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SEC(2006) 1247

COMMISSION STAFF WORKING DOCUMENT

Accompanying document to the COMMUNICATION FROM THE COMMISSION TO THE COUNCIL AND THE EUROPEAN PARLIAMENT The long-term sustainability of public finances in the EU

{COM(2006) 574 final}

EUROPEAN

COMMISSION

DIRECTORATE-GENERAL FOR

Economic and Financial affairs

The long-term sustainability of PUBLIC FINANCES IN the EUropean union

(The complete and definitiveversion will be published asEuropean Economy n° 4/2006)

European Economy

The Long-term Sustainability of Public Finance in the European Union

A report by the Commission services

SEC(2006) xxx

http://ec.europa.eu/economy_finance/publications_en.htm

Acknowledgements

This report was prepared in the Directorate-General of Economic and Financial Affairs under the direction of Klaus Regling, Director-General, and Servaas Deroose, Director for the Economy of the Euro Area and the Union.

The main contributors were Elena Flores, Antoine Deruennes, Per Eckefeldt, and Marko Mršnik.

Specific contributions were provided by Declan Costello, Giuseppe Carone, Declan Costello, Nuria Diez Guardia, Gilles Mourre, Joao Nogueira Martins, Bartosz Przywara and Aino Salomäki.

The country sections in Chapter VI benefited from comments from desk officers in the Directorate for the Economies of the Member States under the responsibility of Director Marco Buti.

Elena Flores coordinated and supervised the production of the report. Fabrizio Melcarne was responsible for statistical and editorial work.

Comments and suggestions by colleagues in the Directorate-General for Economic and Financial Affairs as well as by other services of the Commission are gratefully acknowledged.

Secretarial support was provided by Maria Davi-Pilato and Dominique Prins.

Comments on the report would be gratefully received and should be sent to:

Directorate-General for Economic and Financial Affairs

Macroeconomy of the euro area and the EU

Public Finances in the euro area and the EU

European Commission

B-1049 Brussels

or by e-mail to Elena.Flores@ec.europa.eu

Abbreviations and symbols used

Member States

BE Belgium

CZ Czech Republic

DK Denmark

DE Germany

EE Estonia

EL Greece

ES Spain

FR France

IE Ireland

IT Italy

CY Cyprus

LV Latvia

LT Lithuania

LU Luxembourg

HU Hungary

MT Malta

NL The Netherlands

AT Austria

PL Poland

PT Portugal

SI Slovenia

SK Slovak Republic

FI Finland

SE Sweden

UK United Kingdom

EUR-12 European Union Member States having adopted the single currency (BE, DE, EL, ES, FR, IE, IT, LU, NL, AU, PT, FI), i.e. countries participating in the economic and monetary union without a derogation

EU-25 European Union, 25 Member States

EU-15 European Union, 15 Member States before 1. May 2004 (EUR-12 plus DK, SE and UK)

EU-10 European Union, 10 Member States that joined the EU on 1. May 2004 (CZ, EE, CY, LV, LH, HU, MT, PL, SI, SK)

Other

AR Ageing Report

CAB Cyclically-Adjusted Balance

CBO Congress Budget Office

DR Debt Requirement in 2050

EDP Excessive Deficit Procedure

EMU Economic and Monetary Union

EPC Economic Policy Committee

ERM II European Exchange Rate Mechanism, replacing the original ERM in 1999

ESA95 European System of National Accounts 1995

GDP Gross Domestic Product

IBP Initial Budgetary Position

IMF International Monetary Fund

LTC Long-Term Change in the budgetary position

MTO Medium-Term Objective

NAIRU Non-Accelerating Inflation Rate of Unemployment

PAYG Pay-As-You-Go

PEP Pre-accession Economic Programmes

RPB Required Primary Balance

SCP Stability and Convergence Programmes

SFA Stock Flow Adjustment

SGP Stability and Growth Pact

SNA United Nations System of National Accounts

VAT Value-Added Tax

Table of contents

Chapter I: Long-term sustainability of public finances 15

1. Sustainability of public finances in view of ageing populations 17

1.1. Concept of sustainability of public finances 17

1.2. The sustainability indicators 18

1.3. Deriving the sustainability indicators 18

2. Projecting budgetary developments 19

2.1. Projections of government age-related expenditure 19

2.2. Projecting budgetary balances over a long period 20

3. Interpreting the sustainability indicators 22

3.1. Information on the size of adjustment and the cost of delay 22

3.2. Measure of implicit liabilities 22

3.3. The indicators have no normative content 22

3.4. The indicators do not assess intergenerational equity 23

3.5. The indicators are not sufficient to give a full overview of possible sustainability risks 24

Chapter II: Results of the sustainability analysis 28

1. Overall results of the sustainability indicators and debt projections 29

1.1. The quantitative indicators 29

1.2. Government debt projections 33

2. Comparison with the results of the public finance sustainability analysis in the 2005/06 assessment round of Stability and Convergence programmes 34

3. Comparison of long-term pension projections 37

Chapter III: Sensitivity analysis 41

1. The budgetary impact of modifying underlying assumptions 43

2. Sensitivity tests on the underlying demographic and macro-economic assumptions 43

2.1. Life expectancy 43

2.2. Higher labour productivity growth 44

2.3. Higher employment and higher employment of older workers 45

2.4. Higher interest rate 45

3. Alternative scenarios for health-care and long-term care 47

3.1. Health-care 47

3.2. Long-term care 48

4. Illustrating the sustainability impact of attaining the medium-term objective 49

4.1. The quantitative indicators 49

4.2. Government debt projections 53

5. Conclusions 54

Chapter IV: Qualitative factors 55

1. Government debt and the long-term sustainability of public finances 57

Recent dynamics government debt in the EU Member States 57

2. Pension expenditure projections and risks to public finances 61

2.1. Decrease in the relative level of pensions and risks to public finances 62

Main risks for public finances 62

Assessing risks 63

2.2. The current level of public and private pension expenditure and the current distribution of pensions 64

2.3. Future coverage of private occupational and voluntary pensions 66

2.4. Effective age of retirement 67

2.5. Conclusions 68

3. Revenue projections 70

3.1. Current approach in the EU surveillance framework and alternative approaches by Member States 70

3.2. Treatment of additional revenue projections in the sustainability assessment 72

3.3. Changes in property income over time 73

Property income and proposed way forward 73

Projecting property income 74

3.4. Conclusions 75

4. Stock flow adjustment 78

5. Tax burden 81

6. Contingent liabilities 83

Chapter V: Overall assessment of the risks to the sustainability of public finances 85

1. Reaching an overall assessment of the risks to the long-term sustainability of public finances 87

2. Main sustainability challenges that Member States are facing 90

Chapter VI: Country analysis 93

Belgium 96

The Czech Republic 99

Denmark 102

Germany 105

Estonia 108

Greece 111

Spain 114

France 118

Ireland 121

Italy 124

Cyprus 127

Latvia 130

Lithuania 132

Luxembourg 135

Hungary 138

Malta 141

The Netherlands 144

Austria 147

Poland 150

Portugal 153

Slovenia 156

Slovakia 158

Finland 161

Sweden 164

The United Kingdom 167

Chapter VII: Resources 171

1. References 172

2. Glossary 176

ANNEX I: Deriving the sustainability indicators 180

ANNEX II: Sensitivity tests 188

ANNEX III: Council opinions on the 2005/06 Stability and Convergence Programmes 191

List of tables

Table I.1. Summarizing the indicators 19

Table I.2. Adjustment to the primary balance and the debt concept and sources 21

Table I.3. Projected changes in age-related public expenditure between 2004 and 2030/50 (% of GDP) 27

Table II.1. Results of the sustainability gap calculations in the baseline scenario (% GDP) 30

Table II.2. Government balances (% of GDP) 32

Table II.3. Required primary balance (% of GDP) 33

Table II.4. Projected debt developments in the EU Member States (% of GDP) 33

Table II.5: Change in the age-related budgetary items (between last year of the programme and 2050) 35

Table II.6. Estimated and actual government balances in 2005 36

Table II.7 Evolution of pension expenditure compared: EPC and SCP projections (as change in % of GDP between 2005-2005) 38

Table II.8 Main factors with an impact on the pension projection results over time 39

Table III.1. Impact on the sustainability indicator of changes in demographic and macroeconomic assumptions (deviation from S2 in % points of GDP) 44

Table III.2. Impact on the sustainability indicator of alternative health-care assumptions (deviation from S2 in % points of GDP) 46

Table III.3. Change in the age-related budgetary items up to 2050 (% of GDP) 47

Table III.4. Impact on the sustainability indicator of alternative long-term care assumptions (deviation from S2 in % points of GDP) 48

Table III.5. Government balances in 2005 and the MTOs compared (% of GDP) 51

Table III.6. Results of the sustainability gap calculations in the MTO scenario (% of GDP) 52

Table III.7. Debt developments in the Member States assuming that the MTOs are reached in 2010 (% of GDP) 54

Table IV.1. Gross government debt 2000-2007 (% of GDP) 58

Table IV.2. Change in the benefit ratio over time 61

Table IV.3. Coverage of current pension expenditure for the 12 Member States 64

Table IV.4. Level of assets in occupational/individual pension schemes and coverage 66

Table IV.5. Age at retirement of new flows of retirees and average exit age from the labour market 67

Table IV.6. Employment rates in the EU in 2003 and in the projections 68

Table IV.7: Projections of property income 75

Table IV.8. Property income in EU (% of GDP) 76

Table IV.9. Decomposition of D4 for some countries 77

Table IV.10. Total taxes in the EU Member States (% of GDP) 82

Table V.1. Main factors considered in reaching an overall assessment of public finance sustainability risks 90

List of graphs

Graph I.1. Sustainability gap and required primary balance 23

Graph I.2 Age pyramids for EU25 population in 2004 and 2050 25

Graph I.3 Baseline labour force projection (change in % of people aged 15-64 between 2003 and 2050) 26

Graph I.4 Projected (annual average) potential growth rates in the EU15 and EU10 and their determinants 26

Graph II.1. Decomposition of the S2 indicator 31

Graph II.2. Debt developments in the EU and the euro area 2005-2050 34

Graph II.3: S2 indicator in the baseline scenario compared with the results of the 2005/06 SCPs assessment round and main source of differences 36

Graph III.1. The cost of delay (in % of GDP) 50

Graph III.2. Debt developments in the EU and the euro area 53

Graph IV.1. Composition of the change in debt levels, 2000-2005 59

Graph IV.2. Impact on public finances of maturing private pension schemes 71

Graph IV.3. Stock-flow adjustment in the EU MS, average 2002-2005 (% of GDP) 79

Graph V.1. Overall risk classification and the sustainability gap (S2 in the baseline scenario) 89

List of boxes

Box I.1 Demographic and economic projections in the Ageing Report 25

Box III.1. The 'cost of delay' indicator 50

Box IV.1. Relative level of pensions, replacement rates and the benefit ratio 62

Box IV.2. Impact of indexation rule after retirement 65

Chapter I

Long-term sustainability of public finances

Summary

Population ageing in the European Union will have a significant impact on economic growth and lead to significant pressures to increase public spending. In order to gauge the scale of this challenge, the assessment of long-term sustainability of public finances is part of the regular EU budgetary surveillance, based on the long-term age-related government expenditure projections and on the budgetary strategies presented in the Stability and Convergence Programmes. In this context, consistency between short to medium-term budgetary targets and long-term sustainability is at the core of the analysis.

