Ageing, Social Security, and the Intergenerational Debate – Part 3

I am now using Friday’s blog space to provide draft versions of the Modern Monetary Theory textbook that I am writing with my colleague and friend Randy Wray. We expect to publish the text sometime early in 2014. Comments are always welcome. Remember this is a textbook aimed at undergraduate students and so the writing will be different from my usual blog free-for-all. Note also that the text I post is just the work I am doing by way of the first draft so the material posted will not represent the complete text. Further it will change once the two of us have edited it.

Previous part of this series:

• Ageing, Social Security, and the Intergenerational Debate – Part 1
• Ageing, Social Security, and the Intergenerational Debate – Part 2

Chapter 25 Recent Policy Debates

In this Chapter we consider the following policy debates:

• 25.1: Ageing, Social Security, and the Intergenerational Debate
• 25.2: Twin Deficits and Sustainability Of Budget Deficits
• 25.3: Fixed Versus Flexible Exchange Rates: Optimal Currency Areas, the Bancor, or Floating Rates?
• 25.4: Economic Growth: Demand or Supply Constrained?
• 25.5: Environmental Sustainability and Economic Growth

25.1 Ageing, Social Security, and the Intergenerational Debate

[NOTE: I HAVE EDITED THIS SHORT SECTION FROM PART 2]

Another concept used is the aged dependency ratio, which is, in percentage terms, the number of people above retirement age divided by the number of persons of working age.

Similarly, policy makers sometimes refer to the child dependency ratio, which is, in percentage terms, the number of people below the working age divided by the number of persons of working age.

The total dependency ratio is the sum of the two. The dependency ratio can be manipulated by policy makers by, for example, increasing the “retirement age”, which reduces the numerator and increases the denominator.

A high child dependency ratio requires higher public investments in infant health, education and child-care whereas a high aged dependency ratio requires higher public outlays for health-care and pensions.

With declining fertility rates, the total dependency ratio falls because the proportion of the population in the 0-15 years group declines and more people move into the working age population. This period in a nation’s development has been referred to as the “demographic dividend” because of the higher proportion of potential workers relative to the numbers of people that have to be supported.

Eventually, as fertility rates continue to fall, the dependency ratio begins to rise as a result of workers transitioning between working age and retirement and improved health care outcomes lead to higher life expectancy.

It is argued that this increasing aged dependency ratio indicates the increased pressure on the public budget, which is why the concern about dependency ratios in the public debate is relatively recent. It is clear that as the society shifts from one with high fertility to low fertility and low mortality, the required public outlays change in composition – less schools and child-care facilities and more old-aged care homes and pension support are required.

Figure 24.1 shows the total, child and aged dependency ratios for Australia from June 1971 to June 2051. The data from 1971 to 2012 is based on actual population estimates whereas the dotted lines from 2013 to 2051 are based on the Australian Bureau of Statistics Series B demographic projections.

You can immediately see the changing dynamics of the demography and the way in which this influences the dependency ratio. In the early 1970s, the total dependency ratio was around 58.8 per cent compared to 49.4 per cent in 2012. The population projections suggest the total ratio will reach the same level as 1971 somewhere between 2025 and 2026 as the population ages.

Figure 24.1 Total, Child and Age Dependency Ratios, Actual and Projected, 1971-2051, Australia

What would be the impact of an increase in the retirement age in Australia from 65 years of age to 70 years? Figure 24.2 shows the total and aged dependency ratios for Australia from June 2013 to June 2051 based on the Australian Bureau of Statistics Series B demographic projections. The dependency ratios assume a retirement age of 65 and 70 to highlight the impact of a policy decision to increase the retirement age.

Figure 24.2 shows that, based on the official population projections by the Australian Bureau of Statistics, if the government increased the retirement age from 65 (as it is in 2013) to 70 years of age, the dependency ratio in 2051 would fall from a projected 65.4 per cent to 49.9 per cent. In 2013, the total dependency ratio (assuming a retirement age of 65 years) was 51.3 per cent.

Another way of expressing the dependency ratio is that, for Australia, in 2013 there are 2.03 people of working age to every person who is not of working age. This is projected to fall to 1.54 in 2051.

The aged dependency ratio was 24.5 per cent in 2013 and if the retirement age was held at 65 years this is projected to rise to 38.1 per cent by the 2051. If the retirement age was increased to 70 years of age, the aged dependency ratio would drop to 20.2 per cent by the year 2051.

Thus, policy changes can have rather significant impacts on the dependency ratios.

Figure 24.2 Total and Age Dependency Ratio Projections, 2013-2051, Australia

Source: Australian Bureau of Statistics Series B Population Projections.

