or a proportional labor income tax. As in the original Auerbach-Kotlikoff
analysis, transitions to a consumption tax are projected to produce long-run efficiency gains andeven larger long-run welfare gains, because of transfers in the tax burden to older transition
generations. For labor income taxation, the results are reversed, as long-run generations lose as aconsequence of both reductions in efficiency and transfers to older generations.
The two rows of the table show results for annual population growth rates of 1 percent
and 2 percent. For the lower population growth rate, in which the economy has an older
population, the welfare and efficiency gains are larger under a transition to a consumption tax,
and the welfare and efficiency losses are larger under a transition to a labor income tax. As thediscussion above suggested, when older generations account for a larger share of the population,
the transition effects that make these two tax reforms differ with respect to both efficiency andintergenerational transfers are magnified.

V. Stabilization Policy
What of the macroeconomic effects of societal aging, and the nature of fiscal responses?
We can distinguish longer-term and cyclical issues, although there is little to say about theformer. A lower birth rate translates into a lower rate of aggregate economic growth, ceteris

12

These assumptions include a nested CES utility function with intertemporal elasticity of 0.25 and intratemporalelasticity between contemporaneous consumption and leisure of 0.8, a utility weight of 1.5 on leisure relative toconsumption, a pure rate of time preference of 0.015, Cobb-Douglas production using capital and labor, and an
empirically estimated age-wage profile.

18

paribus. This, in itself, has no obvious implications for fiscal policy, other than that estimates ofpotential output and labor force growth will need to reflect this underlying trend. There is no
obvious reason why fiscal policy, or for that matter monetary policy, will be otherwise
influenced by this change in trend growth, given that it is a gradual and predictable ongoingprocess.
As to cyclical issues, societal aging may influence both automatic stabilizers anddiscretionary fiscal policy. Automatic stabilizers exist on both the tax and spending sides. On
the tax side, revenues rise and fall with income, providing a stabilizing force that depends on
both the tax structure – in particular, the elasticity of tax revenues with respect to income – aswell as the short-run responsiveness of aggregate demand to changes in tax payments. As
discussed above, there may be reasons for modifying the tax structure in response to societal
aging. Even without changes in the structure of taxation itself, tax revenues are likely to shift
among different tax bases, for example with consumption taxes growing in importance relative toincome taxes with the expected increase in the consumption-income ratio. The impact of thisshift on the strength of automatic stabilizers is ambiguous, for there are effects that push in
opposite directions.
On one hand, consumption tax revenues tend to be less responsive to the cycle, precisely
because of consumption smoothing. This may weaken the ability of the tax system to serve as an
automatic stabilizer, although if individuals are smoothing consumption, then the impact ofchanges in current tax payments on current consumption may not be very significant in any case.
On the other hand, the shift toward older consumers should, according to the life-cycle model,
tend to increase the marginal propensity to consume per unit change in tax revenues, making
automatic stabilizers stronger.

19

On the spending side, the strong shift in the composition of government spending toward
old-age entitlement programs may make the automatic spending response to output more procyclical, to the extent that decisions to claim benefits, in particular for retirement and disability
pensions (which also tend to be concentrated among older workers), increase with weakness in
the labor market.13
As to discretionary policy, a shift in tax structure may strengthen the tools available tostimulate aggregate demand. For example, an increased reliance on consumption taxes would
enhance the ability of government to affect not simply disposable income of taxpayers but also
their intertemporal consumption decisions through the use of temporary adjustments in the
consumption tax rate.14 Stimulus measures that rely on substitution effects rather than income
effects have a further advantage related to societal aging, in particular to the budget stressdiscussed above. To the extent that governments cannot credibly commit to sustained fiscal
stimulus, or find it unwise to do so, this works in favor of price-based stimulus – a temporary tax
cut is likely to be more effective than a more sustained one, because the substitution effect isstrengthened. Thus, governments, which over a prolonged period of time are likely to be dealing
with the budget stress of population aging, may at the same time gain more effective tools for
influencing aggregate demand.

13

Empirical evidence for OECD countries suggests that disability claims increase in recessions, with this increase
attributable primarily to weak employment conditions rather than declines in health. See Benítez-Silva et al. (2010).
As to retirement, the evidence is less clear, in part because individuals who depend on their own wealth in addition
to government pensions to finance retirement consumption may experience negative wealth shocks in recession that
may encourage individuals to delay retirement. See Gustman et al. (2011).
14

Indeed, such a policy was adopted by the United Kingdom during the recent recession, via a temporary reductionin the VAT rate beginning late in 2008. See Crossley et al. (2009).

20

VI. Conclusions
Societal aging has several implications for the conduct of fiscal policy, beginning withthe considerable stress put on public sector finances because of large, unfunded and age-based
entitlement programs. There are other effects as well, some of which will present further
challenges to fiscal policy actions, and others that may ease the path somewhat. Even if existing
programs can be modified, a growing share of government budgets will be devoted to old-age
entitlement programs, and both economics and politics suggest that this will reduce the flexibilityof budget determinations.
An aging population also has implications for the design of tax policy, making certain tax
bases – in particular, consumption taxes, and wealth transfer taxes as well – more productive andefficient. As to stabilization policy, the consequences of aging are less clear, both with respect tothe effectiveness of automatic stabilizers and the ability of government to take effective
discretionary actions.