The issue of long-term sustainability is a multi-faceted one. It involves avoiding imposing an excessive burden on future generations and ensuring the country's capacity to appropriately adjust budgetary policy in the medium and long run. For this purpose, the results of the common long-term age-related expenditure projections under current policies, provided in spring 2006 by the EPC/Commission and the current budgetary position are the key inputs to the analysis of the sustainability of public finances.

The new projections provide a comparable, transparent and robust basis for assessing the budgetary implications of demographic change and the sustainability of public finances across Member States. Based on the projected expenditure trends, deficit and debt levels are projected over the long-term. Debt sustainability is derived from the intertemporal budget constraint. It imposes that current total liabilities of the government, i.e. the current public debt and the discounted value of future expenditure including the budgetary impact of ageing populations, should be covered by the discounted value of future government revenue. If current policies ensure that the intertemporal budget constraint is respected, current policies are sustainable.

The assessment of long-term sustainability of public finances goes beyond answering the question whether current policies are sustainable or not. An estimation of the size of the budgetary imbalances is also needed to understand the challenge that policy-makers face. This is provided by sustainability gap indicators that measure the size of a required permanent budgetary adjustment (e.g. a constant reduction of non age-related public expenditure as a share of GDP or a constant increase in public revenue as a share of GDP) that enables to meet one of the following conditions: i) reaching a target of 60% of GDP for the Maastricht debt in 2050 (the S1 indicator), ii) fulfilling the inter-temporal budget constraint over an infinite horizon (the S2 indicator).

The sustainability indicators provide a firm basis to identify the size and the main source of risks to public finance sustainability in the EU Member States. They provide information on and a measure of the size of the required adjustment and of the cost that would result from a delay in addressing the long-term sustainability. In addition, they provide a measure of implicit liabilities – government commitments - related to ageing populations. The indicators have however neither normative content nor do they assess intergenerational equity. To reach an overall assessment of the sustainability of public finances, other factors are taken into account, which allow a better qualification of the assessment with regard to where the main risks are likely to stem from.

.

Sustainability of public finances in view of ageing populations

In the coming decades, Europe's population will undergo dramatic demographic changes due to low fertility rates, continuous increases in life expectancy and the retirement of the baby-boom generation. Ageing populations will pose major economic, budgetary and social challenges. It is expected to have a significant impact on growth and lead to significant pressures to increase public spending.[1] This will make it difficult for Member States to maintain sound and sustainable public finances in the long-term. This is of particular importance in Economic and Monetary Union, as high deficits and rising debt in some countries leading to unsustainable public finances might have an adverse impact on macro-economic conditions for other EMU countries. Therefore, ensuring fiscal sustainability requires time-consistent policies, which involves addressing budgetary imbalances before the budgetary impact of ageing sets in.

Concept of sustainability of public finances

The issue of debt or fiscal sustainability is a multi-faceted issue and there is no agreed definition on what a sustainable debt position is. Blanchard et al (1990) consider that " it is essentially about whether, based on the policy currently on the books, a government is headed towards excessive debt accumulation ".

The time horizon, over which one analyses debt sustainability, depends on its purpose. In some cases, it might be relatively short and the purpose is to evaluate short- to medium-term dynamics of debt (e.g. in the Commission's assessments of the updates of the stability and convergence programmes for the purpose of the budgetary surveillance) or to analyse the dynamics of debt servicing, including in many cases external debt service (e.g. IMF assessment of default risks). [2] In the short to medium-term context, the assessment of the sustainability is conditional upon factors, such as the structure of debt according to maturity, currency of denomination and average terms of new commitments. If the sustainability of external debt is considered, additional factors such as exchange rate dynamics, exports and imports of goods and services in foreign currency and net foreign direct investment are taken into account. Such type of sustainability analysis is mostly used for emerging markets or low-income countries. [3]

In the case of the assessment of the long-term sustainability of public finances, the time horizon needs to be considerably longer to assess the budgetary impact of government commitments, notably regarding pensions. Against such a significant budgetary challenge posed by ageing populations, the latter has been the preoccupation of the EU in recent years and is the prime focus of this report.

Many EU Member States conduct long-term projections and analyse long-term budgetary trends, in particular in view of assessing the budgetary impact of the projected demographic changes. Moreover, other international organizations like the IMF assess long term sustainability (mainly for industrialised countries).[4]

For the purposes of assessing sustainability of public finances over the long-term in view of the budgetary challenge posed by ageing populations, debt sustainability may be defined in two alternative ways:

- A first definition of sustainability is derived from the government's intertemporal budget constraint . It imposes that current total liabilities of the government, i.e. the current public debt and the discounted value of all future expenditure, should be covered by the discounted value of all future government revenue over an infinite horizon. In other words, the government must run sufficiently large primary surpluses in the future to cover the increasing cost of ageing and to pay off interest on outstanding debt. If current policies ensure that the government's intertemporal budget constraint is fulfilled, current policies are financially sustainable. However, since the government's intertemporal budget constraint is defined over an infinite horizon, it does not specify when the adjustment of revenues or expenditures, if any, has to be made: the required adjustment may be made today or at any point in the future. Furthermore, this condition does not imply that debt should reach a specific level (whether it is zero or not).[5]

- The abovementioned condition over an infinite horizon can be approximated by looking over a finite period and to assess if current policies ensure a specific debt target to be reached at a given date. While this finite condition does not ensure the sustainability of public finances after the target year, it gives a clearer policy objective than the intertemporal budget constraint. Given that there are as many possible conditions as there are debt concepts, debt targets and target years, the EU adopted an approach of this second definition, which draws on the compliance with the EMU debt requirement in 2050. [6]

The sustainability indicators

The assessment of long-term sustainability of public finances goes beyond answering the question whether current policies are sustainable or not. An estimation of the size of the budgetary imbalances is also needed. This is provided by sustainability gap indicators that measure the size of a permanent budgetary adjustment (e.g. a constant reduction of non age-related public expenditure as a share of GDP or a constant increase in public revenue as a share of GDP) that enables to meet one of the following conditions:

- reaching a target of 60% of GDP for the Maastricht debt in 2050 (the S1 indicator );

- fulfilling the inter-temporal budget constraint over an infinite horizon (the S2 indicator ).

It should be clear that translating the two sustainability conditions into a permanent adjustment of public expenditure or public revenue has no normative content in the sense that it would favour one policy option over another. It mainly aims at giving a measure of the sustainability risk that is intuitive and "easily" understandable. Alternative presentations of these conditions are also possible. They can be translated into a required primary balance over the medium term, i.e. expressed as a target rather than as a deviation from this target. They can also be translated into a 'stock' measure, often called implicit liabilities or implicit debt, instead of a 'flow' measure as given by the sustainability indicators. The two latter measures should therefore be considered as alternative presentations of the sustainability indicators rather than as new or different indicators (see section 3.2 below for a more detailed presentation).

Deriving the sustainability indicators

The two sustainability indicators translate current and future budgetary imbalances into synthetic measures that can be simply expressed as a sum of three different components:

- the first component relates to the relative position of the current primary balance compared to the primary balance that stabilises the level of debt as a share of GDP over the long-term, further recalled as the debt-stabilizing primary balance . If the initial primary balance is not large enough, the government debt will be on an explosive path even before considering the impact of ageing.[7]

- the second component is specific to the S1 indicator and relates to the initial level of debt. If a country has an initial level of debt larger than 60% of GDP, reaching the debt-stabilizing primary balance will not be sufficient to ensure that the debt reference value is achieved in 2050 and an additional adjustment is therefore necessary.

- the third component relates to the increase in age-related expenditure in the future due to ageing populations. Fulfilling the first two conditions will not be enough to avoid excessive debt accumulation if expenditure are expected to increase (or equivalently if the primary balance is expected to deteriorate) as a share of GDP in the future. An additional adjustment is therefore necessary to cover the increase in expenditure up to 2050 (in the case of S1) or over an infinite horizon (in the case of S2).

This decomposition of the indicators (see Table I.1) gives additional insight to understand the numerical results of the indicators. It also enables to determine for each country whether the risks to the sustainability of public finances stem from the initial budgetary position and/or a large increase in age-related expenditure over the long-term.

Table I.1. Summarizing the indicators

Impact of |

Initial budgetary position | Debt requirement in 2050 | Long-term changes in the primary balance |

Source: Commission services (See table A.1.1. in Annex 1 for a mathematical derivation).

A high positive contribution of the current budgetary position (1st column) signals that the current level of the primary balance, if maintained, will lead to an explosive debt without considering the effect of ageing. A high positive contribution of the long-term changes in the primary balance (last column) signals that the impact of ageing on public expenditure is expected to be large. In this context, a low sustainability gap may cover quite different situations. In some cases, it stems from a debt-stabilizing budget balance and a small ageing impact on public finances. In other cases, it stems from a very strong budgetary position today with large primary surpluses that enable to compensate a significant projected rise in age-related expenditure.

Projecting budgetary developments

Projections of government age-related expenditure

Budgetary projections over the long-term are based on a set of assumptions which can potentially have a very large impact on the results. In a multilateral context, having a common setting for the projections for the purposes of analysing and assessing the long-term sustainability of public finances is therefore essential to ensure comparability of results and equal treatment. This was the main motivation behind the 2006 common budgetary projections exercise, carried out by European Commission together with national authorities working through the Economic Policy Committee. [8]

In a repeat of an exercise carried out in 2001, the long-term projections on how ageing will affect the labour market, economic growth and age-related public expenditure items have been published. [9] The projections were made on the basis of “no policy change”, only reflecting currently enacted legislation, although account is taken of provisions in enacted legislation that enter into force over time. Equally, they reflect the current behaviour of economic agents, without assuming any future changes in behaviour. Projections for public spending on pensions were made using the models of the Member States' authorities. Projections for health care, long-term care, education and unemployment transfers were made using common models developed by the European Commission. The ECOFIN Council of February 2006 agreed that the projections provided a comparable and comprehensive picture of the economic and budgetary impact of ageing populations and they would provide the basis for assessing the sustainability of public finances at EU level.