The standard way of calculating the dependency ratio provides a flawed indication of the relationship between active workers relative to inactive persons, the latter being defined as providing no direct contribution to the production of national income.

The concept of an effective dependency ratio has been developed to address these flaws.

First, the concept of unpaid work is ignored, which as we saw in Chapter 3, is a standard problem of the conventional national accounting framework.

So like all measures that count people in terms of so-called gainful employment, the standard dependency ratio measure ignores major productive activity like housework and child-rearing. The latter omission understates the female contribution to economic growth.

Second, the effective dependency ratio recognises that not everyone of working age, however defined, are actually producing national output and income. There are many people in this age group who are also “dependent”. For example, full-time students, house parents, sick or disabled, the hidden unemployed, and those who have taken early retirement fit this description.

The unemployed and the underemployed should also be included in the category of non-productive people of working age, although the statistician counts them as being economically active within the Labour Force framework.

The inclusion of the unemployed and underemployed significantly impact on the estimated dependency ratio when there is mass unemployment and high rates of underemployment. For example, in August 2013, the Australian labour market data showed that official estimated unemployment was 714,100 and estimated underemployment was 964,300.

Recomputing the dependency ratio (adding these underutilised workers to the numerator and subtracting them from the denominator) produces a total dependency ratio of 69.9 per cent in 2013 compared to the standard estimate of 51.3 per cent.

This analysis shows that for Australia (in 2013), the impact of high labour underutilisation on the dependency ratio is more significant than increasing the retirement age by 5 years.

As we will see, persistent labour underutilisation also exacerbates the implications of a rising dependency ratio because it has adverse impacts on the growth in labour productivity.

Do dependency ratios matter?

A dominant view in the public debate is that a rising dependency ratio indicates that more workers will be relying on the state for pension and health support and less workers will be contributing to the government’s tax base.

The implication of a rising ratio of economically inactive compared to economically active is that the latter will have to bear higher tax burdens to support the increased government spending.

As time passes, it is argued that the state enters a fiscal crisis driven by unsustainable deficits and debt obligations.

These claims underpin the dominant theme used by governments, business lobbyists, and economists to justify a preference for the pursuit of budget surpluses in the context of aeging populations.

For example, in the US there is constant pressure on government to privatise the US social security system as a means of keeping it solvent. Similarly, in Australia, the so-called intergenerational debate, which began in the mid-1990s and is still a powerful political force, was central to the pursuit of budget surpluses by successive federal regimes.

The argument used to support the preference for surpluses in the context of an aeging population is simple:

• The budget deficit cannot be allowed to reach some projected level because the increasing public debt would push interest rates up and ‘crowd out’ productive private investment.
• Increasing debt will impose higher future taxation burdens for future generations, which will reduce their future disposable incomes and erode work incentives.
• People must work longer (retirement ages must be lifted) to accumulate more funds to finance their own retirements and incentives for people to increase the birth rate should be introduced.
• For some nations, higher levels of immigration are required to reverse the ageing bias in the population.

What is the veracity of these arguments from the perspective of the macroeconomic framework we have introduced and developed within this textbook?

It is often suggested that budget surpluses are equivalent to accumulation funds that a private citizen might enjoy as a result of persistent saving. Using this metaphor, accumulated budget surpluses are seen as being ‘stored away’ for the future and thus provide the government with the means to deal with increased public expenditure demands that may accompany the ageing population.
Whether public outlays relating to age-sensitive components of spending rise over time depends on a number of factors including the nominal reductions in outlays associated with less school-related funding and child-care provision, improved standards of health-care, the growth in private retirement funds, among other factors.

However, while the public debate is dominated by considerations of the potential that these “costs” will inevitably rise, a moment’s reflection will assure you that the issue is rather moot.

National government finances can be neither strong nor weak but in fact merely reflect a “scorekeeping” role. We have learnt that when Government boasts that a $x billion surplus, this is tantamount to saying that non-government $A financial asset savings recorded a decline of $x billion over the same period.

Equally, when we say that public net debt is very low over some period this is equivalent to saying that non-government holdings of government debt fell by the same amount over this period. In other words, private sector wealth was destroyed in order to generate the funds withdrawal that is accounted for as the surplus.

However, once we appreciate the equivalents noted above we would conclude that this draining of financial equity introduces a deflationary bias that slows output and employment growth (keeping unemployment at unnecessarily high levels) and forces the non-government sector into relying on increasing debt to sustain consumption.

This idea that accumulated surpluses are allegedly “stored away” and will help government deal with increased future public expenditure demands that may accompany the ageing population lies at the heart of the intergenerational debate misconception. While it is moot that an ageing population will place disproportionate pressures on government expenditure in the future, it is clear that the concept of pressure is inapplicable because it assumes a binding financial constraint.

