Global Aging Pressures: Impact of Fiscal Adjustment, Policy Cooperation, and Structural Reforms

This paper undertakes a rigorous analysis of the effects of policies to respond to the looming demographic pressures in Europe and elsewhere. We examine the impact of fiscal adjustment by itself, and when pursued in combination with tax, labor and product market reforms, using the IMF's Global Fiscal Model (GFM). The model is calibrated to the German economy, as well as to the euro area, and the United States and used to simulate the growth effects of alternative fiscal adjustment strategies to maintain debt sustainability, particularly in the face of global aging pressures. We also explore the international spill-over effects of demographic pressures and associated fiscal adjustment, and the benefits of cooperative action. In addition, we examine the extent to which structural reforms (including tax reform) to boost productivity growth, labor participation, and product market competition could ameliorate the adverse short-term effects of adjustment. The results suggest (i) substantial spill-over effects of aging on debt sustainability through international financial channels; (ii) the preferred adjustment package is broad-based relying on both revenue and expenditure measures while avoiding increases in direct taxes; and (iii) there are substantial benefits from fiscal cooperation. Nonetheless, even a cooperative response has initial contractionary effects, and we show that these effects can be offset by combining fiscal adjustment with expeditious implementation of structural reforms in product and labor markets, as envisaged in the Lisbon Agenda. Moreover, the benefits accrue early and to all income groups if the reforms are implemented as part of a package. To address global aging pressures, this paper undertakes a rigorous analysis of the macroeconomic effects of fiscal adjustment in Europe pursued in combination with tax, labor and product market reforms using the IMF's Global Fiscal Model (GFM). We calibrate the model to a large open European economy (Germany), as well to the rest of the euro area, United States, and the rest of the world. GFM is a multi-country dynamic general equilibrium model specifically designed to explore fiscal policy issues, with strong microfoundations, a wide menu of taxes, and a stylized financial sector block. A key feature of the model is that Ricardian equivalence does not hold owing to overlapping generations in the spirit of Blanchard-Weil, limited access of some consumers to financial markets, and distortionary taxation. Within this framework, the paper explores the following four issues: • First, European countries are facing substantial medium- and long-term fiscal pressures from population aging. Even with the important pension reforms and recent improvements in structural deficits that have been undertaken in a number of countries, maintaining debt sustainability will require substantial fiscal adjustment (including further entitlement reforms) and we assess the relative pros and cons of prefunding future health and pension spending. Such fiscal adjustment could be implemented in a variety of ways and we quantify the effects of