The projections used in the baseline scenario for analysing public finance sustainability include the following five age-related expenditure items:

- Gross public pension expenditure . This consists of pensions for old-age, early retirement, disability, survivors (widows and orphans) and for other specific purposes which should be considered as equivalents or substitutes for these types of pensions, including pensions for reduced capacity to work or for labour market reasons. Pension expenditures are in nearly all countries the most important age-related government expenditure item, both in terms of size at present and in the future and in terms of differences across the EU Member States. The substantial increase in the old-age dependency ratio over the coming decades in the EU leads to increasing pension expenditure in almost all EU countries. However, there is a large diversity with regard to the size of the increase, reflecting mainly differences in the pension arrangements that prevail in the different Member States. Such diversity gives rise to different degrees of risk in terms of public finance sustainability.

- Health-care expenditure . Several scenarios for future trends with regard to expenditure on health-care are available in the Ageing Report. For the purposes of analysing and assessing public finance sustainability, a 'reference' scenario from the Ageing Report is used. This scenario takes account of the combined effects of ageing, the health care status of elderly citizens and the income elasticity of demand for health care goods and services. It is notably assumed that the health status of the populations will improve by half as much as in the constant health scenario.[10]

- Long-term care expenditure . Several scenarios for future trends with regard to expenditure on long-term care are available in the Ageing Report. As it is the case for health-care, a 'reference' scenario from the Ageing Report has been used. This scenario assumes that age-specific disability rates decline at half the pace of age-specific mortality rates. In particular, it is assumed that age-specific disability rates decrease by half of the decrease in the age-specific mortality rates. In this scenario about half of the projected gains in life expectancy up to 2050 would be spent in good health and free of disability. Long-term care projections show quite different patterns across countries mainly due to large differences in initial coverage. Finally, the Ageing Report did not include projections for long-term care for Greece, France, Portugal, Cyprus, Estonia, and Hungary. Since the completion of the Ageing Report, Estonia, France, Hungary and Portugal have provided the required data so that the Commission could run the projections for these countries. However, for Greece and Cyprus, the lack of long-term care projections implies that the total increase in age-related expenditures, and therefore the risks to the long-term sustainability of public finances will be underestimated.

- Education expenditure and unemployment benefits . This consists of direct education expenditure and transfers to households and institutions; and, expenditure on unemployment benefits that follow from the assumptions made on the working-age population, labour market participation and unemployment rates, respectively. The projections show that the relief on public finances due to a lower unemployment rate and a lower relative share of young people can only marginally compensate for the increase of expenditure on pensions, health-care and long-term care.

These long-term common projections estimate the budgetary impact of ageing based on commonly agreed underlying assumptions and under policies currently in place in the EU Member States. They do not assess the efficiency of such policies nor their desirability compared to alternative policies. Indeed, they do not assume changes in policies that could result in an improvement in the health status of the population or higher educational attainment levels. Implementing such policies could contribute to higher labour force participation and higher labour productivity and thus in higher economic activity.[11] Moreover, such policy changes could result in lower public spending over the long-term and thus contribute to the sustainability of public finances. The budgetary impact of alternative assumptions e.g. with respect to the health status of the population is discussed in Chapter III. Moreover, additional sensitivity tests are produced to analyse the impact of various changes in the key assumptions. The demographic and economic projections underlying the government expenditure projections are summarised in Box I.1.

Projecting budgetary balances over a long period

The long-term budgetary projections from the Ageing Report are the main input to project future budgetary developments. To extrapolate debt developments and to calculate the sustainability indicators, one also needs projections and/or assumptions for other public expenditure and revenue items over a long period of time under current policies (see Table I.2):[12]

- interest expenditure are derived according to the evolution of debt and the projected real interest rate which is set at 3% for all countries over the entire period; [13]

- Table I.2. Adjustment to the primary balance and the debt concept and sources

Primary balance | Debt level |

Initial government items | Primary balance i.e. government balance excluding interest expenditure | Maastricht gross debt |

Corrections | Cyclical adjustment | European Commission Spring 2006 economic forecast) | - |

One-off or temporary measures | European Commission Spring 2006 economic forecast | - |

Liquid financial assets in public pension funds | 2005/06 updates of the Stability and Convergence programme |

Switch to private pension fund (if the Eurostat decision is not already implemented) | Eurostat (Euro-indicators news release 48/2006 24 April 2006)* | Eurostat (Euro-indicators news release 48/2006 24 April 2006) |

"Adjusted" government items | Structural primary balance | Adjusted gross debt |

Note:* Interest expenditure are estimated with the level of additional debt and the implicit level of the interest rate in 2005.

Source: Commission services.

- other primary expenditure , as well as total revenue , is assumed to be constant as a share of GDP and equal to the last known year.[14] Temporary factors (business cycle and one-off measures) on the general government balance are however netted out so that such effects are not extended over the long-term. [15]

Two additional corrections have been implemented:

- first , a number of Member States have switched a part of their social security pension schemes into defined-contribution funded schemes. According to the decision of Eurostat (2 March 2004) those schemes should be recorded in the private sector in the national accounts..[16] This implies that pension outlays from those schemes are not included in the long-term projections for public pensions. Symmetrically, the corresponding revenues and the assets in those funds deductible from the Maastricht debt should not be considered as part of the general government.[17] Given that countries are required to implement the Eurostat decision by March 2007, adjusting the budget balance figure is necessary for countries that currently publish general government figures including those funds (DK, HU, PL, SK, SE);

- second , the debt concept used by the Commission, the Maastricht gross debt, is only one of the several different definitions of public debt that can be envisaged. The gross debt concept is defined in the Protocol on excessive deficit procedure annexed to the Maastricht Treaty.[18] The concept has the advantage of being measurable with a high degree of certainty and being comparable across countries in the EU. The choice of focussing on gross debt is therefore logical. However, governments may hold assets which contribute positively to the sustainability of public finances. Since reducing debt or accumulating assets in public pension funds has a similar effect on fiscal sustainability, with the latter strategy however not reflected in the gross debt measure, the net position of liquid consolidated pension fund assets is taken into account in the analysis of public finances sustainability.[19]

Finally, given that the common projections are conducted for the period up to 2050, the total primary balance of the government is assumed to remain constant as a share of GDP after 2050 in order to calculate the intertemporal constraint over an infinite horizon (S2 indicator).

Interpreting the sustainability indicators

Information on the size of adjustment and the cost of delay

First, the sustainability indicators are used to assess if current policies in a country are sustainable or not. A positive value suggests that current policies are not sustainable while a negative value indicates that current policies are sustainable. Projecting long-term budgetary trends requires several assumptions which may not materialise and are therefore subject to uncertainty. As the sensitivity analysis carried out in Chapter III reveals, sustainability indicators are indeed sensitive to a number of assumptions. It may therefore be difficult to assess exactly whether current policies are sustainable or not - particularly for countries for which indicators are close to zero.

Second, the sustainability indicators also give the indication of the magnitude of the budgetary challenge caused by ageing populations: this is particularly important in the budgetary surveillance framework, since fiscal situations are very different across the EU and since countries have reformed pension systems to various degrees. It is also possible to calculate the budgetary cost of a delay in budgetary consolidation: the additional explanatory value of the sustainability indicators is that it estimates the cost of a delay calculated as the increase in those indicators that would follow a postponing of the budgetary adjustment by, e.g. five years.

Measure of implicit liabilities

Sustainability indicators also provide an estimate of implicit liabilities. Implicit liabilities are liabilities that may not be backed by law or contractual obligations but are simply grounded in strong expectations by the public. There are several different concepts for implicit liabilities.[20]

An important aspect is the coverage which can be limited to the pension rights that current workers have accrued so far in the system (sometimes referred to as 'accrued pension debt'). Alternatively, it can be extended to also include future pension rights as well as the continuation of current policies with regard to other public expenditure. Assessing sustainability of current policies needs to measure implicit liabilities on the assumption that the current rules will apply also in the future for current and future generations.

Furthermore, the notion of implicit liabilities could be gross or net of future revenues. A forward-looking concept of implicit liabilities to be meaningful needs to consider not only the future implicit commitments of governments but also their entitlement to receive revenues, i.e. net implicit liabilities.

Against this background, the analysis of public finance sustainability made by the Commission and the Council in the context of budgetary surveillance considers a relatively broad definition of net implicit liabilities that incorporates the projected impact of ageing populations over the long-term. In particular, it includes the projected change in the age-related expenditure items covered by the common projections exercise.

As shown in section I.2 above, the S2 sustainability indicator provides an estimate of the gap between current policies and sustainable policies, which expresses the current level of debt plus the net present value of all future primary deficits as a flow measure i.e. as a perpetual annuity, constant as a share of GDP. It is also possible to express this gap in present value terms, i.e. as a stock measure. The current level of debt (explicit debt) less the net present value of the sustainability gap (net implicit debt) is therefore a measure of the current net implicit debt of the general government (the statistical annex, section 4 provides a formal description). In practice, 'stock' measures (net implicit liabilities) are more volatile than 'flow' measures (sustainability gap indicators), especially with relation to the assumed discount rate. It is arguably also more intuitive to understand the policy implications of a constant budgetary adjustment rather than an additional stock of debt. Measuring long-term public finance imbalances as 'flow' indicators (i.e. sustainability gaps) is therefore preferred to equivalent 'stock' measures (i.e. implicit net debt).

The indicators have no normative content

Sustainability gap indicators are sometimes called tax gap indicators, which refers to one possible interpretation of the indicators i.e. the permanent increase in the tax ratio that would ensure sustainability. This expression can however be misleading since there are different ways to ensure long-term sustainability and a uniform increase in tax over time is only one of them.

Graph I.1. Sustainability gap and required primary balance

[pic] Note: The graph is an illustration the evolution for the primary balance in the "baseline" scenario. The sustainability gap is assumed to be 1.5% of GDP. If the country was to reach a sustainable position only through medium-term budgetary consolidation, reaching the RPB over the medium-term would be sufficient.

Source: Commission services .

Namely, governments typically choose a combination of consolidating the budgetary position over the medium-term (either through expenditure reduction and/or tax hikes) and implementing structural reforms aiming at curbing long-term public expenditure (through lower nominal spending or higher GDP growth). Sustainability indicators should therefore be understood as measures of imbalances and not as a policy invitation to increase taxes in the medium term or to undertake any other specific policy measure.

Instead of presenting public finances imbalances as a gap towards a sustainable situation, it is also possible to present the resulting target in terms of a primary balance that would result from a consolidation in the medium term that ensures sustainability (the required primary balance ). It is also a more stable indicator than the sustainability gap.[21]

The primary balance will evolve in the future in line with the impact of ageing on expenditure (see Graph I.1), but the RPB indicates a sufficient starting position that, if reached, ensures sustainability of public finances under a no policy change assumptions. The required primary balance is not a fixed target over time, not even if structural reforms are implemented.

