Government Institute for Economic Research. Publications 58. Three takes on sustainability

Transcription

1 Govenmen Insiue fo Economic Reseach Publicaions 58 Thee akes on susainabiliy Juha Honkaukia (ed.) Publicaions 58 Sepembe 20

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3 VATT PUBLICATIONS 58 Thee akes on susainabiliy Juha Honkaukia (ed.) Valion aloudellinen ukimuskeskus Govenmen Insiue fo Economic Reseach Helsinki 20

4 ISBN (nid.) ISBN (PDF) ISSN (nid.) ISSN (PDF) Valion aloudellinen ukimuskeskus Govenmen Insiue fo Economic Reseach Akadiankau 7, 0000 Helsinki, Finland Oy Nod Pin Ab Helsinki, Sepembe 20 Gaphic design: Niilas Nodenswan

5 Foewod Finland has a long adiion of planning ahead in anicipaion of looming changes. The opic of his book, susainabiliy and is implicaions fo he economy is a case in poin. Ove he pas wo decades, counless sudies have evaluaed he likely consequences of ageing fo economic gowh and fiscal susainabiliy, and he policy esponses available o alleviae hem. Moe ofen han no hese sudies have used numeical mehods, and o analyze he compound poblems of ageing and sucual change in he economy, he lages Finnish eseach insiues have devoed consideable esouces o develop models capable of ackling hese poblems. This book collecs esuls fom five ecen sudies, all uilizing numeical models, bu focusing on slighly diffeen aspecs of he poblems of ageing and susainabiliy. Togehe, hey give a good oveview of he join capabiliies of he models used in VATT, he Govenmen Insiue fo Economic Reseach, he Bank of Finland, and he ETLA, The Reseach Insiue of he Finnish Economy. I would like o exend my wames hanks o he conibuos, Jukka Lassila and Tamo Valkonen fom ETLA, Juha Kilponen, Helvi Kinnunen, and Ani Ripai fom he Bank of Finland, and Juha Honkaukia and Saaa Tamminen fom VATT. I would also like o hank Jouko Vilmunen fom he Bank of Finland fo his suppo fo he pojec, and Pee Dixon fo aking he ime o commen on he book and fo puing i ino a lage pespecive in his inoducion. Helsinki 9 Sepembe, 20 Aki Kangashaju Dieco Geneal Govenmen Insiue fo Economic Reseach

6 Auhos Juha M. Alho, Pofesso Univesiy of Easen Finland Juha Honkaukia, Reseach Dieco, Docen Govenmen Insiue fo Economic Reseach (VATT) Juha Kilponen, Senio Economic Advise Bank of Finland Helvi Kinnunen, Advise Bank of Finland Jukka Lassila, Reseach Adviso The Reseach Insiue of he Finnish Economy (ETLA) Ani Ripai, Pofesso Univesiy of Helsinki Saaa Tamminen, Reseache Govenmen Insiue fo Economic Reseach (VATT) Tamo Valkonen, Reseach Dieco The Reseach Insiue of he Finnish Economy (ETLA)

7 Conens Inoducion Pee B. Dixon. The Maginal cos of funds in Finland An AGE evaluaion 5 Juha Honkaukia. Inoducion 5.2 The Concep of Maginal Cos of Funds 6.3 An ouline of VATTAGE 8.4 A Back-of-he-envelope model fo undesanding VATTAGE esuls fo he maginal cos of funds.5 The effecs of inceases labou, capial, and consumpion axes 22.6 Concluding emaks The dynamic effecs of a ax efom in Finland 37 Juha Honkaukia Saaa Tamminen 2. Inoducion The VATTAGE model The effecs of he ax efom Conclusions Populaion ageing in a small open economy some policy expeimens wih a acable geneal equilibium model 73 Juha Kilponen Helvi Kinnunen Ani Ripai 3. Inoducion The model Policy designs Long-un effecs of ageing Dynamic effecs Conclusions

8 4. Govenmen funds and demogaphic ansiion Alleviaing ageing coss in a small open economy 5 Helvi Kinnunen 4. Inoducion The Model Simulaions Conclusions Assessing he susainabiliy of healh and long-em cae financing And he usefulness of policy guidelines based on demogaphic foecass 5 Jukka Lassila Tamo Valkonen Juha M. Alho 5. Inoducion Modeling he economics and demogaphics of ageing Finland Susainabiliy of publicly financed healh and long-em cae Susainabiliy and policy ules Summay and conclusions 70

9 Inoducion Pee B. Dixon This book descibes numeical geneal equilibium models ceaed in hee Finish oganizaions: he Govenmen Insiue fo Economic Reseach (VATT); he Reseach Insiue of he Finish Economy (ETLA); and he Bank of Finland (BOF). Each of he models is heoeically igoous, conains deailed daa, is solved by sophisicaed compue pogams and gives insighs on majo policy issues. Many pominen economiss ae scepical abou he value of numeical geneal equilibium modelling. Among hem is my good fiend Max Coden, Ausalia s mos eminen economis. Ofen when I have managed o explain a difficul esul o him, he esponds wih somehing along he lines: Tha s pey obvious. I could have woked ha ou wih a diagam. You don need a big complicaed model fo ha. I have a few eacions o his. Fis I am quiely pleased: once he esul is declaed obvious, I know ha I mus have explained i well. Second, I don doub ha Max could show he esul wih a diagam: no-one is moe billian wih diagams han Max. Bu ha doesn mean ha I, o even Max, could wok ou he esul wihou he help of a fomal model involving mahemaics and compues. Models ofen eveal esuls ha ae no iniially fully anicipaed, bu once evealed hey can be undesood and explained in a simple way. I will go fuhe. A modelling esul ha canno evenually be undesood in a simple way is no woh having. Thid, while Max s shap heoizing can poin in qualiaive diecions, fo many poblems his is no enough. Numeical geneal equilibium modelling combining song heoy wih eal-wold daa povides he bes chance of obaining policy-elevan quaniaive insighs. Economeicians ae also someimes scepical abou numeical geneal equilibium modelling. They woy abou elaionships ha ae specified wihou saisical ess and abou paamees ha ae calibaed by judgemen ahe han esimaed fom a daabase. Bu he poblem is ha if we confine ouselves o modelling ha can be compehensively suppoed by economeic echniques, hen we naow aenion o issues ha have hisoical pecedens. While we should ge as much as we can fom hisoical daabases, we mus be pepaed o build models ha ae capable of descibing Si John Monash Disinguished Pofesso, Cene of Policy Sudies, Monash Univesiy, Ausalia.

10 Pee B. Dixon he behaviou of individuals in siuaions ha have no been expeienced befoe, such as in he case of longe lifeimes in he fuue (Lassila, Valkonen and Alho in chape 5 of his volume). Wih educed eliance on he hisoical ecod, hee is inceased esponsibiliy fo modelles o explain and jusify hei esuls. Wha is he heoy buil ino he model ha leads o he pojeced effec y on vaiable v fom shock x? Is his heoy ealisic? While i may no be possible o povide a fomal economeic jusificaion, ae hee ohe agumens o evidence ha can be bough o bea? All of he modelles conibuing o his book undesand his esponsibiliy. They all wok had o give common-sense and back-of-he-envelope explanaions of hei esuls. The models pesened hee ae well esablished wih hisoies seching back beween 0 and 20 yeas. In each chape, he model descipions ae accompanied by applicaions addessing policy challenges posed by an ageing populaion. This is a majo issue in Finland, and one ha is amenable o analysis via economic modelling. As Juha Honkaukia pus i in he fis chape: The challenge is wo-fold: he ageing of he populaion inceases age-elaed expenses, which should be me wih ising ax evenues; bu i also deceases labou supply, which ends o have he effec of loweing ax evenues. Howeve, as axaion also has an effec on he incenives o wok and o inves, solving his wo-fold poblem calls fo a compehensive e-evaluaion of he sucue of he whole ax sysem. All of he models ace ou in diffeen ways and wih diffeen emphases he ineacions ha Honkaukia descibes. VATT s model is a ecusive dynamic, compuable geneal equilibium (CGE) model wih a deailed indusy dimension. A feaue of he vesion of he model descibed in chape is he specificaion of consumpion/leisue/saving choice by he household seco. This specificaion is ciical fo Honkaukia s applicaion which is concened wih he welfae effecs of diffeen boad-based appoaches o inceasing govenmen evenue: axes on labou; axes on capial; and axes on consumpion. Honkaukia sees inceased axaion and a geneal senghening of Finland s budgeay siuaion as a necessay pelude o building an effecive policy esponse o populaion ageing. His simulaions show a pefeence fo axes on consumpion and capial, ahe han axes on labou. One way of hinking abou his is ha Finland aleady has high axes on labou income, geneaing disoions in favou of leisue and agains consumpion and saving. This siuaion should no be exacebaed by fuhe inceases in labou axes. In chape 2, Honkaukia and Tamminen apply VATT s model o examine he effecs of a specific poposal involving evenue-neual cus in income axes 2

11 Inoducion and inceases in value added and excise axes. In view of he esuls in chape i is no supising ha hey find ha implemenaion of his poposal would incease oveall welfae. VATT s model used in chape eas he household seco as a single uiliymaximizing eniy. In he vesion of he model used in chape 2, his is exended o 0 eniies: households disinguished by income decile. As in mos ohe CGE models, he households in VATT s model ae saic: hey don ge olde o die and hey don change hei pefeences (uiliy funcions). Saic households ae a easonable simplificaion fo he VATT execises epoed in chapes and 2 ha ae concened wih he sho o medium em (going ou no moe han 5 yeas). Howeve, fo looking a long-em issues (going ou say 50 yeas), we mus allow explicily fo demogaphic change. This is done in he ETLA and BOF models. In hese models households evolve dynamically in accodance wih an ovelapping geneaions specificaion. In peiod, households ae classified ino age cohos. In peiod +, new households aive and households fom peiod move on in age, change in composiion o disappea. Households pefeences, including hei pefeences fo wok and leisue, change wih age and composiion as do hei equiemens fo public expendiues on healh and educaion. In he ETLA analysis pesened in chape 5, Lassila, Valkonen and Alho use hei ovelapping geneaions model o calculae changes in he aes of diffeen axes ha will be equied ou o 2060 o finance pensions, age-elaed healh pogams and ohe public expendiues unde a vaiey of demogaphic pojecions. In chape 3, Kilponen, Kinnunen and Ripai use he BOF model o calculae he long-un effecs of changes in life expecancy, aveage eiemen age, feiliy and pension paymens on equied conibuion aes by wokes and fims o pension funds, ax aes and a vaiey of maco vaiables. In chape 4, using anohe vesion of he BOF model, Kinnunen invesigaes he benefis of smoohing ou he financing of pensions o avoid shaply elevaed axes o conibuion aes duing peiods of apid incease in pension liabiliies. By avoiding spikes in ax and conibuion aes, Kinnunen shows ha wok disincenive effecs can be educed, easing he buden of ageing. In an envionmen of quaniaive ignoance, ageing and associaed financing poblems seem fighening. Bu numeical modelling allows us o look a he siuaion in a calm quaniaive fashion. I is ue ha ageing will mean eihe highe axes and conibuion aes o lowe eiemen benefi aes in he fuue. Bu fo me, he quaniaive esuls in his book ae eassuing. Fo example, he 3

12 Pee B. Dixon BOF esuls in chape 3 indicae ha no long-un ageing-elaed inceases in axes and conibuion aes will be equied if eiemen pensions ae educed by 2 pecenage poins in elaion o wages: fom 55 pe cen in a no ageing scenaio o 43 pe cen in he main ageing scenaio. While no one would like o see such a cu in pensions, i should be emembeed ha he cu would be phased in ove many yeas, and ha wih nomal poduciviy and wage gowh, pensions would sill ise in eal absolue ems. Ove he las 5 yeas I have made annual visis o Helsinki o wok fo a couple of weeks wih Juha Honkaukia and his eam a VATT. This has been a wondeful expeience. I have seen fis hand some of he excellen modelling eseach ha has been pefomed in Finland. I am impessed ha majo policy insiuions in Finland ceae, mainain and opeae models of he ype descibed in his book. The exisence of hese models is a esamen o Finland s commimen o evidence-based economic policy. 4

13 . The maginal cos of funds in Finland an AGE evaluaion Juha Honkaukia. Inoducion Coping wih he effecs of an ageing populaion is among he foemos fiscal challenges in mos indusialized counies. The challenge is wo-fold: he ageing of he populaion inceases age-elaed expenses, which should be me wih ising ax evenues; bu i also deceases labou supply, which ends o have he effec of loweing ax evenues. Howeve, as axaion also has an effec on he incenives o wok and o inves, solving his wo-fold poblem calls fo a compehensive e-evaluaion of he sucue of he whole ax sysem. Finland povides an ineesing case fo sudying he pessues of ageing on public finances, as he lage pos-wa baby-boome geneaions ae some yeas olde han in mos ohe counies, and he couny hus aleady has o cope wih he effecs of ageing. The aim of his sudy is o compae he coss of diffeen axes hus poviding analysis and assessmens ha can be used in he evaluaion of ax efoms and he effecs of public spending. We focus on he effecs of labou and capial income axes, and consumpion axes. In he cuen sudy, we model welfae wih he help of a single epesenaive consume, absacing fo he momen fom disibuional issues. We ae using he VATTAGE model o compae he welfae effecs of vaious ax inceases designed o educe Finland s budge deficis by using he concep of maginal cos of funds (MCF) fo diffeen axes. VATTAGE is a MONASHsyle model 2 of Finland documened in Honkaukia (2009). Howeve, unlike he oiginal MONASH model, VATTAGE has been exended o include leisue and savings choice in he specificaion of household behaviou, Dixon Honkaukia. Rimme (20). This exension is necessay fo useful MCF calculaions because he essence of hese calculaions is ax-induced disoions in choices beween consumpion, leisue and savings. The VATTAGE daabase elies on disaggegaed daa on he economy and allows us o disinguish beween commodiy axes and axes on diffeen ypes of faco incomes as well as axes on income ansfes. The aim of his chape is o compae he coss of aising labou income, capial income axes, o consumpion axes. In he cuen sudy, we model welfae wih 2 See Dixon and Rimme (2002). 5

14 Juha Honkaukia he help of a single epesenaive consume, absacing fo he momen fom disibuional issues. Bu even so, VATTAGE conains 82 indusies and 9 commodiies, and i is no easy o see he mechanisms a wok fom he full-scale model. To undesand he esuls, we develop a simple model of he full-scale model, ofen called a Back-of-he-envelope model. The main conibuion of his pape is he developmen of a back-of-he-envelope (BOTE) equaions wha is ofen efeed o as a model of a model o guide he explanaion of MCF esuls geneaed fom a full-scale, dynamic AGE model. We apply he equaion in a discussion of he welfae effecs of aising exa evenue by an incease in he ae of axaion on labou income. The pape is oganized as follows. Secion.2 inoduces he concep of MCF and discusses is applicaion in CGE modelling. Secion.3 oveviews he VATTAGE model and inoduces he exensions necessay o deal wih labousupply and saving-aspecs of axaion. Secion.4 develops he back-of-heenvelope equaions fo explaining MCF esuls fom a full-scale dynamic CGE model. Secion.5 applies he back-of-he-envelope equaion. Concluding emaks ae in secion.6..2 The concep of maginal cos of funds The lage lieaue on he excess buden of axaion suggess ha he coss of aising evenue diffe acoss ax insumens. Bu as agued by Ceedy (2000), measues of excess buden ae ofen concened wih compaisons of disoionay and non-disoionay (such as lump-sum) ax sysems. In pacice, howeve, changes in he ax sysem ofen involve collecing inceased evenue wih an exising, disoed ax sysem o finance inceased public spending, fo example. In he analysis of opimal ax sucue, he use of maginal cos of funds (MCF) based analysis has become popula. Similaly, applied geneal equilibium modelling has gained song momenum especially in analysing he dynamic effecs of lage policy changes. Dahlby (2008) poins ou ha changes on jus one ax ae can affec he collecion of ohe ax ypes due o he common inedependence of he diffeen ax ypes. Similaly, public spending in he fom of a public pojecs o cash ansfes also affecs he evenue colleced fom axes. The analyses of diffeen ypes of policy changes wih dynamic AGE models have also evealed ha he effecs of policies can be significanly diffeen in he long un compaed o he sho un. In he long un all poducion facos ae usually ahe flexible, while in he sho un paiculaly capial and nominal wages show igidiy. Fo hese easons we have seleced o use a dynamic AGE model also fo he analysis of maginal cos of funds. The concep of maginal cos of funds, while elaed o excess buden consideaions, is a boade concep ha akes ino accoun he ype of effecs ha 6

15 The maginal cos of funds in Finland an AGE evaluaion may aise when exising ax sysems ae modified, o when hee ae changes in public spending. Ofen, hee ae boh ypes of effecs. MCF is usually defined as a money-meic measue of he loss of welfae esuling fom he collecion of exa evenue. Supisingly, hee seem o be seveal definiions fo MCF. Hee, we use he definiion EV MCF R whee EV is he equivalen vaiaion esuling fom he ax change and change in evenue. R is he The equivalen vaiaion is ofen nomalised by deducing he change in ax evenue (R) fom EV in he denominao in he above equaion, in ode o accoun only fo he changes in consume s welfae consequenial o he ax sucue change, bu no he incease in public spending iself (Chisaio and Cicowiez, 200). In his case, MCF can be eihe negaive o posiive. Hee, we shall exogenise eal govenmen spending by assuming he exa evenue is used o pay back govenmen deb. This does no isolae ou measue compleely fom ohe govenmen policies, since he pice of public expendiue can be expeced o diffe unde diffeen ax egimes. Pehaps moe impoanly, he value of public ansfes o he households and he ohe secos of he economy is dependen on he changes in elaive pices caused by he ax changes. Bu while his makes he definiion of evenue ages difficul, i does no pose a poblem fo he welfae measue, since he measue should ake hese effecs ino accoun. An example of he applicaion of he MCF concep in he conex of AGE modelling o measuing he poenial effecs of a ax change is Go e al. (2005), which sudies he effecs of a value-added ax efom in Souh Afica. They compae he effecs of an incease in VAT and income axes on diffeen households, finding maked diffeences in MCF acoss household ypes. Cucially, hey assume no changes in faco supplies, govenmen spending o he govenmen s budge balance. Revenue is e-disibued in a lump-sum fashion, whence, as hey poin ou, MCF is moe of a measue of he oveall inefficiency of he economy han ha of jus he ax sysem 3. Woking on Agenina, Chisaio e al. (2007) sudy he impacs of he axes unde diffeen egulaoy sysems. Using he alenaive definiion fo MCF, hey adop simila assumpions o Go e al. and find MCFs anging fom 0.. o 3 MCF EV / R is someimes also efeed o as maginal welfae cos of axaion (Ceedy, 2000). 7

16 Juha Honkaukia 0.5 fo income axes, -0. o 0.3 fo capial income axes, and 0.27 o fo value added axes. In he AGE sudies cied above, he deeminaion of labou supply and saving is no a he cene of he analysis. This is somewha supising, because he heoeical lieaue on MCF consides he effecs on labou-leisue choice exensively. As Dahlby (2009) shows, labou makes affec he coss of axaion in seveal ways. Fis, he effecs of income axes depend on he supply and demand elasiciies fo labou. They also depend on labou/capial aios, as pa of he buden of labou axes is acually bone by capial, depending on whehe he pice of labou inpus is affeced. The lae, in un, depends on he labou make specificaion, ha is, whehe wages ae compeiive, o whehe hee ae wage igidiies. The empiical lieaue on MCF also suggess ha labou supply maes. A sudy by Kleven and Keine (2006) esimaes MCFs fom income axes fo seveal Euopean counies, finding MCFs anging fom 0 o 0.32 fo a popoional incease in income axes, when hey conside labou supply elasiciies fo he inensive magin (ha is, fo hous woked). Tax efoms have been also sudied economeically in seveal ohe Euopean counies, bu o ou knowledge, he concep has no been inoduced in ecen Euopean AGE applicaions. Ou sudy fo Finland is simila in spii o he Souh Afica and Agenina sudies in he sense ha i uses an AGE model fo evaluaing he coss of diffeen ax egimes. Howeve, he calculaion of he maginal cos of funds wih a dynamic, applied geneal equilibium models is sill no common, while he use of saic, applied GE models fo MCF calculaions was saed aleady a long ime ago (Ballad e al,985). Moe impoanly, whee we diffe fom he ealie sudies is ha we inoduce endogenous labou/leisue choice and endogenous saving decisions, allowing us o conside effecs ha ae excluded fom he ealie analyses by he model fomulaion, and binging ou model close o he heoeical lieaue on MCF..3 An ouline of VATTAGE VATTAGE is a dynamic, applied geneal equilibium (AGE) model of he Finnish economy. I can be used o sudy he effecs of a wide ange of economic policies. The VATTAGE daabase conains deailed infomaion on commodiy and income axes as well as on he public secos and hus coves mos policy insumens available o he govenmen. VATTAGE is based on he MONASH-model developed a he Cene of Policy Sudies in Monash Univesiy. MONASH-ype models ae used in counies anging fom China and Souh Afica o he Unied Saes (Dixon and Rimme, 8

17 The maginal cos of funds in Finland an AGE evaluaion 2002) In Euope, models based on MONASH have been developed fo Denmak, Finland, and he Nehelands. In VATTAGE, hee ae hee ypes of ine-empoal links connecing he consecuive peiods in he model: () accumulaion of fixed capial; (2) accumulaion of financial claims; and (3) lagged adjusmen mechanisms, noably in he labou makes. Diffeen fiscal ules fo he balancing of he public seco budges can also be specified. The VATTAGE daabase collecs infomaion on he sucue of he Finnish economy deived fom he naional accouns, aanged in a pesenaion eflecing he heoeical sucue of he model. The daabase also conains he behavioal paamees ha ae used o opeaionalise he behavioal assumpions made in he model. Naional accouns collec daa on he use goods and sevices by indusy and by poduc, bu i also conains accouns fo poducion as well as financial posiions by insiuional seco. (Euosa 997,.) The insiuional secos ae viewed as independen decision-makes (Saisics Finland 2000,.), and i is he behaviou of hese decision-makes ha he model paamees and coefficiens deived fom he daa descibe and conol. A lage pa of he daabase consiss of inpu-oupu daa ha capues he sucue of demand fo inemediae goods and pimay facos by indusies, he final good consumpion by consumes, he public seco, and he es of he wold. Howeve, inpu-oupu daa does no conain daa on income flows, which mus be obained fom ohe souces in naional accouns. Fuhemoe, he daa base also pesens he ansacions in he economy aking place beween he insiuional secos of he economy. In he daabase, ansacions ake place boh beween domesic secos, and beween domesic and foeign secos. The domesic secos ae divided ino hee domesic subcaegoies wheeas he foeign secos epesen foeign counies and mulinaional and inenaional oganizaions. These insiuional secos ae muually exclusive and hei ole in he economy can hus be unequivocally pesened. Fo example, expo demand is final demand fo domesic goods and sevices by he foeign secos. 9

18 Juha Honkaukia Figue The sucue of VATTAGE Theoy Consume Uiliy maximisaion Behavioual ules Consumpion demand Labou supply Saving Real and Financial flows Consumpion Hous woked Faco income Consumpion expendiue Tax oulays Income ansfes Invesmen Fims Pofi maximisaion Supply of goods Demand fo labou Demand fo capial Demand fo maeial inpus Invesmen Poducion Pimay faco use Sales evenue Paymens o pimay facos Taxes and subsidies Invesmen Public seco Policy objecives Demand fo labou Demand fo capial Demand fo maeial inpus Taxaion Re-disibuion Public sevices Pimay faco use Sales evenue Paymens o pimay facos Taxes Income ansfes Res of he wold Exogenous Expo demand Impo supply Wold make pices Impo expendiue Expo evenue Financial flows 0

19 The maginal cos of funds in Finland an AGE evaluaion VATTAGE models poducion wih convenional, nesed poducion funcions. The idea behind indusial classificaion is o goup aciviies whose poducion pocesses o he poducs hey make ae simila. Howeve, VATTAGE also allows fo muli-poducion of commodiies. The VATTAGE daabase uses he naional indusial classificaion TOL 2002, basing on NACE 2002 and ISIC Rev. 3., o classify indusies, and he CPA-classificaion o goup poducs. The deailed daa on commodiies allows us o sudy he poducion of goods almos a a pocess level. In VATTAGE, households ae assumed o be he ecipiens of faco incomes. They also possess asses and liabiliies aboad and domesically, which implies ha a pa of domesic incomes will be channeled aboad. To sudy MCF, we have exended he basic VATTAGE model by allowing households o make endogenous choices beween leisue (o equivalenly labou-supply), consumpion of commodiies and savings. To do his we have adoped he simples appoach, eaing leisue and saving (defeed consumpion) as wo moe commodiies in household choice. The household s poblem has been amended o allow fo he eamen of full income, ha is, income inclusive of he value of leisue. VATTAGE allows fo diffeen eamens of he labou makes. The labou make equaions elae populaion and populaion of woking age, and define unemploymen aes in ems of demand and supply of labou. In dynamic simulaions, labou supply is ypically aken as exogenous, while wages adjus only gadually and unemploymen is deemined endogenously..4 A Back-of-he-envelope model fo undesanding VATTAGE esuls fo he maginal cos of funds.4. Poducion We assume ha he Back-of-he-envelope (heeafe BOTE) economy poduces one good wih a poducion funcion given by Y F K,N,M. () whee Y is oupu; and K, N and M ae inpus of capial, labou and impos. In he BOTE model we assume ha all impos ae used as inemediae inpus. This is a convenien assumpion and no limiing. Unde cos-minimizing assumpions, K, N and M saisfy

20 Juha Honkaukia P *F Y K Q P *F P P Y N W P Y*FM P M*TM. (2). (3). (4) whee F K, F N and F M ae he maginal poducs of capial, labou and impos (deivaives of F); P Y is he pice of a uni of oupu; P Q is he pe-ax enal pe uni of capial ; P M is he c.i.f. pice of a uni of impos; and T M is he powe of he aiff on impos (one plus he ae). Apa fom he aiff on impos, we assume ha hee ae no indiec axes on inpus o poducion. This is ealisic fo Finland. Toally diffeeniaing () and subsiuing fom (2) o (4) gives: P P P *T P P P Q W M M dy *dk *dn *dm Y Y Y (5) whee dy, dk, dn and dm ae he policy-induced deviaions in oupu, capial, employmen and impos..4.2 Household behaviou in he Back-of-he-envelope model We assume ha in each yea he household seco chooses is quaniies of consumpion (C), leisue (L) and eseved consumpion (R) o maximize a uiliy funcion. By eseved consumpion we mean he numbe of unis of consumpion ha he household seco expecs o be able o finance in he fuue hough his yea s saving. In VATTAGE he uiliy funcion is addiive (Sone-Geay). Reflecing his, fo he BOTE model we assume ha households maximize: U (C) U (L) U (R) C L R (6) subjec o P W P C*CP R *R Z *N TW (7) and 2

21 The maginal cos of funds in Finland an AGE evaluaion L H B N (8) whee H is oal hous available fo wok; B is hous in involunay unemploymen; N is hous of employmen; P W is he pe-ax wage ae; T W is he powe of he ax on labou income; Z is household non-labou income; P R is he pice of a uni of eseved consumpion (o be discussed in subsecion.2.6); P C is he pice of a uni of consumpion. In (8), we assume ha involunay unemploymen is no leisue and consequenly gives no uiliy. The pice of consumpion is given by PC P Y*TC (9) whee T C is he powe of he ax on consumpion. The fis ode condiions fom poblem (6) o (9) ae: U (C) *P *T / C Y C U (L) *P /T / L W W U (R) *P / R R (0) () (2) whee he supescip pime denoes deivaive; and is he Lagangian muliplie which can be inepeed as he incease in uiliy ha he household would deive fom an exa dolla of income (a uni incease in Z). In specifying he demand funcions aising fom (0) (), we assume ha he elevan pice fo leisue is he nominal afe ax wage ae. Fo saving, he choice of a pice level is moe complicaed and is eaed in secion (6). To implemen he new fomulaion, we use demand elasiciies wih espec o full income fo leisue of 0.3 which implies a labou-supply elasiciy of oughly 0. on he aveage - and of 0.5 fo savings. 3

22 Juha Honkaukia As is appaen fom he demand equaions, consumpion of commodiies, leisue and saving ae now ineelaed, wheeas in he old model fomulaion, labou make specificaion dives he eacion of employmen o axes, and saving is affeced by axaion only o he exen household disposable income changes. I is no a pioi clea how lage an effec hese diffeences will make and hus he expeimens below also illusae he diffeences in model specificaions. The diffeences beween he new and old model fomulaion can be summaized by compaing he effecs of changes in income and pices on demands in he old and new expendiue funcions. Fom Table, i can be seen ha he new fomulaion inoduces seveal new channels fo axes o have an effec. In he able, he negaive coss-pice effec calls fo a commen. The effec is appaen fom equaion (4), whence i can be seen o eflec he effec of subsisence demands fo commodiies, leisue, and saving on he demand fo ohe goods. Is magniude depends on he consumpion shaes of he ohe goods as well as he levels of subsisence demands. Table The expeced effecs of income and pices on demands Model Demands fo Disposable CPI RW PCAP income OLD Consumpion + NEW Consumpion + Leisue + Saving Economic welfae in he Back-of-he-envelope model We assume ha households in yea deive welfae fom hei consumpion and leisue, bu no fom hei eseved consumpion which will give hem welfae in some fuue yea. Unde his assumpion, welfae (W) in any yea is given by W U (C) U (L) C L (3) and he deviaion in welfae in he yea caused by implemenaion of a policy is calculaed as / / d W U *dcu *dl (4) C L whee dc and dl ae he policy-induced deviaions in consumpion and leisue. Subsiuing fom (0) and () ino (4) gives 4

23 The maginal cos of funds in Finland an AGE evaluaion P P*dC C T W W *dl (5) whee dw. (6) is he moneay gif ha would geneae he same change in household welfae as ha geneaed by he policy..4.4 Naional accouns ideniy and conibuion of accumulaed savings in he Back-of-he-envelope model We define naional savings (S) by PM SY *MCGV P Y (7) whee G is public consumpion; and V is ne paymens of inees and dividends o foeignes. Equaion (7) is expessed in eal ems. To undesand i we can hink of oupu Y as a numbe of bags of whea. Similaly, C, G and V ae numbes of bags of whea ha ae: consumed by households; consumed by he govenmen; and paid o foeign asse holdes. (P M /P Y )*M is he numbe of bags of whea owed o foeignes as paymen fo impos. S is hen he incease in he naion s asses (i.e. saving) calculaed in bags of whea. In deviaion fom (7) can be wien as P P PY PY M M ds dy d *M *dm dc dg dv. (8) Then using (5) in (8) yields, afe eaangemen P P P P W M M Q ds *dn * TM *dm d *M dc dg *dk dv PY PY PY PY (9) The las em in (9) is he conibuion o naional income in yea of he policyinduced change in capial less he policy-induced incease in ne dividends and inees paymens o foeignes. If he policy is implemened in yea hen his conibuion in yea aises fom he accumulaion (da) of policy-induced inceases in savings beween yeas and -. Unde he simplifying assumpion ha invesmens, whehe physical o financial, ean a consan exogenously given ae of eun of, we can wie he las em in (9) as 5

24 Juha Honkaukia P Q *dk dv *da P Y (20) whee da fo yea is given by da ds, (2) o alenaively da da ds fo =, 2,, (22) and da ds 0. (23) The effecs of policies on welfae: an inepeable back of he envelope equaion Reaanging (9) and inseing (20) gives PW P M P M dc *dn * TM *dmd *MdG *dads PY PY PY (24) Fom (8), wih dh = 0, we obain dl db dn. (25) Now subsiuing fom (24), (25) and (9) ino (5) gives M C M W 0.0* * T W*TC * n employmen/leisue effec TW M C M Y W 0.0* *b involunay unemploymen effec Y P *N 0.0* P * M *T * T * m impo effec 0.0* P * M *T * p p ems-of-ade effec P *B TW P *T * *da ds ine-empoal ade-off effec C 0.0*P *T *G *g govenmen consumpion effec Y C (26) 6

25 The maginal cos of funds in Finland an AGE evaluaion whee n, m, p M, p Y, b and g ae policy-induced pecenage deviaions in he vaiables denoed by he coesponding uppe-case symbols. Equaion (26) is a BOTE decomposiion of he effec on welfae in yea of policy changes implemened in yeas o. Employmen leisue effec The fis em on he igh hand side of (26) shows he welfae effec of policyinduced changes in employmen. To undesand his em we should hink of unemploymen, B, and oal hous, H, as fixed: he effecs on welfae of movemens in B ae calculaed in he fouh em on he igh hand side of (26) and, in he deivaion of (26), H was explicily held consan (ha is no affeced by he policy). Wih B and H fixed, inceases in employmen, N, ae a he cos of leisue, L. Howeve, because of ax effecs an exa hou of wok geneaes moe welfae han an exa hou of leisue. Specifically, an hou of wok geneaes P W /P Y exa unis of oupu, see (3). The value o households of his exa oupu is P C *P W /P Y, ha is T C *P W. The value of an exa hou of leisue o households is P W /T W. Thus he ne effec on welfae of an exa hou of labou wih a coesponding loss of one hou of leisue is T C *P W - P W /T W. Fom hee we can quickly aive a he employmen/leisue effec given in (26). Impo effec The second em on he igh hand side of (26) shows he welfae effec of policy-induced changes in impos. To undesand his em we should sa by hinking of K and N as consan: he effecs of movemens in hese vaiables ae accouned fo in he fis and fifh ems. Wih K and N consan, an exa uni of impos geneaes an incease in oupu of P M *T M /P Y unis, see (4). Bu no all of his incease in oupu can be consumed. We should hink of S, G, V and P M /P Y as being consan, wih he effecs of hei movemens accouned fo in ohe ems. Wih hese vaiables consan, (8) implies ha a uni incease in impos mus be financed by a paymen o foeignes of P M /P Y unis of oupu. Thus, a uni incease in impos allows an incease in consumpion of P M *T M /P Y - P M /P Y unis. To find he value of his o consumes we muliply hough by P C. This leads o he second em on he igh hand side of (26). Tems-of-ade effec If he ems of ade deceases by pe cen, ha is if he c.i.f. pice of impos inceases by pe cen elaive o he pice of domesic oupu (p M p Y = ), hen foeignes will need o eceive pe cen moe unis of domesic oupu o pay hem fo any given level of impos. Wih S, K, N and M held consan, his means ha paymens o foeignes mus incease by 0.0*P M *M/P Y unis of 7

