Christopher Ragan

Department of EconomicsMcGill University

andClifford Clark Visiting Economist

Finance Canada

Canada’s LoomingDemographic “Fiscal Squeeze”

Outline of TalkOutline of Talk

1. The basic demographics of aging

2. A looming “fiscal squeeze”

3. Arithmetic thought experiments

4. A few thorny issues

5. Summary and final thoughts

2

A declining fertility rate has reduced the population growth rate ... A declining fertility rate has reduced the population growth rate ...

Source: Statistics Canada and Office of the Chief Actuary’s 23rd Actuarial Report on the Canada Pension Plan.

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

1950 1960 1970 1980 1990 2000 2010 2020 2030 2040

Percent

Historical Projected

Population Growth, 1950-2040

Current fertility rate ~ 1.6 children per woman

Population Growth = Births + Net Immigration – Deaths 3

... which inevitably leads to population aging.... which inevitably leads to population aging.

Source: Office of the Chief Actuary’s 23rd Actuarial Report on the Canada Pension Plan and Statistics Canada.

1970, Population: 21.7 M

8 6 4 2 0 2 4 6 8

0-4

15-19

30-34

45-49

60-64

75-79

90-94

percent of population

Male Female

2008, Population: 33.3 M

8 6 4 2 0 2 4 6 8

0-4

15-19

30-34

45-49

60-64

75-79

90-94

percent of population

Male Female

2040, Population: 41.2 M

8 6 4 2 0 2 4 6 8

0-4

15-19

30-34

45-49

60-64

75-79

90-94

percent of population

Male Female

Distribution of the Population By Sex and Age Group

4

By 2040, Canada’s “providing ratio” will fall by half. By 2040, Canada’s “providing ratio” will fall by half.

Source: Statistics Canada and Office of the Chief Actuary’s 23rd Actuarial Report on the Canada Pension Plan.

Ratio of people aged 15-64 to people aged 65+

0

1

2

3

4

5

2008 2020 2030 2040

(persons)

5

Aging will dramatically reduce the working-age share of the population ... Aging will dramatically reduce the working-age share of the population ...

Source: Office of the Chief Actuary’s 23rd Actuarial Report on the Canada Pension Plan.

Share of people aged 15-64 in Total Population

55

60

65

70

75

1966 1972 1978 1984 1990 1996 2002 2008 2014 2020 2026 2032 2038

Historical Projected

(percent)

Entry of the baby boom generation into the labour market.

Baby boomers gradually reaching retirement age.

6

... and will also cause a shift toward groups with lower LF participation rates … ... and will also cause a shift toward groups with lower LF participation rates …

Source: Statistics Canada.

LF Participation Rate by Age Group

0

20

40

60

80

100

15 to 24 years 25 to 54 years 55 to 59 years 60 to 64 years 65 years and over

1998 2008

(percent)

7

… resulting in a reduction in the aggregate labour-force participation rate. … resulting in a reduction in the aggregate labour-force participation rate.

Source: Statistics Canada and Finance Canada calculations.

Aggregate LF Participation Rate

55

60

65

70

75

1976 1980 1984 1988 1992 1996 2000 2004 2008 2012 2016 2020 2024 2028 2032 2036 2040

Actual Trend

(percent)

Historical Projected

8

Part 1 of the demographic “fiscal squeeze”Part 1 of the demographic “fiscal squeeze”

Declining LF participation rate:

reduced growth in real per capita GDP

(for given productivity growth)

reduced growth in per capita tax base

9

GDP/POP = (GDP/E) x (E/LF) x (LF/POP)

The reduction in future per capita GDP growth.The reduction in future per capita GDP growth.

Source: Finance Canada calculations consistent with January 2009 average private sector forecast

Decomposition of per capita Real GDP Growth

10

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

1971-2008 2009-2040

GDP/POP of which: GDP/E E/LF LF/POP(percent)

Historical Projected

Detail: Productivity is usually measured as GDP per hour whereas here it is measured more simply as GDP per worker.

Part 2 of the demographic “fiscal squeeze”Part 2 of the demographic “fiscal squeeze”

1. Need for more public spending:

Health-Care Spending

Elderly Benefits

2. Offsetting effects expected to be small:

Education, children’s benefits and some social services

11

Not surprisingly, per capita health-care expenditures rise rapidly in later years of life ... Not surprisingly, per capita health-care expenditures rise rapidly in later years of life ...

Source: CIHI.

Per Capita Provincial-Territorial Public Health Spending by Age Group, 2006

0

5

10

15

20

0-14 15-24 25-34 35-44 45-54 55-64 65-74 75-84 85+

(thousands of dollars)

12

... but “other factors” (than aging) will also contribute to rising health-care costs. ... but “other factors” (than aging) will also contribute

to rising health-care costs.