The RPB can be used to compare the actual or planned budgetary strategy with the structural primary balance required for fulfilling the inter-temporal budget constraint. In practice, in the EU sustainability analysis framework, the required primary balance ( RPB ) is calculated as the projected average structural primary balance over the first five years after the programme period plus the S2 indicator and in this report it is calculated over the period 2011-2015.

The indicators do not assess intergenerational equity

Intergenerational fairness is also one of the motivations to address long-term sustainability issues in order to avoid leaving "unpaid bills" to future generations. However, to assess this one needs information on distribution of social benefits, public spending and taxes to different age cohorts in the past and in the future.[22] While partly implicit in the calculations of the indicators, this cannot be done through this aggregate approach used in this report.

The indicators are not sufficient to give a full overview of possible sustainability risks

The sustainability indicators are synthetic tools but they do not necessarily encompass all factors that are relevant for the sustainability analysis.

They are based on demographic, economic and budgetary projections that are surrounded by uncertainties and as such may under- or overestimate risks.

They can only assess the factors taken into account in the framework (mainly ageing and current budgetary imbalances) and therefore do not address other issues that may be relevant for debt dynamics (contingent liabilities, competing budgetary pressures from non age-related expenditure, etc). They do not assess the feasibility of possible government actions. For example, indicators are independent of the current level of taxation, which if already high, may prove difficult to be raised further.

The intertemporal budget constraint does not impose any level of debt. Moreover, an adverse macroeconomic shock or other budgetary developments may lead to an explosive debt already in the short run. These factors point to a careful interpretation of the indicators and need for integrating such considerations in the formulation of an overall assessment (see Chapter IV).

Box I.1 Demographic and economic projections in the Ageing Report

European populations will be much older by 2050 Population ageing in Europe is occurring due to the interaction of four different demographic developments, each with its own cause, and each having different economic policy repercussions. The magnitude, timing and relative importance of these four demographic trends differs considerably across EU countries (for details, see Chapter 2.1 in the Ageing Report (2006)).[23] First, in all EU countries, fertility rates are below the natural replacement rate needed to stabilise the size and age structure of the population. For the EU25, fertility rates in baseline scenario are projected to rise from 1.5 in 2004 to 1.6 by 2030 and to stay constant around that level until 2050. Second, the recent decline in fertility rates followed the post-war baby-boom, and their impending entry into retirement will lead to a transitory (albeit lasting several decades) increase in the old-age dependency ratio which will act as a downward drag on per capita GDP growth and place upward pressure on public spending. Third, having increased by 8 years since 1960, life expectancy at birth is projected to rise by a further 6.3 years for males and by 5.1 years for females by 2050, with most gains resulting from lower mortality rates at older ages. Fourth, annual net migration inflows are projected to fall from an estimated 1.3 million people in 2004 to some 800,000 people by 2015 (0.2% of the population). These net inflows cumulate to close to 40 million people between 2004 and 2050, but they are insufficient to stabilise the age structure of the population. The population in the EU25 will be slightly smaller, but much older, in 2050 (see Graph I.2). Between 2004 and 2050, the number of young persons in the EU25 (aged 0-14) is projected to drop by 19%. From an economic perspective, the key change concerns the working-age population (15-64), which will fall by 48 million, or 16%. In contrast, the elderly population aged 65+ will rise sharply, by 58 million (or 77%) and the fastest growing segment of the population will be the very old (80+) and rise by almost 32 million, or 174%. The old-age dependency ratio (the number of people aged 65 years and above, relative to those between 15 and 64) is projected to double to 51% by 2050 which means the EU will move from having four to only two persons of working-age for every elderly citizen aged 65 or above. Graph I.2 Age pyramids for EU25 population in 2004 and 2050 2004 2050 [pic][pic] Source: EPC and European Commission (2006). Main repercussions for Europe's labour markets and potential growth The overall employment rate of the EU25 is projected to rise from 63% in 2004 to 67% by 2010 and to 70% by 2020. This improved performance mainly results from higher female employment rates, which are projected to rise from just over 55% in 2004 to almost 65% by 2025. The increase is explained by the gradual replacement of older women by younger women who have higher educational attainment and a stronger attachment to the labour market. In addition, the employment rate of older workers (age 55 to 64) is projected to massively increase from 40% in 2004 to 59% in 2025. This reflects the large increases of 5p.p. observed since 2000 (a remarkable reversal of the decades long trends towards earlier retirement during a period slow economic growth) as well as the estimated positive effects of recent pension reforms. Rising employment rates, however, can only provide a temporarily cushion, and eventually the weight of demographic change prevails (see Graph I.3). Three distinct time periods can be observed. Between 2004 and 2011, the size of the EU25 working age population and overall employment levels will continue to rise, and thus can be considered as a "window of opportunity" when conditions will be relatively favourable to undertake structural reforms. Between 2012 and 2017, rising employment rates will offset the projected decline in the size of the working-age population brought about by the baby-boom generation entering retirement. After 2018, the trend towards higher female employment rates will have come to an end and in the absence of further pension reform, the employment rate of older workers is projected to reach a steady state. Having increased by some 20 million between 2004 and 2017, employment during this last period is projected to contract by almost 30 million, giving a reduction of 9 million over the entire 2004-50 time horizon. For the EU25, the annual average potential GDP growth rate is projected to decline from 2.4% in the period 2004 to 2010 to only 1.2% between 2031 and 2050. For the EU10, the fall is much steep, in part due to their less favourable demographic prospects. The sources of growth will alter dramatically. Employment will make a positive contribution to growth in both the EU15 and the EU10 up to 2010, but becomes neutral in the period 2011-2030 and turn significantly negative thereafter. Over time, productivity will become the dominant source of growth, see Graph I.4. Graph I.3 Baseline labour force projection (change in % of people aged 15-64 between 2003 and 2050) [pic] Source: EPC and European Commission (2006). Graph I.4 Projected (annual average) potential growth rates in the EU15 and EU10 and their determinants [pic] [pic] Source: EPC and European Commission (2006). The overall impact of ageing population on public spending Overall, ageing populations is projected to lead to increases in public spending in most Member States by 2050 on the basis of current policies, although there is a wide degree of diversity across countries (see Table I.3). For the EU15 and the Euro area as a whole, public spending is projected to increase by about 4 percentage points between 2004 and 2050. For the EU10, the increase in the overall age-related spending is projected to rise by only about 1.5 percentage points. This apparently low budgetary impact of ageing is mainly due to the sharp projected drop in public pension spending in Poland, which (in common with several other EU10 countries) is partly the result of the switch from a public pension scheme into a private funded scheme. Excluding Poland, age-related spending in the other EU10 countries would increase by more than 5 percentage points of GDP. Most of the projected increase in public spending will be on pensions, health care and long-term care. Potential offsetting savings in terms of public spending on education and unemployment benefits are likely to be limited. |

Table I.3. Projected changes in age-related public expenditure between 2004 and 2030/50 (% of GDP)

[pic]

Total expenditure for pensions does not include Greece. For long-term care, there are no projections available for Greece and Cyprus. Since the release of the Ageing report, FR, PT, EE and HU have provided the data required to conduct the projections for long-term care for these countries. Table I.3 include these projections. The projection results for public spending on long-term care for Germany does not reflect current legislation where benefit levels are fixed. A scenario which comes closer to the current setting of legislation projects that public spending would remain constant as a share of GDP over the projection period.

Note: these figures refer to the baseline projections for social security spending on pensions, education and unemployment transfers. For health care and long-term care, the projections refer to “AWG reference scenarios”

Source: EPC and European Commission (2006).

Chapter II

Results of the sustainability analysis

Summary

The analysis in this chapter reveals that in the absence of reform measures and budgetary consolidation, a considerable sustainability gap of about 3½% of GDP, i.e. the gap between the structural budgetary position in 2005 and a sustainable position, emerges in both the EU and the euro area. Unless measures are taken to fill this gap, the government debt/GDP ratio is projected to remain above 60% over the coming decades for the EU as a whole and towards 2020, it is projected to start rising considerably, reaching almost 200% of GDP in 2050. On the basis of current policies, 11 countries will have a debt/GDP ratio above the 60% of GDP reference value by 2030 and by 2050; another 7 countries will have been added to the list of 'high-debt' countries, implying that debt to GDP ratio will be above 60% in more than two thirds of the Member States.

There is a large variety in terms of the size of the sustainability gap across the EU Member States. This implies that based on the current budgetary position and with no changes in policies, an adjustment is necessary so as to render the public finances sustainable over the long-term for most Member States. In about half of the Member States, a considerable adjustment, of more than 2% of GDP, is required.

The sustainability indicators are decomposed into the impact of: (i) the initial budgetary position which illustrates whether the public finances are sustainable, considering only the current budgetary position, i.e. the current structural primary balance and the current level of government debt; and (ii) the long-term budgetary impact of ageing which reflects the impact of the projected change in age-related government expenditure on public finances.

The initial budgetary position (IBP) illustrates that the public finances are on an unsustainable path even before considering the long-term budgetary impact of ageing populations in about half of the Member States. This implies that for these Member States strengthening of the fiscal position is a matter of urgency, particularly for those which have a high debt/GDP ratio (Italy and Greece). The long-term budgetary impact of ageing (LTC) is most significant in more than a third of Member States, with an increase of close to 5% of GDP or more. These countries have so far made only limited progress in reforming their pension systems or are experiencing maturing pension systems.

The quantitative results in this report are to a large degree similar to those in the 2005/06 assessment round of SCPs although differences emerge due to the use of national projections in the previous exercise as well as due to the 2005 fiscal outturns which were in several cases better than estimated in the 2005/06 stability and convergence programmes, owing in most cases to better-than-expected tax receipts.

Overall results of the sustainability indicators and debt projections

The quantitative indicators

Table II.1 presents the results of the quantitative indicators, which have been calculated on the basis of the structural budgetary position in 2005 and the projected change in age-related expenditure in the period to 2050 according to the methodology described in Chapter I (henceforth referred to as the baseline scenario). A decomposition of the indicators is made in order to determine whether the risks to public finance sustainability can be attributed to the current budgetary position and/or to the long-term budgetary impact of ageing. In particular, this decomposition distinguishes between the impact on the sustainability indicators (S1 and S2) from:

(i) the initial budgetary position – i.e. the gap between the structural primary balance in 2005 and the long-term debt-stabilizing primary balance;[24] and,

(ii) the long-term change in the budgetary position – i.e. the impact of the rise in age-related expenditure on the indicators.[25]

The analysis reveals that there is a large variety in terms of the size of the sustainability gaps as well as of the relative importance of the initial budgetary position (IBP) and the pure impact of ageing (LTC) (see Table II.1 and Graph II.1). Overall, a majority of Member States have sustainability gaps; 16 Member States according to the S1 indicator, and 20 Member States according to the more stringent S2 indicator. This implies that based on the current budgetary position and with no changes in policies, an adjustment is necessary so as to render the public financed sustainable over the long-term for most Member States.