26 Juha Honkaukia oupu, wih a coesponding educion in consumpion. The value of his educion in consumpion can be found by muliplying hough by P C, leading o he hid em on he igh hand side of (26). Involunay unemploymen effec Wih H and N held consan an incease of one hou in involunay unemploymen geneaes a educion in leisue of one hou. The value of an hou s leisue o households is P W /T W. Thus, he effec on welfae of a b pe cen incease in unemploymen is given by he fouh em on he igh hand side of (26). Ine-empoal ade-off effec The policy-induced deviaion in accumulaed saving up o yea allows consumpion o incease by *da unis of oupu in yea wheeas exa saving in yea equies a educion in consumpion of ds unis in yea. On anslaing hese wo effecs (one posiive and one negaive) ino moneay unis by muliplying hough by P C, we obain he ine-empoal ade-off effec which is he fifh em on he igh hand side of (26). In a simulaion in which hee is a susained policy-induced incease in saving, he ine-empoal ade-off effec is negaive in ealy yeas bu posiive in lae yeas. Govenmen consumpion effec In deiving (26) we assumed ha govenmen expendiue does no geneae welfae. Unde his assumpion an incease in govenmen expendiue of one uni, wih a coesponding educion in consumpion of one uni, geneaes a welfae loss wih a moneay value of P C. This leads o he las em on he igh hand side of (26). I would be a elaively simple mae o modify VATTAGE and he BOTE model o allow public consumpion o be welfae geneaing..4.6 The pice P R of eseved consumpion When households in yea save a uni of oupu woh PY dollas, we assume ha hey expec his o be ansfomed ino a uni of capial. [Fo simpliciy we assume ha a uni of capial is ceaed fom one uni of oupu.] They expec he uni of capial o geneae exa unis of oupu in he fuue in line wih he cuen maginal poduc of capial (PQ/PY). They ake ino accoun he powe of he ax on capial income (TK) and ecognize ha hei enilemen o he exa oupu is limied o PQ/(PY*TK). They assume ha he exa oupu ha hey ae eniled o is anslaed ino exa unis of consumpion (an incease in eseved 8

27 The maginal cos of funds in Finland an AGE evaluaion consumpion R) by muliplying by he aio of oupu pices o consumpion pices (PY/PC). Puing all of his ogehe, we have P P Q Y P Y * P Y*TK PC, (27) ha is, saving of PY in yea yields a quaniy of eseved consumpion ha is popoional o he expession on he igh hand side of (27). Whee he faco of popoionaliy is, (27) gives us he pice of a uni of eseved consumpion as P P * Y R P Q / P Y*T K* /TC, (28) ha is, P Y*T C*T K P R * P Q /PY, (29) The ole of PR in VATTAGE is clea fom secion.4.2. If PR inceases elaive o he pices of consumpion (PC) and leisue (PW/TW), hen he household seco allocaes moe of is full income o consumpion and leisue and less o eseved consumpion, ha is less o saving. Thus, unde (29) saving is inhibied by inceases in axes on capial income and simulaed by inceases in he maginal poduc of capial (PQ/PY). An incease in axes on consumpion (TC) geneaes an incease in PR bu i also geneaes an incease in PC. Thus i is no clea a pioi how an incease in consumpion axes affecs he savings/consumpion aio. Howeve, i is clea ha an incease in consumpion axes will incease leisue elaive o boh savings and consumpion..4.7 A Back-of-he-envelope model fo he effecs of axes on he macoeconomy In a dynamic seing, i is no immediaely obvious wha is mean wih a balanced budge. Fixing a defici will affec he accumulaion of deb by he govenmen; bu assuming lump-sum edisibuion of evenue involves moe of a edisibuive ax change analysis han an evaluaion of he coss of specific axes. Hee, we assume ha he exa evenue is spen exhausively by he govenmen. To keep he hee ax scenaios as compaable as possible, we assume he evenue is used o cu he govenmen defici, o, o incease govenmen saving. This implies ha he evenue in he fis hand is used o paying back govenmen deb. Howeve, since any of he axes will affec he abiliy of ohe axes o aise evenue, we do no specify he age in ems of he defici iself, since his migh imply ha eal govenmen spending diffes 9

28 Juha Honkaukia beween he hee scenaios. Fuhemoe, if he aim of he policy is o incease naional saving, hee is a eal possibiliy of govenmen saving cowding ou pivae saving, esuling, again, in diffeences beween he scenaios. We aemp o solve his poblem by specifying he evenue age in ems of naional saving. This implies he same naional saving in each of he scenaios, bu govenmen deficis may vay beween he scenaios. The expeimens consideed in his secion involve he collecion of evenue by aising eihe wage income axes, capial income axes, o all commodiy axes paid by he consume. Fo illusaive puposes, we assume an exa billion euos as he evenue age, o be implemened 200. The ax bases fo he hee axes ae unequal, wih wage income axes esimaed o aise abou 4.3 billion in ou baseline fo 2009, capial axes abou 2.9 billion, and commodiy axes abou 23.4 billion euos. The choice of magniude fo he expeimen will affec he esuls, since MCF depends on he scale of he change. This can easily be seen wih he help of ou BOTE model fo poducion and he consume s choice. Absacing fom inemediae inpus, he value maginal poduc of labou can be expessed as Pg K W *A*f, (30) T L g whee W is he nominal befoe-ax wage ae; P g is he pice deflao fo GDP; T g is he powe of he indiec ax ae applying o poducion in Finland (can also include axes in inpus, bu in his sylized model we will ignoe non-pimay-faco inpus); and A*fK L is he maginal poduc of labou deived fom he consaneuns-o-scale poducion funcion, Y= A*F(K,L). Thus W Pg K *A*f * P T L P c g c, (3) whee W is he nominal pe-ax wage ae; T w is he powe of he ax on labou income; and P c is he pice deflao fo consumpion. Consume pices ae linked o he pice of GDP by Pc P g*tc, whee Tc is he powe of consumpion axes (+ad valoem equivalen ae). 20

29 The maginal cos of funds in Finland an AGE evaluaion Wih a CES poducion funcion, he pecenage change in f(k/l), when K is held consan, is given by: S k % f l, (32) whee l is he pecenage change in employmen, S k is he capial shae in euns o pimay facos and is he elasiciy of subsiuion beween capial and labou. The consume s uiliy maximizaion poblem implies ha labou supply is linked o he demand fo leisue, wih he pice of leisue being given by he afe-ax eal wage, and of full income, which in un is also affeced by eal wages. Thus we have a link beween labou supply and eal wages, which is of he fom l *(w pc w), (33) whee is he elasiciy of labou supply wih espec o afe-ax eal wages, and w, p,and c w ae he pecenage changes in he nominal wage level, consume pices and he powe of wage axes, especively. The elasiciy depends on he shae of labou income, as well as he elasiciy of subsiuion beween leisue and ohe consumpion. We calibae he lae o imply a supply elasiciy of 0., following he esimaes fo seveal EU counies obained in Kleven e al. (2006). Since we assume only one good, we have Subsiuing (33) and (32) in (3), we have, fo pe-ax eal wages, wp C * ac * c g c 2 w, (34) whee C, (35) S k * and S k * C2, (36) and whee is he elasiciy of subsiuion beween capial and labou in () and c he pecenage change in he powe of consumpion axes. Unde ou specificaion, wih a capial shae fom value added a aound 0.35, he value of is eoughly -.84, wheeas C is oughly 0.8. C 2 Fom (34) i is clea ha he base fo diffeen axes is elevan fo he behavio of labou supply and hus fo he economy as a whole. If he ax base is lage as in he case of, he elaive effec on eal wages will be smalle. g 2

30 Juha Honkaukia Finally, he poducion funcion in he BOTE model can be used o ge a ough esimae of he effecs of he axes on GDP. The change in GDP is given by y S ls k+a. (37) k k and he demand fo labou is implied by he poducion funcion, being given by l * wp S L. (38) Once he behavio of eal wages is clea fom (34), we can ge employmen effecs fom (38), which, ecognizing ha capial sock is fixed in he sho un, implies he effecs on GDP. We can now sudy he effecs of ou hee expeimens wih he help of he BOTEs fo poducion and welfae..5 The effecs of inceases labou, capial, and consumpion axes We compae he coss of aising labou income, capial income, o consumpion axes in ems of hei effecs on welfae. We assume ha he evenue age is a billion euos, o be achieved ove fou yeas. This could be modelled as a age on govenmen defici as a fall of 250 million Euos a yea..5. The macoeconomic effecs of labou, capial, and consumpion axes Table 2 below gives ou BOTE calculaions fo he effecs of labou axes on eal wages, employmen, and GDP. Fom he able, i can be seen ha he collecion of 250 million in eal evenue via inceased axes on labou income imply a 0,54 pe cen incease in he powe of labou axes. The powe of axes ove GDP is also affeced, since g will capue he incease in labou axes elaive o value added. The powe of consumpion axes is affeced fo composiional easons: he decease in eal wages implied by boh he BOTE and he simulaion esuls will feed ino he elaive pices of consumpion goods, changing he composiion of he consumpion baske slighly, and hus affecing he evenue fom consumpion axes, fom which we calculae he oveall powe of consumpion axes. The BOTE oveesimaes he magniude of eal wage changes compaed o he acual simulaion unde he paamee values used hee. The BOTE also ovelooks he effec of changes in inemediae and poduc axes on GDP, which in Finland is faily high. In he acual simulaion, a fall in indiec ax evenues is 22

31 The maginal cos of funds in Finland an AGE evaluaion maked and conibues o he oveall fall in GDP, as can be seen fom Figue 2. Accodingly, he BOTE oveesimaes he effec on employmen of eal wages compaed o he full simulaion. The eason fo he posiive conibuion of echnology in he simulaion esuls is only appaen when we conside he sucual effecs of axes falling on he consume. They end o favou expo indusies, whee he poduciviy of labou is highe han in he domesic-make indusies, paly because he fall in eal wages inceases compeiiveness by loweing he ems of ade, paly because he fall in domesic consumpion diecly fees up esouces fo he expo indusies. The lae effec is eviden also wih he ohe axes, bu i is mos maked unde labou axes. This effec is appaen fom Figue 3 which depics changes in he expendiue side GDP, showing expos o benefi bu consumpion o fall. The ems of ade effec is lagely behind a fall in impos, which shows up as a posiive conibuion o GDP. Table 2 The effecs of axes on labou income Tg Tl Tc Technological change Pe ax eal wage (BOTE) Pe ax eal wage (SIM) Pos ax eal wage (SIM) Employmen (BOTE) Employmen (SIM) Real GDP (BOTE) Real GDP (SIM)

32 Juha Honkaukia Figue 2 Conibuions o income-side GDP unde labou axes Figue 3 Conibuions o expendiue-side GDP unde labou axes Cumulaive pecenage diffeence fom baseline 0,5 0 0,5,5 Consumpion Invesmen Govenmen Socks Expos Impos Real GDP 2 24

33 The maginal cos of funds in Finland an AGE evaluaion Table 3 shows ou BOTE fo capial axes. The incease in capial axes is capued by g bu again, also consumpion axes ae affeced fo he composiional easons menioned ealie. Compaed o labou axes, he incease in boh of hese powes is smalle, bu since hee is no compensaing change in labou axes, he effec on eal wages is acually lage han wih labou axes. Thus hee is an incease in labou demand, and again, he expo indusies benefi compaed o he labou ax case. Howeve, he ise in capial axes will end o aise he pe-ax ae of eun on invesmen, which has a negaive impac on invesmen. This can be seen as a negaive conibuion of invesmen o expendiue-side GDP in he sho un in Figue 5, and in he long un as a fall in he conibuion of pimay facos o GDP in Figue 4. Table 3 The effec of axes on capial income Tg Tl Tc Technological change Pe ax eal wage (BOTE) Pe ax eal wage (SIM) Pos ax eal wage (SIM) Employmen (BOTE) Employmen (SIM) Real GDP (BOTE) Real GDP (SIM)

34 Juha Honkaukia Figue 4 Conibuions o income-side GDP unde capial axes 0,2 Cumulaive pecenage diffeence fom baseline 0,5 0, 0,05 0 0,05 0, 0,5 0,2 0,25 Technology Ohe coss Pimay facos Indiec axes Real GDP 0,3 Figue 5 Conibuions o expendiue-side GDP unde capial axes 26

35 The maginal cos of funds in Finland an AGE evaluaion The esuls fo he consumpion ax expeimen ae shown in Table 4. The ise in powe of consumpion axes is pe cen, bu i leads o a fall in consumpion which in un shows up as a fall in he powe of axes on GDP. The BOTE implies a 028 pe cen fall in eal wages, which is highes of all he hee axes consideed hee. Again, he simple BOTE oveesimaes he effec on posiive effec on labou demand and on GDP, bu in he acual simulaion, he fall in indiec ax evenue is accouning fo mos of he fall in GDP fo he fis yeas of he simulaion, as can be seen fom Figue 6. Once he axes cease o ise, afe 204, eal wages no longe fall, and in he longe un he demand fo labou ceases o gow. Even unde consumpion axes labou is dieced o he expoing secos. Invesmen in hese secos gows, bu his is offse by he decease in invesmen in sevice secos, which is why he conibuion of pimay facos o GDP is ulimaely negaive. Table 4 The effec of axes on consumpion Tg Tl Tc Technological change Pe ax eal wage (BOTE) Pe ax eal wage (SIM) Pos ax eal wage (SIM) Employmen (BOTE) Employmen (SIM) Real GDP (BOTE) Real GDP (SIM)

36 Juha Honkaukia Figue 6 Conibuions o income-side GDP unde consumpion axes Figue 7 Conibuions o expendiue-side GDP unde consumpion axes Cumulaive pecenage diffeence fom baseline 0,5 0 0,5,5 2 Consumpion Invesmen Govenmen Socks Expos Impos Real GDP 28

37 The maginal cos of funds in Finland an AGE evaluaion.5.2 The welfae and efficiency effecs of labou, capial, and consumpion axes We now un o he welfae effecs of he hee axes. Figues 8, 9 and 0 show he decomposiion of he welfae effecs in he componens deived in secion.4.5 above. I is appaen ha, unde he assumpion of pefecly compeiive labou makes, he unemploymen effec is no conibuing o he oveall esuls. Similaly, since we have fixed govenmen spending, hee is no conibuion fom govenmen consumpion eihe. The impo effec also plays a mino ole hee. Thus he esuls ae dominaed by he ineempoal and ems of ade effecs bu he diffeences beween he axes ae lagely due o he leisue effec, as can be seen fom Table 5 below, which concenaes on he esuls fo a single yea, namely, 204. The employmen-leisue effec is diven by wha happens o employmen (n). In he absence of involunay unemploymen (assumed in hese simulaions), n is deemined by he choice of leisue. Wih he consumpion ax, households choose less leisue han wih he labou ax. Coespondingly hey choose moe wok (a highe value fo n) wih a consumpion ax han wih a labou ax. This gives a highe value fo he employmen-leisue effec unde he consumpion ax. The key o undesanding his esul is o ecognise ha wih no involunay unemploymen, and exogenous naional savings, he majo welfae poblem of axes is ha hey educe he pice of leisue elaive o he pice of consumpion and saving. This encouages leisue and discouages wok, bu because of ax effecs an, exa hou of wok geneaes moe welfae han an exa hou of leisue. The eason ha he employmen-leisue effec is less posiive 4 fo labou axes han fo consumpion axes is ha he educion in he elaive pice of leisue is geae fo labou axes han fo consumpion axes, wheeas unde capial axes, he fall in he elaive pice of leisue is he lowes of all. Table 5 Welfae decomposiion fo 204 Labou axes Consumpion axes Capial axes Gov. consumpion effec Impo effec Ineempoal effec Leisue effec Tems of ade effec Unemploymen effec Toal effec Wih eihe ax he employmen/leisue effec is posiive. This eflecs posiive income elasiciies of demand. Wih eihe ax in place, households cu back on cuen consumpion, defeed consumpion and leisue. A educion in leisue means ha hey choose moe employmen. 29

38 Juha Honkaukia Figue 8 Welfae decomposiion fo he effecs of labou axes Deviaion fom baseline 0,20 0,00 0,20 0,40 0,60 0,80,00,20,40, EV 0,00 0,32 0,58 0,87,3,5,2,22,27,28,32,34,38,39,43 Gov. consumpion effec 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 Impo effec 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 Ineempoal effec 0,00 0,24 0,47 0,69 0,90 0,93 0,94 0,95 0,96 0,97 0,98,00,0,02,04 Leisue effec 0,00 0,00 0,0 0,0 0,02 0,02 0,0 0,02 0,0 0,02 0,0 0,02 0,02 0,02 0,02 Tems of ade effec 0,00 0,0 0,3 0,20 0,25 0,23 0,27 0,26 0,29 0,28 0,3 0,3 0,34 0,34 0,37 Unemploymen effec 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 Toal conibuions 0,00 0,33 0,6 0,90,7,8,22,22,26,27,3,32,37,38, Figue 9 Welfae decomposiion fo he effecs of capial axes Deviaion fom baseline 0,20 0,00 0,20 0,40 0,60 0,80,00,20,40, EV 0,00 0,37 0,64 0,95,25,2,25,29,28,33,30,35,32,37,34 Gov. consumpion effec 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 Impo effec 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 Ineempoal effec 0,00 0,24 0,47 0,69 0,90 0,89 0,9 0,90 0,9 0,9 0,9 0,92 0,92 0,93 0,93 Leisue effec 0,00 0,02 0,03 0,05 0,06 0,06 0,06 0,06 0,06 0,06 0,06 0,06 0,06 0,06 0,05 Tems of ade effec 0,00 0, 0,5 0,2 0,26 0,22 0,23 0,26 0,24 0,28 0,26 0,30 0,28 0,32 0,30 Unemploymen effec 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 Toal conibuions 0,00 0,33 0,58 0,85,,05,08,0,09,3,2,6,5,9,

39 The maginal cos of funds in Finland an AGE evaluaion Figue 0 Welfae decomposiion fo he effecs of consumpion axes Deviaion fom baseline 0,20 0,00 0,20 0,40 0,60 0,80,00,20,40, EV 0,00 0,29 0,54 0,8,05,07,2,3,7,8,22,23,26,28,3 Gov. consumpion effec 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 Impo effec 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 Ineempoal effec 0,00 0,24 0,47 0,69 0,90 0,92 0,93 0,93 0,94 0,95 0,96 0,97 0,98 0,99,00 Leisue effec 0,00 0,0 0,0 0,02 0,03 0,03 0,03 0,03 0,03 0,03 0,03 0,03 0,03 0,03 0,03 Tems of ade effec 0,00 0,08 0,3 0,20 0,25 0,25 0,28 0,27 0,29 0,29 0,32 0,32 0,34 0,34 0,37 Unemploymen effec 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 Toal conibuions 0,00 0,3 0,58 0,86,3,4,8,7,2,2,25,26,29,3, We nex un o he effecs on govenmen evenues. Ou expeimen has assumed a fixed age fo naional saving, keeping eal govenmen demand consan. Howeve, since a lage pa of govenmen ansfe expendiues ae indexed, he implicaions fo govenmen evenues and govenmen deficis can be expeced o diffe beween he expeimens, since we have shown ha pices will behave diffeenly unde he hee axes. This can be seen in Figues and 2, which show changes in ne ax evenues and he level changes in govenmen deficis, compaed o he equivalen vaiaions in consume welfae. Fom he figues, i is clea ha he labou ax will aise moe evenue han he ohe wo axes unde he naional saving age, bu i will also have he lages absolue welfae effecs. I would appea difficul o compae he elaive meis of he axes wihou aking ino accoun he elaive gain in evenue in popoion o he loss of welfae. Bu hen, his is pecisely wha ou MCF measue does. 3

40 Juha Honkaukia Figue Welfae effecs and oal ne ax evenue fo labou, capial, and consumpion axes Figue 2 Welfae effecs and govenmen defici fo labou, capial, and consumpion axes 32

41 The maginal cos of funds in Finland an AGE evaluaion Figue 3 shows he maginal cos of funds fo he hee axes. The labou ax and capial ax have a highe efficiency cos han consumpion axes. We esimae ha he MCF fom labou axes is aound.5-.6, he MCF fo capial axes almos as high, and he MCF fom consumpion axes aound These esimaes fall in he ange of findings fom ohe counies. Obviously, a numbe of assumpions affec ou esimaes. We shall discuss he mos impoan of hem in he concluding secion. Figue 3 Maginal cos of funds fo labou, capial, and consumpion axes.6 Concluding emaks In his sudy, we have exended he VATTAGE model o include labou/leisue and savings/consumpion choice. We have done his o faciliae he applicaion of he model in he esimaion of he maginal cos of aising funds fom labou, capial and consumpion axes. We have used back-of-he-envelope model fo explaining esuls fom a full-scale dynamic AGE model on he welfae effecs of he imposiion of he axes. Back-of-he-envelope equaions ae necessay fo figuing ou how an AGE model woks and wha has been aken ino accoun in any se of esuls and wha has been lef ou. 33

42 Juha Honkaukia We find ha, unde pefecly compeiive labou makes, welfae effecs ae dominaed by ineempoal, ems-of-ade, and leisue effecs. Accoding o ou esimaes, MCF is lage fo labou han capial and consumpion axes, which can be explained by he effecs of he axes on eal wages wih he BOTE model. This possibiliy is discussed in he heoeical lieaue on MCF as well, bu hee, we can esablish he diffeing <acual ax bases as he oo of he diffeences beween he scenaios. We find ha ineempoal effecs conibue equally much o welfae losses unde all of he axes. Tems-of-ade effecs, in conas, vay moe beween he scenaios. This may be due o he axes affecing capial fomaion diffeenly, which will evenually have an effec on elaive expo pices. We have found i challenging o exclude non-ax elaed policies fom ou ax expeimens. This difficuly is ecognized in lieaue (e.g Dahlby 2008), who discusses he effecs of elaive pices on he measues of MCF. Dahlby also emphasizes he scale-dependency of MCF. We have delibeaely chosen a policy age ha is no diecly linked o he pices of public expendiue naional saving bu since any of he axes we conside will affec he abiliy of ohe axes o aise evenue, and, moeove, he nominal level of govenmen ansfe expendiue, we expec ha he implicaions of diffeen axes fo govenmen deficis ae diffeen. Ou appoach has he advanage of excluding scale effecs. The pape shows ha i is possible o compae he efficiency coss beween ax insumens wih a dynamic AGE modeling appoach, and o isolae he key easons fo he diffeences beween he axes. This povides a poweful ool fo analyzing he effecs of axaion. 34

43 The maginal cos of funds in Finland an AGE evaluaion Refeences Ballad, Chales L. Shoven, John B. Whalley, John (985): Geneal equilibium compuaions of he maginal welfae coss of axes in he Unied Saes, Ameican economic eview, Vol. 75, No. (Ma., 985), pp Blanchad, Olivie Peoi, Robeo (2002): En empiical chaaceizaion of he dynamic effecs of changes in govenmen spending and axes on oupu, The quaely jounal of economics, Novembe 2002, p Böhinge, Chisoph Boees, Sefan Feil, Michael (2004): Taxaion and unemploymen: An applied geneal equilibium appoach, CESifo woking pape no. 272, July Chisaio, Oma O. Cicowiez, Main (200): Maginal cos of public funds and egulaoy egimes: compuable geneal equilibium evaluaion fo Agenina, Revisa de Análisis Económico, Vol. 25, No, oo.79-6, Junio 200. Cicowiez, M. Blanco, A. Chisaio, O.O. (2007): The Maginal Cos of Funds in Agenina 2003: An Analysis of he Ineacion beween he Regulaoy Regime and he Tax Sysem. Pape pesened a he egional meeing on CGE modeling, Saniago de Chile, Apil Ceedy, J. (2000): Measuing Welfae Changes and he Excess Buden of Taxaion. Bullein of Economic eseach, 52:, 2000, , Blackwell, London. Dahlby, B. (2008): The Maginal Cos of Public Funds. Theoy and applicaions. MIT Pess, Cambidge, Massachuses. Dixon, P.B. Honkaukia, J. Rimme, M. (20): The maginal coss of funds in he VATTAGE model of Finland: a back of he envelope jusificaion of he welfae effecs of addiional govenmen evenue. Go, D.S. Keaney, M. Robinson, S. Thiefelde, K. (2005): An analysis of Souh Afica s value added ax. Wold Bank Policy eseach Woking Pape 367. Honkaukia, J. (2009): VATTAGE a Dynamic, Applied Geneal Equilibium Model fo Finland. VATT Reseach Repos 50, VATT, Helsinki. Kleven, J.K. Keine, C.T. (2006): The Maginal Cos of Public Funds: Hous of Wok Vesus Labou Foce Paicipaion. CEPR Discussion Pape 5594, CEPR, London. 35

44 Juha Honkaukia 36

45 2. The dynamic effecs of a ax efom in Finland Juha Honkaukia Saaa Tamminen 2. Inoducion Seveal sudies have analyzed effecs of ax efom poposals wih Applied Geneal Equilibium (AGE) models. While mos of hese sudies have used saic models, hey all demonsae he difficuly of focusing on he effecs semming fom he ax sucue iself. This is especially he case when a efom aims a evenue neualiy o a given evenue age, since changes in axaion end o affec he coss of public spending as well. Moeove, mos sudies find ha igidiies affec he efficiency coss of axaion. Many of he sudies also show ha a ax efom may give ise o disibuional issues. In his chape, we use a dynamic AGE model of Finland o sudy a ecen ax efom poposal unde alenaive assumpions abou ohe policies. We also sudy he effecs of wage igidiies on he effeciveness of he efom. We use he VATTAGE AGE model of Finland o esimae he dynamic effecs of he poposed ax sucue changes and he maginal welfae cos of hese changes in he collecion foms of public funds. VATTAGE is well suied fo he analysis of ax sucue changes as i includes all majo ax ypes and has a deailed indusy dimension fo he Finnish economy a gea seco deail. Hee, he model is exended o cove decilespecific employmen/leisue and saving choices, based on he epesenaive household model developed in Dixon, Honkaukia, and Rimme (20). We focus on he ax efom poposal published in 200 by he Finnish Tax Commiee, consising of expes and epesenaives of inees goups. Boadly, ecognizing he esuls fom pevious eseach, which has found income and copoae axes he mos disoionay wih egad o economic gowh and employmen, and consumpion based axes and popey income axes less disoionay, in is epo (VM, 200) he commiee poposed o: ) cu income and copoae ax aes; and 2) aise he capial ax ae, value added axes and excise axes. Ou pevious wok boadly suppos he basic assumpions behind he commiee s poposal. In paicula, accoding o ou esimaes, he Maginal Cos of Funds (MCF), which compaes he welfae loss fom axaion o he evenue aised, is in Finland consideably highe fo wage and capial income axes han fo consumpion axes. 37

46 Juha Honkaukia Saaa Tamminen Hee, we use he concep of he MCF o sudy he effecs of he poposal and o demonsae, which facos may affec is success. Undelying ou inees fo measuing he efficiency of axaion and ax efoms is he well-known esul fom geneal equilibium heoy, found in e.g. Dahlby (2008) and Liu (2004), ha a govenmen should aim a a ax sucue whee he maginal cos of funds fo each ax ype is he same. The lieaue also suggess ha he ineacions beween diffeen axes, as well as he changes in he cos of public seco poducion induced by a ax efom, will have an effec on MCF. The MCF analysis of Liu (2004) akes ino accoun hese effecs by basing he esimae fo MCF on public excess evenue, ha is, goss evenue less expendiue, while keeping boh public seco inpus and oupus consan. Ou measue fo govenmen evenue is in essence simila o Liu s, and we also fix govenmen expendiue and invesmen in eal ems. Ou aim is o analyze he effecs of he ax efom on efficiency and income disibuion. While ou cenal scenaio will assume pefec compeiion and flexible wages, many pevious AGE sudies on ax efoms sugges ha igidiies in he labou make may affec he efficiency of a efom. Thus, fo example, Chisaio and Cicowiez (200) find ha he welfae cos of axaion depends on egulaoy egimes and also on wage fomaion, wih eal wage igidiy inceasing especially he maginal cos of funds fo labou axes significanly compaed o scenaios wih moe flexible eal wages. Similaly, we find ha wage igidiies can undemine he efficiency gains of he efom. Some sudies also examine capial axes. Fo example, Radulescu and Simmelmay (200), using a saic AGE model, find ha he capial ax efom of 2008 in Gemany ha inceased he capial gains ax, lead o a decease in GDP, invesmen and labou demand. Duae Lledo (2005) uses a dynamic, ovelapping geneaions AGE model o calculae he effecs of a eplacemen of copoae axes and financial ansacion axes in Bazil by a boad-based, unifom fedeal VAT. He finds ha while he efom would no decease incomes, i would have disibuional effecs. In he Finnish case, in conas, he copoae and capial ax efom would likely encouage invesmen on balance. We also find ha he efom would have disibuional effecs, he magniude of which depends on nominal igidiies in he labou makes and also on he social secuiy -elaed ansfes fom he govenmen o he households. Fuhemoe, we find ha seco effecs ae impoan no only fo he sucue of oupu bu also fo he disibuion of faco incomes beween he deciles. The sucue of his chape is as follows. The second secion gives an ouline of VATTAGE and discusses he effecs of income axes unde he new decile specificaion. Secion 2.3 pesens ou analyses of he ax efom poposal sudying maco-level effecs, disibuional effecs, effecs on diffeen indusies, and finally, analyzing he poposal fom he poin of view of efficiency and susainabiliy. Secion 2.4 concludes. 38

47 The dynamic effecs of a ax efom in Finland 2.2 The VATTAGE model 2.2. An ouline of VATTAGE VATTAGE is an applied, dynamic geneal equilibium model fo Finland ha coves he whole economy and models all majo ax ypes including labou income axes, capial axes and indiec axes of vaious foms. The VATTAGE daabase conains deailed infomaion abou commodiy and income axes as well as he expendiues and ansfes of he public seco, hus coveing mos policy insumens available o he govenmen. The model accouns fo changes in public defici and deb and can be used o evaluae he impac of he policy shocks on public seco susainabiliy. Fuhe, he govenmen cos sucue accouns fo he diffeen ypes of public ansfes o households, including e.g. age elaed benefis and unemploymen benefis, as well as public invesmens. VATTAGE is based on he MONASH-model developed a he Cene of Policy Sudies a he Monash Univesiy. MONASH-syle models ae used in counies anging fom China and Souh Afica o he Unied Saes and Ausalia (Dixon and Rimme, 2002). In Euope, models based on MONASH have been developed fo Denmak, Finland, and he Nehelands. VATTAGE is descibed in deail in Honkaukia (2009). To sudy MCF, we have exended he basic VATTAGE by allowing households o make endogenous choices beween hei leisue (o equivalenly labousupply), hei consumpion of commodiies and hei savings (Dixon e al, 20). We have adoped he simples appoach, eaing leisue and saving (eseved consumpion) as wo moe commodiies in household choice. The household s poblem has been amended o allow fo he eamen of full income, ha is, income inclusive of he value of leisue. Fomally, households i maximize he uiliy fom U ic(c i) U il(l i) U ir (R i) subjec o P W P ic *Ci P ir *Ri Z i *Ni T i W and Li Hi Bi Ni whee C is consumpion L is leisue R is eseved consumpion (i.e. saving) H is oal hous available fo wok; () (2) (3) 39

48 Juha Honkaukia Saaa Tamminen B is hous in involunay unemploymen; N is hous of employmen; P W is he pe-ax wage ae; T W is he powe of he ax on labou income; Z is household non-labou income; P R is he pice of a uni of eseved consumpion (o be discussed in subsecion 2.2.6); P C is he pice of a uni of consumpion, and whee he index i denoes decile. In (3), we assume ha involunay unemploymen is no leisue and consequenly gives no uiliy. The pice of consumpion is given by PiC P Y *TiC (4) whee T ic is he powe of he ax on consumpion (ha is, + ad valoemequivalen ae of commodiy axes), P Y is he pice of GDP. The fis ode condiions fom poblem () o (3) ae: U (C ) *P *T / ic i i Y ic U (L ) *P /T / il i i iw iw U (R ) *P / ir i i ir (5) (6) (7) whee he supescip pime denoes deivaive; and is he Lagangian muliplie which can be inepeed as he incease in uiliy ha he household would deive fom an exa dolla of income (a uni incease in Z). As is appaen fom he demand equaions, consumpion of commodiies, leisue and saving ae now ineelaed, wheeas in he oiginal fomulaion of VATTAGE, he labou make specificaion dives he eacion of employmen o axes, and saving is affeced by axaion only o he exen ha households disposable incomes change. In specifying he demand funcions aising fom (5)-(7), we assume ha he elevan pice fo leisue is he nominal afe ax wage ae, wheeas he pice of saving capues he oppouniy cos of cuen consumpion. 40

49 The dynamic effecs of a ax efom in Finland To link he consumpion and labou supply choices, we have coupled daa on decile-specific consumpion wih daa on decile-specific income. On he income side, ou daabases cove decile and occupaion-specific labou, capial and ansfe incomes. To link his daa o labou demand by he 82 VATTAGE indusies, we use indusy and occupaion specific labou daa. This enables us o link he wo daa ses, as illusaed in Figue. Figue Labou income by occupaion and decile To calibae he labou supply elasiciies implied by he uiliy maximizaion poblem in () o (3), we have used he esimaes of Kleven and Keine (2006), who find consideably highe elasiciies fo lowe income deciles han fo highe ones. On he aveage, he implied elasiciy of supply is hee aound 0., wih he elasiciy in he lowes wo income deciles neaing bu being well below 0. fo he highe-income deciles. Decile-specific consumpion daa sems fom VATT s income-disibuion model (TUJA). The paamees fo he decile-specific consumpion funcions cove 9 commodiies, and have been esimaed using he lage consumpion daa bases of he income-disibuion model. They ae epoed in Honkaukia, Kinnunen and Rauhanen (20). 4

