The Demographic Time Bomb

Forecast for Dependency Rates

Source: Dept for work and Pensions

Many Western OECD economies are facing an unwelcome population projection. As the baby boomer generation starts to retire (around 2016), the dependency ratio (number of people not working to number of people working) is forecast to rise. This ageing population is exacerbated by declining birth rates which is reducing the number of working age adults. Some countries are affected more than others. For example:

• Italy number of adults 16-65 is forecast to fall from 35 m to 26.1 m. Combined with an ageing population and a National Debt of over 100% to start with it looks pretty grim.
• UK Dependency ratio is forecast to rise from: 0.34 to 0.65 by 2040.
• In the US statistics from federal reserve suggest a fall in number of workers to dependants from: 0.63 to : 0.53 in 2080
  

Impact of Ageing Population

• Fall in Income Tax Receipts. Retired people will pay very little if any income tax.
• Increased spending on Pensions: Governments are committed to make pension commitments to everyone over the age of 65.
• Health Care. 50% of health care is focused on people in the last year of their lives.

The government will be faced with higher spending commitments and lower tax receipts. If the government doesn't radically change policy, national debt is likely to increase. Furthermore, the government will not be borrowing to finance sustainable investment but making transfer payments which don't boost productivity.

Is it Really The End of the World?

Some doomsayers suggest that the ageing population could really cripple western economies leaving governments with unmanageable debts - leading to inflation and / or higher interest rates. However, bear in mind.

Source: National Bank Denmark

• Some Countries are much more affected than others. The outlook looks bleak for Italy and Japan, but, not too bad for UK, Denmark and US.
• There will also be a decline in young dependants (people under 16). Therefore, the government will be able to spend less on education and child benefit.
• Economic growth of 2.5% should increase the nations capacity to meet rising spending commitments. If economic growth averages 2.5% and national debt increases by 2.5%, then national debt as a % of GDP will remain the same. This means that tax rates will not have to rise to meet interest payments on the consistent national debt. The problem will come if National debt increases faster than economic growth.
• Compared to the 1960s and 1970s, female labour market participation rates have dramatically increased. This helps increase the number of effective workers to economically inactive. (However, this has been offset to some extent by declining male participation rates.)

What Choices Do the Government Have?

With prospect of higher spending and relatively lower tax receipts, the government may have to consider some politically unpopular policies.

1. Raise retirement age to reflect longer life spans. In 1950, average life expectancy was 75. It is now 86. But a higher retirement age will not be welcomed by people who have been planning and expecting to retire at 65. Governments may delay implementation of higher pension age for several years.
2. Higher tax rates. Increasing income tax to pay for an ageing population hardly inspires. The argument is higher tax rates will reduce productivity and deter people working. The impact of higher taxes on labour productivity is less than many claim, but, it would still be an unwelcome development
3. Cut spending. Making people pay for private health care and private nursing homes is one solution. But, it would inevitably require an extensive and unpopular means tested scheme to decide who can't afford. It won't please children seeing a fall in their inheritance levels.
4. Immigration. Immigration of young workers will be one of the easiest solutions to the demographic time bomb. But, immigration is equally unpopular.

The problem is arguing for the above policies is hardly going to win you favours with the electorate, therefore there is a politically pressure to keep delaying these policies for later. Which policy would you be happy to accept?