In about half of the Member States, a considerable adjustment, of more than 2% of GDP, is required (see Graph II.1). In the EU as a whole and in the euro-area, the sustainability gap is about 2¼ % of GDP according to the S1 indicator and about 3½ % of GDP according to the S2 indicator. In both cases, the long-term budgetary impact of ageing is the main factor behind the sustainability gaps. The EU aggregates however mask considerable variety between the Member States.

The long-term budgetary impact of ageing

The indicator reflects the large differences of the budgetary impact of ageing on public finances and notably the large differences between countries with regard to the change in pension expenditure to 2050 – ranging from a reduction in Estonia, Malta and Poland to an increase of more than 10% of GDP in Cyprus. It reflects the diversity in public pensions arrangements, their degree of maturity and the effects of pension reforms enacted so far. Differences in other age-related expenditure items projections are smaller; the difference between the projected highest and lowest increase is respectively 1.7% and 1.9% of GDP for expenditure on long-term care and education; around 1% of GDP for health-care expenditure and 0.5% of GDP for unemployment benefits. The projected increase in health-care and long-term care is, aside from the projected demographic change, notably affected by current spending as a share of GDP, i.e. the current public provision of health-care and long-term care.

The decomposition of the sustainability gap indicators provides information on the pure budgetary impact of ageing, the long-term change in the budgetary position (LTC) . The size of the contribution of the LTC for the S2 indicator is in general higher than for the S1 indicator, as the latter only takes into account budgetary developments up to 2050 (see Annex I for more details). However, the ranking of the countries according to the S2 indicator corresponds relatively well with that of the S1 indicator across countries (see Table II.1). In the following paragraphs the results from the S2 indicator are referred to:[26]

- The long-term budgetary impact of ageing (LTC) is very significant in Luxemburg, Cyprus, Slovenia, Portugal, Ireland, Spain, Belgium, Hungary and the Czech Republic, with an increase of close to 5% of GDP or more. These countries have so far made only limited progress in reforming their pension systems or are experiencing maturing pension systems. In some countries (e.g. Hungary and Slovenia), pension reforms were introduced in the late 1990s which curtailed pension spending; however, recent policies have gone in the opposite direction, resulting in part in a back-tracking of the previous reform.

Table II.1. Results of the sustainability gap calculations in the baseline scenario (% GDP)

Change in age-related expenditure |

S1 | S2 |

2001-2005 | Difference between | 2005 | 2005 |

average | 2005 and 2001 | outturn | outturn |

BE | 0.2 | 0.5 | 0.6 | 0.1 |

CZ | -4.3 | 3.1 | -2.5 | -1.4 |

DK | 2.9 | 3.8 | 5.4 | 5.2 |

DE | -3.4 | 0.3 | -3.0 | -3.1 |

EE | 1.5 | 0.9 | 1.5 | 1.5 |

EL | -5.9 | 0.1 | -5.3 | -5.3 |

ES | -0.2 | 2.8 | 1.3 | 1.3 |

FR | -3.3 | 0.1 | -2.5 | -3.1 |

IE | 0.0 | 2.2 | 1.5 | 1.9 |

IT | -3.5 | 0.7 | -3.4 | -3.9 |

CY | -4.0 | 1.2 | -2.1 | -2.9 |

LV | -1.2 | 1.8 | -0.2 | -0.1 |

LT | -1.4 | 0.2 | -1.2 | -1.1 |

LU | 1.2 | -6.5 | -1.3 | -1.3 |

HU | -5.6 | -2.4 | -5.8 | -6.3 |

MT | -6.1 | 5.0 | -2.4 | -3.1 |

NL | -1.0 | 2.3 | 1.0 | 1.0 |

AT | -0.7 | -0.8 | -1.0 | -1.0 |

PL | -3.3 | 0.7 | -2.6 | -2.6 |

PT | -3.9 | 0.3 | -5.1 | -5.2 |

SI | -2.5 | 3.2 | -1.4 | -1.5 |

SK | -4.3 | 3.8 | -2.4 | -1.6 |

FI | 3.6 | -1.6 | 3.2 | 3.2 |

SE | 1.6 | 0.7 | 3.0 | 2.6 |

UK | -2.3 | -3.7 | -3.3 | -3.3 |

Source: Commission services.

As shown in Chapter I, a change in the initial structural primary balance results in, ceteris paribus , a corresponding change in a sustainability indicator. In practical terms, an improvement in the structural primary balance of e.g. 1% of GDP reduces, ceteris paribus , the initial budgetary position and the sustainability gap by 1% of GDP.

The current budgetary position in 2005 can be compared to the recent past. Table II.2 provides the cyclically-adjusted balances for 2005, on average over the period 2001-2005, and the change in the cyclically adjusted balance between 2001 and 2005.[29] This table also provides the structural balance in 2005, i.e. the cyclically-adjusted balance net of one-offs and temporary measures.

It reveals that the cyclically-adjusted balances (CABs) were better in 2005 than on average over the period 2001-2005 in 18 countries (1% point of GDP or more in 11 of those) while for 6 countries the 2005 CAB was weaker than the average over 2001-2005.

Overall, for the EU25, the cyclically-adjusted budgetary position in 2005 was ½% of GDP higher than the average over the period 2001-2005.[30]

As noted above, one way to cope with the budgetary implications of ageing is to achieve and maintain sound public finances. This can be illustrated by the required primary balance (RPB), which is derived from the S2 sustainability indicator. The RPB indicates the structural primary budgetary position over the medium-term that is consistent with sustainable public finances. The RPB as well as the structural primary balances are shown in Table II.3.

In this table two sets of structural primary balances are given for countries which have not yet implemented the Eurostat decision regarding the classification of funded defined contribution pension schemes but which are required to do so from March 2007 (DK, HU, PL, SK, SE). The figure in parenthesis includes the revenue reducing impact of the implementation of this reclassification. Given that the required primary balance is calculated excluding funded defined contribution pension schemes on the expenditure side, the required primary balance should be compared to the current structural primary balance excluding the revenue from those pension schemes.

Table II.3. Required primary balance (% of GDP)

Structural | Required | Increase in |

primary | primary | age-related |

balance | balance | expenditure |

2005 | Average | between 2010 |

2011-2015* | and 2050 |

BE | 4.5 | 6.2 | 6.6 |

CZ | -0.2 | 5.4 | 7.7 |

DK | 7.1 (6.2) | 3.5 | 4.5 |

DE | -0.3 | 4.4 | 4.0 |

EE | 1.7 | -1.0 | -1.8 |

EL | -0.3 | 2.8 | 1.4 |

ES | 3.1 | 6.4 | 8.9 |

FR | -0.5 | 3.4 | 3.2 |

IE | 3.1 | 5.5 | 7.8 |

IT | 0.6 | 3.8 | 2.3 |

CY | 0.5 | 9.0 | 11.7 |

LV | 0.5 | 1.7 | 1.6 |

LT | -0.3 | 1.9 | 2.1 |

LU | -1.2 | 7.7 | 8.4 |

HU | -2.5 (-3.6) | 6.2 | 7.1 |

MT | 0.9 | 0.2 | -0.6 |

NL | 3.6 | 4.4 | 5.2 |

AT | 1.7 | 2.2 | 1.1 |

PL | -0.2 (-1.7) | -0.4 | -3.2 |

PT | -2.5 | 7.6 | 9.7 |

SI | 0.2 | 7.3 | 9.9 |

SK | 0.2 (-0.4) | 2.9 | 3.7 |

FI | 4.7 | 3.4 | 5.0 |

SE | 4.2 (3.2) | 2.2 | 2.4 |

UK | -1.1 | 3.8 | 4.2 |

Note: the required primary balance is given as an average over the period 2011-2015. In the assessment of the stability and convergence programmes, the required primary balance was calculated as an average of the required primary balance over the next five years after the programme period, which ends in 2008, 2009 and 2010 depending on the country. A common period of 2011-2015 for all countries ensures relatively comparable results with the last and future rounds of assessment of stability and convergence programmes.

Source: Commission services.

The required primary balance is the primary balance that is sufficient to pay interest on outstanding debt and to cover the increase in age-related expenditure: it therefore mainly depends on the projected increase in age-related expenditure and, to a lesser degree, on the current level of the debt. There is a large dispersion with regard to the required primary balance among Member States, ranging from almost 10% of GDP to below zero, which mainly reflects the large dispersion of the projected changes in age-related expenditure (see last column of Table II.3). Reaching and sustaining very high structural primary balances implies running considerable government surpluses, which might prove difficult in view of competing budgetary pressures.

Government debt projections

Another way to look at the prospects for long-term public finance sustainability is to project the debt/GDP ratio over the long-term using the same assumptions as for the calculations of S1 and S2. The debt/GDP ratio is projected to remain above 60% of GDP over the coming decades for the EU as a whole and towards 2020, it is projected to start rising considerably, revealing that the public finances are on an unsustainable path (see Graph II.2). The projected deterioration of the public debt situation is more pronounced in the euro area than in the entire EU due to a higher initial level of debt.

The debt/GDP ratio is currently above the Treaty reference value of 60% of GDP in nine countries (BE, DE, EL, FR, IT, CY, MT, AT and PT), which makes debt reduction a matter of urgency in these cases (see Table II.4). For countries with a very high government debt level, i.e. above 100% of GDP such as Greece and Italy, public finance consolidation is therefore of utmost importance. The issue of the importance of the current level of debt in the context of the sustainability of public finances is discussed further in Chapter IV.1 of this report.

Table II.4. Projected debt developments in the EU Member States (% of GDP)

Gross debt |

2005 | 2010 | 2030 | 2050 |

BE | 93.3 | 72 | 31 | 83 |

CZ | 30.5 | 28 | 49 | 207 |

DK | 35.8 | 6 | -96 | -162 |

DE | 67.7 | 74 | 123 | 261 |

EE | 4.8 | -3 | -64 | -178 |

EL | 107.5 | 106 | 147 | 255 |

ES | 43.2 | 25 | -16 | 72 |

FR | 66.8 | 70 | 120 | 239 |

IE | 27.6 | 10 | -18 | 31 |

IT | 106.4 | 110 | 142 | 261 |

CY | 70.3 | 63 | 77 | 249 |

LV | 11.9 | 6 | 1 | 29 |

LT | 18.7 | 17 | 23 | 77 |

LU | 6.2 | 10 | 88 | 268 |

HU | 58.4 | 79 | 189 | 493 |

MT | 74.7 | 73 | 78 | 79 |

NL | 52.9 | 37 | 9 | 47 |

AT | 62.9 | 56 | 42 | 63 |

PL | 42.5 | 56 | 45 | 40 |

PT | 63.9 | 79 | 192 | 528 |

SI | 29.1 | 27 | 67 | 274 |

SK | 34.5 | 31 | 40 | 134 |

FI | 41.1 | 18 | -37 | -42 |

SE | 50.3 | 32 | -21 | -41 |

UK | 42.8 | 48 | 100 | 239 |

EU12* | 70 | 67 | 87 | 196 |

EU25* | 63 | 61 | 79 | 180 |

Note: *Aggregates exclude Greece.