The concept of the taxpayer funding government spending is misleading. Taxes are paid by debiting accounts of the member commercial banks accounts whereas spending occurs by crediting the same. The notion that “debited funds” have some further use is not applicable.

When taxes are levied the revenue does not go anywhere. The flow of funds is accounted for, but accounting for a surplus that is merely a discretionary net contraction of private liquidity by government does not change the capacity of government to inject future liquidity at any time it chooses.

The standard government budget constraint assumption that deficits lead to future tax burdens because the debt accumulated during the deficit period has to be paid back is also problematic. The government budget constraint is not a “bridge” that spans the generations in some restrictive manner. Each generation is free to select the tax burden it endures. Taxing and spending transfers real resources from the private to the public domain. Each generation is free to select how much they want to transfer via political decisions mediated through political processes.

To say that there is no binding financial constraint on a currency-issuing government spending is not the same thing as saying that government should therefore not be concerned with the size of its deficit. The size of the deficit (surplus) will be market determined by the desired net saving of the non-government sector. The more robust non-government spending is, the lower will be the deficit (which may, under some conditions become a surplus).

The responsibility of government to ensure that its taxation/spending policies are set at the right level to ensure that total spending is sufficient to maintain full employment and is neither inflationary or deflationary.

This insight puts the idea of sustainability of government finances into a different light. Societies do need to meet the real challenges that will be posed by rising dependency ratios.

All societies should aim to provide first-class health care and viable pension systems, which combine to produce high real standards of living for all citizens.

The capacity to achieve those aims depends on the availability of real goods and services rather than the erroneous concern about whether the currency-issuing government can afford to purchase them if available.

Ensuring the availability of real goods and services depends on maintaining high levels of employment and productivity as the dependency ratio rises.

While lifting labour force participation by older workers is sound there have been sufficient jobs available for all workers to make that policy effective.

Running surpluses now and maintaining persistently high levels of unemployment and underemployment is contrary to what is required. Governments should strive to ensure that teenagers are fully occupied in formal schooling, technical training and/or employment. High rates of youth unemployment prevent the future workers from acquiring the necessary skills and experience that will underpin a highly productive workforce.

Further, encouraging increased casualisation in the workforce and rising underemployment is not a sensible strategy for the future because it reduces the incentive to invest in one’s human capital. Individuals will only outlay resources on education and training if there is an expectation of a return on that investment. The increasing proportion of precarious and low-paid part-time work opportunities in advanced nations, partly due to the excessively tight fiscal positions governments are choosing to adopt, reduce the expectation of a net return on skill development.

It is also imperative to invest in public education at all levels to ensure a highly-skilled workforce is created. Trying to generate unnecessary budget surpluses by cutting funding to public education will undermine that essential objective.

Public funding of research is also essential to foster increased knowledge accumulation, invention and innovation which will underpin strong rates of productivity growth.

You will appreciate that these issue go beyond the realm of economics and government finances. Rather, they focus on political choices. The ability of government to provide necessary goods and services to the non-government sector, in particular, those goods that the private sector may under-provide is independent of government finance.

Any attempt to link the two via fiscal policy “discipline:, will not increase per capita GDP growth in the longer term. The reality is that fiscal drag that accompanies such “discipline” reduces growth in aggregate demand and private disposable incomes, which can be measured by the foregone output that results.

Running surpluses as a means of stockpiling financial resources for the future does not guarantee that there will be sufficient real resources available in the future.

If there are sufficient real resources available in the future – in part, because nations have invested in high productivity strategies – then their distribution between competing needs will become a political decision.

Long-run economic growth that is environmentally sustainable will be the single most important determinant of sustaining real goods and services for the population in the future. Principal determinants of long-term growth include the quality and quantity of capital (which increases productivity and allows for higher incomes to be paid) that workers operate with. Strong investment underpins capital formation and depends on the amount of real GDP that is privately saved and ploughed back into infrastructure and capital equipment. Public investment is very significant in establishing complementary infrastructure upon which private investment can deliver returns. A policy environment that stimulates high levels of real capital formation in both the public and private sectors will engender strong economic growth.

Conclusion

NEXT PART OF THIS CHAPTER – Twin Deficits and Sustainability Of Budget Deficits

Advertising Feature

I hate advertising and ban it from my blog – unless it is about my band! This event is down at Phillip Island, Victoria in early November – the Saturday before the world famous Melbourne Cup horse race. A beautiful part of the world – among my favourite surf spots are on the Island – and a great vineyard.

For more information go to the – Pressure Drop Home Page.

Saturday Quiz

The Saturday Quiz will be back again tomorrow. It will be of an appropriate order of difficulty (-:

That is enough for today!

(c) Copyright 2013 Bill Mitchell. All Rights Reserved.