1. Generational aspects of fiscal policy under changing demographic forecasts Jukka Lassila (ETLA) MoPAct workshop Helsinki, June 2016

2. Motivation and aim In an economy with ageing population, we analyze long-run fiscal strategies, with a novel method. (fiscal strategy – a set of rules and practices describing how policy parameters change) What does this method tell us about intergenerational fairness? The ultimate aim is to find strategies that could be described as both fiscally sustainable and intergenerationally fair.

3. Intergenerational equity 1.between contemporary generations 2.in public transfers between generations 3.in private transfers between generations 4.between contemporary and future generations, as yet unborn Piachaud, Macnicol and Lewis (2009)

4. Intergenerational equity in public transfers and services PAYG pensions are a good reference because – young people pay, old receive, and cohort sizes vary with aging population – pension policy changes always(?) hit some cohorts more than others. Many similarities in other public sector areas, but also differences – issues unrelated to age (administration, defence) – age-neutral instruments (VAT, municipal taxes) – stabilization issues

5. Previous studies Jensen, Nødgaard and Pedersen (2002): Tax smoothing v. debt smoothing Miles and Iben (2000): Winners and losers from pension reform, bequests Auerbach and Lee (2009): generational uncertainty and risk sharing in pension systems, in context of economic and demographic uncertainty, with the goal of finding properties that do not result from some particular demographic circumstances. Elder (1999): Individuals do not know the duration of a tax cut with certainty. Revised expectations and optimization. Focus on capital formation (closed economy).

6. Auerbach and Hassett (2001) ”…how and when to deal with long-term fiscal imbalances that are at once very significant and very uncertain,…” ”…stylized models in search of more general conclusions regarding the nature of optimal policy responses.” (OLG with 2-period lives) Here: Finnish public institutions, OLG with 16- period lives Starting point: Lassila – Valkonen – Alho, Int. J. of Forecasting 2014

9. Alho: Forecasting demographic forecasts Int. J. of Forecasting 2014 “We assume that an approximation to the predictive distribution of the future population is available in terms of simulated population counts. The required conditional expectations are then obtained by averaging the future evolution of a set of sample paths that come from the neighborhood of a target path. This is formally equivalent to n-nearest neighbor kernel regression.”

10. The economic model Open-economy Auerbach – Kotlikoff type general equilibrium model Overlapping generations, life-cycle optimization Forward-looking firms, maximizing share value Perfect foresight, except for demographics where forecasts are believed in A revised demographic forecast every 5-year period. Households and firms re-optimize. Re-optimization leads to (perceived) changes in welfare

11. Demography-related features in the model Earnings-related pensions (DB, with longevity adjustment) and their funding (partial) National pensions, means-tested on earnings- related pensions Health and LTC costs, depending both on age and proximity to death Public education costs and some transfers Aggregation: How many people in what age doing what (working or not, consuming, saving, paying taxes, getting transfers etc.)

16. Welfare changes under which strategies? Base strategy (”current policy”) Base strategy with conditional VAT changes – Raise VAT by 2% if forecasted debt/GDP exceeds 60 % within 20 years Tax smoothing policies – Based on forecasts, periodically revised – With varying smoothing horizons

17. Base strategy Mandatory pension contributions adapt to pension expenditure Health and long-term care costs are financed partly by municipal taxes, which adapt. Part of health and LTC is financed by state aid to municipalities. State tax rates are held constant, so changes in expenditure and tax bases go into public debt. Consolidation after 55 years (smoothing taxes from 2068-72 to 2143-47)

18. Tax smoothing policies Government sets a constant VAT rate so that the state’s debt/GDP gets back to initial level after, say, 50 years – if the population forecast comes true. VAT rate updated when new forecast arrives. Municipalities: constant income tax rate, debt/GDP back to initial level after 50 years – if forecast is good. Updated every period. Earnings-related pensions: constant contribution rate, funds back to normal level after 50 years, updates Consolidation after 50 years (smoothing taxes from 2063-67 to 2143-47)

19. Welfare changes under base strategy, 50 % predictive limits CV, % of consumption 40-4480-84 from revisions-1.01 - +1.08 -4.17 - +3.62

20. Welfare changes under base strategy, 50 % predictive limits CV, % of consumption 40-4480-84 from revisions-1.01 - +1.08 -4.17 - +3.62 from consolidation-4.82 - -2.93 -5.49 - -3.24

21. Welfare changes under base strategy and tax smoothing, 50 % predictive limits CV, % of consumption from revisions 40-4480-84 Base-1.01 - +1.08 -4.17 - +3.62 50 yrs-1.49 - +0.97 -4.79 - +3.50 from consolidation Base-4.82 - -2.93 -5.49 - -3.24 50 yrs-2.16 - +0.69 -2.37 - +0.56

22. Welfare changes under tax smoothing 50 % predictive limits Smoothing horizon CV, % of consumption from revisions 40-4480-84 20 yrs-1.55 - +1.08-4.85 - +3.70 50 yrs-1.49 - +0.97-4.79 - +3.50 from consolidation 20 yrs-4.55 - +1.68-4.88 - +1.52 50 yrs-2.16 - +0.69-2.37 - +0.56

24. Which intergenerational aspects does our method address 1.between contemporary generations - revision effects by age, consolidation effects by age 2.in public transfers between generations - yes, next slide 3.in private transfers between generations - not dealt with 4.between contemporary and future generations - comparing revision effects to consolidation effects

26. Should strategies include client fees?

27. Pre-announced client fees?

28. Should strategies include client fees? Pre-announced client fees? Prefunding?

29. Some observations on smoothing Forecast-based tax smoothing is imperfect, sometimes grossly so. Still it probably improves intergenerational fairness. With smoothing, public debt is well in control. However, the EU’s debt rule and other fiscal rules may be violated. In practice only few speak about or do smoothing, let alone 50 year debt targets. – Canadian pension system (CPP) uses forecasts explicitly, and goes to great length to reduce doubts concerning forecast manipulation. – Swedish NDC system ignores forecasts completely. – Finnish earnings-related pension system (TyEL) aims at smoothing Municipalities in Finland cannot take debt to any significant amount. They could (but don’t) prefund for future health and LTC expenditure. With aging populations, tax smoothing strategies cause tax increases.