Source: Commission services.

On the basis of current policies, 11 countries will have a debt/GDP ratio above the 60% of GDP reference value by 2030 and by 2050; another 7 countries will have been added to the list of 'high-debt' countries, implying that more than two thirds of the Member States will be breaching the 60% threshold.

Graph II.2. Debt developments in the EU and the euro area 2005-2050

[pic] Note: Since long-term pension projections for Greece were not available in time for the completion of this report, the EU and Euro-area aggregates are calculated without Greece.

Source: Commission services.

Comparison with the results of the public finance sustainability analysis in the 2005/06 assessment round of Stability and Convergence programmes

The quantitative results in this report are to a large degree similar to those in the 2005/06 assessment round of SCPs. Yet there are two main sources of differences (see Graph. II.3).

First, the results of the common projections exercise were not available in time for the submission of the stability and convergence programmes. The national projections were therefore used in the assessment of the sustainability of public finances.[31] Some of the budgetary items covered by the Ageing Report were missing in the stability and convergence programmes, for health-care (ES, LU, HU and PL), long-term care (DE, EE, EL, ES, FR, CY, LU, HU, MT, NL, PL and SK), education (ES, FR, LU, HU, NL and SI) and unemployment benefits (DK, ES, FR, CY, LU, HU, NL, PL, SI, FI and UK).

Moreover, the drivers behind health-care and/or long-term care were sometimes different, leading to more dynamic health-care expenditure in the programmes than in the Ageing Report projections in a number of cases (BE, CZ, FR, IE, CY, NL, PT, SI, FI and SE) and in two cases to less dynamic health-care expenditure (EE and MT).

Finally, for two countries Cyprus and Hungary, labour productivity growth and real GDP growth were assumed to be substantially higher in the convergence programmes than in the Ageing Report, limiting the increase of age-related expenditure as a share of GDP (See Table II.5).

Second, for a number of countries, the 2005 fiscal outturns were better than estimated in the 2005/06 stability and convergence programmes, owing in most cases to better-than-expected tax receipts (see Table II.6). In particular, in the Czech Republic, Denmark, Estonia, Latvia, Lithuania, Slovakia and Sweden the government balance was at least 1% of GDP higher than expected in the SCPs, in nominal terms but also in structural terms according to the commonly agreed methodology for calculating output gaps. Yet, some factors, which are not related to the business cycle, could be of temporary nature and significant for some countries, such as volatile tax revenues related to oil/gas prices. This would call for prudence in terms of policy conclusions since such budgetary developments may not be of a permanent nature.

Table II.5 : Change in the age-related budgetary items (between last year of the programme and 2050)

Pension | Health care | Long-term care | Education | Unemployment benefits | Total age-related |

SCP | outturn | SCP | outturn |

BE | 0.0 | 0.1 | 0.0 | 0.1 |

CZ | -4.8 | -2.6 | -3.4 | -1.4 |

DK | 3.6 | 4.9 | 3.6 | 5.2 |

DE | -3.3 | -3.3 | -3.0 | -3.1 |

EE | 0.3 | 1.6 | 0.4 | 1.5 |

EL | -4.3 | -4.5 | -4.8 | -5.3 |

ES | 1.0 | 1.1 | 1.2 | 1.3 |

FR | -3.0 | -2.9 | -3.3 | -3.1 |

IE | 0.3 | 1.0 | 1.1 | 1.9 |

IT | -4.3 | -4.1 | -4.0 | -3.9 |

CY | -2.5 | -2.4 | -3.1 | -2.9 |

LV | -1.5 | 0.2 | -1.7 | -0.1 |

LT | -1.5 | -0.5 | -2.3 | -1.1 |

LU | -2.3 | -1.9 | -1.5 | -1.3 |

HU | -6.1 | -6.1 | -5.7 | -6.3 |

MT | -3.9 | -3.3 | -3.8 | -3.1 |

NL | -1.2 | -0.3 | 0.0 | 1.0 |

AT | -1.9 | -1.5 | -1.6 | -1.0 |

PL | -2.9 | -2.5 | -2.9 | -2.6 |

PT | -6.0 | -6.0 | -5.0 | -5.2 |

SI | -1.7 | -1.8 | -1.2 | -1.5 |

SK | -4.1 | -2.9 | -2.8 | -1.6 |

FI | 1.8 | 2.6 | 2.1 | 3.2 |

SE | 1.6 | 2.9 | 1.6 | 2.6 |

UK | -3.1 | -3.5 | -2.9 | -3.3 |

Source: 2005/06 updates of stability and convergence programmes, Commission services calculations, Commission services Spring 2006 economic forecasts.

Graph II.3: S2 indicator in the baseline scenario compared with the results of the 2005/06 SCPs assessment round and main source of differences

[pic]

Note: The graph compares

- The results of the '2005' scenario of the assessment of the 2005/06 stability and convergence programme. In this scenario, it is assumed that the structural primary balance is stable at the 2005 level over the programme period and thereafter evolves in line with the projected change in age-related expenditure according to the stability/convergence programme.

- The results presented in this chapter. It similarly assumes that the structural primary balan ce is stable at the 2005 level over the period up to 2010 and thereafter evolves in line with the projected change in age-related expenditure according to the Ageing Report in the years after 2010.

Source: Commission services.

Comparison of long-term pension projections

Table II.5 presents the change in pension expenditure as a share of GDP between 2005 and 2050 in consecutive projections: the common projection exercises in 2001 and 2006 - and Member States' projections as included in their stability and convergence programme updates.[32] It reveals that, for most countries, the change in pension expenditure as a share of GDP has been revised over time, sometimes significantly.

The revisions of projected changes in pension expenditure over the long-term are due to several factors, notably but not exclusively due to reforms of pension systems. The effects of pension reforms enacted since 2001 is noticeable in several countries (DE, EL, FR, IT, NL, AT, FI and SI). Except for Slovenia where the indexation of pension after retirement was made more generous for pensioners in 2005, reforms resulted in a smaller increase in pension expenditure.

However, other not policy-related changes also had significant impact on the projections, notably demographic assumptions (DK, ES, IE and PT), economic assumptions (LU, CY, HU and PL) or coverage of expenditure (inclusion of public sector employee in UK and LU, exclusion of quasi-mandatory scheme in LV and HU). Changes may be linked to new models (IE for public pension, LU regarding the treatment of cross-border workers) or also to new assumptions regarding pensions. This is the case for the United Kingdom, where indexation rules are not fixed in a long-term perspective and where the increase in pension expenditure in the 2005 CP is partly linked to a change in the assumptions regarding indexation. Finally, countries have also extended the period over which pensions are projected (e.g. FR and PL).

Table II.7 sums up the main reasons behind the change in the projections. It mainly focuses on the changes that had a large impact in the change in pension expenditure as a share of GDP. Smaller changes are therefore not explained. Moreover, one should not read the change in the projections from one year to the next as the result of one single factor (for example a pension reform) since it is sometimes difficult to disentangle the different factors at play (see the Ageing Report 2006, section 3.3.1). This comparison shows that the changes are in many cases related to policy changes or result from a better coverage of public pension expenditure, improved methodology or a longer period of projections. These changes increase the comparability between countries and improve the assessment of long-term sustainability of the public finances.

Some changes are however due to a different set of assumptions regarding demographic developments or the long-term economic outlook. It is interesting to note that such factors may have an impact on projections that are of the same magnitude as far-reaching pension reforms (i.e. a couple of points of GDP). It shows the crucial importance of using the common framework to ensure comparability of the projections and of the sustainability assessments in the context of the EU's multilateral budgetary surveillance.

Table II.7 Evolution of pension expenditure compared: EPC and SCP projections (as change in % of GDP between 2005-2005)

Common projections | Updates of the stability and convergence programmes | Common projections |

2001 | 2001 | 2002 | 2003 | 2004 | 2005 | 2006 |

*Change between 2005 and 2040; ** Change between 2002 and 2050; *** Change between 2005 and 2020.

Source: EPC report 2001, EPC report 2006, Stability and convergence programmes.

Table II.8 Main factors with an impact on the pension projection results over time

Pension reform | Coverage | Demographic assumptions | Economic assumptions | Modelling |

Higher life expectancy | Higher labour productivity | Higher employment of older workers | Higher employment | Higher interest rate |

BE | 0.1 | -0.6 | -0.2 | 0.4 | 0.4 |

CZ | -0.1 | -0.8 | -0.5 | 0.4 | 0.8 |

DK | 0.1 | -0.6 | -0.2 | 0.4 | 0.6 |

DE | 0.1 | -0.5 | -0.2 | 0.3 | 0.3 |

EE | -0.2 | -0.7 | -0.5 | 0.3 | -0.3 |

EL | 0.0 | -0.4 | -0.2 | 0.2 | 0.6 |

ES | 0.0 | -0.5 | -0.3 | 0.3 | 0.4 |

FR | 0.0 | -0.6 | -0.3 | 0.4 | 0.5 |

IE | 0.0 | -0.7 | -0.4 | 0.4 | 0.2 |

IT | 0.0 | -0.4 | -0.2 | 0.2 | 0.3 |

CY | -0.1 | -0.4 | -0.2 | 0.2 | 0.0 |

LV | -0.3 | -0.8 | -0.6 | 0.2 | -0.5 |

LT | -0.2 | -0.5 | -0.4 | 0.2 | -0.4 |

LU | -0.1 | -0.7 | -0.3 | 0.4 | -1.4 |

HU | 0.0 | -0.6 | -0.5 | 0.3 | 0.2 |

MT | 0.1 | -0.5 | -0.6 | 0.3 | 0.2 |

NL | 0.0 | -0.4 | -0.2 | 0.2 | 0.4 |

AT | 0.1 | -0.5 | -0.2 | 0.3 | 0.5 |

PL | -0.1 | -0.6 | -0.4 | 0.3 | -0.4 |

PT | 0.1 | -0.5 | -0.2 | 0.3 | 0.8 |

SI | -0.2 | -0.6 | -0.5 | 0.2 | 0.8 |

SK | -0.1 | -0.7 | -0.5 | 0.3 | 0.4 |

FI | 0.0 | -0.5 | -0.3 | 0.3 | 0.3 |

SE | 0.0 | -0.6 | -0.3 | 0.4 | 0.9 |

UK | 0.3 | -0.8 | -0.1 | 0.6 | -0.1 |

EU25 | 0.1 | -0.6 | -0.2 | 0.4 | 0.3 |

EU12 | 0.1 | -0.5 | -0.2 | 0.3 | 0.4 |

Standard deviation | 0.1 | 0.1 | 0.1 | 0.1 | 0.5 |

Note: Results are given for the S2 indicator as a reference to the Ageing Report reference scenario which is used in the calculations of the indicators in Chapter I. Therefore the table shows the impact on S2 indicators that would result from using the alternative scenarios instead of the Ageing Report reference scenario. However, most scenarios have been designed as a reference to the pure ageing scenario, i.e. changing one hypothesis compared to the 'pure ageing' scenario. The differences versus the reference scenario therefore include the result of the variant (i.e. constant health-status) plus the assumptions made in the reference scenario (see Annex).