Source: OECD cost pressure scenario and author’s calculations.

Increase in Public Health Spending

0.0

0.5

1.0

1.5

2.0

2.5

3.0

2020 2022 2024 2026 2028 2030 2032 2034 2036 2038 2040

Contribution from other factors

Contribution from aging

(percent of GDP)

Spending pressures will likely come from income growth and the development of advanced (and costly) new treatments.

FYI: Total public spending on health care increased from 5.4 to 7.5 percent of GDP between 1975 and 2008.

13

Rising elderly benefits will also put upward pressure on government spending as the population ages. Rising elderly benefits will also put upward pressure on government spending as the population ages.

Source: Chief Actuary (scenario: benefits rates indexed at inflation plus 60% of the assumed real wage growth) and author’s calculations.

Increase in Elderly Benefits (~ OAS + GIS)

0.0

0.2

0.4

0.6

0.8

2020 2022 2024 2026 2028 2030 2032 2034 2036 2038 2040

(percent of GDP)

Taken together, health and elderly benefits will add roughly 3.5 percentage points of GDP to public spending between 2020 and 2040!

14

We can view the fiscal squeeze in terms of the growing divergence between per capita spending and tax revenues We can view the fiscal squeeze in terms of the growing divergence between per capita spending and tax revenues

2020 2030 2040

100

per capita G and T

Growth rate of tax revenues will fall (but will still be positive) …

G/POP = (G/GDP) x (GDP/POP) T/POP = (T/GDP) x (GDP/POP)

… but spending will grow faster due to health-care costs. “Fiscal

Squeeze”

T/POP

G/POP

Hold this constant15

What (non fiscal) polices are available to Canadian governments to deal with this challenge? What (non fiscal) polices are available to Canadian governments to deal with this challenge?

1. Increase immigration rate?

2. Increase fertility rate?

3. Increase labour-force participation rate?

4. Restrain the growth of health-care spending?

5. Increase the productivity growth rate? (more on this later)

16

What broad fiscal choices are available?What broad fiscal choices are available?

1. Restrain spending growth- especially on non-age-related items?

2. Increase tax rates (or the “tax burden”)

3. Defer the problem increase borrowing (debt)

17

Source: OECD, CIHI, and author’s calculations.

Spending and Revenue Paths From 2020 to 2040

Can these costs be absorbed purely through debt?Can these costs be absorbed purely through debt?

-1

0

1

2

3

4

2020 2022 2024 2026 2028 2030 2032 2034 2036 2038 2040

~ 35 p.p. Increase in FPT Debt-to-GDP Ratio

(percentage points of GDP)

Spending

Revenue

HealthSpending

and Elderly

Benefits(3.5 p.p.)

18

0

20

40

60

80

100

1995 2000 2005 2010 2015 2020 2025 2030 2035 2040

Historical Projected

(percent)

Debt Ratio Constant at its 2009-10 level

For Canadian governments, this would mean a return to the high-debt situation of the mid 1990s. For Canadian governments, this would mean a return to the high-debt situation of the mid 1990s.

Source: Author’s calculations.

FPT Debt-to-GDP Ratio

High Debt!

Suppose we want to impose a “debt ceiling” at 60%.

19

Many alternatives to stay under this “debt ceiling”:Many alternatives to stay under this “debt ceiling”:

#1. “Front-loaded” debt-reduction strategy:

Further reducing debt before the full impacts of aging materialize

#2. “Back-loaded” fiscal-adjustment strategy:

Restrain non-age-related spending and/or increase taxes as the impacts of aging materialize

#3. Many others as well …

20

#1: Front-Loaded Debt-Reduction Strategy#1: Front-Loaded Debt-Reduction Strategy

Source: Author’s calculations.

FPT Debt-to-GDP Ratio

10

20

30

40

50

60

70

80

90

1995 2000 2005 2010 2015 2020 2025 2030 2035 2040

No Action

Front-Loaded Debt ReductionStrategy

Historical Projected

(percent)

25 %

21

But this requires considerable fiscal discipline over the next decade by all levels of government. But this requires considerable fiscal discipline over the next decade by all levels of government.

Source: September Update of Economic and Fiscal Projections, provincial-territorial Public Accounts and author’s calculations.

FPT Budget Balance

-80

-60

-40

-20

0

20

40

60

2009-10 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

3 % GDP Growth: $41 B Surplus per Year

3.5 % GDP Growth: $39 B Surplus per Year

4 % GDP Growth $36 B Surplus per Year

(billions of dollars) The required budget surpluses depend on future GDP growth!