50 Juha Honkaukia Saaa Tamminen Baseline scenaio The lieaue on MCF suggess ha welfae coss ae scale-dependen. This means ha he baseline scenaio of he economy maes fo he esuls of he analysis. VATTAGE baseline is consuced o confom o medium-em official foecass a he maco level. Howeve, a he seco level, i is based on an exensive sudy of he sucual ends of he economy, as well as a vey lage scale foesigh effo encompassing dozens of seco and egional expes. This secion gives a bief descipion of he pocedues followed in foming he baseline. The sucual ends concen changes in demand paens by commodiy and use (domesic consumpion, expos o EU and elsewhee, invesmen, and he public seco) ha sem fom a hisoical analysis of he developmen of he Finnish economy (Honkaukia and Maila 20). In he hisoical analysis, VATTAGE uses daa on he acual changes in demand, poducion, elaive pices and he ax sucue ove a peiod of he ime o decompose he obseved changes in he economy ino conibuions by sucual vaiables. Fo example, hisoical analysis allows us o show ha he lages conibuion o he 37.3 pe cen GDP gowh fom 995 o 2004 semmed fom employmen, which alone would have explained a 5.7 pe cen incease in GDP. Moe impoanly, we find ha echnological change mainly pimay faco poduciviy gowh explained 8.3 pe cen of GDP gowh, while ade and domesic pices ogehe explained moe han 0 pe cen of GDP s gowh. The hisoical analysis is conduced a commodiy and indusy level and allows us o obain ends fo he developmen of faco poduciviy and demand paens, which can be used in foecasing he baseline fo he fuue. The baseline foecas also uses maco and, o an exen, indusy level foecass fom ohe sudies. We use macoeconomic foecass fo he ealy yeas of he scenaio, and populaion and age-elaed expendiue foecass fo he whole scenaio. The main medium-em macoeconomic assumpions in ou scenaio confom o he medium em foecas of he Minisy of Finance and he EU Ageing Woking Goup. In he longe un, macoeconomic developmen is deemined by populaion ends, which affec public demand fo sevices and ohe public expendiues, as well as pivae consumpion, wheeas indusy-level developmen depends on poduciviy ends and commodiy-level expo ends. The baseline also evaluaes he developmen of public seco deb and defici, given policy measues aleady aken. The seco-specific baselines have been developed in he conex of a long em foesigh pojec, whee we have benefied fom he scuiny and commens of dozens of seco and egional expes and inees goups (Honkaukia, Ahokas and Maila, 200; Ahokas and Honkaukia, 200). 42

51 The dynamic effecs of a ax efom in Finland A Back-of-he-envelope model of he effecs of income ax cus One of he key findings of he MCF lieaue is ha labou supply esponses have a lage impac on he efficiency of he ax sysem. In his secion, we sudy he labou supply esponses in VATTAGE o changes in labou income axes and o changes in axes on ansfes, which fom a significan pa of he Tax Commiee s poposal. To see wha he esponses depend on, we use a sylized model of he full simulaion model, a back-of-he-envelope (BOTE) model, o see wha he cucial mechanisms ae and how hey can be expeced o wok in he full simulaion. The link beween labou supply decisions and poducion can be illusaed wih a simple back-of-he-envelope model of he full model. Fo simpliciy, we shall only conside value added, which, fo he whole economy, is given by Y A*F K,L. (8) VATTAGE assumes ha invesmen akes ime. Since we wan o sudy he sho-un connecions beween axes, labou supply and poducion, we can hen focus on he sho un poducion funcion (assuming a fixed capial sock), given by K Y A*F (9) L We assume ha labou is paid is value maginal poduc, which is given by Pg K W *A*f (0) Tg L whee W is he nominal befoe-ax wage ae; P g is he pice deflao fo GDP; T g is he powe of indiec axes applying o poducion in Finland, powe of a ax being defined as ( + ad valoem-equivalen ae of indiec axes); and A*fK L is he maginal poduc of labou deived fom he consaneuns-o-scale poducion funcion, Y= A*F(K,L). Thus he eal pe-ax wage level is given by W Pg K *A*f * () Pc Tg L Pc whee W is he nominal pe-ax wage ae; T w is he powe of he ax on labou income (+ ax ae on labou income); and P c is he pice deflao fo consumpion. 43

52 Juha Honkaukia Saaa Tamminen Consume pices ae linked o he pice of GDP by Pc P g *Tc, whee Tc is he powe of consumpion axes (+ad valoem equivalen ae). Wih a CES poducion funcion, he sho-un changes in he maginal poduc of capial ae given by (2) whee l is he pecenage change in employmen, S k is he capial shae in euns o pimay facos and is he elasiciy of subsiuion beween capial and labou. The consume s uiliy maximizaion poblem implies ha labou supply is linked o he demand fo leisue, wih he pice of leisue being given by he afe-ax eal wage, and of full income, which in un is also affeced by eal wages. Thus we have a link beween labou supply and eal wages, which is of he fom (3) whee is he elasiciy of demand fo labou supply wih espec o pe-ax eal wages, and whee he lowe case vaiables w, p,and c w ae he pecenage changes in he especive uppe-case vaiables fo nominal wage level, consume pices and he powe of wage axes, especively. depends on he shae of labou income, as well as he elasiciy of subsiuion beween leisue and ohe consumpion. We have calibaed he lae o imply an aveage supply elasiciy of 0., following Kleven e al. (2006). Subsiuing (3) and (2) in (), we have, fo he pecenage change of he peax eal wages, whee S k % f l l *(w p ) c wp C * ac * w c g c 2 w, (4) and C, (5) S k * C 2 S k *, (6) and whee is he elasiciy of subsiuion beween capial and labou and c he pecenage change in he powe of consumpion axes. Unde ou 44

53 The dynamic effecs of a ax efom in Finland specificaion, wih a capial shae fom value added a aound 0.35, he value of is oughly -0.84, wheeas C is oughly 0.8. C 2 Equaion (4) gives a concise BOTE fomula fo undesanding he aggegae effec of changes in axes on eal wages. We can use his fo inepeing he esuls, and also fo foming a pio fo he expeced simulaion esuls. To sudy how an income ax cu may affec labou supply, we fis simulae he effecs of a cu in axes on wage income alone. Unde ou assumpion of phasingin, he ax ae on labou income would fall by abou 2.3 pe cen on he aveage each yea beween 202 and 205. Table BOTE fo esuls of wage ax cus (deviaion) Tg Tl Tc Technological change Pe ax eal wage (BOTE) Pe ax eal wage (SIM) Pos ax eal wage (Boe) Pos ax eal wage (SIM) Labou supply (BOTE) Labou supply (SIM) Employmen (SIM) Real GDP (BOTE) Real GDP (SIM) Consumpion (SIM) Invesmen (SIM) Expos (SIM) Impos (SIM) The esuls of his simulaion fo he fis yeas of he policy ae shown in Table as deviaions fom baseline (i.e. cumulaive pe cen changes). Fom he able, i can be seen ha he policy cus he powe of labou axes by half a pe cen in 202. I also affecs he aveage powe of consumpion axes. This is due o disibuional effecs boh in consumpion paens and ove deciles: he oveall consumpion of highly axed commodiies inceases less han consumpion on he aveage. Fuhemoe, oveall consumpion acually falls fo hose deciles of whose incomes wages fom a lage pa (he lowes hee income deciles). Based 45

54 Juha Honkaukia Saaa Tamminen on equaion (4), we expec eal afe ax wages o ise, which accoding o equaion (3) should cause an incease in labou supply. As he able shows, his is wha happens in he full simulaion. Finally, based on equaion (9), we can hen also calculae he effec on GDP. The effecs on he GDP componens shown in Table can be undesood saing fom he labou supply esponse. Conside he GDP ideniy YCIGXM. (7) Recalling he sho-un poducion funcion in equaion (9), fom he fac ha moe labou is now available i follows ha GDP (Y) mus ise in he sho un (since he capial sock is fixed). Fom he incease in incomes i is also clea ha consumpion (C) ises. Boh of hese effecs conibue o an incease in invesmen (I). Howeve, since GDP inceases only a lile (value added only inceases slighly because of he small labou inpu conibuion), bu consumpion inceases elaively moe, hee mus be a educion in (X-M) (i.e. expos less impos), since we assume ha govenmen demand (G) is fixed. The mechanism behind his is a ise in he domesic pice level, which pus expos in a disadvanage and leads o a deeioaion of he ade balance. Fom Table, i is clea ha BOTE oveesimaes he labou supply incease. This is due o he fac ha he simple BOTE fomula fo labou supply does no conside he effecs on disposable income due o he effecs on he oveall pice level (which ises as he economy expands as a esul of he ax cu boosing consumpion). The BOTE also misses effecs ising fom income disibuion. The full simulaion akes ino accoun he effecs of income ax pogession, as well as he diffeences in he supply elasiciies of labou beween he deciles. In he acual simulaion, boh of hese effecs ae impoan, since he ax beaks ae smalle fo he mid- and high-income deciles, whose labou supply elasiciies have been esimaed o be lowe han aveage, han hose of he low-income deciles, whose supply elasiciies ae hough o be highe han aveage. Oveall, hese effecs accenuae he labou supply esponse; indeed, when we un he same simulaion in he single-household VATTAGE, using he aveage elasiciy of supply fo labou, he labou supply incease is smalle han unde he decile specificaion. On he ohe hand, if we un he decile model unde he assumpion of equal popoional ax cus fo each decile, he esponse is lage han unde pogession. Clealy hen, ax pogession and diffeences beween he deciles labou supply elasiciies do make a diffeence, moivaing he use of a mulihousehold model. Befoe uning o he analysis of he full efom poposal, we conside he effecs of changes in ohe axes. In he poposal, he labou income ax cu is 46

55 The dynamic effecs of a ax efom in Finland compensaed fo wih an incease in indiec axes. This is significan fom he poin of view of labou supply, since he esuling ise in he domesic pice level will have opposie effecs on eal wages han he income ax cu. Table 2 shows ou esuls fo his simulaion. The BOTE pedics only a small incease in pos ax eal wages and labou supply; in he acual simulaion, eal wages and labou supply ise even less by 205. Consequenly, hee is no sho-un boos o GDP (he sligh fall in GDP is due o a negaive conibuion of indiec ax evenues o GDP). Howeve, he falling pe-ax eal wage is making invesmen moe pofiable, o he exen ha hee is a ems-of-ade adjusmen also in his case. Table 2 BOTE fo esuls of income ax cus and consumpion ax ises (deviaion) Tg Tl Tc Technological change Pe ax eal wage (BOTE) Pe ax eal wage (SIM) Pos ax eal wage (Boe) Pos ax eal wage (SIM) Labou supply (BOTE) Labou supply (SIM) Employmen (SIM) Real GDP (BOTE) Real GDP (SIM) Consumpion (SIM) Invesmen (SIM) Expos (SIM) Impos (SIM) Finally, we conside he effecs of a cu in capial income axes in connecion wih an incease in indiec axes on inemediae inpus. The esuls fo his simulaion ae given in Table 3. We esimae ha he combined effec of he Tax Commiee s poposals fo capial and copoae axes would amoun o a one pecen decline in he aveage capial income ax ae ove he nex fou yeas. The diec effecs on invesmen ae posiive, since hey amoun o an incease in he afe-ax ae of eun on invesmen. Howeve, he esuls on invesmen also depend on he es of he economy, and cucially, on he effecs on labou supply. 47

56 Juha Honkaukia Saaa Tamminen While he cu in capial axes does no diecly ene ou BOTE fo eal wages, indiec axes do, and he effec of highe indiec axes amouns o aising he powe of indiec axes on GDP by 0.06 pe cen in 202. This causes a fall in eal wages, labou supply, and GDP. In he simulaions, consumpion is also falling because of he ise in he pice level. Table 3 BOTE fo esuls of capial ax cus and indiec ax ise (deviaion) Tg Tl Tc Technological change Pe ax eal wage (BOTE) Pe ax eal wage (SIM) Pos ax eal wage (Boe) Pos ax eal wage (SIM) Labou supply (BOTE) Labou supply (SIM) Employmen (SIM) Real GDP (BOTE) Real GDP (SIM) Consumpion (SIM) Invesmen (SIM) Expos (SIM) Impos (SIM) The effecs of he ax efom 2.3. The ax commiee s poposal fo a ax efom The Tax Commiee published is poposal a he end of 200. The commiee was asked wih developing a model fo esucuing he whole ax sysem, wih he aim of impoving he compeiiveness of he Finnish economy and inceasing he employmen ae. The commiee poposed o make ax collecion moe dependen on VAT evenue insead of income and copoae axes as peviously. This change should fi he anicipaed in he Finnish populaion sucue, as he populaion shae of pensiones is inceasing, while ha of he woking-age populaion is falling. Inceases in excise axes of vaious commodiies wih negaive exenaliies (e.g. 48

57 The dynamic effecs of a ax efom in Finland alcohol, lo of suga conaining poducs, fuels and eleciciy) wee also poposed, based on he invese elasiciy ule 5. Income and copoae axes, in conas, would be loweed in ode o encouage employmen and he esablishmen of companies. The changes wee inended o be budge neual, i.e. wihou effecs on oal ax collecion. Table 4 below pesens in deail he planned changes, which have been used also as he shocks in he modelling scenaios. We impose he poposed changes on he aes implied by he model daabase. Fo mos axes, his is saighfowad. We assume ha he efom is phased in gadually, ove he nex fou yeas saing in 202. Afe 205 all ax aes ae assumed o emain unchanged. Table 4 Poposed changes on diffeen ax aes. Souce: VM (200), Saisics Finland Tax ype Income ax Capial axes Change in ax collecion 2060 million pe yea +500 million pe yea 800 million pe yea +200 million pe yea Copoae axes Value added axes (VAT) Excise ax +000 million pe yea % change Noificaions Toal change in colleced income axes: 9,2 pe cen, which equals aveage.75 pecenage poin decease in he income ax ae. Capial ax up fom 28% o 30% Copoae ax down fom 26% o 22% All VAT aes 2 pecenage poins up Alcohol ax up by 0% Candy and ice ceam ax up by 33% (on op of he ax aise of 20) and he same ax pecenage o be applied o all swee bakings and comfiue Tax on sof dinks up by 00% Consume eleciciy and all fuel axes up by 0% Income deciles specific changes in income axes wee calculaed fom micodaa wih VATT s TUJAmico simulaion model. Modelled ogehe in he VATTAGE model These inceases in excise axes ae addiional o he enegy and suga poduc ax inceases of Based on his ule, he opimal ax ae of a commodiy should be invesely elaed o he demand elasiciy of he poduc (e.g. Dahlby, 2008). The demand elasiciies of all he poducs lised ae elaively inelasic and povide, hence, an easy age fo he collecion of addiional ax evenue. 49

58 Juha Honkaukia Saaa Tamminen Wih egad o he excise axes, he final epo of he ax commiee does no povide specific assumpions on he exac change pe excise ax. The assumpions below on he pe cen changes ae based on he income inequaliy analysis of he epo, p. 27 (VM, 200). In Finland, as in ohe Scandinavian counies, he income ax aes ae pogessive (i.e. depend on he income level) and, hence, he new, lowe income ax aes wee also defined jus as a new pogessive ax aes vaying by income (VM, 200). In VATTAGE, income ax aes can be defined only fo he 0 diffeen income deciles, no by he deailed pogession funcion. Theefoe, he changes in he income deciles specific aveage income ax aes wee fis calculaed wih household level micodaa and he TUJA mico simulaion model of VATT. Table 5 below specifies he calculaed changes in he aveage income ax ae fo all 0 household income deciles. The shocks in he fis scenaio follow sicly hese new ax aes calculaed by he TUJA model. The pe cen changes inseed o he model as shocks ae pesened in he fouh column. Table 5 Change in he aveage income ax ae pe household income decile Household income decile 200 Aveage income ax ae* New ax ae* Change by 205, %, 7,6 6,6 2,8 % 2 0,7 9,9 7,8 % 3 3,0,8 9,0 % 4 4,7 3,2 0, % 5 5,6 4,0 0,4 % 6 6,7 5,0 0,2 % 7 7,8 6,0 9,8 % 8 9,0 7,2 9,7 % 9 2,0 9, 9,4 % 0 27,4 25, 8, % All 9,0 7,3 9,2 % Souce: VATT, TUJA micosimulaion model * Income ax ae is specified as he aveage income ax pecenage ove a epesenaive household in each household level income decile. In he VATTAGE model copoae axes and capial axes ae summed up o a single capial ax ae. The ne effec of a decease in he copoae ax and an incease in he capial ax on his ae was esimaed on he basis of he shaes of hese wo especive ax foms in he accumulaed capial ax collecion. In he model, all copoae afe-ax pofis ae assumed o be edisibued o he households since hee is no infomaion on he (fuue) dividend payou aios. In pacice, he dividend payou aios have vaied heavily fom yea o yea and only a pa of he dividends of Finnish companies ae edisibued nowadays o 50

59 The dynamic effecs of a ax efom in Finland Finnish households. If copoae pofis wee assumed o be fully axed again as capial income of households (as in pacice copoae pofis paid off as dividends ae double axed in Finland), he ne shock of he wo ax ae changes would be undeesimaed. Hence, aking he consevaive appoach, copoae pofis disibued o he households wee no assumed o be axed again in he main modelling scenaios. In he main scenaios, he oveall effec of he copoae axes and capial income axes hen amouns o an aveage pe cen fall compaed o baseline. We do, howeve, also conside he seco effecs of he copoae ax cus in one of ou alenaive scenaios, wih he aim of exploing invesmen esponses o he copoae ax cus. The planned addiional incease of 2 pecenage poins in all value added axes (VAT) and in he above menioned excise axes ae assumed o be phased in saing 202. VATTAGE akes in o accoun boh he value added axes and excise axes among he poduce s inemediae consumpion ax ae and in he consume s consumpion ax ae. The changes ae commodiy-specific, affecing all uses of a commodiy in equal popoion (ha is, possible iniial diffeences in commodiy ax aes beween uses emain in place in he simulaions) The macoeconomic effecs of he ax poposal We now un o he analysis of he acual poposal. In his main scenaio, we assume compeiive labou makes, wih flexible eal wages. We assume ha only axes on wage incomes and capial incomes ae cu, and ha social secuiy ansfes and pensions ae indexed o oveall consume pices. The effecs of he policy on expendiue aggegaes ae shown in Figue 2 in deviaion fom (i.e., he level change compaed o baseline expessed in pecenage changes). The esuls can be undesood wih he help of equaions (9) and (7); he fall in employmen leads o a fall in value added accoding o (9); Household consumpion falls because of ising pices; Invesmen is iniially boosed by he cu in capial axes, which aises he expeced ae of eun on invesmen; Finally, since GDP is falling a he same ime as domesic absopion in gowing, he ade balance mus evenually deeioae. 5

60 Juha Honkaukia Saaa Tamminen Figue 2 Change in expendiue aggegaes in policy The GDP effecs can be decomposed ino he conibuions of changes in supply and demand componens o he oveall change in GDP, which shows he elaive impoance of each componen. Figue 3 sudies he conibuions of he income aggegaes and shows ha he fall in pimay facos (pimaily labou) and ohe coss (including pofis) ae diving he fall in GDP. The conibuion of axes on GDP, on he ohe hand, is posiive afe a while, showing he effecs of he change owads commodiy axes. Figue 4 shows he conibuions of he expendiue aggegaes. Afe he iniial boos o invesmen, all expendiue aggegaes decline. The deeioaion of he ade balance, which shows as a negaive conibuion of expos o GDP gowh, also has a posiive conibuion o GDP semming fom he falling impos. 52

61 The dynamic effecs of a ax efom in Finland Figue 3 Conibuions of income aggegaes on GDP in policy Figue 4 Conibuions of expendiue aggegaes on GDP in policy 53

62 Juha Honkaukia Saaa Tamminen We nex sudy he effecs of labou make igidiies on he welfae coss of a ax efom. We assume eal wage adjusmen o ake he fom W W E LS 2 W, old W, old E, old LS, old, (8) whee and 2 ae adjusmen coefficiens which ake he values 0.4 and., following he esimaes of McMoow and Roege (2000). Equaion (8) saes ha cuen eal wages only adjus wih a lag o changes fom he expeced (old) baseline wages (W), employmen (E), and labou supply (LS). The specificaion in (2) is compaible wih many heoies abou cenalized wage seing, as discussed in Dixon and Rimme (2002) and does no necessiae he explici modelling of he wage-seing unions age funcion in an applicaion such as ous. The effec of wage igidiies following (2) in ou seing is o dive a gap beween labou supply and labou demand. The main effec of wage igidiies is ha adjusmen o changes in axaion akes place paly via employmen since now he pe-ax eal wage, which is deemining equilibium employmen, falls by less han unde flexible wages, since i is no longe diven by uiliy maximizaion and cos minimizaion. As a esul, hee is now a moe ponounced fall in employmen in he sho un. This shows as a gap beween labou supply which is sill deemined by households uiliy maximizaion and he pos-ax eal wages - and labou demand, which implies an incease in he ae of unemploymen. In he longe un, howeve, employmen ends o ecove as eal wages gadually adjus. I can be seen fom Figue 5 ha, unde wage igidiies, mos GDP aggegaes fall deepe han unde flexible wages. Consequenly, he fall in expos is also lage as he labou coss ae now adjusing wih a lag. The paen of ou esuls maches well he empiical findings of e.g. Blanchad and Peoi (2002) on he dynamic effecs of ax changes on GDP, consumpion and invesmen. 54

63 The dynamic effecs of a ax efom in Finland Figue 5 Changes in expendiue aggegaes unde wage igidiies The lage fall in employmen can also be seen fom he conibuions of income aggegaes o GDP, shown in Figue 6. Since in he sho un capial is fixed, he fall in employmen causes a lage effec on GDP han unde flexible wages. This can be seen fom he income-side GDP aggegaes in Figue 5, which show a lage negaive conibuion of pimay facos on GDP han unde pefec compeiion. The effecs of he efom on demand aggegaes in Figue 7 show ha he wage igidiy makes he efom less beneficial fo invesmen and aggavaes he negaive expo effecs. 55

64 Juha Honkaukia Saaa Tamminen Figue 6 Conibuions of income aggegaes on GDP in policy unde wage igidiies Figue 7 Conibuions of expendiue aggegaes on GDP in policy unde wage igidiies 56

65 The dynamic effecs of a ax efom in Finland Disibuional effecs The ax efom poposal conains elemens ha can be expeced o have disibuional effecs. Because of income ax pogession, he highe eaning deciles should benefi elaively less fom he ax cus han he lowes income deciles. On he ohe hand, he shae of labou income is much highe in he highes income deciles han in he lowes, wheeas ansfe income age-elaed and social secuiy fom he lages pa of incomes in he lowes-income deciles. The poposed lowe oveall axaion of capial incomes migh be expeced o benefi he highes-eaning deciles. Howeve, he incidence of inceased consumpion axes is no necessaily clea a pioi; hee ae elemens, enegy axes, fo example, whee pevious sudies have found evidence of egessive effecs, bu as he inceases also apply o many sevices, whose consumpion shaes in he highe eaning deciles ae highe han in he lowes deciles, one could also expec some opposie effecs. Hee, we measue disibuional effecs in ems of equivalen vaiaion. This is a boade measue han consumpion-based measues alone, since i akes ino accoun he effecs of he poposal on labou supply as well as hose on consumpion and saving. Figue 8 shows welfae effecs unde he assumpion of wage flexibiliy as deviaions fom he baseline. A siking esul is ha he poposal would only have a maginal effec he welfae of he lowes and highes income deciles. In he longe un, he welfae of he highe eaning deciles would impove, howeve. Thee is a naual explanaion fo his. Ove he couse of he decade, labou makes will become ighe as labou supply is pojeced o sa o fall owads he end of he decade. This is efleced in eal wages, whose ise benefis especially he highe income deciles. Employmen is also impoving in he sho un in many of he middle-income deciles, as shown in Figues 0 and, and even in he long un, may be falling less han aveage. 57

66 Juha Honkaukia Saaa Tamminen Figue 8 Equivalen vaiaion unde flexible wages (deviaion) Convesely, he lowe income deciles depend moe on ansfe incomes, and whehe hei incomes keep up wih he geneal ise in puchasing powe depends on he indexaion of ansfe incomes. Hee, we assume ha ansfes ae indexed o he consume pice index. Unde his assumpion, in Figue 0, we find ha he lowes income deciles would evenually see is welfae decline. This is due o he high shae of goods wih high indiec ax conen in hei consumpion baskes, which leads he pice index of consumpion fo hese paicula deciles o ise moe han he oveall CPI does. Below, we sudy how he esuls would change if ansfes wee also indexed o eal wages. 58

67 The dynamic effecs of a ax efom in Finland Figue 9 Equivalen vaiaion unde wage igidiies (deviaion) Figue 0 Effecs on employmen unde flexible wages 59

68 Juha Honkaukia Saaa Tamminen Figue Effecs on employmen unde wage igidiies The indexaion of ansfe incomes can be seen as a genuine policy decision. Hee, we show ha indexaion has a lage impac on he oveall effecs of he efom. Figue 2 shows ha wih indexaion of he benefis o boh pe-ax eal wages and he CPI, he cu in income axes is no lage enough o compensae fo he highe consumpion axes. Consequenly, hee is a moe ponounced fall in household demand, and only he posiive effecs of lowe capial axes emain. Figue 3, in un, shows ha he disibuional effecs of he efom also depend on indexaion; wih he alenaive indexaion scheme, he lowes-income deciles sand o lose fom he efom fom he ouse, as hei incomes would deeioae in elaive o wage-eanes who would be compensaed wih he cu in income axes - a appoximaely he ae of eal wage gowh. 60

69 The dynamic effecs of a ax efom in Finland Figue 2 Macoeconomic effecs wih indexaion o eal wages and CPI (deviaion) Figue 3 Equivalen vaiaion wih indexaion o eal wages and CPI (deviaion) 6

70 Juha Honkaukia Saaa Tamminen Figue 4 2 Equivalen vaiaion wih indexaion o eal wages and CPI, all income ax changes (deviaions) D0 D D2 D3 D4 D5 D6 D7 D8 D Seco effecs I has aleady been noed ha he efom encouages invesmen by impoving he euns o capial. Hee, we conside he effecs of he efom unde wo specificaions. Fis, we evaluae he effecs assuming a geneal fall in he capial income ax ae wihou aking ino accoun he seco-specific effecs of copoae axes. Second, we allow fo he effec of he copoae axes on he peceived ae of eun in each seco. Indusy esponses o he ax sucue changes depend on hei elaive labou inensiy, as well as inemediae goods inensiy, since he ax efom aises he ax on many commodiies. Figue 5 shows ou esuls on employmen fo indusy aggegaes, while Figue 6 shows he esuls on invesmen unde he fis specificaion. I is clea fom he esuls ha he efom has he effec of a leas iniially encouaging invesmen in he capial-inensive, expoing secos. Inceased invesmen also dives an incease in employmen in hese secos. Many sevice secos ae also elaively capial inensive, benefiing fom he efom. 62

71 The dynamic effecs of a ax efom in Finland Figue 5 Effecs on employmen (deviaion) Figue 6 Effecs on invesmen (deviaion) 63

72 Juha Honkaukia Saaa Tamminen Figues 7 and 8 show invesmen and employmen unde he second specificaion. Invesmen inceases makedly moe in mos secos, bu especially in he labou inensive manufacuing indusies, which include, fo example, he eleconics indusy. Remakably, unde neihe model specificaion does employmen in he labou inensive indusies incease pemanenly. We suspec ha his may be an indicaion of a mismach of skills, since, in he long un, labou supply inceases only modeaely o no a all in he deciles (fom D4 upwads) ha have a high shae in he high-skill, indusial occupaions. Fo example, only abou 8 pe cen of pocess wokes, who consiue ove 40 pe cen of manufacuing indusy employees, ae epesened in he hee lowes income deciles, wheeas hei shae is close o o above 0 pe cen in all deciles fom D4 o D8, whose employmen is falling moe in he long un han ha of he lowe income deciles. Neveheless, in he sho un his poblem does no appea o be pesen, since he middle-o high income deciles employmen is inceasing in he sho un, and hei labou supply even in he long un. Figue 7 Effecs on employmen, seco-specific copoae axes (deviaion) Cumulaive deviaion fom baseline Foes indusies Consucion Enegy Heavy indusies Pivae sevices Public sevices and adminisaion Pimay poducion Tanspo sevices Manufacuing indusies Reail sevices

73 The dynamic effecs of a ax efom in Finland Figue 8 Effecs on invesmen, seco-specific copoae axes (deviaion) Cumulaive deviaion fom baseline Pivae sevices Public sevices and adminisaion Reail sevices Consucion Enegy Tanspo sevices Pimay poducion Foes indusies Heavy indusies Manufacuing indusies Effecs on ax evenue and efficiency In his secion, we summaize he effecs of ou simulaions fom he poins of view of he susainabiliy of public seco finances and he efficiency of he ax sysem. We measue efficiency by calculaing he Maginal Cos of Funds fo he scenaios sudied above. As Dahlby (2008) poins ou, changes in even one ax ae can have effecs on he collecion of ohe axes due o he inedependency of diffeen ax ypes. The advanage of MCF is ha i summaizes he oveall effecs fom he welfae poin of view aking ino accoun he effecs of hese ineacions. We define he maginal cos of funds as: EV,, (9) whee EV is he equivalen vaiaion in welfae. I measues he moneay value of he loss in uiliy esuling fom pice changes due o he new ax policy. Equivalen vaiaion is calculaed wih he help of he expendiue funcion e(p,u), in which p 0 indicaes he pice of poducs a he pe-ax change siuaion and U 0 and U he level of consume s uiliy a he pe-ax change and pos-ax change siuaions especively. Unde his definiion, he MCF fo a pue ax incease would be geae han one, indicaing ha he collecion of addiional evenue involves a welfae cos. Fo a 65

74 Juha Honkaukia Saaa Tamminen ax efom, howeve, i is possible ha MCF <, which implies ha he efom is welfae impoving. I is also possible ha MCF is negaive, whence i needs o be fuhe specified whehe he welfae effec is a Paeo impovemen (posiive welfae effec and posiive change in ax evenue) o a deeioaion (negaive welfae effec wih negaive change in ax evenue). Figue 9 shows he changes in nominal ax evenue aggegaes in millions of Euos in ou cenal scenaio wih flexible wages and full indexaion of social secuiy and age benefis. In nominal ems, he efom sas wih vey nea evenue neualiy, wih inceased commodiy ax evenues compensaing fo he loss in income ax evenue. Ove ime, as sucues adjus, he govenmen sas unning a suplus (negaive defici). Thus he efom would appea unbalanced in he long un fom he poin of view of eal evenue and defici. Bu hee ae ohe consideaions. Since he economy is gowing, i is no necessaily he conibuion o suplus ha maes, bu he susainabiliy of public seco finances. This is sudied in Figues 20 o 22, which show he deviaion in ne ax evenues which is posiive in ou cenal case, showing he efom is acually evenue gaining even unde diffeen specificaions. A key finding of he sudy is pesened in Figues 20 o 22. We find ha he MCF fo he efom would iniially be faily high, which is o be expeced since i akes ime fo capial socks o adjus. Evenually, howeve, he MCF would sele o aound 0.5. This indicaes ha he efom would be welfae impoving in he long un. The gains ae undemined in he alenaive ansfe indexaion scheme, since consumes incomes fall moe on he aveage. Finally, unde he secospecific copoae ax cus, welfae gains ae also eviden, and hey ae also achieved soone han in he main case. The figues also epo he change in he EU susainabiliy indices in absolue ems compaed o he baseline; a negaive value indicaes he index obains a lowe value han in he baseline, meaning oveall axaion could be loweed while sill eaching he same deb o GDP aio age as in he baseline. The esuls hen sugges ha, in ems of susainabiliy, he efom is indeed neual o even slighly susainabiliy-impoving in ou cenal case. 66

75 The dynamic effecs of a ax efom in Finland Figue 9 Changes in ax evenue (Mio euo) g g MEURO Indiec ax evenue Tansfes o households Real ne ax collecion Capial ax evenue Real equivalen vaiaion Govenmen defici Real govenmen defici Labou ax evenue Figue 20 Effecs on susainabiliy and efficiency 4,5 Ne ax evenue (deviaion fom 4 baseline) 3,5 3 Naional saving 2,5 2,5 0,5 0 0,5 Maginal cos of funds Susainabiliy 2 (change fom baseline) Susainabiliy (change fom baseline) 67

76 Juha Honkaukia Saaa Tamminen Figue 2 Effecs on susainabiliy and efficiency, seco-specific copoae axes (deviaion) Figue 22 Effecs on susainabiliy and efficiency wih eal wage and CPIbased indexaion of ansfes 68

77 The dynamic effecs of a ax efom in Finland 2.4 Conclusions In he cuen sudy, we have examined he effecs of he ecen ax efom poposal of he Tax Commiee on he economy as a whole and on he efficiency of axaion in paicula. We have also sudied he poposal s disibuional and seco effecs. Ou cenal findings ae ha while he poposed income ax cus iniially boos labou supply in some deciles, ove ime, aggegae labou supply is likely o fall. This effec is found in many ohe sudies as well and is due o he posiive income effec of he ax cu. Because of he fall in labou supply, GDP is also likely o fall. We find ha he poposal would be likely o simulae expos, invesmen in he sho un, bu in he long un, as consumpion picks up, he effec on expos would be negaive. The poposal would also iniially educe income diffeences, bu in he long un, he disibuional effecs depend on he indexaion of social secuiy benefis and pensions, as well as he exen of income ax cus on hese incomes. In ems of efficiency, we find he poposal welfae impoving in ou cenal scenaio, which assumes flexible eal wages. In accod wih many ohe sudies, we also find ha wage igidiies would undemine he efficiency gains in he sho un. In some especs, ou sudy also demonsaes he ambiguiy in defining a ax efom. As in many ohe sudies, we have assumed ha public expendiue on commodiies and invesmen does no espond o he eal changes caused by he ax efom. Even so, hee ae many ypes of public expendiue ha do depend on hese changes, and consequenly we find ha a efom inended o be neual does have effecs on he govenmen s ne ax evenues and is defici ove ime. Howeve, we show ha on impac, he poposal is vey nealy evenue neual, and, moeove, i is close o neual in he long un in he sense ha i has only a small impac on he susainabiliy of a long-em deb age. 69