Source: Commission services.

Table III.3. Change in the age-related budgetary items up to 2050 (% of GDP)[43]

Health care | Long-term care |

SCPs | AR | SCPs | AR |

BE | 1.9 | 1.2 | 1.1 | 0.9 |

CZ | 2.6 | 1.7 | 0.3 | 0.4 |

DK | 1.1 | 0.8 | 1.1 | 1.1 |

DE | 1.1 | 1.0 | : | 1.0 |

EE | -0.3 | 0.8 | : | 0.3 |

EL | 1.5 | 1.6 | : | : |

ES | : | 2.1 | : | 0.3 |

FR | 2.4 | 1.5 | : | 0.2 |

IE | 2.7 | 1.8 | 1.0 | 0.6 |

IT | 0.9 | 1.2 | 0.4 | 0.7 |

CY | 1.9 | 1.0 | : | : |

LV | 0.6 | 0.8 | 0.1 | 0.3 |

LT | 0.8 | 0.7 | 0.2 | 0.3 |

LU | : | 1.1 | : | 0.6 |

HU | : | 0.9 | : | 0.6 |

MT | 0.5 | 1.7 | : | 0.3 |

NL | 3.2 | 1.2 | : | 0.6 |

AT | 1.2 | 1.4 | 0.7 | 0.9 |

PL | : | 1.2 | : | 0.1 |

PT | 1.1 | 0.4 | 0.6 | 0.4 |

SI | 2.9 | 1.4 | 1.0 | 1.1 |

SK | 1.4 | 1.7 | : | 0.5 |

FI | 1.8 | 1.3 | 2.4 | 1.6 |

SE | 1.3 | 1.0 | 2.9 | 1.8 |

UK | 1.5 | 1.7 | 0.6 | 0.8 |

Source: Commission services.

A higher interest rate gives more weight to the current level of outstanding debt and less weight to future budgetary developments. While such a hypothesis of real interest rates (4% real interest rate) may look pessimistic in the future, it underlines possible short-term risks regarding the evolution of debt. Indeed, a higher interest rate/growth rate differential can not be excluded in the short/medium run. If such an outcome was to materialize, this would lead to a faster increase of debt in the medium-term, raising concerns regarding the sustainability of public finances even before taking into account the impact of ageing (the importance of debt level is addressed in Chapter IV.1).

Alternative scenarios for health-care and long-term care

Health-care

In addition to the uncertainties regarding the future demographic and economic outlook, there are also large uncertainties regarding the main drivers of health-care and their potential impact on the public finances. There has been an upward trend in health-care expenditure as a share of GDP in most Member States in the past, despite differences in the institutional arrangements and the health status prevailing in the different Member States.[44] At the same time, the increase in the old-age dependency ratio in the EU has been limited.[45] Indeed, whether the increase in life expectancy will result in longer years spent in good health or not, whether new technologies and medical progress will result in lower or higher cost are important questions that may receive ambiguous empirical answers and strongly influence the projections.

Such uncertainties led to the simulations of several alternative scenarios of the future evolution of health-care in the Ageing Report. The reference scenario chosen in the Ageing Report takes into account the results of two alternative scenarios (constant health and income elasticity) compared to the pure 'ageing' scenario.[46] The projections of this reference scenario are quite close to the ‘pure ageing’ one since the relieving impact of the better health status of citizens is compensated for by a higher income elasticity.

The sensitivity tests show that public spending on health is sensitive to changes in the health status of elderly citizens, in fact improved health status halve the projected increase in health-care expenditure. This points to the possible budgetary alleviating impact of policies aiming at improving the health of elderly citizens (see Table III.2). Health-care expenditure is also very sensitive to even relatively modest changes in the assumptions on income elasticity of demand, and also on the evolution of unit costs.[47] Increased demand for health-care services could occur due to higher pressure for a better quality of health services in the face of rising per capita income. More dynamic spending could also occur if prices within the health sector, mostly wages of skilled workers and pharmaceuticals, were to grow faster than in the economy as a whole. In particular, the net impact of technological progress on health-care spending is ambiguous: while it will reduce unit cost for existing cures, it will increase the supply of treatments which can induce higher demand for health-care services.

Table III.4. Impact on the sustainability indicator of alternative long-term care assumptions (deviation from S2 in % points of GDP)

pure ageing | constant disability | increase formal care | benefit indexed on price |

BE | 0.2 | -0.2 | 0.4 | : |

CZ | 0.1 | -0.1 | 0.4 | : |

DK | 0.3 | -0.3 | : | : |

DE | 0.2 | -0.2 | 0.6 | -0.7 |

EE | 0.1 | -0.1 | 0.2 | : |

EL | : | : | : | : |

ES | 0.0 | 0.0 | 0.6 | : |

FR | 0.1 | -0.1 | 0.4 | : |

IE | 0.1 | -0.1 | 0.3 | : |

IT | 0.1 | -0.1 | 0.8 | : |

CY | : | : | : | : |

LV | 0.1 | -0.1 | 1.7 | : |

LT | 0.1 | -0.1 | 0.5 | : |

LU | 0.2 | -0.2 | 0.6 | : |

HU | 0.1 | -0.1 | 0.6 | : |

MT | 0.1 | -0.1 | 0.1 | : |

NL | 0.1 | -0.1 | 1.0 | : |

AT | 0.0 | 0.0 | : | : |

PL | 0.0 | 0.0 | 0.2 | : |

PT | 0.1 | -0.1 | 0.4 | : |

SI | 0.2 | -0.2 | 1.1 | : |

SK | 0.1 | -0.1 | 0.3 | : |

FI | 0.4 | -0.4 | 0.9 | : |

SE | 0.6 | -0.6 | 1.1 | : |

UK | 0.2 | -0.2 | 1.5 | : |

EU25 | 0.1 | -0.1 | 0.7 |

EU12 | 0.1 | -0.1 | 0.6 |

Standard deviation | 0.1 | 0.1 | 0.4 |

Source: Commission services.

Moreover, many of these alternative scenarios (except the unit-cost scenario) would lead to a relatively uniform impact across countries. However, it cannot be excluded that if the institutional features of the public health-care systems in the Member States[48] were explicitly modelled, a larger diversity across Member States might be present (e.g. as regards effectiveness of aggregate budgetary control measures, micro incentives for patients and health-care professionals favouring rational resource use, etc.).

As shown in Table III.3, Member States reported in the SCPs in most cases more dynamic health-care expenditure in their programmes than in the Ageing Report baseline projections (BE, CZ, FR, IE, CY, NL, PT, SI, FI and SE).[49] This is also the case for long-term care in the case of Ireland, Finland and Sweden. This is mainly explained by different assumptions concerning the drivers of spending increases in national projections compared with the reference scenario in the Ageing Report.[50] For example, in several of the national projections it is assumed that wages in the health-care/long-term care sectors increase faster than assumed in the Ageing Report. When countries establish their fiscal targets (e.g. in the context of the new SGP), they may choose to use a more prudent approach regarding the future evolution of health-care, and also long-term care, to prepare themselves for higher provision of public care. Such alternative (and more dynamic) scenarios are more appropriate to understand the fiscal objectives that countries have set for themselves.

Long-term care

In the baseline scenario, long-term care projections show a larger set of outcomes due to a large diversity in the current public provision on long-term care in the EU (which ranges today from 0.1% of GDP in Poland to 3.8% of GDP in SE). The current level of public spending on long-term care as a share of GDP has a strong impact on the projected future spending. As a result, alternative assumptions will show a larger diversity across Member States for long-term care than for health care.

Moreover, in contrast with sensitivity tests on pensions or health care, there is a scenario which departs from the “no-policy change" assumption. The "increase in formal care" scenario assumes a 1% decrease in the number of persons receiving informal care up to 2020, with half of the additional persons receiving formal care going to institutions and the other half receiving formal care at home (see Table III.4). This would increase the sustainability gap by more than ½% of GDP in the EU. Such a change in policy is not considered in the reference scenario, following the no-policy change approach of the Ageing Report. However, the scenario points to the additional pressure on public finances that could result from an increasing gap between the need of formal care and services provided by the general government. In particular, Member States with low levels of formal care provision at present – and correspondingly low levels of public spending – will also experience a large increase in the projected number of older persons in need of care. Pressures may therefore emerge in the future for policy changes to increase formal care provision if countries would rely less on informal care. Such a scenario cannot be excluded in view of the rather large projected increase in labour force participation, especially among women. Employment rates of women are projected to increase by 10 percentage points between 2003 and 2050 on average in the EU, and by more than 15 percentage points in Spain, Malta and Poland.

Finally, it should also be noted that under the existing rules in Germany, all long-term care benefits are fixed by law. Keeping them constant in nominal terms – with no indexation at all – cannot be considered as meaningful of constant policy approach in a long-term analysis of this kind. Thus an alternative scenario was run assuming an indexation on price. Calculations following this approach would lead to a constant share of long-term care in GDP and would reduce the sustainability gap for Germany by 0.7% of GDP. However, if unit costs of supplying long-term care increase more than general price level of the economy, this could lead to an increasing gap between needs and provisions of public long-term care.