22

#2: Back-Loaded Fiscal-Adjustment Strategy#2: Back-Loaded Fiscal-Adjustment Strategy

Source: Author’s calculations.

Fiscal Adjustments between 2020 and 2040

-0.5

0.5

1.5

2.5

3.5

2020 2022 2024 2026 2028 2030 2032 2034 2036 2038 2040

~ 15 p.p. Increase in FPT Debt-to-GDP Ratio

(percentage points of GDP)

Revenue Increases

1.5 p.p.

Spending Cuts

3.5 p.p.

23

As shown, the policy mix is roughly balanced between G, T, and debt.

This alternative also honours the “debt ceiling”, but does not avoid the need to make difficult decisions. This alternative also honours the “debt ceiling”, but does not avoid the need to make difficult decisions.

Source: Author’s calculations.

Federal-Provincial-Territorial Debt-to-GDP Ratio

10

20

30

40

50

60

70

80

90

1995 2000 2005 2010 2015 2020 2025 2030 2035 2040

No Action

Back-Loaded Spending Reduction Strategy

Front-Loaded Debt Reduction Strategy

Historical Projected

(percent)

25 %

24

Which decisions? Tax burden increases by 1 pp of GDP and total spending falls by 1 pp of GDP between 2020 and 2040.

A Key Difference? A Key Difference?

1. Both approaches honour the “debt ceiling” and both involve making difficult decisions.

2. But they have very different implications for intergenerational equity.

3. Who “should” pay for the baby-boom generation’s old-age health care?

25

A Few Thorny IssuesA Few Thorny Issues

1. Aren’t we getting steadily richer?

2. Would higher productivity growth help?

3. A Federal-Provincial Dimension?

26

#1: Won’t our growing income provide the resources necessary to finance these health-care costs?

#1: Won’t our growing income provide the resources necessary to finance these health-care costs?

1. I have already assumed a baseline rate of productivity growth (1.3% p.a.).

2. So, it is true that real living standards are rising throughout the projection period.

3. But I have also assumed a constant tax burden (in option #1) or a rising tax burden (option #2), so these rising incomes are already built into tax revenues.

4. So the size of the challenge is not overstated.

27

#2: Can a higher productivity growth rate help ease the fiscal squeeze?

#2: Can a higher productivity growth rate help ease the fiscal squeeze?

1. Yes -- subject to some important caveats:

2. How will increases in GDP translate into greater demand for health-care (and other) spending?

Is the income elasticity for health care > 1?

3. Will governments be able to restrain the spending pressures created by income growth?

28

Impact of higher productivity growth on revenues and spending as shares of GDP Impact of higher productivity growth on revenues and spending as shares of GDP

2020 2030 2040

0

Change in ppts of GDP

“Fiscal Squeeze”

If G/GDP could be reduced as productivity growth rises, the fiscal squeeze would be eased.

T/GDP

G/GDP3.5

Crucial question: As GDP rises more quickly, which elements of public spending will be unaffected, so that G/GDP falls?

Some possible effects of higher productivity growth on the fiscal squeeze: Some possible effects of higher productivity growth on the fiscal squeeze:

Recall that baseline productivity growth is assumed to be 1.3 % per year.

Additional productivity growth rate required to keep the debt ratio below the 60% ceiling (with no change in the tax burden)

If only age-related spending is unaffected by higher productivity growth:

~ 0.4 percentage points

If all public spending is unaffected by higher productivity growth: ~ 0.2 percentage points

30

#3: The Federal-Provincial Dimension#3: The Federal-Provincial Dimension

1. Provision of direct health-care services is a provincial jurisdiction.

2. The federal government plays an important role with federal transfers (as well as by providing health-care services to special groups).

3. How will the coming fiscal squeeze be shared between the two levels of government?

31

Summary and Final ThoughtsSummary and Final Thoughts

1. The coming demographic forces will lead to much higher spending on “age-related” items.

2. We must adjust to this increase in spending – but how?

3. Regard to intergenerational equity suggests reducing the debt ratio well ahead of 2020.

4. But this means a fairly rapid return to a balanced budget, followed by substantial budget surpluses.

5. How do we maintain public support for such surpluses?

32

Summary and Final ThoughtsSummary and Final Thoughts

6. Apart from debt reduction, there are several actions that governments can take.

7. Restraining spending and/or increasing taxes in the future is another approach.

8. Policies aimed at increasing the LF participation rate can also play a role (eg., immigration, retirement, etc..).

9. Faster productivity growth will:

1. certainly be good for living standards

2. probably help to ease the fiscal squeeze

33

Questions?Questions?

34