78 Juha Honkaukia Saaa Tamminen Refeences Ahokas, Jussi Honkaukia, Juha (200): Poliiikkaoimien vaikuukse yövoiman apeeseen Suomen aloudessa , VATT Tukimukse 6, joulukuu 200. Ballad, Chales L. Shoven, John B. Whalley, John (985): Geneal equilibium compuaions of he maginal welfae coss of axes in he Unied Saes, Ameican economic eview, Vol. 75, No. (Ma., 985), pp Blanchad, Olivie Peoi, Robeo (2002): En empiical chaaceizaion of he dynamic effecs of changes in govenmen spending and axes on oupu, The quaely jounal of economics, Novembe 2002, p Böhinge, Chisoph Boees, Sefan Feil, Michael (2004): Taxaion and unemploymen: An applied geneal equilibium appoach, CESifo woking pape no. 272, July Chisaio, Oma O. Cicowiez, Main (200): Maginal cos of public funds and egulaoy egimes: compuable geneal equilibium evaluaion fo Agenina, Revisa de Análisis Económico, Vol. 25, No, oo.79-6, Junio 200. Dahlby, Bev (2008): The maginal cos of public funds: heoy and applicaions, MIT Pess, ISBN Dixon, P.B. Honkaukia, J. Rimme, M. (20): The maginal coss of funds in he VATTAGE model of Finland: a back of he envelope jusificaion of he welfae effecs of addiional govenmen evenue, Pape pesened a he 4 h Annual Confeence on Global Economic Analysis, Venice, Ialy, June 20. Duae Lledo, Vico (2005): Tax Sysems unde Fiscal Adjusmen: A Dynamic CGE Analysis of he Bazilian Tax Refom, IMF Woking Pape WP/05/42. Honkaukia, Juha (2009): VATTAGE A dynamic, applied geneal equilibium model of he Finnish economy, Govenmen Insiue fo Economic Reseach (VATT), Reseach epo 50, July Honkaukia, Juha Ahokas, Jussi Maila, Kimmo (200): Työvoiman ave Suomen aloudessa vuosina , VATT Tukimukse 54, helmikuu 200. Honkaukia, Juha Kinnunen, Jouko Rauhanen, Timo (20): Alenneujen avonlisäveokanojen aloudellise vaikuukse, TEM apoeja, 2/20. Kleven, Henik Jacobsen Keine, Claus Thusup (2006): The maginal cos of public funds: Hous of wok vesus labou foce paicipaion, Jounal of Public Economics 90 (2006), p

79 The dynamic effecs of a ax efom in Finland Liu, Liqun (2004): The Maginal Cos of Funds and he Shadow Pices of Public Seco Inpus and Oupus, Inenaional Tax and Public Finance,, 27-29, McMoow, K.C. Roege, R. (2000): Time-Vaying Naiu/Nawu. Esimaes fo he EU s Membe Saes, Economic papes 45, ECFIN, Bussels. Radulescu, Doina Simmelmay, Michael (200): The Impac of he 2008 Geman Copoae Tax Refom: A Dynamic CGE Analysis, Economic Modelling, Volume 27, Issue, Januay 200, p Valiovaainminiseiö (VM) (200): Veouksen kehiämisyöyhmän loppuapoi, Valiovaainminiseiö 5/200. 7

80 Juha Honkaukia Saaa Tamminen 72

81 3. Populaion ageing in a small open economy some policy expeimens wih a acable geneal equilibium model 6 Juha Kilponen Helvi Kinnunen Ani Ripai 3. Inoducion Populaions in mos of he indusialized counies ae ageing. Demogaphic paens ae especially ponounced in some Euopean economies whee old-age dependency aio ae se o ise consideably. The key facos behind his end ae a slowdown of populaion gowh and a subsanial incease in longeviy. Many Euopean counies have begun o pepae fo demogaphic change. In many Euopean counies whee ax aes ae aleady a vey high levels, an addiional fiscal buden on labou could have deimenal effecs on fuue economic pefomance. One of he main ideas fo esolving he issue has been o design pension efoms ha incease incenives o wok longe and/o o cu pension benefis. One pominen example fom Euope is Finland, whee he pension efom effecive fom he sa of 2005 inoduced a flexible eiemen age of fom 63 o 68. Unde he laes pension efom, he pension level is now linked moe explicily han befoe o exi age and hus wih o conibuions made by he insued. This is expeced o incease incenives o wok longe. Fuhemoe, saing fom 2009, changes in life expecancy will effec pension levels. In addiion, pension indexaion has been changed so ha all pensions will be indexed using a weigh of 0.8 fo living coss and 0.2 fo wages, in conas o he ealie `midway index' applied up o age 65. This will conibue o some eosion of he value of pensions compaed o wage level in he fuue. The lae efoms ae clealy aemps o modeae he fiscal impac of gowing pension expendiues. In his pape, we develop a acable dynamic geneal equilibium macoeconomic model ha allows us o accoun fo demogaphic ansiion. The model feaues dynamic opimizaion of a small open economy wih an inenaionally given eal inees ae and a non-sochasic balanced gowh pah deemined by labou saving echnological developmen and populaion gowh. Opimal 6 This is based on he Bank of Finland Discussion Pape Juha Kilponen - Helvi Kinnunen - Ani Ripai: Populaion ageing in a small open economy - some policy expeimens wih a acable geneal equilibium model, No 28/2006, Bank of Finland. 73

82 Juha Kilponen Helvi Kinnunen Ani Ripai consumpion and labou supply decisions ae based on Gele's (999) acable ovelapping geneaion model, exended fo disoionay axes and ime-vaying eiemen and deah pobabiliies 7. Pensions ae condiioned on aggegae wage level and on demogaphic end, and he model feaues a paially funded pension sysem. The funded pa of he pension sysem is consideed conacual saving (asses accumulaed by he pension fund) and he PAYG pa as a ansfe fom wokes o pensiones. These ansfes ae financed by collecing pension conibuions fom fims and wokes. Finally, we quanify he unceainy associaed wih demogaphic pojecions, by allowing fo sochasic vaiaion in he key vaiables diving demogaphic ends. The esuls of simulaions highligh he key ole played by feedback effecs fom axaion in he assessmen of economic coss of ageing. When he esponses of labou supply, eal wages, and hence pivae consumpion, o highe axaion ae consisenly accouned fo, he economy seles a a level of axaion clealy above ha geneally esimaed in mechanical susainabiliy calculaions. Even if he effecive eiemen age wee o incease as expeced, he buden fom pension paymens alone would cause he ax ae o ise o a level above ha winessed in he wos yeas of Finland's ecession of he mid-990s. Resuls fom sochasic simulaions suppo his view, by showing ha a lenghening of woking ime has only a mino alleviaing impac on he fiscal buden of ageing: Only a small facion of he sochasic vaiaion in an endogenously deemined income ax ae is explained by he sochasic vaiaion in he lengh of woking ime. Finally, if he pension eplacemen ae falls, as seems likely unde he cuen pension egime, hee would be a much smalle incease in axaion in esponse o ising dependency aio. The aveage decline in he level of pensions elaive o wage developmens, howeve, aises a concen ha he falling puchasing powe of pensions elaive o wage developmens will exe pessue on ohe social secuiy schemes. The cuen pension scheme, which appeas o be financially susainable, may hus in pacice geneae coss o local and cenal govenmen in he fom of highe expendiues on income suppo and ohe benefis. The es of he pape is oganized as follows inoduces he model, including a descipion of he pension sysem. Secions discuss he esuls fom vaious policy expeimens including a sensiiviy analysis and sochasic simulaions. Secion 4.7 concludes. 7 Keuschnigg and Keuschnigg (2004), Feeo (2005), Roege (2005), Kaa and Thadden (2006), Fujivaa and Teanish (2006), and Gafenhofe, Jaag, Keuschnigg and Keuschnigg (2006) develop he Gele (999) model fuhe and sudy diffeen aspecs of populaion ageing in hei models. 74

83 Populaion ageing in a small open economy 3.2 The model 3.2. Geneal feaues The model developed in his pape feaues dynamic opimizaion of a small open economy wih an inenaionally given eal inees ae and non-sochasic balanced gowh pah. On he balanced gowh pah, economic gowh is deemined by exogenously given gowh of labou-saving echnology and populaion. Households' saving decisions, and hence accumulaion of financial asses, ae influenced by households' desie o smooh consumpion ove ime. Individuals ae expeced o have finie lives consising of wo disinc peiods. Following Gele (999), we label he households living in hese wo diffeen peiods `wokes' and `eiees'. The likelihood ha a woke will lose pa of his labou income a eiemen, induces he o discoun he fuue income seam a a highe ae han ohewise. This educes consumpion and inceases saving. In his sense, wokes save fo a ainy day and fo eiemen. 8 The planning hoizon of pensiones is shoe han ha of wokes due o he peiodic pobabiliy of deah. Theefoe pensiones' popensiy o consume ou of wealh is geae han ha of he woking-age populaion. In ode o capue changing labou supply incenives of he eldely, we assume ha `eiees' paicipae in he labou makes. Howeve, compaed o wokes, hei labou efficiency is lowe. Lowe labou efficiency can capue issues such as pa-ime wok and possibly lowe poduciviy. A moe geneal, elasic labou supply allows demogaphic change o feed ino adjusmen of capial and invesmen via he capial-labou subsiuion effec. Individuals eceive ansfes fom boh he cenal govenmen and pension funds. Howeve, in ode o mainain analyical acabiliy, pensions ae elaed o he pevailing aggegae wage level, and no o individual chaaceisics 9. The 8 This view is geneally consisen wih he sudy of Gouinchas and Pake (2002), who find ha empiically obseved saving paens accod wih fowad-looking opimizing behaviou in a life-cycle seup wih income unceainy. Thei sudy suggess ha he pecauionay saving moive in ealy life implies ha beween 60 and 70% of non-pension wealh is due o pecauionay saving. 9 In conas o lage scale ovelapping geneaions models, such as Auebach-Kolikoff (987), we do no follow individual cohos wihin he wo age goups. This limis ou abiliy o model he demogaphic change and pension sysem in a vey deailed manne. We also need o absac fom many ohe poenial souces of heeogeneiy in consumpion and labou supply behaviou, such as diffeing educaional levels. Howeve, we can sill specify he eiemen and 75

84 Juha Kilponen Helvi Kinnunen Ani Ripai pension sysem is chaaceised as paially funded. We conside he funded pa of he pension sysem conacual saving (asses accumulaed by he pension fund) and he PAYG pa as a ansfe fom wokes o pensiones. These ansfes ae financed by collecing pension conibuions fom fims and wokes as noed above. The model is closed by fiscal ules. Given ha we disinguish beween cenal govenmen and he pension fund, one fiscal ule deemines he pension fund's long-em ne lending ae, while he ohe deemines he cenal govenmen `deb aio'. Supply side (poducion sucue) is based on CES poducion echnology wih faco augmenaion in he undelying echnological pogesses and nominal and eal igidiies Demogaphics Consumes ae assumed o be bon as wokes. Condiional on being a woke in he cuen peiod, he pobabiliy of emaining one in he nex peiod is, while he pobabiliy of eiing is. These ansiion pobabiliies ae independen of individuals' employmen enue, so ha he aveage enue of woking is. In ode o allow fo a non-saionay demogaphic sucue, we allow fo ime vaying pobabiliies. Once an individual has eied she faces a peiodic pobabiliy of deah of ( ). Given ha he suvival pobabiliy is assumed o be independen of eiemen enue, bu ha i may depend on calenda ime, he aveage eiemen peiod a each poin of ime is. Allowing fo ime vaiaion in he eiemen and deah pobabiliies enables us o geneae demogaphic `shocks' ha feed ino he dependency aio gadually ahe han insanly. w Le N denoe he sock of wokes alive a ime. We hen assume ha w n new wokes ae bon a +. This implies ha we can se woke w populaion o gow a some exogenous goss gowh ae of Nˆ w w w w w N ( n ) N N N ˆ N w () deah pobabiliies, as well as he gowh ae of woking-age populaion, in such a way ha demogaphic ansiion can be capued wih easonable accuacy a he aggegae level. Similaly, linking pensions o demogaphics, we can oughly mimic he associaed ends in pensions and public expendiues. 76

85 Populaion ageing in a small open economy whee ˆ w w N n. Given age-independen pobabiliies of eiemen and deah and ha cohos ae lage, he eiee populaion ( N ) evolves accoding o w N ( ) N N (2) N whee efes o he sock of eiees populaion a ime. Wih some N manipulaion, i is shown ha he eiee-o-woke aio,, evolves accoding o w N N N w w w Nˆ Nˆ (3) w Defining he sock of whole populaion as N N N, we can expess he gowh ae fo he whole populaion as a funcion of eiee o woke aio and gowh ae of woking age populaion as follows Nˆ N w w N Nˆ w (4) In he seady sae he demogaphic change has ended, so ha Nˆ Nˆ w Nˆ (5) Nˆ (6) Households Pefeences A household's pefeences ae expessed ecusively using he consan elasiciy aggegao V [ c c c u ( C, l ) E ( V ) ]. (7) V is he value funcion, and gives he subjecive ime pefeence. The paamee c capues ineempoal subsiuion. A special case of, applied hee, coesponds o a ype of isk neualiy whee agens ae indiffeen egading isk bu eain a non-ivial pefeence fo he ime a which 77

86 Juha Kilponen Helvi Kinnunen Ani Ripai consumpion occus (cf. Fame, 990) 0. This special case is analyically acable, since i geneaes linea decision ules even wih (idiosyncaic) isk o income, asse eun and lengh of life. In addiion o isk neualiy and a ecusive sucue of pefeences, we assume ha individuals enjoy uiliy fom consumpion, C, as well as leisue, l ), accoding o he uiliy funcional ( u( C, l ) C v ( l ). v (8) whee v is he elasiciy of peiod uiliy wih espec o consumpion. Taking ino accoun he wo disinc peiods of life, as well as eiing and deah pobabiliies, he pefeences of a household can be summaized as whee V z z v z v c z [ C ( l ) ] [ E ( V z)] c c w w E ( V w) V ( ) V, E ( V ) V,. (9) (0) and whee z w, indicaes whehe he individual is a woke o eiee especively. The willingness o smooh consumpion ove ime implies a finie (consan) ine-empoal elasiciy of subsiuion /( c ). The eiees effecive discoun faco is adjused o ake ino accoun he peiodic pobabiliy of deah. We assume a pefec annuiies make in ode o eliminae he impac of unceainy abou ime of deah: A eiee's emaining wealh a deah is invesed in a muual fund, which invess i in he available financial asses in each peiod of ime. Those suviving o he following peiod each eceive a eun ha is popoional o his conibuion o he fund. Fo insance, if R is he goss eun pe uni invesed by he fund, he goss eun fo a suviving eiees is a ime R. / 0 Assumpion of isk-neualiy is impoan. Fo insance, analysis of welfae effecs of social secuiy efoms ae impoanly affeced by he eamen of isk. A mandaoy social secuiy sysem imposes an implici ax on households, so ha hee is a educion in expeced life-cycle income (due o social secuiy conibuions). Howeve, if he social secuiy sysem educes he vaiance of life-cycle income by pooling he income isk beween young and old geneaion, hee is poenially a adeoff beween a educion in expeced life-cycle income and he vaiabiliy: The educion of welfae due o mandaoy social secuiy would hen be lowe fo isk-avese households han fo isk-neual ones. 78

87 Populaion ageing in a small open economy Wokes, in un, face he isk of decline in wage income a eiemen. Howeve, since an individual's pefeences ae ove he mean of he nex peiod's value funcion, only a desie he smooh consumpion ove ime will affec he consumpion paen in he face of idiosyncaic income isk. Thus a woke simply foms a ceainy equivalen of his andom uiliy, as shown in equaion (9) Reiees A eiee bon a ime j and eiing a ime k, and who suvives a leas unil +, solves he maximizaion poblem s.. [ jk jk v jk v c jk max V jk jk C ( l ) ] [ E ( V C, l )] c c () A jk jk R A W ( ) l jk T jk P C c jk (2) jk jk whee R denoes afe-ax goss ae of eun on financial asses A, T denoes pensions, and is he labou efficiency of eiees wih espec o c wokes. P is a pice index of consumpion, o be deemined lae. is he WP oal labou income ax ae including pension conibuion ae,, o be discussed lae. Fom he fis ode condiion fo labou, we fis deive a sandad labou supply condiion l jk c jk v P C v ( ) W (3) Solving he eiee's maximizaion poblem wih espec o consumpion, using (3)) and hen aggegaing ove eiees esuls ino following aggegae consumpion equaion P C c [ R A H S ]. (4) H and S denoe discouned afe-ax values of labou income and pensions, and ε π is eiees maginal popensiy o consume ou of wealh. Moe specifically H ( ) W L Nˆ H R / (5) 79

88 Juha Kilponen Helvi Kinnunen Ani Ripai S T Nˆ S R /. (6) Since oal social secuiy paymens (pensions) ae disibued equally among eiees, he goss gowh ae of eiees enes ino he discoun faco. The Nˆ discoun faco fo human wealh is similaly augmened by N. A eiee's maginal popensiy o consume ou of wealh evolves accoding o he following non-linea diffeence equaion ˆ W W / P / P c c ( ) ( ) v c c c R ( Pˆ c ) c c (7) c c c whee P ˆ P / P. A eiee's maginal popensiy o consume vaies wih he c eal inees ae R Pˆ / as well as wih expeced changes in eal ne wage income. Due o he fac ha suvival pobabiliy can vay ove calenda ime, i influences on eiee's effecive discoun ae and inoduces addiional dynamics ino he maginal popensiy o consume equaion. As in he sandad Yaai (965) and Blanchad (985) models, likelihood of deah ( ) in (7) aises he eiees' maginal popensiy o consume. This can be seen easily by consideing a limiing case of logaihmic pefeences ( ) and when suvival pobabiliy is consan. In his case (8) Wokes As egads wokes, he decision poblem fo he woke bon a ime s, is max V ws ws C, l ws [ C ws v ( l ) ] ws v c [ E ( V ws )] c c (9) s.. A ws R A ws ( ) W l ws T ws P c C ws (20) ws T denoes financial ansfes o woking age and is he oal labou income ax ae. The fis ode condiion fo labou yields sandad labou supply condiion 80

89 Populaion ageing in a small open economy l ws v v P c ( C ws ) W (2) Ine-empoal maximizaion in un gives ise o a faily complicaed Eule equaion, bu again he wokes' consumpion plan aggegaes o P c C w [ R A w H S w w ]. (22) w w is a woke's maginal popensiy o consume, while H and S denoe he human and social secuiy wealh, especively. Maginal popensiy o consume ou of wealh is a non-linea fis ode diffeence equaion W W / P c c / P c c c R ˆ c P c c (23) whee is he faco ha weighs he goss eal eun. This faco evolves accoding o [ ( ) c c ] (24) is he aio of a eiee's maginal popensiy o consume o ha of a woke. The enlaged discoun ae due o he pesence of in he denominao of (25) - (26) means ha wokes value human wealh and social secuiy less han in he infinie hoizon case. This in un ends educe woke's consumpion and incease saving. Impoanly, noice also ha disoionay axes incease he wokes' discoun faco. w w H in (22) is a discouned sum of woke's wage bill (in ne ems) and S is he sum acoss wokes alive a of he capialized value of social secuiy (in ne ems). Boh of hese measues ake ino accoun of coesponding discouned values a he ime of eiemen. Fomally, 8

90 Juha Kilponen Helvi Kinnunen Ani Ripai 82 (25) and ae he values of human wealh and social secuiy fo a woking eiee who eied a ime + bu was sill woking a ime. The faco augmens he discoun ae of he capialized value of a woke's social secuiy because wih finie lives, he shae of oal social secuiy enilemens going o hose cuenly alive declines ove ime as he woking-age populaion gows. By simila agumen, enes ino he discoun faco of human wealh Disibuion of wealh and aggegae consumpion Given ou assumpions on pefeences and populaion dynamics, hee is no need o keep ack of how asses and consumpion ae disibued wihin he goups of eiees and wokes. Howeve, since maginal popensiies o consume diffe as beween he wo goups, we mus keep ack of he disibuion of asses beween he wo goups. Consequenly, we need a sae equaion fo disibuion of wealh. Le be he shae of financial asses held by eiees and le be he shae of financial asses held by wokes. I can be shown ha eiees' shae of financial wealh evolves accoding o (27) Noe ha in he limiing case of logaihmic pefeences ( ) maginal popensiy o consume is consan and equal o. ˆ ˆ ˆ ˆ ) ( ) ( w w w w w w w w N R N R N R W L N R c c S S T S H H H ) ( H j S w N ˆ w N ˆ A A w A A / ) ( ) ( ) ( A W N A A R H S T (24)

91 Populaion ageing in a small open economy Aggegae pivae consumpion can hen be obained simply by summing up (5) f A and (22), using and ha all asses ae evenually held by domesic A consumes Asses P c C H w w [ R A H S ] [ (28) Thee ae seveal ypes of financial asses available fo consumes: domesic S W govenmen bonds, foeign bonds, and socks issued by domesic fims F A p A A A. In addiion, i is assumed ha all he asses accumulaed by he pension fund ae hold by domesic consumes. Domesic one-peiod bonds pay a nominal eun, while he goss eun on socks is deemined accoding o he pofis of he fims in he model. Foeign F bonds pay a eun, which is exogenously given. The abiage condiion equaes ex ane euns of domesic and foeign bonds, o give ise o uncoveed inees ae paiy (UIP) condiion. The shae pice is he nominal pice (exdividend) of a uni of equiy in peiod. The faco defining he goss eun on D socks is he fims. This goss eun is defined as R A H S D F [ A ( K ) D ]/ A F (29) K whee denoes he copoae ax ae. Opimal consumpion plans can be combined wih he abiage equaion fo holding diffeen asses. This yields wo equaions ha elae he afe-ax inees aes o each ohe S D S denoes he nominal exchange ae, denoes domesic sho-em nominal F S inees ae and denoes coesponding foeign sho em inees ae. is ax ae a souce. The lae is a sandad UIP condiion. In addiion o his, we assume an exogenously deemined isk-pemium vs. domesic bonds fo socks issued by he domesic fims Labou makes S S ( ) F S S The model feaues nominal wage igidiy in he fom of quadaic adjusmen coss. A woke faces quadaic adjusmen if when i has been allowed o e-se he wage. Fo hose no able o opimize in peiod, he wage is adjused using S 83 (30) (3)

92 Juha Kilponen Helvi Kinnunen Ani Ripai he seady sae gowh ae of wages. This seady sae gowh ae of wages, denoed by dw, equals seady sae poduciviy gowh plus inflaion. The behavio of aggegae nominal wages is hen chaaceized by he following wo wage ae equaions W v c w P C / v w [ N L ] w qdw q W EW 2 2 ( ( q) dw ) 2 q( ( q) dw ) W 2 2 ( ( q) dw ) dw 2 ( ( q) dw c w w w whee P C is consumpion of wokes, N is woke populaion, L denoes he numbe of wokes demanded, q (0,) is he exogenous pobabiliy ha deemines how ofen a andomly chosen woke is allowed o e-se he wage. The equaion fo opimal wage W is deived diecly fom he aggegae vesion of woke's labou supply decision. Given ha wokes' and eiees' labou efficiency diffe, we define aggegae effecive labou supply index L as 2 W ) (32) (33) L L w L (34) Hee (0,) denoes he elaive efficiency of a uni of eiees' labou. Labou w demand fo wokes L is deived fom (34) by assuming ha eiees ae always on hei labou supply cuve a pevailing wage ( W), and ha he domesic inemediae goods poduce is always on is labou demand cuve Public seco The geneal govenmen (public seco) is divided ino wo secos, labeled sae (cenal govenmen) and pension funds. The sae collecs axes on labou WS K C income a he ae fom capial gains a and fom consumpion a. The S sae consumes C and pays ansfes o wokes and o eiees. In he budge consain hese oal ansfes ae denoed T S. In addiion, he sae issues onepeiod govenmen bonds amouning o A and paying a nominal eun of S. In each peiod, he following budge consain holds 84

93 Populaion ageing in a small open economy ( A WS K C FS P T C S S P A ( W L C C A S ) (ne lending) (copoae income ax evenues) (indiec axes) (fims' social secuiy conibuions) (govenmen consumpion) (oal ne ansfes) S C W L S F w W L ) (income ax evenues) (inees paymens) (35) Fiscal policy ule Typically, models like his ae closed by eihe a ax ule o by a lump sum ansfe ule. We use a ahe geneal fom of ax ule ha sabilizes he evoluion of govenmen deb via labou income ax. Fomally, he ax ule akes a paial adjusmen fom 2 ws ws ws ws S S ( ) 2 ( A A ) / Y (36) The ax ule has wo aacos and Ā S /Y owads which he ax, and consequenly he deb o oupu aio ae sabilized. Benchmak values fo he paamees and 2 have been calibaed o 0.3 and 0. especively. and A S / Y can be se such ha he public deb o oupu aio each waned seady sae values Sauoy pension fund Thee ae seveal moivaions fo consideing he pension fund(s) sepaaely fom he cenal govenmen. Fis, when he pension scheme is defined benefi and paly funded, we should conside he funded pa of he pension sysem as conacual saving, as opposed o disceionay saving, while he PAYG pa should be consideed a diec ansfe fom young geneaion (wokes) o old geneaion (pensiones). 3 In Finland, whee appoximaely 25% of he pensions ae funded boh feaues ae quaniaively impoan. Second, pension conibuions ae consideed a leas paly as axes. Analogously wih he pevious secion, his means ha he way in which he inceasing fiscal buden of aging is financed along he demogaphic ansiion 2 See e.g. Railavo (2004) fo discussion of alenaive fiscal policy ules and hei sabiliy popeies 3 In Finland, appoximaely 25% of he pensions ae funded. 85

94 Juha Kilponen Helvi Kinnunen Ani Ripai pah is of cucial impoance fo he economy's labou make esponses o ageing. The adeoff is clealy beween popoions of demogaphic ansiion financed by changing he pension fund asse posiion and by changing he conibuion aes. 4 Accodingly, we assume ha he economy's pension fund is adminisaed sepaaely fom he cenal govenmen. The fund collecs pension conibuions PR fom he pivae seco and disibues pensions o eiees oaling T. Pension P funds accumulae financial asses A. In each peiod, heefoe, he following flow budge consain holds fo he pension fund ( A T PR P P A A W L ) (ne lending) (social secuiy conibuions of employe and emplo (oal ansfes paid o eiees) P P (inees paymens) (37) P FP WP whee is oveall pension conibuion ae, consising of employe PR and employee conibuions. Finally T denoes pensions and ohe ansfes fom pension funds o eiees Conibuion ule Ine-geneaional disibuion of he fiscal buden of ageing is no acively managed by insiuional conol buil ino cuen pension schemes in geneal. Accoding o Fenge and Weding (2003) `i meely jus happens'. Consequenly, ine-geneaional disibuion is hadly an issue in devising he conibuion ule fo a model like ous. In a defined benefi pension sysem, such as in Finland, he conibuion ae is adjused o mainain he pension fund's fiscal balance. One way o wie he pension fund's conibuion ule, is o assume ha he conibuion ule sabilizes he ne lending-o-oal wage aio a some pedeemined long-un level. 5 Consequenly, we wie a simple `ne lending' ule ha sabilizes he ne lending-o-oal-wages aio a a pe-specified age level. Fomally 4 A hid impoan consideaion is ha pension funds hold he savings fo he households ha ae compleely illiquid. Households ae hus no able o boow, o ae limied o a small amoun, agains hei savings accumulaed in he pension funds. This means ha households do no see pensions accumulaed in pension funds as pefec subsiues fo moe liquid foms of saving, such as bonds and equiy. This is suppoed by empiical findings accoding o which gowh in paially funded pension schemes does boos pesonal saving, bu no one-o-one. The cuen vesion of he model, howeve, does no addess his issue. 5 Indeed, in Finland, pension funds' oal ne lending elaive o aggegae wages has been ahe sable duing he las 25 yeas. 86

95 Populaion ageing in a small open economy P P P ( A A 3 ( W L P ) A P WL ) (38) P Whee AWL is he age level fo ne lending-o-oal-wages and 3 is an adjusmen paamee. This fom is flexible enough fo policy opion P expeimens. Fo insance seing A a zeo and 3 high epesens a pue PAYG P sysem. In ou benchmak simulaions, we se 0.5 and A Pension expendiues Allowing idiosyncaic hisoical dependence in social secuiy and pension paymens would make he model moe ealisic, bu i would sacifice analyical acabiliy. We hus link he model's pension expendiues/ansfes o he demogaphic sucue and aggegae wages, by wiing T R N W (39) whee e / W is he aveage pension ae evaluaed a he iniial seady sae level of aggegae wages W. Since he wage ae W is endogenous, we obain pojecions fo pension expendiues once we se a deeminisic pah o aveage R pension ae. Toal pension expendiues T ae hus linked o aveage wages and numbe of pensiones in he model. Fuhemoe, making use of ou demogaphic assumpions, we can expess pension expendiues pe capia in ems of he dependency aio, wages and pension ae: T N R N N W W (40) Poducion seco The supply side is based on a single inemediae good ha can be used in he poducion of final goods. Poduces of his inemediae goods combine capial and labou using a consan-elasiciy-of- subsiuion (CES) poducion funcion and opeae in monopolisic poduc makes. Pices of final goods ae sicky in he fom of Calvo-picing. Domesic poduces of inemediae poducs puchase hei capial inpus (capial sevices) in a compeiive capial make (fom companies poviding capial sevices) in which capial is feely sold and ansfeable fo use by ohe companies. Building up new capial geneaes cos - adjusmen coss - in he fom of los capial sock. Domesic inemediae goods ae combined wih impoed inemediae goods o poduce final goods of hee kinds: consumpion goods, capial goods and expoed goods. The poducion funcion o, ahe, aggegao is CES. The 87

96 Juha Kilponen Helvi Kinnunen Ani Ripai poducion diffes acoss final goods in ems of elasiciy of subsiuion. All hee ypes of final poduces opeae in compeiive poduc makes, in which hey ake he make pice fo hei poducs as given in hei own decisionmaking. Finally, nominal impo pices ae assumed o be sicky in a manne coesponding o domesic inemediae goods pices. I is also assumed ha, in he sho un exchange ae pass-hough o impo pices is incomplee. This is due o he fac ha a fixed poion of impo companies pice hei poducs in he local cuency Domesic inemediae goods poduce The domesic composie inemediae good,, is poduced accoding o a consan elasiciy of subsiuion (CES) poducion funcion, which combines a coninuum of individual goods ( j) j 0, (Dixi and Sigliz, 977) Y Y Y 0 Y ( j) z z dj. z z The paamee [, ) deemines he elasiciy of subsiuion /( ). Cos minimizaion implies he following condiional demand funcion fo he individual good j P ( j) Y ( j) P z The pice index fo he composie domesic inemediae good is Y P 0 P ( j z z ) dj z z Domesic inemediae goods, Y ( j), ae poduced by poduces opeaing in monopolisic make. The poducion echnology and he faco augmening echnical ends ae exogenously given. The poducion funcion is of he CES ype and akes a specific consan-euns-o-scale fom 6 Y ( j) / K L F K ( ) L 6 Jalava, Pohjola, Ripai and Vilmunen (2006) povide evidence ha his may be a easonable appoximaion fo he Finnish pos-wwii daa. 88

97 Populaion ageing in a small open economy The facos of poducion include homogeneous capial sevices,, and labou F inpu L. and denoe ime-vaying 7 capial and labou-augmening echnical pogess especively. The elasiciy of echnical subsiuion is given by /( ), whee is he subsiuion paamee and he shae paamee in L he poducion funcion. The echnical change is labou-augmening,, in he balanced gowh pah. Cos minimizaion implies he following eal maginal coss K MC ( j) P ( j) F R W ( ) K L P ( j) P ( j) R F F whee denoes he nominal enal pice of capial sevices and W ( ) W epesens nominal labou coss including employes' pension and social secuiy conibuions. In he seady-sae pices P( j) ae deemined by makup, ) ove maginal coss ( z P( j) MC ( j) (4) The fis ode condiions (in logs) wih espec o capial sevices and labou ae given by w F p p log log( ) log K log( ) log( ) log ( )( y L ( )( y k ) l ) (42) (43) Due o he monopolisic compeiion in he make fo oupu, he slope of he demand cuve, log( ), enes ino boh fis ode condiions. The dynamics of he pice level P ( j) of poduce j aise fom he assumpion ha a fim changes is pice level when i eceives a andom `pice-change signal'. A consan pobabiliy of eceiving a pice change signal is given by ζ( [0,] ). Since hee is a coninuum of inemediae poduces, ζ also epesens he shae of poduces ha have eceived such a signal and hus ae able o change hei pices. The aveage ime beween pice changes is given by /( ). Solving he fis ode condiion and lineaizing in a sandad way yields he following aggegae picing equaion fo he inemediae goods poduce 7 See Ripai and Vilmunen (200) fo fuhe discussion of hei popeies and esimaes using aggegae Finnish daa. 89