Illustrating the sustainability impact of attaining the medium-term objective

The quantitative indicators

A vast majority of Member States’ budgetary plans involves consolidating the budgetary position over the medium-term. This is required by the Stability and Growth Pact for countries which have not yet reached their medium-term objective (MTO) and by the budgetary pressures arising from ageing populations in the EU over the coming decades. Reconciling this policy challenge with the medium-term budgetary policy formulation process was an important factor in the reform of the Stability and Growth Pact in 2005. As a part of the new SGP, MTOs that reflect country-specific characteristics were introduced.[51]

In order to illustrate to what extent the in most cases budgetary consolidation can contribute to reduce risks to public finance sustainability a scenario is run in which it is assumed that all Member States attain their MTOs in 2010. The MTO is defined as the structural government balance. For the purposes of long-term public finance sustainability analysis, the structural primary balance underlying the MTO in 2010 is required. The structural primary balance in 2010 is calculated with the following assumptions:

- the general government balance is assumed to converge in a linear fashion towards the MTO in 2010 and the cyclical impact is assumed to be zero by 2010;

- the interest rate on debt in 2010 is assumed to be the implicit interest rate on debt in the last year of the stability/convergence programme of the country concerned.[52]

Interpreting the MTO scenario

The MTO scenario is essentially a sensitivity test related to the initial budgetary position.

Box III.1. The 'cost of delay' indicator The 'cost of a delay' indicator shows the increase in the sustainability indicators that would result from a delay of five years in implementing budgetary consolidation compared to the baseline. As shown in Graph III.1, it would result in an increase of the sustainability indicators for the EU of around 0.3 p.p. as measured by the S2 indicator and of around 0.4 p.p. of GDP for the S1 indicator. The cost of a delay is proportional to the size of the sustainability gap and is therefore significantly larger for countries with large sustainability gaps (notably Hungary, Portugal and Slovenia as regards the S2 indicator), underlying the urgency in implementing reforms in those countries. First, the cost of a delay for the EU as a whole may look relatively small: this is largely because countries which do not implement budgetary consolidation during the next five years have a long period of time to reimburse additional interest on debt (up to infinity in the case of S2 and up to 2050 in the case of S1). However, this does not mean that reforms can be indefinitely postponed; the size of the necessary adjustment increases over time, making it more costly to implement reforms in the future than today. Graph III.1. The cost of delay (in % of GDP) [pic] Source: Commission services. |

First, it does not mean that the Commission expects all countries to reach the MTO exactly in 2010; some countries had already attained their MTO in 2005 while some might reach it only after 2010. About half of the Member States do not reach their MTO by the end of the stability/convergence programme period, which in most cases is in 2008 and in general a target year beyond the last year of the programme is not given.

Second, the interpretation of this scenario will depend on whether the country is above or below its MTO. For countries which have not yet reached their MTO, it illustrates how much consolidating public finances can contribute to the long-term sustainability of public finances. By contrast, for countries who are already above their MTO in 2005, the MTO scenario implies a fiscal loosening and thus a negative impact on sustainability.

Third, for countries where the debt/GDP ratio is expected to remain broadly unchanged over the medium term (i.e. up to 2010), the date when the MTO is reached, whether it is 2005 or 2010, implies a similar underlying primary balance. However, some countries with a rapidly declining debt over the next years, notably Belgium and Denmark, can expect a significant reduction of interest expenditure. Therefore, keeping the MTO target for the deficit implies a lower primary balance over the medium-term than today and therefore a higher sustainability gap.

Finally, it is a possible sensitivity test of the impact of the changes in the budgetary position on the sustainability indicators. It is different from the 'programme' scenario which is carried out in the assessment of the stability and convergence programmes. In the 'programme' scenario, it is assumed that the public finances over the medium-term evolve as planned in the stability/convergence programme and the last year of the programme is the starting point for the long-term sustainability projections.[53] Another sensitivity test regarding budgetary consolidation is the cost of a delay indicator which estimates the change in the sustainability indicators that would result from postponing the budgetary adjustment (see Box III.1).

Table III.5. Government balances in 2005 and the MTOs compared (% of GDP)

balance in 2005 | Primary | in the | in 2010 |

SCP 2005/06 | outturn | Balance 2005 | SCPs | used in the MTO scenario |

S1 | S2 |

Total | IBP | DR | LTC | Total | IBP | LTC |

debt |

2005 | 2010 | 2030 | 2050 |

BE | 93.3 | 74 | 52 | 129 |

CZ | 30.5 | 30 | 43 | 188 |

DK | 35.8 | 18 | 23 | 98 |

DE | 67.7 | 64 | 37 | 65 |

EE | 4.8 | 0 | -25 | -82 |

EL* | 107.5 | 90 | 18 | -56 |

ES | 43.2 | 30 | 33 | 198 |

FR | 66.8 | 60 | 41 | 66 |

IE | 27.6 | 17 | 37 | 157 |

IT | 106.4 | 97 | 32 | 1 |

CY | 70.3 | 57 | 42 | 172 |

LV | 11.9 | 9 | 26 | 92 |

LT | 18.7 | 16 | 22 | 76 |

LU | 6.2 | 10 | 74 | 240 |

HU | 58.4 | 61 | 51 | 155 |

MT | 74.7 | 65 | 16 | -58 |

NL | 52.9 | 46 | 70 | 176 |

AT | 62.9 | 54 | 23 | 18 |

PL | 42.5 | 45 | -33 | -163 |

PT | 63.9 | 65 | 64 | 208 |

SI | 29.1 | 27 | 65 | 270 |

SK | 34.5 | 31 | 16 | 66 |

FI | 41.1 | 25 | 26 | 96 |

SE | 50.3 | 34 | -3 | -1 |

UK | 42.8 | 42 | 44 | 114 |

EU12* | 70 | 62 | 38 | 83 |

EU25* | 63 | 55 | 33 | 76 |

Note: * No pension projections were available for Greece and the change in the debt/GDP ratio is therefore underestimated in the case of Greece. Pension expenditure was projected to rise between 2005 and 2050 by 12.4% of GDP in the 2001 common projections exercise and 10.2% in the 2002 update of the Greek stability programme. The aggregate results for the European Union (EU25) and the Euro-area (EU12) exclude Greece.

Source: Commission services.

Conclusions

The results of the indicators are sensitive to the different hypotheses used in the calculations and as such the exact level of the sustainability gap is subject to some uncertainty, notably as regards the evolution of health-care expenditure which depends on the assumptions made. In particular, a low sustainability gap does not suggest that there is no risk at all to the long-term sustainability of public finances; rather, it suggests that the challenges and the size of the adjustment are smaller than in other EU countries. The sensitivity of the indicators should be put in perspective with the large diversity shown by the indicators in the EU (ranging from -3% of GDP to 10% of GDP in the baseline scenario). In particular, large sustainability gaps are likely to remain so even under alternative and more favourable hypothesis and therefore can be considered robust enough to signal large fiscal imbalances.

Moreover, budgetary consolidation over the medium-term can very efficiently limit the public finance sustainability challenge over the long-term; a significant part of the sustainability risks would be reduced if countries were to reach the medium-term objectives for the government finances that they have set for themselves.

In addition, public spending on health-care is sensitive to the health status of elderly citizens. This suggests that policies geared towards increasing the health status of elderly persons can result in non-negligible budgetary savings.

Besides, further pressures on government expenditure on long-term care cannot be excluded in the future since there may be an increasing gap between the need for formal care and the services provided by the public sector, notably in countries where the current coverage is limited.

Finally, the sensitivity tests also show that changing the underlying assumptions does not necessarily have a uniform impact across EU countries; for example, some public pension schemes are more resilient than others with respect to an increase in life expectancy.

Chapter IV

Qualitative factors

Summary

The sustainability indicators are indispensable tools for assessing the long-term sustainability of public finances but other factors are also taken into account to reach to an overall assessment.

Firstly, while the sustainability indicators already include information on the current level of the debt, they do not incorporate all the specific risks faced by countries with a large initial level of debt. For example, high-debt countries are more vulnerable to negative growth rate/interest rate shocks and have to maintain high primary surpluses for a prolonged period of time, which might be difficult to achieve in view of competing budgetary pressures. Countries which have a high current level of gross debt, above the 60% of GDP reference value, need to ensure its steady reduction. The current level of gross debt is therefore an important factor when reaching an overall assessment of the risks to the long-term sustainability of public finances.

Moreover, the ratio of the average pension and the average wage in the economy – the so-ca lled benefit ratio – is projected to decrease substantially in some EU countries. While contributing positively to public finances sustainability, such a decrease may raise concerns about the adequacy of public pensions that could translate into pressure for higher public spending. In this context, the risks to public finances will crucially depend on the reaction of individuals regarding their future retirement arrangements: accept a lower pension, work longer or increase their savings. Those individual choices will have very different effects on public expenditure and revenues. In that respect, the question of information current and future pensioners have regarding their future rights is central to ensure that current workers are making appropriate choices for the level of their individual savings in view of the planned length of their working lives and the level of their pension. The success of reforms aiming at increasing the retirement age is also crucial.

To date, no common projections of government revenue have been made at the EU level. Yet, demographic changes may have also an impact on the size and sources of tax revenues; and consequently public revenue developments may have an impact on the sustainability of public finances. However, except in a few cases where large country-specific trends can be identified (notably the tax treatment of private pensions), the impact of revenue projections is more limited, leading to a limited impact on the assessment of the sustainability of public finances. In addition, a more consistent way of treating property income could lead to a higher sustainability gap compared to the baseline scenario, notably in the few countries where property income is relatively large.

Stock-flow adjustments (SFAs) are supposed to cancel out over the medium term in the projections; i.e. the debt level is assumed to be driven only by the general government deficit. Given the level of SFAs in some countries in the recent past, this may not be the case. If maintained over the long-term, persistent debt-increasing SFAs may imply further risks on long-term sustainability.

The level of current tax ratio has no impact on the calculations of the sustainability indicators. Nevertheless, the current level of tax burden can be a relevant element in the analysis of the long-term sustainability of public finances. Namely, in the light of the projected increases in the age-related expenditures in the long term, the information regarding the current tax burden provides an important indicator of a government's capacity for a direct increase in revenues.

Finally, the sustainability indicators include explicit debt and implicit liabilities but do not include information on contingent liabilities which may increase pressure on public finances if they materialize. The impact of contingent liabilities although rather limited on the sustainability indicators, could be large on debt. At this stage the lack of data prevents a systematic use of this factor in the sustainability analysis.

Government debt and the long-term sustainability of public finances

In the analysis about the long-term sustainability of public finances, the concept of debt-to-GDP ratio plays a central role. A country is often considered to be in an unsustainable situation if the debt-to-GDP ratio reaches a level beyond which the country faces difficulties in issuing new debt.[55] Since this maximum level of debt, beyond which it is considered as unsustainable, is not defined ex-ante, sustainability is measured by looking at the dynamics over time, in particular whether debt is stable, declining or increasing.[56] Besides being already integrated in the long-term debt projections on the basis of which the sustainability indicators are calculated, the current debt level provides additional information on the sustainability of public finances, in particular in the light of the following stylised facts:

- High debt countries are more vulnerable to negative interest rate/growth rate shocks through