21

References
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MIT Press, pp. 77-100.
Auerbach, Alan J., 2009, “Long-Term Objectives for Government Debt,” FinanzArchiv 65(4),December, pp. 472-501.
Auerbach, Alan J., 2011, “Long-Term Fiscal Sustainability in Major Economies,” Bank forInternational Settlements Working Paper No. 361, November.
Auerbach, Alan J., and Kevin Hassett, 2001, “Uncertainty and the Design of Long–Run Fiscal
Policy,” in A. Auerbach and R. Lee, eds., Demographic Change and Fiscal Policy. Cambridge:
Cambridge University Press, pp. 73-92.
Auerbach, Alan J., and Laurence J. Kotlikoff, 1987, Dynamic Fiscal Policy. Cambridge:
Cambridge University Press.
Auerbach, Alan J., and Ronald Lee, 2011, “Welfare and Generational Equity in Sustainable
Unfunded Pension Systems,” Journal of Public Economics 95(1-2), February, pp. 16-27.
Benítez-Silva, Hugo, Richard Disney, and Sergi Jiménez-Martín, 2010, “Disability, Capacity for
Work and the Business Cycle: an International Perspective,” Economic Policy 63, July, pp. 483536.
Board of Trustees, Federal Hospital Insurance and Federal Supplemental Medical Insurance
Trust Funds, 2012, The 2012 Annual Report of the Board of Trustees of the Federal Hospital
Insurance and Federal Supplementary Medical Insurance Trust Funds. Federal Hospital
Insurance and Federal Supplemental Medical Insurance Trust Funds, Washington, DC, April 23.
Board of Trustees, Federal Old-Age and Survivors Insurance and Disability Insurance TrustFunds, 2012, The 2012 Annual Report of the Board of Trustees of the Federal Old-Age andSurvivors Insurance and Federal Disability Insurance Trust Funds. Federal Old-Age andSurvivors Insurance and Disability Insurance Trust Funds, Washington, DC, April 23.
Congressional Budget Office, 2011, CBO’s 2011 Long-Term Budget Outlook, June.
Congressional Budget Office, 2012, The Budget and Economic Outlook: Fiscal Years2012 to 2022, January.
Cooley, Thomas. F., and Jorge Soares, 1996, ‘‘Will Social Security Survive the Baby-Boom?’’
Carnegie-Rochester Conference Series on Public Policy 45, pp. 89-112.
Crossley, Thomas, Hamish Low, and Matthew Wakefield, 2009, “The Economics of a
Temporary VAT Cut,” Fiscal Studies 30(1), March, pp. 3-16.
22

Gustman, Alan L., Thomas L. Steinmeier, and Nahid Tabatabai, 2011, “How did the Recessionof 2007-2009 Affect the Wealth and Retirement of the Near Retirement Age Population in the
Health and Retirement Study?” NBER Working Paper 17547, October.
International Monetary Fund, 2010a, “From Stimulus to Consolidation: Revenue andExpenditure Policies in Advanced and Emerging Economies,” Fiscal Affairs Department, April
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23

Table 1. Efficiency and Long-Run Welfare Gains:
Transition from a 30% Income Tax

New System:

Consumption Tax

Labor Income Tax

Population Growth
Rate (percent):

Long-Run
Welfare Gain

Efficiency
Gain

Long-Run
Welfare Gain

Efficiency
Gain

1

6.29

1.71

-3.46

-2.31

2

5.57

1.34

-3.15

-1.59

Notes:
Taste and technology parameters are taken from the base case in Auerbach andKotlikoff (1987).
All other taxes and national debt are set to zero, for simplicity.
Long-run welfare gains are expressed as percent increases in lifetime resourcesof generations in the long run.
As in Auerbach and Kotlikoff (1987), efficiency gains are welfare gains of
post-reform generations when gains or losses of transition generations areneutralized using lump-sum taxes and transfers and remaining gains or losses
are spread evenly among post-reform generations.

Figure 1. Fiscal Gaps through 2060
0.15

0.1

Fraction of GDP

0.05

0
AT AU

BE

CA

DE DK

EL

ES

FI

FR

IE

IT

JA

NL NO NZ

-0.05

-0.1

-0.15

-0.2
Baseline

Source: Auerbach (2011)

No Initial Debt

No Pension or Health Growth

PT

SE

UK USA

Figure 2. Mandatory Federal Health Spending Under CBO’s Alternative Fiscal
Scenario and Different Assumptions About Excess Cost Growth After 2021
12.0

10.0

Percent of GDP

8.0

6.0

4.0

2.0

0.0
2011

2014

2017

No Excess Cost Growth

Source: CBO (2011)2020

Slowing Growth

2023

2026

2029

2032

Excess Cost Growth of 2.0 Percentage Points

Figure 3. Share of U.S. Federal Non-Interest Spending, 1972-2022
70

60
Discretionary
Percent of Non-Interest Spending

50

40
Social Security + Medical

30

20

10

0
1972

1975

1978

Source: CBO (2012)

1981

1984

1987

1990

1993

1996

1999

2002

2005

2008

2011

2014

2017

2020