98 Juha Kilponen Helvi Kinnunen Ani Ripai ( )( ) p Ep mc p. (44) Inflaion is deemined by expeced inflaion and log makup υ ove he eal maginal coss mc. p Capial enal fims Capial is a homogeneous faco of poducion ha is owned by a fim ha ens capial o poduces of domesic inemediae goods. I opeaes unde pefec compeiion. Physical capial accumulaion geneaes eal adjusmen coss in he fom of los capial sock. Capial accumulaion is given by K p I S p p p p K K, K K, 2 K (45) whee S() denoes he adjusmen coss of physical capial sock and K is he capial depeciaion faco. The capial enal fim maximizes is expeced discouned pofis max E M, { I } s0 s K s (46) subjec o he capial accumulaion equaion (45) and he definiion of capial sevices, 8 p. Is momenay pofis ae given by K K K R K R K P I I p p p p p K S K, K, K ) K p I P ( 2 K (47) The pice index of invesmen goods,, is he pice index of he domesic invesmen good eaile and R denoes enal ae fo capial. Fuue pofis ae discouned using he nominal sochasic discoun faco (picing kenel) s C C M U ( C ) P /[ U ( C ) P ]. The fis ode condiion wih espec o capial, s p K sock s is given by s P I 8 Fo simpliciy we assume ha capial sevices ae deemined by he lagged value of physical capial sock. In a moe geneal case by Ripai and Vilmunen (2004) capial sevices depend also on he endogenous uilizaion ae. This exension ales he esuls only in business cycle fequencies and is hus beyond he inees of his sudy. 90

99 Populaion ageing in a small open economy 9 (48) Due o he end-of-peiod iming of physical capial sock, he accumulaed physical capial is in use in he following peiod. Hence, he expeced following peiod's enal ae govens he cuen peiod invesmen decision. The adjusmen cos funcion is quadaic in changes of he physical capial sock (49) The usual `invesmen equaion' can be obained by subsiuing he paameic vesion of adjusmen coss ino he fis ode condiion Poducion of final goods The economy is inhabied by wo eailes ha poduce final goods, one poducing consume goods and he ohe capial goods. They combine domesic inemediae inpus, poduced by inemediae goods poduces, and impoed goods and sevices, and opeae unde pefec compeiion. The demand fo eailes' oupu is given by consumpion and invesmen of he pivae and geneal govenmen secos. The oupu of he consumpion-goods eaile divides ino he pivae consumpion and public puchases of make goods,. The capial-goods eaile faces simila demand compising pivae seco and public seco invesmen,. The poducion echnology is CES fo boh eailes 9 is he especive shae paamee and he especive subsiuion paamee ( ). denoes impos and he domesic inemediae good. Cos minimizaion geneaes following pice indices, 9 We absac fom he ime-vaying faco augmening echnical pogess, which eflecs changes in pefeences fo domesic and impoed inemediae goods.. 0 ),, ( ),, ( ),, ( ,, 2 p p p I K p p p I p p p I K K K P M E K K K P R M E K K K E P S S S R. 2 (.) 2 2 p p p K K K S SF H T C C C S T I I I T j j j j j C I j M Y Q j j j,, ) ( / j j j j /( j M j Y j j j j j j j j Mj j j c j P P P ) ( ) ( ) (

100 Juha Kilponen Helvi Kinnunen Ani Ripai and he condiional faco demands, Y M j j j j j ( ) P c ( ) P j P ( j Mj c j ) P C Q j j Q j. C The consumpion-goods eaile pays he indiec axes,. Hence he ax base fo indiec axes consiss of pivae consumpion and govenmen puchases. No indiec axes ae levied on invesmen goods. The elasiciy of subsiuion beween impoed consumpion goods and domesic inemediae poducs has been esimaed by Ripai and Vilmunen (2004). Using C coinegaion echniques hey find ha ˆ (sandad eo 0.049) C implying ha he elasiciy of subsiuion is 4.4. is calibaed a The esimaion of elasiciy of subsiuion beween impoed invesmen goods and domesic inemediae goods suggess a value of 2.2, which is given by he I esimae of ˆ (sandad eo 0.83). This means ha he facos ae I goss-subsiues. The calibaed value of he shae paamee is X The expoe is a fim ha combines domesic inemediae inpus Y and R impoed aw maeials M o poduce expo good X in compeiive makes. Technology and pefeences ae idenical o hose of he eailes. Ripai and Vilmunen (2004) assume ha he impoed-aw-maeials-augmening echnical change may conain a deeminisic linea ime end. This end capues he sucual change in inpu usage of expos. The esimae of he elasiciy of X subsiuion is 0.45, implying ha.27 (sandad eo 0.378). No supisingly, he poin esimae suggess ha he impoed aw maeials and he domesic inemediae inpu ae goss-complemens in he poducion of expoed X goods and sevices. The calibaed value of he shae paamee is Impoing fims Impoed goods and sevices ae used by he eailes and he expoe. They combine impoed and domesically poduced inemediae goods o poduce final consumpion, capial and expoed goods. The consume goods and sevices (including 5% of impoed enegy) ae used by he consumpion-goods eaile, capial goods and sevices ae used by he capial-goods eaile, and he expoe uses enegy and inemediae goods in poducing expoed goods. Boh eailes opeae unde pefec compeiion in he oupu makes. A model fo impo pices of impos by main use, i.e. fo he eaile seco, is deived by via he appoach of Bes and Deveeux (996) and (2000) applied o he Finnish 92

101 Populaion ageing in a small open economy aggegae impo daa by Feysäe (2003). A poion of impoes pice hei poducs in local (Finnish) cuency and he ohe impoes in poduces' own cuencies. Thei picing conains idenical ficions in he fom of Calvo (983b), ie hey can change hei pice only if hey eceive a andom signal allowing hem o opimize a new pice. Thei maginal coss ae idenical. The aggegaion of picing behaviou ove hese wo ypes of impoes yields an impo-pice Eule equaion whee impo pices depend on expeced fuue impo pice inflaion, cuen and expeced fuue changes in foeign exchange aes, and on impoes' eal maginal coss. This bings incomplee exchange ae pass-hough ino he model Make equilibium All makes ae in equilibium a all poin of imes. The capial goods make is in equilibium when he supply of capial sevices by he capial-enal fim equals he demand fo capial sevices by inemediae goods poduces. Similaly he labou makes ae in equilibium when he demand fo labou s D equals is supply, L L. In he inemediae goods seco, he demand fo inemediae goods by eailes and expoes equals oal supply Y C Y I Y X Y. (50) Makes fo final goods clea when P S X W P C S I C G W M H I W C I T T X, (5) W W whee P is he aggegaed expo pice of compeing economies and M is aggegae impos of expo makes. When make cleaing condiions hold, he wokes' and pensiones' budge consains and, he geneal govenmen budge consain (2) and (20) he pension fund's budge consain (budge, pension fund) imply he following equaion fo he accumulaion of foeign asses S A W ( F ) S A P X P M P M P M W X MR R MC C MI I adebalance (52) 20 As incomplee exchange ae pass-hough is no essenial fo he ageing simulaions povided in his pape, we absac fom explici deivaion. Deivaion is povided in Ripai and Vieola (2004). 93

102 Juha Kilponen Helvi Kinnunen Ani Ripai The cuen accoun balance is given by F W accoun by S A. 3.3 Policy designs W W S ( A A ) and he faco income 3.3. An oveview of he pension sysem and pension efom in Finland The model developed above will be used o sudy populaion ageing and policy expeimens in he small open economy of Finland. Fis, we se ou he Finnish pension scheme and pension efom effecive since The pension scheme in Finland is defined benefi in he sense ha pension benefis ae no diecly dependen on conibuions of wokes o employmen pension schemes o/and he yields of pension funds. Insead, of oal benefis being changed, i has been conibuion aes ha have been aleed in esponse o possible shofalls in he balance. When hee has been a dange of a shofall in he ageed funding ae, he level of conibuions has been aised. The second geneal feaue of he Finnish sysem is he negligible ole of pivae and occupaional pension schemes of pivae fims. Nealy all old age pensions ae povided by employmen pension insiuions o naional pension insiuions closely conolled by he sae. The laes efom, effecive fom he sa of 2005, changed he pension sysem in line wih moe acuaial pinciples. Wih he inoducion of flexible eiemen age, 63 o 68, he level of pensions becomes linked moe explicily han befoe wih exi age and hus wih conibuions made by he insued. Fuhemoe, saing fom 2009, changes in life expecancy will have an effec on pension levels. In addiion, pension indexaion has been changed so ha all pensions will be indexed using weighs of 0.8 fo living coss and 0.2 fo wages, wheeas befoe a `midway index' was applied up o age 65. This will conibue o a compaaive eosion in pension values, and hus o a decline in he pension eplacemen aio, compaed o wage level. Conibuions ae colleced fom employes and employees. Cuenly, 6.8% is colleced on aveage fom employes and 4.6% fom employees. I has been ageed ha fuhe changes in conibuion aes will be shaed equally (50-50) beween employes and employees. Due o he benefi-based naue of he Finnish employmen pension sysem, long-em aggegae pension expendiue can be appoximaed simply fom demogaphic facos and paamees deemining aveage pension benefis. The mos impoan facos ae naually demogaphic ends and he aveage age a which people sa o daw pensions, which ogehe deemine he oal numbe of pensiones. The aveage level of pensions is affeced by wage levels and he pension index, and hus by consumpion pices and poduciviy developmens. In addiion, changes in life expecancy will have an effec on level of benefis so ha he eplacemen ae became dependen on exi age. 94

103 Populaion ageing in a small open economy Model's calibaion iniial seady sae Fo he pupose of simulaing he model, he quaniy vaiables ae de-ended by he labou-augmening echnical faco L, populaion N and he numeaie pice level P. As fo labou make vaiables, he nominal wage is scaled by he labou augmening echnical change L and consumpion deflao P C. Labou supply indices ae scaled by populaion N. Finally, all he ohe pice vaiables ae de-ended by he numeaie pice level. In ode o se up he model fo demogaphic simulaions and policy expeimens, we assume ha he economy is iniially in he seady sae. The economy is gowing on he balanced gowh pah and he demogaphic sucue is sable. The model's key paamees ae hen calibaed o eflec he main feaues of he Finnish economy. The key paamees ae calibaed so ha he key `gea aios', faco shaes, paicipaion aes, demogaphic sucue as well as fiscal vaiables eflec he siuaion in he Finnish economy on aveage duing he las 0 yeas. The paamees of he poducion funcions wee esimaed using co-inegaion mehods (Johansen, 995), and he paamees elaed o capial sock adjusmen coss, depeciaion funcion and impo pices ae esimaed using GMM. 2 Tables (calibemand) (calibupply) chaaceize he calibaion of some of he key paamees and esuling values of he key endogenous vaiables. We nex commen on he calibaion of key paamees. In ode o fi he paicipaion aes obseved we se he elaive efficiency of eiees a oughly 30%. Elasiciy of peiodic uiliy wih espec o consumpion was a 0.8 and ine-empoal elasiciy of subsiuion a 0.4. The public-finance lieaue ends o use values well below uniy fo he ine-empoal elasiciy of subsiuion, while he RBC lieaue pefes lage value of. Typically, smalle value of makes he economy eac moe songly o fiscal simulus (Table ). Reflecing a calibaed value of peiodic uiliy of consumpion, he value fo he Fisch elasiciy of labou supply fo wokes is in line wih inenaional micoeconomic sudies, which epo he values of Kuismanen (2005a, 2005b) has also esimaed compensaed labou supply elasiciies using Finnish Labou Foce suvey daa. Depending on he daa sample and mehods used, his esimaes ange fom 0.08 o The disibuion of wealh beween woking-age and eldely pesons seems easonable in ligh of he demogaphic sucue: 7% of he model economy's oal financial wealh is owned by eiees. is an addiional faco ha muliplies he woke's discoun faco. P 2 Fo deailed descipion of esimaion saegies, see Ripai and Vilmunen (2004). 22 Bayomi, Laxon and Peseni (2004) use he value 0.33 in he sandad calibaion of GEM fo he euo aea. 95

104 Juha Kilponen Helvi Kinnunen Ani Ripai This addiional discoun faco is clealy highe han hose obained in Gele (999). The diffeence is lagely explained by he disoing naue of axes. Similaly, eiees maginal popensiy o consume is `only' 60% highe han ha of he wokes. 23 Table Calibaion of key demand side paamees Vaiable Explanaion Value subjecive discoun faco, paamee v elasiciy of peiodic uiliy wih espec o F w consumpion Ine empoal elasiciy of subsiuion, paamee Labou efficiency of eiees, paamee Relaive maginal popensiy o consume, vaiable Woke's maginal popensiy o consume, vaiable Disibuion of financial asse wealh, vaiable Addiional discouning faco Fisch elasiciy of labou supply (wokes), vaiable Fisch elasiciy of labou supply (pensiones), vaiable Regading paamees affecing mos songly o pension sysem and demogaphic sucue, we assume ha individuals wok on aveage 43 yeas and say in eiemen fo abou 5 yeas. Annual gowh ae of woking age 23 We assume ha aveage expeced ime beween pice changes is 5 quaes, while wage changes occu on aveage only evey 8 quaes. In compaison o he lieaue, wage changes occu seldom, bu he values eflec he Finnish cenalized wage seing sysem and he fac ha cenalized wage conacs ae usually se fo - 2 yeas ime in Finland. Similaly, he Calvo paamee fo pices is on he high side. 96

105 Populaion ageing in a small open economy populaion is se a 0.8% pe annum (Table 2). The seady sae eiee woke aio hen amouns o 33 %, in accod wih ecen daa The pension ae is calibaed a 0.55, which, given endogenous aveage wage and demogaphic sucue means, ha pension expendiues amoun o 20%% of oal wages, also oughly in accod wih ecen daa. Finally, he pension conibuion ae o employees is 3.9 pe cen, while he employees' conibuion ae amouns o 5.4%, so ha oveall pension conibuion ae is 9.3%. Table 2 Calibaion of key paamees of he pension sysem Vaiable Explanaion Value Expec 4.8 ed ime of eiemen, in yeas, paamee Expeced ime of woking, in yeas, paamee 43. w Nˆ WP FP R T Annual gowh ae of woking age%, paamee Old age dependency aio, vaiable Pension conibuion ae of he wokes%, implici Pension conibuion ae of he fims%, paamee Pensions,% of wage sum, vaiable Pension ae Regading public seco (excluding pension fund) i is assumed ha he seady sae deb o oupu aio is 60%, while oal public consumpion amouns o 20.8% of oupu (Table 3). Toal social secuiy ansfes o wokes ae 6.4% of oupu. Finally labou income ax ae is calculaed endogenously so as o saisfy he sae's budge consain, while he es of he ax paamees have been se exogenously eflecing he cuen ax sysem in Finland. 97

106 Juha Kilponen Helvi Kinnunen Ani Ripai Table 3 Calibaion of key paamees of he sae Vaiable Explanaion Value S a WS K C FS S c SW T Fiscal ule adjusmen, paamee Deb (% of oupu), vaiable Income ax ae% of wokes, implici Copoae ax ae%, paamee Indiec ax ae%, paamee Fim's social secuiy conibuion ae, paamee Public consumpion (% of oupu), vaiable Toal ansfes o wokes (% of oupu), vaiable Regading he supply side of he economy, we assume ha he eal inees ae is abou 2.4% pe annum (Table 4). The economy gows on he balanced gowh pah a he ae of 2.3% pe annum, eflecing he labou-saving echnical change and seady sae gowh ae of he populaion. Given he small size of Finland in he euo aea, he feedback fom Finnish economy o euo aea level is vey modes. Thus a easonable appoximaion is ha he euo aea policy ae is exogenous and ha he nominal exchange ae is fixed. The foeign nominal inees ae deemines he domesic nominal inees ae up o he UIP condiion. On he balanced gowh pah, inflaion is se a 2.0% in accod wih he inflaion age of he ECB. Pice makup and he shae pice-o-equiy aio ae oughly in accod wih empiical evidence, 24 while capial shae paamee and elasiciy of subsiuion beween capial and labou have been esimaed fom hisoical daa by Ripai and Vilmunen (200). Capial depeciaion ae is se o 8% pe annum. 24 Kilponen and Sanavia (2005) esimae fom micodaa ha he pecenage shae of opeaing pofis in he value of goss oupu in Finnish manufacuing fims was oughly 8% duing he las decade. 98

107 Populaion ageing in a small open economy Finally, Table 5 summaizes key `gea aios', faco shaes, ne foeign asse posiion and employmen aes a iniial equilibium. Compaison wih ecen daa shows ha he model fis he daa easonable well. The model's cuen calibaion, howeve, involves some difficulies in capuing he elaively low invesmen and pivae consumpion shaes obseved in he daa. Table 4 Calibaion of key paamees fo he supply side Vaiable Explanaion Value R F c / Pˆ Real inees ae, p.a., vaiable 2.4 Y Oupu gowh ae, p.a., vaiable 2.3 ˆ Labou saving echnical change p.a., paamee L K F A / Capial depeciaion ae, paamee Pice makup, paamee Pice o equiy aio, vaiable capial shae paamee El. of subsiuion beween capial and labou

108 Juha Kilponen Helvi Kinnunen Ani Ripai Table 5 Gea aios, faco shaes and paicipaion aes Vaiable Explanaion The daa Seady Sae H c i x m ls k / l w a l w l l Pivae consumpion shae, % Pivae invesmen ae, % Expo shae, % Impo shae, % Labou shae, % Capial inensiy Ne foeign asses, % Employmen ae, % Wokes Reiees Shaes calculaed in nominal ems excep fo capial inensiy Policy expeimens In ode o faciliae analysis of faily complex geneal equilibium effecs associaed wih ageing and diffeen assumpions ha can be made abou he pension paamees, we designed some alenaive demogaphic scenaios and policy expeimens. The long-un implicaions of ageing populaion ae eaed as shocks o he iniial sae of unchanged demogaphic age sucue and seady pace of populaion gowh. We pefomed five diffeen simulaions alogehe, as epoed in able Shocks. 00

109 Populaion ageing in a small open economy Table 6 Demogaphics shocks elaive o iniial seady sae Expeimen Change I II III IV V Expeced peiod of eiemen, yeas Gowh ae of wokes, pecen annually Expeced woking ime, yeas Pension eplacemen ae, % poins 0 μ* *endogenous The shock simulaing populaion ageing incopoaed boh he highe life expecancy pojeced in he populaion foecas and he slowdown in he gowh of woking-age populaion. Highe life expecancy was simulaed by inceasing he expeced peiod of eiemen by 5 yeas (able Shocks, columns I-II) and hen supplemening he shock wih a longe expeced woking ime of 2.5 yeas, while aking ino accoun he slowdown of he gowh of woking age populaion (Table 6, column III). Expeimen II is a pue demogaphic shock ha capues he main demogaphic ends. Accoding o he laes populaion pognoses, he fases gowh in he old age dependency aio will ake place in he 2020s and 2030s, when he baby boom geneaion, bon afe he Second Wold Wa, eies. Afe ha, he aio will gow a a slowe pace. The oveall dependency aio is pojeced o level off by he 2030s. Immigaion is foecas o emain insignifican, a only 5000 pesons a yea ne. Finally, accoding o Saisics Finland esimaes, he life expecancy fo men will ise fom he cuen 75. yeas o 82. yeas by Fo women he coesponding figues ae 8.8 and 86.8 yeas. Feaues inheen in he pension scheme, i.e. defeed eiemen in esponse o acceleaed accual and a lowe eplacemen ae, wee buil ino he demogaphic effecs by loweing he pension eplacemen ae by 0 pecenage poins (column IV). The analysis was compleed wih an equilibium calculaion whee he eplacemen ae was endogenously defined while he ae of employee conibuion was kep unchanged, a is iniial seady sae level (column V). 0

110 Juha Kilponen Helvi Kinnunen Ani Ripai 3.4 Long-un effecs of ageing 3.4. Inceasing life expecancy Incease in life expecancy pojeced in he demogaphic foecas fo Finland alone would have a ponounced effec on he economy's long-un equilibium. Exension of he peiod of eiemen by five yeas, as assumed in he calculaion, would imply an incease in he old-age dependency aio of pecenage poins. This would lead o 6.3 pecenage poin incease in oal pension expendiues elaive o oal wages. Tax buden on labou would aise by moe han 3.7 pecenage poins and would be efleced in falling employmen aes. The oal conibuion ae would ise by 6.7 pecenage poins. (Table 7, column I). Given age cohos of he same size and a sable feiliy ae, highe life expecancy alone would impose a consideable buden on he economy. The falling employmen ae of wokes is aibuable o a highe ax buden on labou, so ha he afe-ax wage ae declines slighly. These facos ae efleced in ising eal wages in he long-un. The consumpion esponse, measued as a shae of oupu, eflecs households' diffeen maginal popensiies o consume. Reiees own a lage shae of he economy's financial wealh and ae moe willing han wokes o consume i. Mio effec of his is ha capial shae is highe in he aged economy Declining feiliy ae Consideing ha age cohos eneing he labou make ae smalle han hose wihdawing, he old-age dependency aio would incease by almos 6 pecenage poins (Table fiscalongem, column II). Tax ae and employmen esponses would also be ponounced, in ha he pension conibuion ae would incease by 8.8 pecenage poins and he income ax ae by 3.4 pecenage poins. The employmen ae would fall by almos 6 pecenage poins eflecing a maked incease in eal wages. The pivae consumpion shae would incease by 6.2 pecenage poins elaive o he iniial sae of consan populaion gowh. The majo incease in ax aes is elaed no only o pension expendiues bu also o he song esponse of wokes' employmen aes. This educes ax bases, even if eiees supply moe labou. Reiees posiive labou supply esponse is aibuable o a longe eiemen peiod. 02

111 Populaion ageing in a small open economy Table 7 Long-un effecs of ageing Final Seady Sae, Change Vaiable Explanaion I II III IV V Old age dependency aio** P a) Conibuion ae** WS Labou income ax ae** R T WL w c) ( )w c) Pension expendiue/wage sum** Real wage* Afe ax eal wage* H c l w l l k w a Pivae consumpion shae* Wealh disibuion** Employmen ae** Wokes Reiees Capial shae* Ne foeign asses** b) Pension eplacemen ae** y Oupu, efficiency unis * Pecenage change elaive o iniial seady sae ** Change, pecenage poins elaive o iniial seady sae a) Conibuion ae kep fixed a iniial seady sae, b) endogenous, c) in effociency unis 03

112 Juha Kilponen Helvi Kinnunen Ani Ripai Pension efom and a lowe eplacemen ae I has been esimaed ha he pension efom will exend labou foce paicipaion by an aveage of 2-3 yeas. This alone would clealy ease he buden of an ageing populaion (Table 7, column III). The need o incease he conibuion would be educed by.8 pecenage poins. Similaly, he need o aise he labou income ax ae would decease almos as much, compaed o he pue demogaphic shock. This would in un be efleced in smalle employmen losses in he long-un. The decline in aveage eplacemen induced by he ules of pension indexaion also has a consideable effec on susainabiliy of he pension scheme. This effec was measued by he assumpion ha he aio of aveage pension o aveage wage would decline by 0 pecenage poins, i.e. clealy less han ha suggesed by he calculaion discussed above. This would consideably educe he need o aise he conibuion ae in esponse o populaion ageing in he long-un. The labou income ax ae could be kep a he cuen level, and conibuion aes would need o be aised only by.3 pecenage poins. (Table 7, column IV). Pension expendiue would aise 4.7 pecenage poins less han he figue euned by he pevious simulaion (column III). Accoding o he esuls of he equilibium calculaion based on given ae of conibuion, we find ha pensions would, in he long-un, have o decline fom hei cuen levels by 2 pecenage poins elaive o aveage wages (Table 7, column V). This would ensue ha he aio of pension expendiue would incease only by % pecenage poin elaive o oal wages in esponse o populaion ageing. Howeve, eal wages would sill incease by 0%, while he employmen ae would fall by 3 pecenage poins. Once moe, eiees' incenives o wok would be impoved, pimaily because of he wealh effec compaed o he pevious expeimen. Finally oupu would emain viually inac in his case. 3.5 Dynamic effecs Dynamic opimizaion and pefec foesigh assumpion implies ha he ansiion pahs of he macoeconomic vaiables eflec he way in which opimizing agens pepae fo a new demogaphic siuaion. These adjusmen pahs ae fuhe complicaed by ou assumpion ha demogaphic sucue is changing ove ime. The adjusmen pahs can ypically involve ove- o undeshooing of fowad looking vaiables, even hough he ansiional pah of a demogaphic shock is a smooh slowly evolving pocess. One such vaiable is consumpion, which ypically iniially jumps and hen begins gadually o adjus o he new long-un seady sae. This is efleced in ove- o undeshooing of wages and employmen, given ha leisue and consumpion ae non-sepaable in he peiodic uiliy. 04

113 Populaion ageing in a small open economy Figue shows how he model economy esponds o a pue anicipaed shock o eiemen age (I) and o he shock whee he feiliy ae dops as descibed in expeimen II. 25 Figue Pue demogaphic shocks and ansiion.(blue line coesponds o expeimen I and ed line o expeimen II. Peiods ae quaes.) Afe a empoay dop in disibuion of wealh (in favou of wokes), eiees evenually hold a lage shae of he economy's financial wealh. The woke's ax buden on labou follows a simila paen. Aggegae consumpion eacs in advance of anicipaed demogaphic change and sas sabilizing well befoe he demogaphic change is ove. Beyond he esponse of aggegae consumpion, hee ae opposie esponses of eiees and wokes. While he wokes incease saving fo eiemen by educing hei consumpion, and also because of a highe ax buden, eiees espond posiively. Reiees ae also now moe numeous as shown by he gadual ise in he dependency aio. A lowe feiliy ae, besides 25 All he simulaions wee done using DYNARE, vesion

114 Juha Kilponen Helvi Kinnunen Ani Ripai inceasing life expecancy, gadually inceases he dependency aio and leads o a fuhe incease in he pension conibuion ae. This effec is also associaed wih a slighly highe consumpion shae and lowe employmen ae. 26 Figue 2 illusaes how an exension of woking life and a lowe eplacemen ae alleviae he effecs of a pue demogaphic shock. Consumpion shae is pacically inac (ed (lighe gay) line), while he need o incease conibuion aes gadually ease along wih a less ponounced incease in he dependency aio. Capial shae inceases iniially wih he exension of woking life bu evenually euns o a vey close o he same level as wih a pue demogaphic shock. Longe woking ime means ha hee is a oughly one pecenage poin impovemen in employmen ae compaed o a pue demogaphic shock. Exending he simulaion by aking ino accoun also a lowe pension eplacemen ae shows ha he consumpion shae may now fall in he sho and medium em. A dop in he eplacemen ae educes pensiones' pemanen income, wih a subsequen empoay fall in consumpion levels. As he need o aise he conibuion ae gadually eases, employmen impoves ahe quickly, while consumpion bounces back only afe a seveal decades. Mioing his, hee is also a empoay fall in capial shae and a pemanen fall in disibuion of wealh held by he eiees Highe long-un capial and consumpion shaes ae compaible wih he Blanchad-Yaai asse make equilibium condiion. In essence, he condiion poduces a posiive elaionship beween consumpion and capial sock, as equied by he cuen accoun balance in an open economy. 27 These esuls ae naually subjec o unceainy egading calibaed and esimaed paamee values of he model, as well as assumpions on he exenal envionmen of he economy and demogaphic pojecions. In paicula ine-empoal subsiuion ( ) and elasiciy of peiodic uiliy wih espec o consumpion ( ) guide he dynamic and long un esponse of consumpion, eal wages and employmen, which in un mae how he ax buden on labou evolves in esponse o populaion ageing. Subsequen sensiiviy analysis shows ha a highe value of ine-empoal subsiuion miigaes he effecs of pue demogaphic shock on axes, while he opposie is ue fo lowe values of. Paamee affecs pimaily on he long-un esponse of he economy o populaion ageing as well as he iniial seady sae. Sensiiviy analysis suggess ha highe values of lead o somewha smalle esponse of he conibuion ae which in un is associaed wih a slighly smalle negaive esponse of employmen. 06

115 Populaion ageing in a small open economy Figue 2. Exensions of woking life and lowe eplacemen ae ease fiscal buden of ageing.(red line coesponds fo expeimen III, blue line o expeimen IV; baseline is a pue demogaphic shock; peiods ae quaes Demogaphic unceainy Populaion scenaios and ageing eflec pojeced changes in feiliy aes and longeviy. These populaion scenaios ae howeve subjec o much unceainy. OECD (2005) has epoed ha in he case of Finland, oveall unceainy suounding longeviy and feiliy ae pojecions suggess ha he dependency aio will flucuae ±0 pecenage poins aound he official scenaio. 28 Rahe simila esuls wee obained in he pojec `Unceain Populaion of Euope' (UPE) funded by he EU Commission. In his pojec, sochasic populaion foecass wee geneaed by simulaing 3,000 alenaive pahs of fuue developmen fo age-specific moaliy, feiliy and ne migaion fo diffeen Euopean counies. These diffeen scenaios wee hen combined ino 28 Assessing he obusness of demogaphic pojecions in OECD counies, Fedeic Gonand, Economics Depamen Woking Papes, No. 464, OECD) 07

116 Juha Kilponen Helvi Kinnunen Ani Ripai populaion scenaios using he classical coho-componen book-keeping equaions. Based on he esuling age-specific coho ables fom diffeen simulaions, able demogaphic unceainy, Table summaizes he saics elaed o he old-age dependency aio elevan o he model. This helps us ancho he degee of unceainy elaed o he old-age dependency aio in Finland and hus quanify he degee of unceainy elaed o demogaphic ends. The able suggess ha isks of making lage eos in populaion foecass incease afe 2020, making he confidence limis expand quie fas (see also Alho (998)). Table 8 Summay saisics fom sochasic populaion simulaions (based on own calculaions fom hp:// ) Yea Min Mean Max S.E In ode o quanify how he demogaphic unceainy feeds ino he model's oucomes, we ake expeimen III as a baseline (see able Shocks), bu allow fo sochasic vaiaion in eiemen pobabiliy ( ), suvival pobabiliy ( ) w and woke's gowh ae Nˆ. Allowing fo sochasic vaiaion in hese vaiables geneaes sochasic vaiaion fo he model's endogenous vaiables along he ansiion pah. 29 We calibae he unceainy in eiemen pobabiliy and suvival pobabiliy such ha he 90% confidence inevals fo woking ime and eiemen ae especively ±2 and ±4 yeas a he final seady sae of he model. Fuhemoe, we assume ha he populaion gowh ae has a 90% confidence ineval of 0.5% in annual ems. This geneaes empiically plausible vaiaion in dependency aio, amouning o a 4% sandad eo. Figue 3 shows he 90% confidence inevals geneaed by hese assumpions on he elevan demogaphic 29 DYNARE's funcions foecas and soch_simul allow mixing of deeminisic and sochasic shocks.we ae indebed o Michel Juillad fo developing hese funcions. 08

117 Populaion ageing in a small open economy vaiables, while able demogaphic unceainy, Table 9 summaizes he esuls fo seleced endogenous vaiables a he final seady sae. Figue 3 Mean oucome and 90% confidence inevals geneaed by he sochasic vaiaion in eiemen pobabiliy, suvival pobabiliy and populaion gowh ae. I is eviden ha hee much unceainy abou economic oucomes of he model, once unceainy as o demogaphic sucue is accouned fo. A sandad eo of 4% fo he dependency aio anslaes o oughly a 3 pecenage poin sandad eo in he labou income ax and conibuion aes. Vaiaion in he employmen ae is oughly 2 pecenage poins. Sochasic simulaions allow us also o quanify he elaive impoance of diffeen demogaphic shocks o economic oucomes. This can be done by looking a (asympoic) vaiance decomposiion as geneaed by he sochasic simulaions of he model. Alhough he esuls of vaiance decomposiion depend on he assumed elaive sandad eos of he shocks, columns 5-7 in able demogaphic unceainy, Table 2 clealy sugges ha lenghening he woking ime has ahe mino effec on alleviaing he fiscal buden of ageing: Only abou 3% of he sochasic vaiaion in he conibuion ae is explained by he 09

118 Juha Kilponen Helvi Kinnunen Ani Ripai vaiaion in woking peiod. Sochasic vaiaion in he ime spen in eiemen is clealy moe impoan. Table 9 Asympoic momens fom sochasic model simulaions fo seleced model s vaiables Vaiable Explanaion Mean Sandad Eo Vaiance Decomposiion ω γ P Dependency aio Conibuion ae WS Labou income ax ae T R WL Pension sum exp/wage y Oupu, unis efficiency L/N 4 Employmen ae Woking ime, yeas ( ) Reiemen, yeas W Nˆ Gowh ae of wokes a) All he momens ae evaluaed a final seady sae 0

119 Populaion ageing in a small open economy 3.6 Conclusions As indusialized counies pepae fo populaion ageing, pension efoms have been designed wih he aim on inceasing incenives o wok longe and/o cuing pension benefis. One pominen example fom Euope is Finland, whee he laes pension efom inoduced a flexible eiemen age of beween 63 and 68. Using a acable dynamic geneal equilibium model calibaed o Finland, we show ha even if he effecive eiemen age wee o incease as expeced, he buden fom pension paymens alone would cause he income ax ae o ise o a level above ha winessed in he wos yeas of ecession in he mid-990s. A sochasic simulaion execise suggess also ha lenghening he woking ime has a ahe mino impac on alleviaing he fiscal buden of ageing: only a mino pa of he sochasic vaiaion in he conibuion ae is explained by he vaiaion in woking peiod. On he conay, if he eplacemen ae falls, as seems likely unde he cuen pension egime, hee would be a much smalle incease in axaion in esponse o gowing expendiue on pensions. The aveage decline in he level of pensions elaive o wage developmens in un aises seveal concens. In Finland, whee supplemenay pension funds ae of mino impoance by inenaional sandads hee is a isk ha he falling puchasing powe of pensions elaive o wage developmens will exe pessue on ohe social secuiy schemes. The employee pension scheme, which appeas o be financially susainable, may hus in pacice geneae coss o local and cenal govenmen in he fom of highe expendiue on income suppo and ohe benefis. Refeences Alho, J. (998): A sochasic foecas of he populaion of Finland. Kasauksia 998/4, Saisics Finland. Auebach, A. J. Kolikoff, L. J. (987): Dynamic Fiscal Policy. Cambidge Univesiy Pess, Cambidge, England. Bes, C. Deveeux, M. B. (996): The exchange ae in a model of picing-omake. Euopean Economic Review, 40, Bes, C. Deveeux, M. B. (2000): Exchange ae dynamics in a model of picing-o-make. Jounal of Inenaional Economics, 50,

120 Juha Kilponen Helvi Kinnunen Ani Ripai Bisöm, P. Klaavo, T. Risku, I. Sihvonen, H. (2005): Eläkemeno, -maksu ja ahaso vuoeen 2075 (pension expendiue, conibuions and eseve funds pojeced unil 2075). Repos of he Finnish Cene fo Pensions, No. 36. Blanchad, O.J. (985): Deb, deficis and finie hoizons. Jounal of Poliical Economy, 93(2), Calvo, G. (983a): Saggeed conacs in a uiliy-maximizing famewok. Jounal of Moneay Economics, 2, Calvo, G. A. (983b): Saggeed pices in a uiliy-maximizing envionmen. Jounal of Moneay Economics, 2, Diamond, P. (965): Naional deb in neoclassical gowh model. Ameican Economic Review, 55, Dixi, A. Sigliz, J. (977): Monopolisic compeiion and opimum poduc divesiy. Ameican Economic Review, 67, Fame, R. E. (990): Rince pefeences. Quaely Jounal of Economics, 05, Fenge, R. Weding, M. (2003): Ageing and fiscal imbalances acoss geneaions: Conceps and measuemen. CESifo Woking Pape, No Feeo, A. (2005): Demogaphic ends, fiscal policy and ade deficis. Mimeo, New Yok Univesiy. Feysäe, H. (2003): Pice seing behavio in an open economy and he deeminaion of Finnish foeign ade pices. Suomen Pankki, Helsinki. Bank of Finland Sudies, E:25. Fujivaa, I. (2006): Moneay policy in a life-cycle economy: Disibuional consequences of moneay policy ule. Unpublished manuscip, Bank of Japan. Gele, M. (997): Govenmen deb and social secuiy in a life-cycle economy. Woking Papes 6000, Naional Bueau of Economic Reseach. Gele, M. (999): Govenmen deb and social secuiy in a life-cycle economy. Canegie-Rochese Confeence Seies of Public Policy, 50(), 6 0. Gafenhofe, D. Jaag, C. Keuschnigg, C. Keuschnigg, M. (2005): Pobabilisic aging. Discussion Pape No , Depamen of Economics, Univesiä S. Gallen. Jalava, J. Pohjola, M. Ripai, A. Vilmunen, J. (2006): Biased echnical change and capial-labou subsiuion in Finland, Topics in Macoeconomics, 6, Aicle 8. Available in hp:// opics/vol6/iss/a8. 2

121 Populaion ageing in a small open economy Johansen, S. (995): Likelihood-Based Infeence in Coinegaed Veco Auoegessive Models. Oxfod Univesiy Pess, Oxfod. Kaa, E. Thadden, L. V. (2006): Moneay aspecs of demogaphic changes. Unpublised manuscip, Euopean Cenal Bank. Keuschnigg, C. Keuschnigg, M. (2004): Aging, labou makes and pension efom in Ausia. Univesiy of S. Gallen, Depamen of Economics, Woking Pape seies Kilponen, J. Ripai, A. (2006): Labou and poduc make compeiion in a small open economy simulaion esuls using a DGE model of he finnish economy. Bank of Finland Discussion Papes 5/2006. Kilponen, J. Sanavia, T. (2004): Compeiion and innovaion - micoeconomeic evidence using finnish daa. Govenmen Insiue fo Economic Reseach (VATT) Reseach Repo No. 3/2004. Kuismanen, M. (2005): Labou supply and pogessive income axaion: An empiical sudy using alenaive daa ses. Mimeo, Euopean Cenal Bank. Lassila, J. Valkonen, T. (2005): Yksiyisalojen eläkeuudisuksen aloudellise vaikuukse (financial implicaions of he efom of he pivae-seco pension scheme). The Reseach Insiue of he Finnish Economy, Seies B 2. Railavo, J. (2004): Sabiliy consequences of fiscal policy ules. Bank of Finland Discussion Papes /2004. Ripai, A. Vieola, H. (2004): Picing-o-make and impo pices in Aino model. Unpublished manuscip, Bank of Finland, Helsinki. Ripai, A. Vilmunen, J. (200): Declining labou shae evidence of a change in he undelying poducion echnology? Bank of Finland Discussion Pape 0/200. Ripai, A. Vilmunen, J. (2004): Fims and echnologies in Aino model of he finnish economy. Unpublished manuscip, Bank of Finland, Helsinki. Roege, W. (2005): Assessing he macoeconomic and budgeay impacs of sysemaic pension efoms in he EU. Mimeo, Euopean Commission. Viianen, J. (2002): Risk avesion and ineempoal subsiuion in aggegae consumpions: Finland Univesiy of Joensuu, Business and Economics Discussion Papes No. 3. Weil, P. (989): Ovelapping families of infiniely-lived agens. Jounal of Public Economics, 38, Yaai, M. E. (965): Unceain lifeime, life insuance and he heoy of consume. Review of Economic Sudies, 32,

122 Juha Kilponen Helvi Kinnunen Ani Ripai 4

123 4. Govenmen funds and demogaphic ansiion - Alleviaing ageing coss in a small open economy 30 Helvi Kinnunen 4. Inoducion Populaion ageing will have pofound effecs on PAYG public pension schemes all ove he wesen wold. Financing of pomised pension benefis equies lage ax hikes causing disoions fo he labou make and income disibuion acoss geneaions. Fo he Euopean counies, whee he old age dependency aio is expeced o oughly double duing he nex fou decades, he ageing sess is paiculaly sevee. Consequenly, in ode o ensue susainabiliy of public pension schemes, a seies of pension efoms ae consideed. In addiion, povisions fo pefunding of public pension schemes ae aken in mos Euopean counies 3. By funding pa of he fuue pension oulays govenmens y o smooh he ax buden ove ime. This pape focuses on he ole of govenmen funds duing demogaphic ansiion. Moe specifically, we analyse o wha exen public pension funds can be used as an insumen o lowe he adjusmen coss duing he demogaphic ansiion. Adjusmen is consideed unde condiion ha he long em susainabiliy of he public pension schemes will be mainained. We conside he ole of he public pension funds in Finland, which conains feaues cucial fom he poin of his sudy. The Finnish pension sysem is paly funding PAYG wih defined benefi feaues. Mos impoanly, subsanial public pension funds ae aleady colleced bu neveheless he siuaion of public finances is unsusainable equiing inceases in pension conibuion aes in he long em. Ohe key feaue fom he poin of view of his sudy is ha pension funding is collecive. This means ha pension funding ae do no affec he expeced fuue wealh of households. In addiion, while pension benefis ae eanings-elaed a invidual level 32, on he aggegae level changes in he geneal conibuion aes 30 This is based on he Bank of Finland Discussion Pape Helvi Kinnunen: Govenmen funds and demogaphic ansiion - alleviaing ageing coss in a small open economy No 2/2008, Bank of Finland. 3 See discussions on Euopean pension efoms fo example in Holzmann, MacKella and Rukowski (2003) 32 Pension conibuions accue o fuue pension benefis accoding o ceain accual aes wihou uppe limis in pension benefis. 5

124 Helvi Kinnunen do no affec pension benefi. Accodingly, changes in conibuions will have he same kinds of efficiency coss as hose aibued o wage axaion. Finally, Finland is hi by an excepionally lage demogaphic shock, and, conay o mos ohe Euopean counies, in Finland demogaphic change is aleady in pogess. In addiion, unlike in mos Euopean counies, he coveage of he mandaoy public pension scheme is exensive. In pacice, pivae volunay pension insuance is quie negligible. Role of he pension funds in alleviaing economic eacions on demogaphic change aises fom he disoioy effecs of he labou axaion. If axaion could be loweed by cuing down pefunding, we could educe he disoions on behaviou aising paiculaly fom he subsiuion of leisue fo wok in esponse o axaion on labou. By educing deadweigh loss, he lowe axaion could also change allocaion of esouces. In a small open economy labou make eacions lowe wage levels and, accodingly, pension coss, which fo is pa incease he shae of pension paymens he eun on pension funds coves. These channels ae incopoaed ino he DSGE model we use in his sudy. I includes wo age goups and faciliaes analysing disoionay effecs of fiscal and pension policy esponses o ageing. The defined benefi PAYG pension sysem wih wage-dependen pension benefis and collecive pefunding is incopoaed ino he model. Households' wealh includes social secuiy wealh in he fom of discouned pension enilemens, independen of funding and conibuion aes, and ageing shocks epesen cuen populaion pognoses. The model conains sepaae fiscal policy ules and accouns fo he sae and public pension insiuion. Moeove he supply side is explicily modelled. Kilponen, Kinnunen, Ripai (2006) consideed demogaphic shock and he consequences of some policy expeimens using he same DSGE model. I was calibaed o epesen he Finnish pension scheme, demogaphic developmens as well as macoeconomic elaions. Tha pape highlighed he cenal ole of esponses of wokes and eiees o ax changes. This pape exends his analysis by modifying fiscal policy ules in ode o give an acive ole o he pension funds in smoohing ageing effecs on he economy. Focus is also moe on he nea fuue when he demogaphic shock is lages. Ohe lieaue elaing his pape is Gues (2008) of ax smoohing beween geneaions wih explici disoionay ax effecs. Also Oksanen (2003 and 2008) examined inegeneaional ax smoohing bu wihou explici ax eacions. Close o ou poin of view is also funding adjusmen in a small open economy examined in Bovenbeg and Knaap (2008). Pension funding and fiscal policy ules ae sudied in Jafaov and Leigh (2007). Geneally, in he lieaue of pension funding, he focus has been in analysing consequences of movemen fom a publicly povided 6

125 Govenmen funds and demogaphic ansiion PAYG based pension scheme owads pivae invesmen based funding 33. Also he effecs of pension funding on financial makes, capial movemens and he macoeconomy in muliegion models have been invesigaed 34. Ohewise ageing-elaed sess on he economy has been ypically analysed by evaluaing pension efoms unde clea ax-benefi links, whee efficiency losses in ems of employmen have been ypically absen 35. In addiion, since he analysis usually have concenaed on he closed economy case, a funding-induced incease in naional saving ends incease eal capial fomaion and poduciviy, heeby impoving long em gowh pospecs. In ou case, unde a public pefunding famewok wih weak o absen ax-benefi linkages, he advanages of funding ae no clea-cu, paiculaly since in a small open economy famewok eal inees ae eacions do no suppo economic gowh. Besides he coss of ax disoions, in defined benefi famewok, pefunding does no incease he wealh of households. Simulaion expeimens of his sudy indicae ha subsanial gains can be achieved by funding adjusmen duing demogaphic ansiion. Cuing down on pension pefunding a a ime when he pace of ageing is a is peak educes he necessay ax hikes and simulaes labou supply gowh a he momen when he labou make is ighes. Unde lowe funding, ageing leads o less gowh of labou coss, bee employmen and fase poducion gowh. Given he collecive naue of pension funding, cuing back on funding did no edisibue welfae beween eiees and wokes. By loweing wage pessues and consequenly pension benefis, a smalle pefunding is needed o poduce he same welfae level han in he benchmak wih unchanged pension funding ae. In he seady sae, cu down of funds by 20 pecenage poins of he wage bill did no lowe he welfae level. The es of he pape is oganized as follows. Secion 3.2 inoduces he model, including a descipion of he pension sysem. Secions 3.3 discuss he esuls fom policy expeimen. Secion 3.4 concludes. 4.2 The Model Ou analysis is based on Gele's (999) ovelapping geneaions model. I meges he pepeual youh model of Yaai (965) and Blanchad (985) wih an impoan aspec of life-cycle behaviou. The model is an exension of Gele's 33 See fo example Feldsein (2005), Begsom and Haman (2007), Demange (2007) and MCMoow and Roege (2004) as well as OECD (2007) fo discussions of coss of pension pefunding. 34 Aanasio e al. (2006) and Bösch-Supan e al. (2003) as well as Saaenheimo (2004) 35 See fo example Jaag, Keuschnigg, and Keuschnigg (2007) and Nickel, Rohe and Theophilopoulou (2008). 7

126 Helvi Kinnunen model in he sense ha i allows fo disoionay axaion and ime vaying demogaphics. Households ae fowad looking wih sochasic ansiion fom wok o eiemen and fom eiemen o deah, which capues he life cycle behaviou of households. The defined benefi pension sysem is pa of households' social secuiy wealh and, accodingly, fuue pension enilemens ae consideed equal o ohe public ansfes. OLG feaues of he model faciliae invesigaing inegeneaional aspecs. Supply side (poducion sucue) is based on CES poducion echnology wih faco augmenaion in he undelying echnological pogess and nominal and eal igidiies. The model is closed by fiscal ules. Budgeay solvency of public finances is achieved by seing an explici age fo public pension funds and a deb age fo ohe govenmen finances. In a small open economy, any imbalance beween domesic savings and invesmen is efleced in he ne foeign asse posiion. Given ou focus on he policy of public funding, he key elaionships ae he seing of fiscal policy ules and he way axaion affecs he labou make, households' wealh and inegeneaional wealh disibuion 36. The benchmak fo he simulaions is an economy whee ageing-elaed demogaphic change is aleady incopoaed in he model oucome Households A household smoohs consumpion ove he lifecycle and lives fo wo disinc peiods: in he fis peiod as a woke and in he second as a eiee. Tansiions fom wok o eiemen and fom eiemen o deah ae capued by paamees measuing he lengh of he woking peiod and life-expecancy Demogaphics and pefeences Demogaphic paamees vay in ime and ae se o poduce a ealisic N demogaphic sucue. Dependency aio,, is expessed as N w N N w w w Nˆ Nˆ () whee he numbe of woking populaion ae w n ˆ gows a an exogenous gowh w N and is he pobabiliy ha an individual emains a woke in he 36 The model and he impac of populaion ageing in a DSGE model is epoed in deail in Kilponen, Kinnunen and Ripai (2007). 8

127 Govenmen funds and demogaphic ansiion nex peiod, while he pobabiliy of eiing is. Once an individual has eied, she faces a peiodic pobabiliy of deah of ). ( In he seady sae, he demogaphic change has ended, so ha Nˆ (2) Nˆ ˆ ˆ w N N (3) Households smooh consumpion ove he lifecycle and maximize a welfae funcion fomulaed sepaaely fo woke and eiee. Wokes' pefeences eflec he peiod a wok and he expeced peiod a eiemen while eiees ake ino accoun, beyond eiemen peiod, also he 'ineim' peiod when hey paicipae in he labou make upon eiemen. This caegoising is needed o enable us o capue he ax effecs on labou supply of eiees. Pefeences ae summaized as whee V z z v z v c z [ C ( l ) ] [ E ( V z)] c c w E ( V w) V ( ) V, w (4) E ( V ) V,. (5) z w, indicaes whehe he individual is a woke o eiee. The finie (consan) ineempoal elasiciy of subsiuion /( c) indicaes he willingness o smooh consumpion ove ime. Paamee is he elasiciy of peiodic uiliy wih espec o consumpion. The eiees' effecive discoun faco akes ino accoun he peiodic pobabiliy of deah. A Reiee The maximisaion poblem fo a eiee bon a ime j, eiing a ime k and suviving a leas unil is: [ v jk jk jk v c jk max V jk jk C ( l ) ] [ E ( V C, l )] c c (6) 9

128 Helvi Kinnunen 20 s.. jk c jk jk jk jk C P l W A R A T ) ( (7) whee R denoes afe-ax goss ae of eun on financial asses A jk and jk T denoes pension benefis. Reiees who paicipae in he wokfoce ae assumed o have los pa of hei efficiency compaed o wokes. Relaive efficiency is denoed by. Efficiency slow-down capues, besides eal labou poduciviy, also ohe facos ha lowes eiees' labou inpu as measued by wok days, such as pa ime wok. Paamee is he subjecive discoun faco, c P is a pice index fo consumpion and is he oal labou income ax ae including pension conibuion ae, WP. Reiees' human capial is H and social secuiy wealh S. Wealh is valued on a ne basis, afe wage axes and axes levied on pension income as well as pension conibuions. Maximizing wih espec o consumpion and aggegaing ove eiees esuls in he following aggegae consumpion equaion fo eiees ]. [ c A R C P S H (8) whee is eiees' maginal popensiy o consume ou of wealh. H and S epesen discouned afe-ax labou income and pensions. They evolve as / ˆ ) ( R N L W H H (9). / ˆ R N S T S (0) The gowh ae of eiees N ˆ is eneed ino he discoun faco because oal social secuiy paymens (pensions) ae disibued equally among eiees. Also he discoun faco fo human wealh is augmened by he gowh ae of eiees. Reiee's maginal popensiy o consume ou of wealh evolves accoding o he following non-linea diffeence equaion: ) ˆ ( ) ( ) ( / / c c c c c c c c v P R P W P W ()

129 Govenmen funds and demogaphic ansiion c c c whee P ˆ P / P. A eiee's maginal popensiy o consume vaies wih he eal inees ae, ˆ c R / P, as well as wih expeced changes in eal ne wage income. In addiion, he suvival pobabiliy, influences a eiee's effecive discoun ae, heeby inoducing fuhe dynamics ino he maginal popensiy o consume equaion. A Woke The maximaion poblem fo a woke bon a ime s is [ v ws ws ws v c ws max V ws ws C ( l ) ] [ E ( V C, l )] c c (2) s.. A R A ( ws ws ) W l ws T ws P C c ws (3) ws whee T denoes financial ansfes o wokes and is he oal labou income ax ae. Afe ineempoal maximizaion, he woke's consumpion plan aggegaes o P C c w [ R A w H S w w ]. (4) w whee is he woke's maginal popensiy o consume and H denoe human and social secuiy wealh. and S w Maginal popensiy o consume ou of wealh follows a non-linea fis ode diffeence equaion: W W / P / P c c c c c R ˆ c P c c whee is he faco ha weighs he goss eal eun evolves accoding c R / P (5) ˆ. This faco o [ ( ) c c ] (6) 2

130 Helvi Kinnunen 22 whee is he aio of a eiee's maginal popensiy o consume o ha of a woke. w H is he discouned sum of a woke's wage bill (in ne ems) and w S is he sum acoss wokes alive a of he capialized value of social secuiy (in ne ems). Boh of hese measues ake accoun of he coesponding discouned values a he ime of eiemen. Fomally, w w w w N R W L N R c c ) ( ˆ ˆ H H H w w w w N R N R ) ( ˆ ˆ S S T S (8) ) ( H and j S ae he values of human wealh and social secuiy fo a woking eiee who eies a ime bu is sill woking a ime. The enlaged discoun ae due o he pesence of in he denominao means ha wokes value human wealh and social secuiy less han does a eiee. This ends o educe he woke's consumpion and incease saving compaed o a eiee. The faco w N ˆ augmens he discoun ae of he capialized value of a woke's social secuiy because he shae of oal social secuiy enilemens going o hose cuenly alive declines ove ime as he woking-age populaion gows. By a simila agumen, w N ˆ enes ino he discoun faco of aggegae human wealh Labou and wages Sandad labou supply fo a eiee bon a ime j, eiing a ime k and suviving a leas unil and a woke bon a ime s evolve as jk c jk W C P v v l ) ( (9) (7)

131 Govenmen funds and demogaphic ansiion l ws c ws v P C v ( ) W (20) whee denoes axes levied on labou income. In he model, he woke faces a quadaic adjusmen in e-seing he wage ae. A facion of wokes is assumed o adjus wages in each peiod. Fo hose no able o opimize in he peiod, he wage is adjused using he seady sae gowh ae of wages, denoed dw, which equals he seady sae poduciviy gowh ae plus he inflaion ae. The behaviou of aggegae nominal wages is hen chaaceized wo wage ae equaions: W v c w P C / v w [ N L ] w qdw q W 2 ( ( q) dw q( ( q) dw 2 ( ( q) dw EW ) ) W ) dw 2 ( ( q) dw 2 W ) (2) (22) whee P c C w is consumpion of wokes, N w is woke populaion, L w denoes he numbe of wokes demanded, q (0,) is he exogenous pobabiliy ha deemines how ofen a andomly chosen woke is allowed o e-se he wage. The equaion fo he opimal wage ae, W, is deived diecly fom he aggegae vesion of woke's labou supply decision. Wokes' and eiees' aggegae labou supply is deived by muliplying individual labou supplies by populaion shaes: L c v P C ( ) v ( ) W (23) L W c w v P C ( ) v ( ) W (24) Aggegae labou supply is measued by he effecive labou supply index, L, which akes ino accoun diffeences in wokes' and eiees' labou efficiency: 23

132 Helvi Kinnunen L L w L (25) Labou demand fo wokes, L w, is deived by assuming ha eiees ae always on hei labou supply cuve a he pevailing wage ( W ), and domesic inemediae goods poduces ae on hei labou demand cuve Wealh disibuion, financial asses and aggegae consumpion Since wokes discoun wealh a a highe ae han eiees, hey end o consume a smalle pa of any wealh incease. This means ha he disibuion of wealh is an essenial elemen in aggegae consumpion. Using pevious equaions fo human and social secuiy wealh, he shae of A financial wealh held by eiees A evolves accoding o R A ( ) A ( ) W N T A / ( S H ) (26) whee H and pensions as defined above, and ou of wealh. S denoe discouned afe-ax values of labou income and is eiees maginal popensiy o consume Assuming ha all asses ae evenually held by domesic consumes, aggegae pivae consumpion is P c C H [ R A H w S w ] [ R A H S ] (27) Individuals eceive ansfes fom boh he cenal govenmen and pension funds. Howeve, in ode o mainain analyical acabiliy, pensions ae elaed o he pevailing aggegae wage level bu no o individual chaaceisics. Financial asses available o consumes consis of hee iems: domesic govenmen bonds, A S, foeign bonds, A W, and socks issued by domesic fims, A F. Pension funds inves in he same asses. Thei invesmen is denoed by p A. In simulaions, asse euns on domesic and foeign bonds ae assumed o S F equalize ( ). The shae pice D is he nominal pice (ex-dividend) of a uni of equiy in peiod. The faco defining he goss eun on socks is fims' pofis,. This goss eun is defined as D 24

133 Govenmen funds and demogaphic ansiion D F [ A ( K ) D ]/ A F (28) whee K denoes he copoae ax ae Welfae Wokes welfae can be wien using (Vjk) and (Vws) and he coesponding opimaliy condiion fo consumpion and labou as V w c w c v P C / P ( ) v ( ) W v (29) Reiees' welfae evolves analogously o ha of he wokes wih diffeences only in popensiy o consume and in labou efficiency ae: V ( ) c R c v P C / P ( ) v ( ) W v (30) Given ha agens maximise welfae ove hei life-cycles, welfae measues epesen discouned fuue value fo an aveage woke o a eiee a each momen. Consequenly, he welfae effecs of a policy o economic shock depends on is diec impac on wealh and on is impac on discoun aes. Moeove, welfae is affeced by ax-disoions fom he labou make Social secuiy Pension expendiues and fiscal balances The model's pension expendiues ae linked o he demogaphic sucue and R aggegae wages such ha T N W, whee e /W is he aveage pension ae evaluaed a he iniial seady sae level of aggegae wages W. Toal pension expendiues, T R, ae hus linked o aveage wages and he numbe of pensiones. Making use of ou demogaphic assumpions, we can expess pension expendiues pe capia in ems of he dependency aio, wages and pension ae: T N R N N W W (3) Pension expendiue is he componen ha bings ageing sucue o social secuiy wealh. Ohe ansfes fo households ae assumed o evolve in line wih 25

134 Helvi Kinnunen poducion gowh. In simulaing demogaphic shocks, we have pension benefis depend on wage developmens ove he longe ime, heeby imiaing he acuaial sucue of he pension sysem. Geneal govenmen is divided ino wo secos: sae govenmen (cenal and local govenmens) and pension funds. Sepaaion of secos allows us o invesigae pension funding apa fom ohe fiscal policy quesions. This is wellgounded fom he inegeneaional viewpoin since ax eamen diffes fo eiees and wokes. On he public spending side, in un, pension oulays ae in pinciple equal o ohe public ansfes no linked o ax paymens. In ha sense pension funding is equivalen o govenmen deb 37. The fiscal balance of he sae consiss of hee axes: labou income is axed a he ae WS, capial gains ax levied a he ae K and consumpion axed a he indiec ax ae C. Sae expendiue iems ae consumpion, C S, ansfes o fims and households, T S, and inees paymens on govenmen deb wih S nominal ae of,. The sae issues govenmen bonds amouning o A in a ne basis. In each peiod, he following budge consain holds: ( A WS K C FS P T C S S P A ( W L C C A S ) (ne lending) W L ) (income ax evenue) (copoae income ax evenue) (indiec axes) (fims' social secuiy conibuions) (sae consumpion) (oal ne ansfes) S C W L S F w (inees paymens) (32) Accodingly, he fiscal balance of public pension funds consiss of pension conibuions levied on wage income. Pensions ae financed by collecing pension conibuions fom fims and wokes as well as fom evenue fom P FP WP pension funds. The oveall pension conibuion ae is, wih sepaae aes fo employes' and employees' conibuions. Pensions o eiees 37 In pacice, sepaaion is well-gounded also because adminisaion of pension funds is usually independen fom he cenal govenmen. Fo example in Finland pension policy is quie independen fom ohe public adminisaion and fiscal policy seing. Even hough he govenmen in he end makes fomal decisions on conibuion aes, pension funds ae de faco govened by an eniy ouside he govenmen consising of hee paies: labou union, nsuance companies and he govenmen. Fo moe deailes see Finnish Cene fo Pensions (2007). 26

135 Govenmen funds and demogaphic ansiion PR oal T and include, besides old age pensions, disabiliy pensions and ohe pensions. Pension funds accumulae financial asses A P. In each peiod he following flow budge consain holds fo he pension fund: ( A T PR P P A ) (ne lending) (oal ansfes paid o eiees) P A P W L (social secuiy conibuions of employe and employee) (inees paymens) (33) Fiscal ules The model is closed by he ax ule and conibuion ae ule se sepaaely fo he sae and he public pension funds. Fiscal ages ae se o mainain susainabiliy in ems of he SGP equiemen fo geneal govenmen finance. The sae ages he deb/gdp aio and adjuss he labou income ax ae o sabilize deb a he ageed level wihin a 'pope' ime hoizon. The fiscal ule is of ax diffeence ype 38 : ws S S S S ( A A ) / Y 2 ( A A ) / Y (34) S whee A / Y is an exogenous age fo he acual indebedness aio. If he govenmen spending aio is exogenous, he deb will also ende he seady sae ax ae exogenous, in effec deemined unambiguously by he deb aio. The paamees and 2 deemine he speed of adjusmen. In he benchmak simulaions, he deb aio is a consan se a he seady sae value of 0.5. Values of he adjusmen paamees wee se a =0.08 and 2 =0.9, which cause he deb aio o poceeding smoohly o he age wihin he peiod of demogaphic changes. Using he same analogy, he pension conibuion ae is ageed a he pension funds o wages aio. Fomally, P P P P P ( A A ) / W L 2 ( A A ) / W L (35) whee Ā P / W L is he age level fo he pension fund. In benchmak simulaions, we se 38 See he discussion of Michell, Saul and Wallis (2000) on he popeies of fiscal ules in maco models. See also Railavo (2004) fo a discussion of alenaive fiscal policy ules and hei sabiliy popeies. 27

136 Helvi Kinnunen A P P / W L / A /( W L ) ( / ) A /( W L ) P (36) P whee is old age dependency aio and A / W L. 6 is he ageed value of he pension fund elaive o he wage sum in he seady sae. The fase he change in he dependency aio, he slowe he funding ae will appoach he age. Alogehe, in ou benchmak, given ages will bing he ne deb of geneal govenmen o abou 20 pe cen of GDP, which epesens he susainabiliy aio of unchanged ne deb posiion ha is applied as a susainabiliy cieia of in he famewok of public suveillance in he EU Poducion The supply side is based on a poducion sucue whee domesic inemediae goods ae combined wih impoed inemediae goods o poduce final goods, boken down ino consumpion goods, capial goods and expo goods. Poduces of inemediae goods combine labou and and capial using CES poducion echnologies wih faco-augmening echnical ends exogenously given. The poducion diffes acoss final goods in ems of elasiciy of subsiuion. Poducion of Inemediae Goods The poducion funcion fo inemediae goods, Y ( j), is Y ( j) / K L F K ( ) L. F K L whee K is capial, L labou, paamees and denoe ime-vaying capial and labou-augmening echnical pogess especively, /( ) is elasiciy of echnical subsiuion wih he subsiuion paamee and he shae paamee in he poducion funcion. The echnical change is labouaugmening on he balanced gowh pah. Cos minimizaion implies he following eal maginal coss: MC ( j) P ( j) K R ( ) P j ( ) F W ( ) L P j whee R denoes he nominal enal pice of capial sevices and F F W ( ) W epesens nominal labou coss including employes' pension and social secuiy conibuions., 28

137 Govenmen funds and demogaphic ansiion In he seadysae, pices P ( j) ae deemined by he makup, ( z ) ove maginal coss: P( j) MC( j) (37) The fis ode condiions (in logs) wih espec o capial sevices and labou ae given by w F p p log log( ) log K log( ) log( ) log ( )( y L k ) ( )( y l ). (38) (39) The aggegae picing equaion fo inemediae goods poduces, assuming Calvo picing, is of he fom p E p mc p (40) whee capues he fequency of pice changes. Inflaion is deemined by expeced inflaion and log makup ove he eal maginal coss mc p. Poducion of Final Goods Final goods poduces combine domesic inemediae inpus and impoed goods. Poduces ake he make pice fo hei poducs as given, since poduc makes ae se o be compeiive. The demand fo eailes' oupu is given by consumpion and invesmen of he pivae and geneal govenmen secos. The oupu of he consumpion-goods eaile divides ino he pivae consumpion T H SF and public puchases of make goods, C C C. The capial-goods eaile faces simila demand compising pivae seco and public seco invesmen, T S I I I. The poducion echnology fo consumpion and invesmen goods is: Q j j j j j / j j j T Y ( ) M, j I, C j is he especive shae paamee and j j j paamee ( /( )). j he especive subsiuion j Y he domesic M denoes impos and inemediae good. Cos minimizaion geneaes following pice indices, P j ( c ) j ( ) j j j j j Mj P P ( ) j j j j 29

138 Helvi Kinnunen and condiional faco demands Y M j j j j j ( ) P c ( ) P j P ( j Mj c j ) P C Q j j Q j. The consumpion-goods poduce (eaile) pays he indiec axes, C. Hence he ax base fo indiec axes consiss of pivae consumpion and govenmen puchases. No indiec axes ae levied on invesmen goods. The expoe is a fim ha combines domesic inemediae inpu, Y X, and impoed aw maeials, M R, o poduce expo good, X, in compeiive makes. Technology and pefeences ae idenical o hose of he eailes. Capial enal fims Poducion capial is modelled as a homogeneous faco of poducion ha is owned by a fim ha ens capial o poduces of domesic inemediae goods. The capial enal fim opeaes unde pefec compeiion. Physical capial accumulaion geneaes eal adjusmen coss in he fom of los capial sock. Capial accumulaion is given by K p I S p p p p K K, K K, 2 K (4) whee S () denoes adjusmen coss of physical capial sock and K is he capial depeciaion faco. The capial enal fim maximizes is expeced discouned pofis max E M, { I } s0 s K s (42) subjec o he capial accumulaion equaion (4) and he definiion of capial sevices 39 p,. Is momenay pofis ae given by K K 39 Fo simpliciy we assume ha capial sevices obain a lagged value of physical capial sock. In a moe geneal case capial sevices would depend also on he endogenous uilizaion ae. This exension ales he esuls only in business cycle fequencies and is hus beyond he scope of his sudy. 30

139 Govenmen funds and demogaphic ansiion 3 ),, ( 2 K p p p p p I p I K K K K K K P R K I P R K S (43) The pice index fo invesmen goods, P I, is he pice index of he domesic invesmen good eaile and R denoes enal ae fo capial. Fuue pofis ae discouned using he nominal sochasic discoun faco (picing kenel) ] ) ( /[ ) (, C s C s s s P C U P C U M. The fis ode condiion wih espec o capial sock K p is given by. 0 ),, ( ),, ( ),, ( ,, 2 p p p I K p p p I p p p I K K K P E M K K K P R E M K K K E P S S S (44) Due o he end-of-peiod iming of physical capial sock, he accumulaed physical capial is in use in he following peiod. Hence, he expeced following peiod's enal ae,, R govens he cuen peiod invesmen decision. The adjusmen cos funcion is quadaic in changes of he physical capial sock:. 2 (.) 2 2 p p p K K K S (45) The usual `invesmen equaion' can be obained by subsiuing he paameic vesion of adjusmen coss fo he shae paamee in he fis ode condiion Make Equilibium All makes ae in equilibium in evey peiod. The capial goods make is in equilibium when he supply of capial sevices by he capial-enal fim equals he demand fo capial sevices by inemediae goods poduces. Similaly, he labou makes ae in equilibium when he demand fo labou equals is supply, D s L L. In he inemediae goods seco, he demand fo inemediae goods by eailes and expoes equals oal supply:. X I C Y Y Y Y (46) Makes fo final goods clea when

140 Helvi Kinnunen P S X W P C S I C G W M H I W C I T T X, (47) whee P W is he aggegaed expo pice of compeing economies and M W is aggegae impos of expo makes. When he make cleaing condiions hold, he wokes' and pensiones' budge consains (7) and (3), he geneal govenmen budge consain (36) and he pension fund's budge consain (37) imply he following equaion fo he accumulaion of foeign asses: S A W ( F ) S A P X P M P M P W X MR R MC C MI ade balance I M (48) W W The cuen accoun balance is given by S ( A A ) and he faco income F W accoun by S A Key model paamees The following model's key paamees ae calibaed o eflec he main feaues of he Finnish economy 40. Table Key model paamees Households β Subjecive discoun faco, paamee 0,99 υ Elasiciy of peiodic uiliy w consumpion 0,80 σ Ine empoal subsiuion elasiciy, paamee 0,45 ξ Labou efficiency of eiees, paamee 0,30 є Relaive maginal pospensiy o consume, vaiable,59 π Woke's maginal pospensiy o consume, vaiable 0,09 Ω Addiional discouning faco,0 w Elasiciy of wokes' labou supply, vaiable 0,26 Elasiciy of pensiones' labou supply, vaiable 0,23 40 Calibaion pinciples ae descibed and discussed in deail in Kilponen and Ripai (2006). 32

141 Govenmen funds and demogaphic ansiion Poducion ˆ Labou saving echnical change p.a., paamee 2,08 L K Capial depeciaion ae, paamee 0,08 Pice makup, paamee,08 F A / Pice o equiy aio, vaiable 5.0 Capial's shae, paamee 0,0 Elasiciy of subsiuion beween capial and labou 0,72 Public Finances Fiscal ule adjusmen, paamee Fiscal ule adjusmen, paamee 0.90 S a Cenal govenmen deb (% of oupu) 0.50 P a Pension funds (% of wage bill).70 c S Public consumpion (% of oupu) 20.8 SW T Tansfes o wokes (% of oupu) 6.40 K Copoae ax ae %, paamee 9.2 C Sales ax ae %, paamee 2.0 Real inees ae R F ˆ c / P Real inees ae, p.a., vaiable 2,40 Given ou inees in disoionay effecs of axes, he cucial paamee affecing ou esuls is he peiodic uiliy of consumpion, which deemines he labou supply elasiciies. The elasiciy of uiliy is calibaed a 0.80 and i poduces uncompensaed labou supply elasiciy values of This is boadly in line wih elasiciies applied in he sandad Euopean models. Elasiciy of labou supply is of couse highly unceain. Concening he ageing issues, some auhos have agued ha Euopean elasiciies could be much highe if, fo example, all he ways in which axes affec labou-supply decisions of eiees 33

142 Helvi Kinnunen wee aken popely ino accoun 4. An acuaially unfai defined benefi sysem, in paicula, end o aise he implici ax ae fo a eiee. High ax aes also ceae incenives fo ealy eiemen. Unfounaely, ou model seing does no allow us o invesigae hese impacs. In pinciple fo Finland, whee mandaoy public pension scheme is excepionally exensive and ax-benefi links ae paiculaly weak, he calibaed values of labou supply elasiciies can be consideed consevaive. 4.3 Simulaions 4.3. Benchmak economy The benchmak fo simulaions is an economy whee demogaphic changes have aleady passed hough o he economic sucue, e.g. labou make, poducion and public finances. Afe demogaphic shock, he economy gows along a new seady sae gowh pah whee he old age dependency aio is pemanenly highe han in he iniial seady sae wihou ageing. The demogaphic shock is calibaed using paamees fo he dependency aio and pobabiliy of deah o closely epesen he siuaion Finland is facing. Public finances ae susainable in ems of he SGP definiion wih govenmen ne deb emaining unchanged in he long em 42. The wage ax ae and pension conibuion aes adjus o keep he sae deb and pension funds a he cuenly pevailing level in elaion o GDP o wage bill. Ohe ax paamees, as well as govenmen consumpion as a shae of GDP ae assumed o emain unchanged. Table 2 pesens he main fiscal and macoeconomic vaiables a he seady sae befoe and afe a pemanen demogaphic shock. 4 Accoding o Jacobs (2008) uncompensaed elasiciy of ax base could double in Euope if besides labou supply, also eiemen and leaning ae endogenised. 42 Moe pecisely, he susainabiliy condiion epesens susainabiliy wih he S2 indicao fulfilling he ineempoal budge consain ove an infinie hoizon. 34

143 Govenmen funds and demogaphic ansiion Table 2 Public finances, labou make and households' welfae: The seady sae in he economy wihou ageing and in he aged economy (benchmak) Wihou ageing Aged economy Income ax ae % of wokes, implici Pension conibuion ae (fims and wokes), implici Pension expendiue (% of oupu), vaiable Employmen ae, wokes Employmen ae, eiees Oupu gowh, % Pivae consumpion pe capia Disibuion of financial asse wealh, vaiable Capial oupu aio Ne foeign asses % of oupu Unde unchanged govenmen ne funds, eflecing he seep incease in he old age dependency aio, labou ax aes had o incease alogehe by abou 7 pecenage poins in he long em (able 2) 43. Boh he pension conibuion ae and wage ax ae should incease. As a consequence, because of disoionay axaion, he employmen ae of wokes would be in he seady sae much lowe han unde saionay demogaphy. Tha dominaes he oveall employmen developmens. Reiees' employmen ae inceases slighly, which is due o he fac ha eiees' desie o compensae a decline in afe ax wealh dominaes he negaive effec caused by a decline in wage compensaion. Also eal gowh will be slowe, consumpion pe capia lowe and eiees' shae of financial wealh much lage han in he iniial seady sae. A moe deailed descipion of ageing effecs is epoed in Kilponen, Kinnunen and Ripai (2007). 43 Noe ha possible effecs of pension efom wee no included. Accoding o Minisy of Finance (2007), he diec effec of ageing on geneal govenmen would amoun o 8 p.p. of GDP. Finnish Cene of Pensions esimaes ha pension conibuion ae should be inceased by 4 p.p.(see Bisöm e al.(2008) ). Boh insiuions ook efom ino accoun. 35

144 Helvi Kinnunen Alogehe, in he benchmak, susainabiliy of public finances equies lage ax hikes. The ax buden should incease duing he peiod when govenmen is a ne cedio in he financial make and he labou make is exemely igh Funding adjusmens duing demogaphic ansiion In his secion we conside govenmen asses as an policy opion in alleviaing ageing sess. Simulaion esuls ae compaed o he benchmak siuaion whee govenmen funds emain unchanged in elaion o GDP. In he following simulaions we change pension fund ageing in wo ways: We endogenise funding ae o espond invesely o changes in he dependency aio (see 38) and educe he age fund-o-wage sum aio fom he cuen.7 o.4 afe compleion of demogaphic change by he end of he 2050s. The magniude of ageed pension funds epesens he level ha would mainain susainabiliy of he public finances and would keep ax aes close he benchmak in he seady sae. In ems of geneal govenmen ne asses o GDP, ha means a decline fom he pevailing level of 25 pe cen of GDP o abou o 0 pe cen (Figue ). Ne lending of Geneal Govenmen would un in o a sligh defici amouning o pecenage poin of GDP a is highes a he beginning of he peiod. 44. Figue Adjusmen in govenmen funds 30 Govenmen funds (pension funds sae deb) % of GDP Benchmak Funds adjused 44 Since unde nomal assumpion he eal inees ae exceeds he eal gowh ae, educing funding will weaken pension fund balances and cause conibuion aes o incease lae. 36

145 Govenmen funds and demogaphic ansiion Given he small open economy envionmen wih fixed inees aes, he counepa of he weakening of he geneal govenmen financial posiion is in ne foeign financial asses. A educion in govenmen asses means ha he cuen accoun suplus declines due o lowe naional saving. Ne foeign asses decline by abou 0 pecenage poins as a consequence of fund un-down in he long un (Figue 2). Figue 2 Foeign ne asses in he benchmak and simulaion 30 Ne foeign asse, % of GDP Benchmak Funds adjused The op panel of figue 3 shows ha he slowing of pension fund accumulaion would clealy ease he ax buden on labou. The need o aise he pension conibuion ae emains abou 3 pecenage poins lowe up o 2020 and he incease in wage axes would emain abou 2 pecenage poins smalle duing he same ime. The diffeence vesus he benchmak in oveall ax buden on labou peaks o 5.5 pecenage poins a he midpoin of he 2020s. Pension conibuion aes could say lowe han in he benchmak also fo quie a long ime, coveing he enie peiod of demogaphic ansiion. In ou expeimen, ax aes acually do no each he benchmak level unil afe fou decades. 37

146 Helvi Kinnunen Figue 3 Resuls of an expeimen whee funding ae declines Pension conibuion ae 0,3 0,275 0,25 0,225 0,2 0,75 0, Wage ax ae 0,4 0,38 0,36 0,34 0,32 0,3 0, Benchmak Funds adjused Benchmak Funds adjused Employmen ae: eiees 0,27 0,26 0,25 0,24 0,23 0,22 0,2 0, Employmen ae:wokes 0,740 0,735 0,730 0,725 0,720 0,75 0, Benchmak Funds adjused Benchmak Funds adjused,6,4,2 0,8 0,6 0,4 0,2 0 Aveage wage, deviaion fom he benchmak, % 0, ,6 0,4 0,2 0 0, ,4 0,6 0,8,2 Capial labou aio, dev. fom he benchmak 38

147 Govenmen funds and demogaphic ansiion Labou make eacions o lowe ax aes indicae subsanial employmen gains (second and hid panel of Figue 3). The employmen ae of wokes would be nealy one pecenage poin highe on aveage duing he nex 5 yeas and eiees' employmen would impove even in absolue ems as a eacion o a ax cu. Reiees' labou supply eacs songe han wokes' eflecing a wage se-up fo he model wih eiees eacing along hei labou supply cuve. Wokes' employmen eacions ae moe subdued because an incease in aveage wage will educe labou demand. Due o he incease in aveage wages and labou supply, he capial-labou aio declines afe a ax cu bu inceases lae on, a aound 205. A lowe ax buden inceases he pesen value of he ne human capial as well as social secuiy wealh, since pension benefis ae subjec o income axaion (Figue 4). Impoved wealh booss consumpion and labou demand. The consumpion level would say duing he demogaphic ansiion abou 2 pecenage poins above he benchmak. GDP eal gowh will exceed benchmak by moe han pecenage poin on aveage duing he same peiod. This epesens subsanial economic gains fo he economy. The model wih heeogeneous agens allows us o conside inegeneaional effecs of fund adjusmen. Figue 4 shows ha consumpion of eiees consanly ises a bi moe han ha of wokes. Reiees and wokes diffe wih espec o planning hoizon and combinaion of wealh. Reiees' shoe planning hoizon means ha any policy changes ha affec hei ne pesen value of wealh is smoohed ove a shoe peiod han ha of wokes. This and eiees' lage maginal popensiy o consume ou of wealh lead hem o espond moe songly han wokes o ax changes. Bu lowe funding has pacically no effec on income disibuion. Welfae measues confim he oveall esul. Duing he ansiion peiod, boh eiees and wokes ae bee off wih ahe simila welfae gains amouning o -2 pe cen (Figue 4, boom panel). 39

148 Helvi Kinnunen Figue 4 Resuls of an expeimen whee funding ae declines 3 2,5 2,5 0,5 Consumpion pe capia, dev. fom benchmak, % 3 2,5 2,5 0,5 0 Consumpion deviaion fom he benchmak, % Reiees' consumpion pe capia Wokes' consumpion pe capia 4,5 4 3,5 3 2,5 2,5 0,5 0 Welfae: deviaion fom he benchmak, % ,6,4,2 0,8 0,6 0,4 0,2 0 GDP: deviaion fom he benchmak, % Reiees Wokes 0, Sensiiviy analysis In sensiiviy analysis we used alenaive assumpions of some key paamees of he model. We conduced he same simulaion expeimen allowing paamee esimaes o vay aound he values used in he base simulaions 45. Fis we se he peiodic elasiciy of consumpion, v, a slighly highe o lowe han in he benchmak. Fund adjusmens ae paiculaly sensiive o cus in he elasiciy paamee (Figue 5). In paicula, a lowe elasiciy value senghens he labou supply eacion (see 29 and 20). Then lowe funding wih a lowe ax ae gives a songe boos o labou supply, allowing fo lage ax educions. This also impoves afe ax wealh compaed o he benchmak simulaions and 45 The chosen pocedue was no quie accuae since he balanced gowh pahs wee no conolled fo. If seady sae values change subsanially, due o paamee changes, hen he analysed deviaion fom benchmak migh no be guie compaable. This bias seems o elae o low values of he paamee v and paiculaly he eacions of eiees' paicipaion. The employmen ae of eiees ges quie diffeen iniial and final seady sae values wih a lowe paamee value han in he benchmak. 40

149 Govenmen funds and demogaphic ansiion can be seen o have lage effec on consumpion pe capia. Insead, an incease of he same magniude in he elasiciy of consumpion would make hadly any diffeence compaed o he benchmak (see Figue 5). Figue 5 Alenaive eacions on funds adjusmen: elasiciy of peiodic uiliy of consumpion vaies Pension Conibuion ae 0, , ,0 0,05 0,02 0,025 0,03 0,035 0,04 0,045 Wage ax ae 0,005 E 7 0, ,0 0,05 0,02 0,025 0,03 0,035 0,04 0,045 Employmen ae: eiees 0,055 0,045 0,035 0,025 0,05 0,005 0, ,05 0,025 0,035 0,045 Employmen ae: wokes 0,02 0,05 0,0 0, ,005 0,0 Consumpion pe capia, % 4 3,5 3 2,5 2,5 0, Elas. of peiodic cons. low: ν =0.79 Baseline simulaion esul ν=0.82 Elas. of peiodic cons. high: ν =0.85 Secondly, we vaied he ineempoal elasiciy of subsiuion paamee,. Figue 6 indicaes only a sligh vaiaion in ax aes, employmen and consumpion. Lowe values fo he IES paamee, when households ae slighly moe willing o allow consumpion o vay ove ime, bings foewod slighly he gains of funds adjusmen in ems of consumpion pe capia. 4

150 Helvi Kinnunen Figue 6 Alenaive eacions on funds adjusmen: Ineempoal elasiciy of subsiuion (IES) vaies Pension Conibuion ae 0, , ,0 0,05 0,02 0,025 0,03 0,035 0,04 Wage ax ae 0, , ,0 0,05 0,02 0,025 0,03 Employmen ae: eiees 0,035 0,03 0,025 0,02 0,05 0,0 0, , ,0 0,05 Employmen ae: wokes 0,02 0,0 0,008 0,006 0,004 0, , Consumpion pe capia, % 2,5 2,5 0,5 El. of subs. bew. cap. and labou low: ρ =0.65 Baseline simulaion esul ρ=0.72 El. of subs. bew. cap. and labou high: ρ = Finally, he elasiciy of subsiuion beween capial and labou, was vaied. A noiceable effec is ha, wih a highe elasiciy of subsiuion, employmen of wokes impoves a bi moe bu somewha lae hen in he benchmak (Figue 7). If capial and labou ae moe eadily subsiuable, lowe pension conibuion aes fo employes induce hem o demand moe labou (see e.g. 4). 42

151 Govenmen funds and demogaphic ansiion Figue 7 Alenaive eacions of he adjusmen: Elasiciy of subsiuion beween labou and capial vaies Pension Conibuion ae 0, , ,0 0,05 0,02 0,025 0,03 0,035 0,04 Wage ax ae 0, , ,0 0,05 0,02 0,025 0,03 Employmen ae: eiees 0,035 0,03 0,025 0,02 0,05 0,0 0, , ,0 0,05 Employmen ae: wokes 0,02 0,0 0,008 0,006 0,004 0, , Consumpion pe capia, % 2,5 2,5 0,5 El. of subs. bew. cap. and labou low: ρ =0.65 Baseline simulaion esul ρ=0.72 El. of subs. bew. cap. and labou high: ρ = Besides unceainies associaed wih paamee values, impoan isks ae naually elaed o demogaphic ends. Using sochasic populaion foecass fo Finland, Lassila and Valkonen (2008) epoed subsanial vaiaions in foecass. Fo example, hey found a 50 pe cen pobabiliy ha he numbe of pime age wokes in Finland is beween 2.4 million and 2.8 million. Unceainy as o aggegae labou supply howeve incease wih a long lag when he feiliy isk is ealised, which will ake place afe 2-3 decades Seady sae esuls The simulaion expeimen shows ha ageing coss can be loweed by adjusing funding ae o smooh ax eacions duing he ansiion peiod of demogaphic change. In he long em, hee exiss a lowe level of funding ae ha poduces he same welfae level and ax aes han in he benchmak economy whee 43

152 Helvi Kinnunen funding ae was assumed o emain unchanged. Table 3 shows ha in he seady sae he levels of labou axaion, employmen, consumpion and welfae emain pacically he same as in he benchmak, even hough some 20 pecenage poins of GDP less financial esouces wee devoed o pension funding. This is because smalle ax inceases han in he benchmak led o a slighly lowe wage level heeby making he poducion sucue slighly moe labou inensive. A lowe wage level also means lowe pension benefis compaed o he benchmak. Consequenly, he popey income of pension funds will cove a lage shae of pension paymens, which helps o each he benchmak welfae and consumpion levels wih smalle pefunding. Noe also ha, even unde lage fund adjusmens, ax aes and welfae effecs emain quie modes (Figue 8). Fo example, moving fom a pue PAYG sysem o cuen funding level would lowe he ax aio by only some 2 pecenage poins. This would educe he welfae of consumes by abou pecenage poin. Table 3 Long em effec of funding adjusmen Seady saes Benchmak Lowe funding Pension funds, % of wage bill Sae deb, % of GDP Pension conibuion ae Sae axes Employmen ae, wokes Employmen ae, eiees Wealh disibuion Consumpion pe capia Welfae, wokes Welfae, eiees Capial oupu aio

153 Govenmen funds and demogaphic ansiion Figue 8 Reacions of welfae and pension conibuion ae on funding adjusmen in he seady sae 0,285 0,28 0,275 0,27 0,265 0,26 0,255 0,25 0,245 Conibuion ae and pension funding 0,9,0,2,4,6,7,9 2, 2,3 2,4 2,6,5 Welfae effec of funding in comp. o benchmak 0,5 0 0,5 0,9,0,2,4,6,7,9 2, 2,3 2,4 2,6, Discussion of Resuls In he above analysis he lack of a ax-benefi link is cucial. Changes in conibuion aes do no affec expeced pension benefis, which, a he 45

154 Helvi Kinnunen individual level, depend only on accual paamees and pas wages. Disoions fom he labou make ae of key impoance fo ou esuls. In he elaed lieaue on pension policy, he degee of acuaiy has ypically been pinpoined as a cucial condiion fo macoeconomic eacions and inegeneaional income disibuion. If adjusmens in pension paamees would diecly affec individual pension benefis, i would ende conibuion paymens simila o invesmens in annuiies. Any policies ha impove he acuaial ae will hen lessen he disoionay effecs of he pension sysem. Fo example Fische and Keuschnigg (2007) found ha efoms ha senghened he ax-benefi link clealy simulaed labou supply, even hough he esponses of olde wokes and pime age wokes wen in opposie diecions. Even in a DB pension scheme, changes in conibuion aes do no enail efficiency losses if he benefis change accodingly. Jaag, e.al. (2007) also epoed ponounced economic gains fom Ausian pension efom, which gealy impoved he acuaiy of he pension sysem. Also Nickel, Rohe and Theophilapoulou (2008) found ha seady sae consumpion impoved unde a policy package compising a cu in pension level and a cu in popoional copoae axes. Supply side gains fom lowe ax disoions boosed long em gains by changing faco pices. In he pesen sudy, despie pefunding, hee is no diec link beween fund eun and pension benefi. In ohe wods, he size of pension fund affec households' social secuiy wealh only hough changes in conibuion aes. An individual's benefi a eiemen depends, no on he pefomance of asse pices duing ha ime, bu on his eanings duing his woking yeas. Unlike in an invesmen-based sysem, he acuaial pesen value of benefis is no equal o ha of social secuiy savings. Consequenly, funding affecs disoions only o he exen ha i educes pessues fo conibuion ae hikes. This conass wih he lieaue of pension funding, whee ypically economic gains fom funding have been found o come fom a educion in disoions. Fo example, accoding o Feldsein (2005), deadweigh losses fom social secuiy insuance could clealy be diminished by moving owads an invesmen-based funding sysem. On he ohe hand, he esul exends ha of Gues (2008) who consideed ax smoohing effecs unde ax disoions. Gues epoed lifeime uiliy gains fo fuue geneaions ha would ouweigh he losses o cuen geneaion available by smoohing ax by funding. Ou esuls indicae ha unde ax disoions, fuhe gains ae available if funding ae would be adjused o espond lage demogaphic shocks. 4.4 Conclusions Given he gowh in he old-age dependency aio, ensuing susainabiliy of public finances equies a subsanial incease in ax buden o a down-gading of social secuiy in mos Euopean counies. This buden diffes by couny, depending on iming of ageing, coveage and geneosiy of he public pension scheme, as well as he degee of pefunding. Ou expeimen highlighed he use 46

155 Govenmen funds and demogaphic ansiion of he opion of adjusing public funds in Finland whee ageing poblems ae moe sevee han in any ohe Euopean couny, bu whee, on he ohe hand, quie focal policy measues have aleady been aken o pepae fo ageing sess. In his pape aleady colleced public funds wee used as an addiional policy opion o alleviae he coss ax hikes pose fo he economy duing he ansiion o an olde populaion sucue. The analyical ool was he DSGE model, which feaues he Finnish pension scheme wih defined benefi, high bu collecive funding and ax disoions. A simulaion expeimen illusaes ha, duing he ansiion o an olde populaion sucue, ageing coss can be loweed allowing he decline in public funds o smooh he ax eacions. Lowe ax aes simulae labou supply when he labou make is igh. Easing he funding age leads o a slowe gowh in he coss of labou, bee employmen and fase poducion gowh. Given he collecive naue of pension funding, a educion in funding edisibued welfae beween eiees and wokes. Alogehe, he expeimen indicaed quie subsanial gains achievable wih a funding adjusmen duing demogaphic ansiion. Since inees ae eacions wee absen in he open economy, even empoaily lowe axaion could change faco pices heeby endeing he poducion sucue moe labou inensive. In he expeimen, he funding ae could be loweed by 20 pecenage poins of he wage bill wihou any losses in welfae. As discussed in his pape, Finland's public pension scheme is unique in many especs. Sill, ou expeimen highlighs issues common o all public pension schemes. Concening effos o incease public pension funding in ohe Euopean counies, he long em coss of funding depend on how funds could be used o smooh ageing pessues. In mos Euopean counies, he old age dependency aios sa o acceleae in abou 20 yeas ime, which means ha pension funds, could be accumulaed befoe he labou make becomes exemely igh. This ceaes oom fo fiscal policy o alleviae labou shoages when ageing sesses ae a hei highes level. 47

156 Helvi Kinnunen Refeences Aiyagai, S.R. McGaan, E.R (998): The opimum quaniy of deb, Jounal of Moneay Economics 42, p Aanasio, O. Kiao, S. Violane, G. L. (2007): Global demogaphic ends and social secuiy efom, Jounal on Moneay Economics 54, Begsom,T. C. Haman, J. L. (2008): Demogaphics and he Poliical Susainabiliy of Pay-as-You-Go Social Secuiy in Pension Saegies in Euope and in he Unied Saes, Fenge, R. de Menil G. Pesieau (eds.), Massachuses Insiue of Technology, Bisöm, P. Elo, K. Klaavo, T. Risku, I. Sihvonen, H. (2008): Sauoy pensions in Finland. Long-em pojecions 2007, Finnish Cene fo Pensions, Repos 2008/. Blanchad, O. J. (985): Deb, deficis and finie hoizons, Jounal of Poliical Economy 93(2), Bovenbeg, A.L. Knaap, T. (2008): Aging, Funded Pensions and he Duch Economy in Pension Saegies in Euope and in he Unied Saes (Fenge, R. de Menil, G. Pesieau (eds.), Massachuses Insiue of Technology, Bösch-Supan, A. Ludwig, A. Wine, J. (2006): Ageing, Pension Refom and Capial Flows: A Muli-Couny Simulaion Model, Economica 73, Conesa, C.C. Gaiga, C. (2008): Opimal Responce o a Tansioy Demogaphic Shock, in Pension Saegies in Euope and in he Unied Saes, (Fenge, R. de Menil, G. Pesieau (eds.), Massachuses Insiue of Technology, Demange, G. (2007): Fee Choice of Unfunded Sysems: A Peliminay Analysis of a Euopean Union Challenge, in Pension Saegies in Euope and in he Unied Saes (Fenge, R. de Menil, G. Pesieau (eds.), Massachuses Insiue of Technology, Feldsein, M. (2005): Rehinking Social Insuance, The Ameican Economic Review, Mach 2005, -24. Fische, W.H. Keuschnigg, C. (2007): Pension efom and labou make incenives, CESifo Woking Pape No. 2057/2007. Gele, M. (999): Govenmen deb and social secuiy in a life-cycle economy, Ganegie-Rochese Confeence Seies of Public Policy 50() Gues, R. (2008): Smoohing he Fiscal Coss of Populaion Ageing in Ausalia: Effecs on Inegeneaional Equiy and Social Welfae, The Economic Recod, Vol. 84, NO. 265, June 2008,

157 Govenmen funds and demogaphic ansiion Hemming, R. (998): Should Public Pensions be Funded, IMF Woking Pape WP/98/35. Holzmann, R. MacKelle, L. Rukowski, M. (2003): Acceleaing he Euopean Pension Refom Agenda: Need, Pogess and Concepual Undepinnings. in Pension Refom in Euope: Pocess and Pogess, Holzmann, R. Oensein, M. Rukowski, M. (eds.), The Wold Bank. Jaag, C. Keuschnigg, C. Keuschnigg, M. (2007): Pension Refom, Reiemen and Life-Cycle Unemploymen, Manuscip, Univesiy of S. Gallen, Novembe 29, Jacobs, B. (2008): Is Pesco Righ? Welfae Sae Policies and he Incenives o Wok, Lean and Reie, CESifo Woking Pape No. 2277/2008. Jafaov, E. Leigh, D. (2007): Alenaive Fiscal Rules fo Noway, IMF Woking Pape, WP/07/24. Kilponen, J. Kinnunen, H. Ripai, A. (2006): Populaion ageing in a small open economy - some policy expeimens wih a acable geneal equilibium model, Discussion Pape 28/2006, Bank of Finland. Lassila, J. Valkonen, T. (2008): Demogaphic unceainy and pension pojecions in J.M. Alho S.E.H. Jensen Lassila, J. (eds.) Unceain Demogaphics and Fiscal Susainabiliy. Cambidge Univesiy Pess. McMoow, K. Roege, W. (2004): The Economic and Financial Make Consequences of Global Ageing, Euopean and Tansalanic sudies, Spinge. Michell, P.R. Saul, J.E. Wallis, K.F. (2000): Fiscal policy ules in macoeconomic models: pinciples and pacice, Economic Modelling 7, Minisy of Finance (2007): Sabiliy pogamme updae fo Finland 2007, Minisy of Finance, Finland, Economic and economic policy suveys 4c/2007. Nickel, C. Rohe, P. Theophilopoulou, A. (2008): Populaion Ageing and Public Pension Refoms in a Small Open Economy, Woking Pape Seies No 863/2008, Euopean Cenal Bank. OECD (2007): Pensions a a glance: public policies acoss OECD counies, 2007 Ediion, OECD. Peucci, A.R. (2002): Govenmen Deb, Agen Heeogeneiy and Wealh Displacemen in a Small Open Economy, Fondazione Eni Enico Maei Oksanen, H. (2003): Populaion Ageing and Public Finance Tages, Euopean Commission Economic Papes, No. 93/2003. Oksanen, H. (2008): Pension sysems, ageing and he sabiliy and gowh pac, CESifo woking pape, No XXX/

158 Helvi Kinnunen Railavo, J. (2005): Essays on macoeconomic effecs of fiscal policy ules, Bank of Finland Sudies, E:33. Saaenheimo, T. (2005): Ageing, inees aes and financial flows, Bank of Finland Reseach Discussion Papes, No 2/2005. Yaai, M. E. (965): Unceain lifeime, life insuance and he heoy of consume. Review of Economic Sudies 32,

159 5. Assessing he susainabiliy of healh and long-em cae financing - and he usefulness of policy guidelines based on demogaphic foecass Jukka Lassila, Tamo Valkonen and Juha M. Alho Inoducion Susainabiliy of public finances is essenial fo peseving he possibiliy o cay ou soveeign fiscal policy. This peequisie is emphasized when he policy objecive is o un an exensive welfae sae, as in Finland. The long-em fiscal susainabiliy of a welfae sae is vulneable especially o demogaphic isks. Expeiences show ha a couny can lose is fiscal auonomy fo a long peiod of ime due o lack of foesigh and fiscal discipline. The welfae losses caused by fiscal cises can be lage and hei incidence abiay. Ye despie is impoance, asonishingly lile eseach has been done on fiscal susainabiliy unde unceainy. Long-em susainabiliy of public finances is egulaly assessed by, e.g., he Euopean Commission. The poblem is ha he accouning-based evaluaions conside fuue unceainy as an issue ha can be managed by pesening a baseline scenaio and some moe o less ad hoc alenaives. These calculaions also miss he poenial feedback fom high public deb o he economy. Quoing Leepe (200), fiscal policy is based on alchemy and moneay policy on science. We employ an impoved mehod o evaluae he long em susainabiliy of fiscal policy unde demogaphic unceainy. We highligh how his mehod can be used o es a isk shaing ule ha shifs he exa expendiue buden of vey unfavoable demogaphics fom municipaliies o he sae. Moe specifically, we assume ha a ceiling is pu on he aveage municipal ax ae. If demogaphic developmens incease municipaliies healh and long-em cae expendiue moe han allowed by his ceiling, he sae finances he shofall by deb. We also sudy cases whee he govenmen uses he infomaion povided by demogaphic pojecions o pepae fo bad fuue oucomes by educing public indebedness. 46 We hank Eija Kauppi fo efficien model pogamming. We ae gaeful fo he Naional Audi Office of Finland fo financial suppo and hei saff fo simulaing discussions. We also hank Oui Honkaukia and Niku Määänen fo commens. 5

160 Jukka Lassila, Tamo Valkonen and Juha M. Alho We use 200 sample pahs fom a sochasic populaion pojecion as an inpu in an economic model o assess pobabilisically he susainabiliy of public finances. The economic model is a numeical ovelapping-geneaions model of he ype oiginaed by Auebach and Kolikoff (987). We have peviously esed vaious policy ules assuming ha he ealized sample pah fom a sochasic populaion pojecion is immediaely obseved by he agens of he model and followed wih pefec foesigh unil deah (Lassila and Valkonen, 2008). In he cuen sudy households and fims expec demogaphics o evolve accoding o foecass. Each peiod a new populaion pojecion is geneaed and he agens eopimize hei decisions. In he nex secion he economic model and he links beween populaion pojecions and fuue public healh and long em cae expendiues ae esablished. Secion 5.2 also jusifies ou aenion o demogaphic unceainy by showing how adically populaion pojecions have changed duing he las decade. The secion also descibes how foecas evisions can be embedded in sochasic populaion pojecions. Secion 5.3 pesens he baseline sochasic assessmen of he susainabiliy of healh and long-em cae financing in Finland. In secion 5.4, some policy alenaives and guidelines ae sudied. Secion 5.5 concludes wih key findings of he susainabiliy oulook and emaks on fuue developmens of he appoach used. 5.2 Modeling he economics and demogaphics of ageing Finland 5.2. The economic model A hoough analysis of he ineacion beween public finance and populaion ageing necessiaes he use of economic models ha ae able o fully use he ich infomaion in populaion saisics and pojecions. The model should, e.g., be able o aggegae he eacions of he individuals, epesening bih cohos of vaious sizes, o oal pivae consumpion and labou supply. I should also encompass wih sufficien peciseness he ineacion beween he populaion sucue and public seco evenues and expendiue. Moeove, he model should descibe he behavio of he individuals in siuaions ha have no been expeienced befoe, such as in case of living longe in he fuue. Dynamic geneal equilibium models, wih ovelapping geneaions of household, ake ino accoun he ineacion beween demogaphic sucue and he faco makes of he economy, encompassing heeby implicaions of gowh models. They can also poduce oucomes wih simila peciseness as acuaial pension models and geneaional accouns, since i is possible o model he pension sysem ules and deailed links beween age of he household geneaions and public expendiues and evenues. They sui well o policy analysis, since households and fims eac o policy. Fo he same eason, hey ae able o ack 52

161 Assessing he susainabiliy of healh and long-em cae financing he sensiiviy of he public seco finances o vaiaion in facos ouside domesic policy s each. The numeical models ha saisfy hese condiions can be classified as successos of he ovelapping-geneaions model of Auebach and Kolikoff (987). We use in ou simulaions a model called FOG, which is based on he Auebach - Kolikoff model adiion. The model, which is descibed in moe deail in, e.g., Lassila and Valkonen (2008), is modified o descibe a small open economy and calibaed o he Finnish economy. The populaion pojecions wih hei embedded foecass ae used as inpus in he model. The diving foces of he model economy ae he ansiions in he demogaphic and educaional sucue of he populaion and he end gowh of labou poduciviy. Populaion is ageing due o longe lifeimes, low feiliy aes and he ansiion of baby boomes fom woking age o eiemen. Educaional level impoves in he fuue since he cuen middle-aged geneaions have on aveage lowe level of educaion han he young ones. Each household geneaion in he model is divided ino hee educaional goups wih diffeen lifeime poduciviy pofiles deemined by empiical obsevaions of ecen wage pofiles. The educaional shaes ae supposed o develop in fuue in line wih he official pojecions. This aises he aveage poduciviy of labou. Public expendiues have song connecion o he age of individuals in he model. Povision of public sevices is allocaed mainly eihe o he ealy yeas (day cae and educaion) o o he las en yeas (healh cae and old age cae). Similaly, income ansfes ae disibued mainly eihe o young families o o eied individuals. This is why changes in he demogaphic sucue ae so impoan fo public expendiues. We assume ha all income ansfes (excep he eaning-elaed pensions) ae fully indexed o wages because any ohe assumpion would have damaic consequences o income disibuion in he vey long em analysis. Expendiue ha is no age-elaed is assumed o gow a he same ae as he GDP. The gowing numbe of people in old age and nea deah inceases he demand fo healh and old age cae; his is descibed in subsecion We assume ha hese demogaphy-diven addiional sevices ae poduced by he pivae seco, bu he public seco pays fo all he poducion coss. These sevices ae poduced using labou and inemediae goods as inpus. Thee is no poduciviy gowh in he poducion. The shaes of employees in pivae and public seco ae kep consan. Public seco evenues oiginae fom wo ypes of souces. The majoiy of he eceips ae accumulaed by income axes, consumpion axes and social secuiy conibuions. Anohe noewohy evenue souce is he yield of he public seco wealh. The yield of he wealh is impoan especially fo he pension 53

162 Jukka Lassila, Tamo Valkonen and Juha M. Alho funds, bu also he sae has subsanial financial asses. Some of he sae s asses ae less liquid and yield less han he make ae, such as loans of he Housing Fund of Finland. The lowe liquidiy may un ou o be a poblem if he goss deb heaens o each vey high levels. We assume ha he modeled subsecos of he geneal govenmen - he municipal seco, he public and he pivae seco pension fund, and he naional social secuiy insiue have hei own budges, which ae balanced eihe by social secuiy conibuions o eaned income axes. The only excepion is he sae budge, which is balanced by boowing. Eaned income ax backes ae adjused wih he gowh of he economy. The pension funds follow hei cuen pefunding plans, and pension conibuions ae endogenous. Households ae modeled o eac o he income and subsiuion effecs of axes and social secuiy conibuions. Labou inpu is deemined paly by exogenous assumpions and paly by endogenous adjusmens in he model. Exogenous facos ae end gowh of labou poduciviy (.75% pe annum in pivae goods poducion), demogaphics, educaional gains and unemploymen. The model is calibaed so ha he end labou poduciviy gowh and he following highe wages do no affec he ohewise endogenous labou/leisue choice of he households. The FOG model consiss of five secos and hee makes. The secos ae households, enepises, he geneal govenmen descibed above and a foeign seco. The labou, goods and capial makes ae compeiive and pices balance supply and demand peiod-by-peiod. Thee is no money o inflaion in he model. The uni peiod is five yeas, and he model has 6 adul geneaions living in each peiod. We assume ha he pe-ax ae of eun on saving and invesmens is deemined in global capial makes. The couny has, howeve, some monopoly powe in he ade of goods, which makes he ems of ade endogenous. Foeign economies ae assumed o gow wih he end gowh ae of he domesic labou poduciviy. Real wage adjuss o equalize he value of maginal poduc of labou and labou coss in he pivae poducion (excl. pivae healh cae and LTC). The es of he wokes, who povide ax-funded sevices poduced in he pivae and he public seco, ean he same wage. In ou analysis we subsiue he pefec foesigh assumpion wih an appoach whee decision makes sequenially opimize hei behaviou accoding o evised demogaphic foecass. We jusify he use of a evised foecass mehodology by wo viewpoins: Fis, i seems clea ha households in ealiy do no ake unceainies elaed o hei fuue conibuion aes o benefis fully ino accoun when making hei savings and labou supply decisions. These unceainies ae vey seldom discussed, le alone quanified, in e.g. he popula 54

163 Assessing he susainabiliy of healh and long-em cae financing pess. Second, by making he exeme assumpion ha households ignoe hese unceainies alogehe and base hei decisions on deeminisic foecass, we avoid he difficulies elaed o geneal equilibium heeogeneous agen models wih aggegae unceainy. This allows us o use a model ha includes deailed descipions of ahe complex pension and ohe welfae sysems Healh and long-em cae expendiue in ageing Finland Some illnesses and injuies boh hasen he deah and incease he healh and long-em cae (LTC) coss in he las yeas of life. Thus when modeling he dependence of healh and LTC expendiue on populaion and is age sucue, i is easonable o include also moaliy as an explanaoy vaiable. This can be used in long-em pojecions also, since populaion foecass include also moaliy, implicily o explicily. Ou saing poin is Häkkinen e al. (2006), who used individual-level healh and LTC expendiue fo a lage sample of pesons in ages 65+ in 998. Accoding o hei calculaions, 49% of healh expendiue and 75% of LTC expendiue wen o pesons who died in Fom hese figues one can deduce ha 5% of healh and 25% of LTC expendiue was no diecly deah-elaed, because hey occued o pesons ha wee sill alive five yeas lae. Fuhemoe, pa of he expendiue fo hose who died obviously had no causal connecion wih deah. A peson who died because of lung cance in 2002 may have been eaed fo a dislocaed shoulde in 998. Using moaliy daa, we can esimae he shae of expendiue occuing o hose who die wihin five yeas, assuming ha poximiy o deah has no effec on he expendiue. To do his by age goup, we have o use also daa fo 2006, and implicily assume ha he pe capia supply and uni coss of healh and LTC sevices wee he same as in 998. The weighed aveage of his shae, esimaed ove 5-yea age goups fo pesons aged 65 and above, was 28% of healh and 48% of LTC. These ae smalle shaes han Häkkinen e al. (2006) epo. The diffeence in healh expendiue shae, 2%, can be inepeed as a lowe limi fo he healh cos ha poximiy o deah causes. A coesponding lowe limi fo LTC is 27%. Thus 2 49% of healh expendiue and 27 75% of LTC expendiue has links o poximiy o deah. Thus he Finnish daa shows ha hee ae coss ha depend on he poximiy o deah and coss ha do no depend on i. Assuming ha he lae, wihin each age goup, ae on aveage he same pe capia, we could calculae he shae of he fome. This was 29% in healh expendiue and 5% in LTC expendiue. We modeled i o be he same pe capia, iespecive of he peson s age. Thus he 55

164 Jukka Lassila, Tamo Valkonen and Juha M. Alho oal expendiue depends boh on he numbe of people in each age goup and he numbe of people who will die wihin he nex five yeas. The esuls concening healh expendiue ae pesened in Figue. Figue Healh cae coss pe capia a 2006 pices Addiional cos if peson dies in 5 ys ETLA Aveage healh coss pe capia in diffeen age goups vay beween 000 and Poximiy o deah causes an addiional cos of abou Since mos deahs occu in old age, he oal coss in old age goups ae much highe han in young o middle-aged goups. The coesponding esuls fo LTC ae in Figue 2 Poximiy o deah again causes an addiional cos of abou 5000, almos he same as in he case of healh. The age pofile of LTC coss is vey diffeen fom healh cae. Thee ae vey small coss below age 75, bu afe ha he coss ise apidly and exceed fo he oldes goup. Alhough pe capia LTC coss ae much highe han healh coss in vey old ages, aggegae healh coss ae highe han LTC coss, because he bulk of he populaion is in ages below

165 Assessing he susainabiliy of healh and long-em cae financing Figue 2 Long-em cae coss pe capia a 2006 pices Addiional cos if peson dies in 5 ys ETLA Noe also ha he bas in Figues and 2 can be hough of as coss of inceasing life expecancy. If we had modeled he coss o depend eniely on age, hen he aveage pe capia coss would have been highe, and he coss of addiional yeas in life expecancy would also have been highe. Ou way of modeling in fac poduces smalle oal cos pojecions fo Finland han alenaive mehods used by, e.g., he Euopean Commission and he Minisy of Finance. We also exclude all cos effecs elaed o impovemens in he sandad and availabiliy of hese sevices. Alhough cos-wise we ae on he opimisic side hee, ou esuls show ha financing hese coss will no be unpoblemaic Foecasing demogaphic foecass To illusae how long-em demogaphic foecass can change subsanially in a elaively sho ime, Figue 3 shows fou foecass, made beween 2002 and 2009, fo he fuue populaion in Finland. The oal populaion was foecased in 2002 o be abou 5 million in The view has changed gadually, and he laes foecas is abou 6. million in Tha means a 22 pecen diffeence beween foecass made duing seven yeas. 57

166 Jukka Lassila, Tamo Valkonen and Juha M. Alho Thee wee lage and sysemaic changes also in he numbe of woking-age populaion and he numbe of eldely. These changes can be aced back o changing views on feiliy, migaion and longeviy. They have affeced empiical susainabiliy evaluaions in vaious ways. Thee ae moe people woking (good fo ax evenues), moe eiees (cosly fo public finances) and people live longe (good fo individual welfae bu cosly fo public finances). Figue 4 shows he foecass fo he numbe of people aged 65 and ove. Alhough he changes have been significan, hey all show he basic feaue of an ageing sociey: he numbe is gowing. The issue is quaniaive populaion is ageing bu we don know how much. Saisical mehods of expessing demogaphic unceainy have been developed by many eseaches (see e.g. Alho and Spence, 2005). These mehods quanify unceainy pobabilisically, based on analyses of pas demogaphic daa and he views of expes. Feiliy, moaliy and migaion ae consideed as sochasic pocesses. The paamees of hese pocesses ae fied o mach he eos of pas foecass (see Alho e al., 2008). Again, judgmen may be used. Theeafe, sample pahs fo fuue populaion by age-goups ae simulaed. We deal wih demogaphic unceainy by using such sochasic populaion pojecions. We also py moe infomaion ou of sochasic populaion pojecions han has been done peviously. In essence, we add demogaphic foecass fo he fuue ha sa in diffeen ime poins in simulaed populaion pahs. Given he unceainy of populaion foecasing, i migh seem ha ying o foecas wha fuue populaion foecass ae like, would be nealy hopeless. We ague, howeve, ha foecass ae, fo boh heoeical and pacical easons, moe egula han acual developmens. As a pacical eason, i should be menioned ha he developmen of he ecen pas ofen has a heavy influence on pojecions of he emoe fuue. Sochasic populaion pojecions ae poduced by a compue pogam PEP (fo a descipion, visi hp:// Anohe compue pogam FPATH exends he applicaion of esuls fom PEP o fowad-looking OLG models, whee agens ae allowed o evise hei lifeime economic plans as hey ealize ha populaion has no evolved accoding o he expeced pah. Fo his pupose FPATH calculaes a numeical appoximaion o he condiional expecaion of fuue populaion a fuue yeas fo a (ypically andom) subse of pahs We can hink of he condiional expecaion as being a foecas of wha would be a foecas in a fuue yea. This mehodology is new, and is descibed in moe deail in Alho (20) and in Lassila, Valkonen and Alho (20). 58

167 Assessing he susainabiliy of healh and long-em cae financing Figue 3 Populaion in Finland, as foecased by Saisics Finland Mill Mill ETLA Figue 4 Populaion in ages 65+ in Finland, as foecased by Saisics Finland Mill Mill ETLA 59

168 Jukka Lassila, Tamo Valkonen and Juha M. Alho The sochasic pojecion fo populaion in ages 65+ in Finland is pesened in Figue 5. Half of he simulaion oucomes ae in he shaded aea aound he median. 0% of he oucomes ae above he 90% line and 0% ae below he 0% line. Figue 6 descibes populaion in ages 65+ in one pah of he simulaed populaion pojecions fo Finland, poduced by he pogam PEP. The solid line is he acual simulaed pah, and he doed lines epesen he foecased foecass fo he pah. The foecass lie nicely below he acual pah, esembling hose in Figue 4. This is no geneally ue in ohe simulaed pahs, whee he foecass can and do boh oveesimae and undeesimae he acuals. Figue 5. Pedicive disibuion of populaion in ages 65+ in Finland Mill. 0 % 50 % pedicive ineval Median 90 % Mill ETLA 60

169 Assessing he susainabiliy of healh and long-em cae financing Figue 6. Populaion in ages 65+ in Finland in one simulaed pah Mill. 2 Mill ETLA Sochasic susainabiliy analysis A well-known definiion of he susainabiliy of fiscal policies is he OECD view: Susainabiliy is basically abou good housekeeping. I is essenially abou whehe, based on he policy cuenly on books, a govenmen is headed owads excessive deb accumulaion. (Blanchad e al. 990, p. 8). Moe pecisely: Fiscal policy can be hough of as a se of ules, as well as an inheied level of deb. And a susainable fiscal policy can be defined as a policy such ha he aio of deb o GNP evenually conveges back o is iniial level (p. ). Fowad-looking appoaches o susainabiliy, like he one we apply hee, pojecs fuue values fo he deeminans of he deb dynamics and develops measues ha quanifies he needed adjusmen if unsusainable dynamics is deeced. The qualiy of daa and he elabouaeness and sophisicaion of he models used have developed a lo in he pas few yeas, bu hee is sill much oom fo impovemen The pocess of developing long-em budges is in is infancy, and hee is neihe a single analyical appoach no a fiscal ule fo susainable developmen ha has achieved ageemen as bes pacice. Ulla (2006). 6

170 Jukka Lassila, Tamo Valkonen and Juha M. Alho Ou sochasic susainabiliy analysis can be descibed by fou seps 48. Fisly, a lage numbe of sample pahs of he key vaiables ae poduced using sochasic models. Secondly, fuue public expendiue and axes associaed wih each of hese pahs ae simulaed using an economic model. Thidly, he simulaion esuls ae descibed and he pobabiliy of susainabiliy poblems is evaluaed. Fouhly, alenaive policies ae fomulaed, hei esuls ae simulaed, and he oucomes ae evaluaed. Sudies ha uilize sochasic populaion pojecions mainly use accouning models o analyze he susainabiliy of pension sysems (e.g. CBO, 200 and Auebach and Lee, 2006). The mehod of sochasic foecasing has been applied also o he uni coss of healh cae, see Boads of Tusees (2003). Lassila and Valkonen (2004) analyze how pefunding could smooh he coss of healh and LTC in ime. The effecs of boh economic and demogaphic unceainy on aggegae public finances ae sudied in a simila accouning famewok by Lee and Tuljapuka (200). Alho and Vanne (2006) and Sefon and Weale (2005) used geneaional accouning o pefom a coesponding isk analysis. Alho e al. (2002) and Alho, Jensen, Lassila and Valkonen (2005) wee he fis o analyze ageing using a lage se of OLG model simulaions; he applicaion concened he Lihuanian economy. Feh and Habemann (2006), Dape e al. (2008) and Alho e al. (2008) pesen simila esuls fo some ohe counies. Lassila and Valkonen (2008) analyze fiscal susainabiliy of he Finnish public seco using sochasic pojecions o descibe he unceain fuue demogaphic ends and asse yields. They also analyze hee policy opions aimed a impoving susainabiliy. 5.3 Susainabiliy of publicly financed healh and long-em cae Thee is a policy baseline ha is used in each of he 200 model uns. I is ou inepeaion of he policy cuenly on books. In his baseline, welfae ansfes and sevices ae povided accoding o cuen ules and pacices. In case of sauoy pensions and expendiues municipaliies, he cuen financing ules ae followed. Sae ax aes ae held consan, so vaiaion in expendiue and ax bases causes vaiaion in public deb. Pension conibuion ae adap o expendiue and o he wage bill, which vay fom one demogaphic pah o anohe. Aggegae healh and long-em cae 48 Thee is also anohe banch of numeical sochasic susainabiliy analysis. I analyses he vulneabiliy of deb o advese shocks. Susainabiliy simulaions ae pefomed ypically fo he sho o medium em using highly aggegaed economeic models (see e.g. Mendoza and Oviedo, 2004). 62

171 Assessing he susainabiliy of healh and long-em cae financing coss depend on populaion age sucue and poximiy o deah. They ae financed by municipal axes, which hus also depend on demogaphic vaiables. Pa of healh cae and LTC expendiue is, howeve, financed by sae gan o municipaliies. The ules of sae gans in he model ae in line wih ou advanced pojecions of he healh and long em cae expendiue, explained in secion The cuen ules give oo much weigh o age sucues, and using hem in he model would esul in a diffeen public deb and municipal ax combinaion. We descibe he oucomes of his baseline policy fis on goss public deb and on a oal ax measue, which consiss of social secuiy conibuions, municipal axes and all sae axes. Boh deb and axes ae elaed o GDP. Figue 7 descibes he oucomes ha we can expec his base policy o poduce in he 2060s. Each do epesens he siuaion in one populaion pah. The oucomes ae sepaaed only by demogaphic developmens, and he economic eacions of he households and fims o boh pojeced and acualized demogaphics. Figue 7 Public deb and axes in Finland in he 2060s Public deb, % GDP Reinha-Rogoff Maasich Toal axes / GDP, % Finland 2000 Sweden 2000 ETLA In an ageing sociey, i is he naue of his baseline policy ha pension conibuions and municipal axes will incease. This inceases oal axes in elaion o GDP. We do no know by how much, bu can make pobabilisic saemens. As each sochasic populaion pah is equally likely, and hus also he dos in Figue 7 ae equally likely, couning he numbe of dos wihin given deb and ax aio limis yields coesponding pobabiliies. The ax aio has abou one-hid chance of exceeding he highes value hus fa in Finland, 47.2% in 63

172 Jukka Lassila, Tamo Valkonen and Juha M. Alho In all he simulaions he ax ae ises makedly bu says below ha in Sweden in 2000, 5.8% of GDP, which is he highes ae ecoded so fa in he EU s ax saisics. Despie gowing oal axes, indebedness is also likely o incease. Sae ax aes ae held consan, and he incease in sae gans o municipaliies, due o gowh in healh cae and LTC expendiue, is financed by boowing. The goss deb/gdp aio is likely o ise ove he Maasich limi, and wih a 0% pobabiliy ove he 90% level ha Reinha and Rogoff (200) conside hamful fo economic gowh. Moeove, such a jump in he deb aio would epesen a huge esouce shif fom fuue geneaions o he cuen ones. The baseline demogaphic pojecion geneaes a faily small susainabiliy gap, abou 2% of GDP. Bu ceainly he possibiliy of much bigge poblems canno be uled ou. Thee is abou 30% chance of axes becoming highe han eve befoe in Finland and a he same ime deb exceeding he Maasich cieion. Fuhemoe, hee is an 8.5% chance fo he vey difficul oucome ha ax aes ae highe han in 2000 and indebedness exceeds 90%. I is vey likely ha a adical policy change would ake place long befoe such numbes ae ealized. In ha sense he baseline simulaions pesened give a pobabilisic view of he esilience of he cuen policy ules o demogaphic unceainy. If oal axes in he sociey limis social expendiue, hen hee is a ade-off beween pensions on one hand and healh and LTC expendiue on he ohe hand. Thus we canno evaluae he susainabiliy of healh and LTC financing eniely alone. Toal axes may no, howeve, be he mos elevan ax measue in assessing he susainabiliy of healh and LTC financing. They ae financed o a gea exen by municipal axes, which we assume o ise accoding o expendiue. The following Figue 8 shows he elaionship beween he simulaed healh cae and LTC expendiue and he aveage municipal ax ae in he 2060s. Again, each do epesens diffeen demogaphic scenaio. The posiive coelaion is easily obsevable. The unfavoable demogaphic scenaios geneae high expendiue, which compel he municipaliies o aise axes. The highes aveage municipal ax aes ae no likely o occu, since hey would mean vey high ax aes in he municipaliies wih he oldes populaion sucue. Thee is also a simila posiive coelaion beween he sae and municipal finances. This is shown in Figue 9. Fom he viewpoin of he aggegae susainabiliy of he public finances his posiive coelaion educes he possibiliies of isk shaing beween he sae and municipaliies. Noe hough ha alhough ageing affecs he saes and municipaliies in many simila ways, 64

173 Assessing he susainabiliy of healh and long-em cae financing hei quaniaive consequences diffe. Oulay pessues and ax base effecs do diffe. When municipal expendiue is high, so is he sae s, and in ou simulaions his leads o high deb. Bu high deb can occu also wihou high municipal axes. Figue 8 Healh and long-em cae expendiue and municipal axes in he 2060s in Finland Healh & LTC, % GDP ETLA Aveage municipal ax ae Figue 9 Public deb and municipal axes in he 2060s in Finland Public deb, % GDP ETLA Aveage municipal ax ae 65

174 Jukka Lassila, Tamo Valkonen and Juha M. Alho 5.4 Susainabiliy and policy ules The base policy conains many ules ha affec he way public finances adjus o changing demogaphics. Besides hose concening pension conibuions and municipal axes, hee is longeviy adjusmen of pension benefis, and seveal indexing ules. Despie hese adjusmens, i seems fom he 2060 oucomes ha fiscal policy does no eac o expeced difficulies in public finances in a sufficien manne. In many empiical susainabiliy analyses his is he case houghou, as Leepe (200) ciicizes. In ou model-based analysis we can go fuhe and sudy he effecs of specific addiional policy ules. Since he baseline is poblemaic fom he poin of view of municipaliies, he sae may conside aking ove he esponsibiliy fo healh and LTC financing. We assume ha in such a siuaion he sae finances he whole healh and LTC sevice coss above a ceain limi value fo he aveage municipal ax ae. This could happen in pacice in he fom of e.g. naional insuance poposed by Foss (2003). We illusae his by selecing a limi of 23% fo he aveage municipal ax ae, and call his Policy ule 2 (Rule is he baseline policy; see Table ). The aveage fo 200 was abou 9%. If he diffeences in municipal ax aes will say he same as in 200, an aveage of 23% would mean ha he op aes would be a leas 25% and he lowes aes above 20%. The 23% limi fo municipal axes is me wih close o 20% pobabiliy. Fom Figue 9 i is eviden ha hey ae all cases whee public deb is poblemaic in any case. If he sae coninues o keep ax aes consan, aking moe esponsibiliy fo healh and LTC financing ineviably leads o even highe indebedness. This is illusaed in Figue 0. As hese oucomes mus be consideed unsusainable, we sudy alenaives whee he sae eacs by aising he VAT ae, based on diffeen policy ules o guidelines. We sudy wo alenaives (Policies 3 and 4 in Table ) whee he sae acs on expeced aveage municipal ax ae. The measue is o incease he VAT ae pemanenly by 2%-poins. The quesion is hen, how fa decision-makes should look, in ode o impove hings. We compae a ule whee he sae looks fowad, and bases he VAT decision on he 0-yea foecas of he municipal ax ae, o a backwad-looking ule whee he sae acs on he obseved municipal ax ae. We show ha he deb poblems become smalle if he sae acs on foecass han if i acs on obseved developmens. The impovemen is no big, howeve, and does no emove he hea of a deb poblem. A much bee esul is obained if he VAT incease is based on expeced developmen of he deb/gdp aio, insead of he expeced aveage municipal ax ae (Policies 5 and 6 in Table ). 66

175 Assessing he susainabiliy of healh and long-em cae financing Figue 0 Public deb and municipal axes, wih ceiling, in he 2060s in Finland Public deb, % GDP ETLA Aveage municipal ax ae In Table he 200 simulaion oucomes in 2060 ae divided ino seveal caegoies. Nomal ax aes ae hose below he Finnish 2000 oal ax ae, 47.2% of GDP. High is any ax ae above he nomal. Public goss deb, as pe cen of GDP, is consideed nomal if i is below he Maasich eay level of 60%. Above ha i is high, and if i exceeds he 90% level i is classified as vey high. These limis ae of couse abiay bu seve a pupose. The deb limis ae self-eviden; 60% is based on EU policies and 90% is based on an exensive sudy by Reinha and Rogoff. The ax ae limi is sicly couny-specific. If one consides he vey high deb oucomes as he main hea fo susaining he baseline policy, hen we noe ha compaed o he baseline, all ohe policy ules consideed diminish he pobabiliy of high indebedness. Boh wihou and wih he municipal ax ceiling, he likelihood of vey high deb in he 2060s was slighly above 0%. If he sae akes ove he healh and LTC expendiues above he 23% municipal ax ceiling and inceases he VAT ae by 2%-poins a he same ime, he pobabiliy declines o 8%. If he sae inceases he VAT ae aleady when anicipaing he financing swich, he likelihood declines o 6.5%. These ae noable impovemens. The pobabiliy can, howeve, be educed much moe if he sae s VAT decision is based on he public deb/gdp cieion insead of he municipal ax ule. And also wih he deb cieion i is bee o use a fowad-looking han a backwad-looking ule. 67

176 Jukka Lassila, Tamo Valkonen and Juha M. Alho Table Base policy and policy ule oucomes in 2060 (shae of cases in diffeen deb-ax caegoies,%) (Policy ) (Policy 2) (Policy 3) (Policy 4) (Policy 5) (Policy 6) Nomal deb and nomal axes Baseline 37,5 Baseline wih 23% ceiling fo aveage municipal ax 37,5 Policy (2) + VAT inceased when aveage municipal ax a ceiling 37,5 Policy (2) + VAT inceased when aveage municipal ax foecas o exceed 23% wihin 0 yeas 37,5 Policy (2) + VAT inceased when deb/gdp aio exceeds 60% 48,0 Policy (2) + VAT inceased when deb/gdp aio foecas o exceed 60% wihin 0 yeas 53,5 Nomal deb and high axes 5, 0 5,0 5,0 6,5 8,5 25,5 Nomal deb, oal 42,5 42,5 42,5 44,0 66,5 79,0 High deb and nomal axes 26,0 26,0 26,0 24,5 9,0 3,0 High deb and high axes 2,0 20,5 23,5 25,0 9,5 4,5 High deb, oal 47,0 46,5 49,5 49,5 28,5 7,5 Vey high deb and nomal axes 2,0 3,0,5,0,0 0,5 Vey high deb and high axes 8,5 8,0 6,5 5,5 4,0 3,0 Vey high deb, oal Nomal axes, oal 0,5 65,5,0 66,5 8,0 65,0 6,5 63,0 5,0 58,0 3,5 57,0 High axes, oal 34,5 33,5 35,0 37,0 42,0 3,0 68

177 Assessing he susainabiliy of healh and long-em cae financing Inceasing he VAT ae means inceasing he oal ax buden in he economy. Sill he deb-based policies, (5) and (6) in Table, incease he pobabiliy of oucomes wihin he nomal deb and nomal axes aea. They do incease he ax ae bu no enough o exceed he Finnish ecod in Figues and 2 compae he mos effecive policy (6) wih baseline amended wih he municipal ax ceiling. Figue Fequency disibuion of public deb, as% of GDP, in he 2060s Feq. % Baseline Policy ule Feq. % Public deb, % GDP Baseline (2): sae ax aes consan, municipal axes adap up o a ceiling, pension conibuions adap Policy ule (6): VAT condiional on 0 yea foecas of public deb /GDP aio ETLA Figue 2 Fequency disibuion of oal axes, as% of GDP, in he 2060s Feq. % Baseline Policy ule Feq. % Toal axes / GDP, % Baseline (2): sae ax aes consan, municipal axes adap up o a ceiling, pension conibuions adap Policy ule (6): VAT condiional on 0 yea foecas of public deb /GDP aio ETLA 69

178 Jukka Lassila, Tamo Valkonen and Juha M. Alho Figue confims he view ha fowad-looking ax policy can effecively educe he hea of fuue deb poblems. Figue 2 shows ha axes in oal incease because of his policy, bu no vey much. The expeced value of oal axes/gdp, maked wih a cicle in he figue, inceases by abou half a pe cen. 5.5 Summay and conclusions Analysing fiscal susainabiliy and calculaing susainabiliy gaps elies heavily on demogaphic pojecions. These pojecions ae changed a egula o iegula inevals. These changes ae no always mino in fac hey ae ofen lage. In his pape we have analysed wha implicaions hese ineviable changes have fo susainabiliy analysis and fo policy conclusions. We have specifically focused on he fiscal pessues ha financing healh and long-em cae (LTC) wih municipal axes, wih help fom sae aid, will bing abou in ageing Finland. We ask whehe his financing sysem is susainable in he specific sense ha ciizens can ely on eceiving he sevices in he fuue. As fuue is ineviably unceain, no definie answe can be given. We can, howeve, quanify some unceainies and illusae and evaluae hei effecs. We can fom a pobabilisic view of he public deb and axaion developmens ha financing healh and LTC will cause. This view hen seves as a basis fo ou evaluaion of he susainabiliy of he sysem, o, phased diffeenly, of he cedibiliy of he pomise concening publicly financed healh and LTC sevices in he fuue. We chose he ime span so ha i should suffice fo hose who ae abou o leave he labou make. If one is 50, hen he hoizon should be a leas 50 yeas, fo living up o 00 yeas will no be ae. If a 50-yea old does no hink ha pomises concening fuue welfae sevices ae fully cedible, she o he sill has 0 20 yeas o ake individual pecauionay measues while being pa of he labou foce. Geneal assessmen of susainabiliy Even wih ou assumpions of fuue healh and LTC demand, which ae low compaed o hose used in ohe fiscal pojecions made fo Finland, difficulies in susainabiliy loom lage. In ou baseline policy, municipal axes adjus o healh and LTC expendiues and changes in he ax base, and pension conibuions adjus o pension oulays. In an ageing sociey, i is he naue of his baseline policy ha axes will incease. The oal ax/gdp aio has abou one-hid chance of exceeding he highes value hus fa in Finland, 47.2% in In all simulaions he ax ae says below ha in Sweden in 2000, 5.8% of GDP, which is he highes ae ecoded in EU s ax saisics. 70

179 Assessing he susainabiliy of healh and long-em cae financing Despie gowing ax aes, indebedness is also likely o incease. The deb aio is likely o ise ove he Maasich limi, and wih a 0% pobabiliy ove he 90% level ha Reinha and Rogoff (200) conside hamful fo economic gowh. Whehe his policy line would be susainable o no, is a mae of opinion. Some may find mos of he oucomes geneally plausible, ohes no. Bu as fuue uses of hese welfae sevices we ae no saisfied wih he oulook. The possibiliy of poblems is oo high. Thee is abou 30% chance of axes becoming highe han eve befoe in Finland and a he same ime deb exceeding he Maasich cieion. Fuhemoe, hee is an 8.5% chance fo he vey difficul oucome ha ax aes ae highe han in 2000 and indebedness exceeds 90%. We hink ha he likelihood of cus in healh and LTC sevices in he fuue is oo high wih he baseline policy, and hus some amendmens o alenaives should be consideed. Noe also ha if oal axaion in he sociey limis social expendiue, hen hee is a ade-off beween pensions on one hand and healh and LTC expendiue on he ohe hand. Thus we canno evaluae he susainabiliy of healh and LTC financing eniely sepaaely. If pension financing would be solved in a simila way o ha in Sweden, wih a fixed conibuion level, hen his poblem would disappea. Municipal aspec An addiional and independen susainabiliy isk comes fom he municipal seco. If he aveage ax ae ises o a high level, i is vey likely ha some small municipaliies would need o aise hei axes o a level ha would no be accepable in pacice. The sae would need o sep in. We assume hee ha in such a siuaion he sae finances he whole healh and LTC sevice coss above a ceain limi value fo he aveage municipal ax ae. We illusae his by selecing a limi of 23% fo he aveage municipal ax ae. The aveage fo 200 was abou 9%. If he diffeences in municipal ax aes will say he same as in 200, an aveage of 23% would mean ha he op aes would be a leas 25% and he lowes aes above 20%. Whehe municipal axes each he limi, depends on he demogaphic developmens in he fuue. In ou simulaions his happens in almos 20% of he cases. Bu if ha happens, he sae is aleady indebed. In all baseline simulaions whee he aveage municipal ax ae exceeds 23%, he public deb exceeds 60% of GDP. Even if he sae would incease is own ax aes o cove he financing ask ha exceeds he limi, he deb poblem is bound o be lage. The sandad of sevices would no doub be unde hea. 7

180 Jukka Lassila, Tamo Valkonen and Juha M. Alho Can he sae do bee? Yes. I can pepae in advance. We fis sudy alenaives whee he sae acs on expeced aveage municipal ax ae. The acion is a pemanen incease in he VAT ae. The quesion is hen, how fa should he decision-makes look, in ode o impove hings. We show ha he likelihood of fuue deb poblems become much smalle if he sae has a 0- yea hoizon han if i acs on obseved developmens. Secondly, we sudy policies whee he VAT ise is condiioned on he public deb siuaion insead of municipal axes. These policies un ou o be moe effecive. And again, a 0-yea hoizon ahead is bee han a backwad-looking ule. Alhough demogaphic foecass ae eoneous, hey appea o conain enough infomaion o be useful in policy design. Policy lessons We have shown ha any susainabiliy measue is unceain, and ha he unceainy is lage. This is in accod wih pevious sudies, and by iself bound o make policy consideaions difficul. The good poin is, we can give quaniaive assessmen of he unceainy and illusae he vaious oucomes of he base policy. Alhough he magniudes of ageing ae unceain, and foecas eos pobably lage, ageing policies mus espond in advance. Unceainy should no imply inacion. Inacion is a policy choice, and hee a ahe poo one. Ou simulaions show ha foecass conain infomaion and can be used in policy design. Thee should be a plan fo wose han expeced fuue developmens. Acions can include posponed condiional measues. They should fom a coheen pogam, wih well-defined hesholds. They should also be cedible. The cedibiliy equiemen may be difficul o opeaionalize, bu as long as he siuaion is good o looks good, elying on fuue acions may be a viable opion. Thee is no much poin in aguing abou he exac size of he susainabiliy gap. The quesion is whehe he policy cuenly on books is susainable in he foeseeable fuue wih a easonable pobabiliy. Relying on expeced developmens, wih a 50% pobabiliy, is no easonable. I is a gamble, like ossing a coin. Heads, and you ll ge he sevices a leas as pomised, ails, and you ll ge less? Ceainy is no achievable, bu he isk can be educed. Any alenaive policy oucome is also unceain. Bu we can again descibe and illusae hem. This hopefully helps us o hink of possible ways ha poblems and difficulies may aise. The policy ule analysis could have been used o deive also he welfae effecs of diffeen policy choices in addessing susainabiliy poblems. This could be 72

181 Assessing he susainabiliy of healh and long-em cae financing especially useful when consideing posponing decisions. Thei coss, and whom hey occu o, can be illusaed, hus avoiding one of he ciical fauls in using unsusainable pahs descibed in Leepe (200). We conside such wok a necessay ingedien in fuue analysis. Mehodological lessons We have amended sochasic populaion pojecions wih embedded and gadually updaed demogaphic foecass. A each ime-poin on each populaion pah consideed hee is also a simulaed demogaphic foecas fo he fuue. The agens in he economic model make hei fuue plans based on his demogaphic foecas ha pevails hee and hen. A new demogaphic foecas is made when he economy moves o he nex peiod, and agens updae hei plans. Technically he ee-like combinaion of sochasic populaion pojecions wih embedded demogaphic foecass is obained by join use of compue pogams FPATH and PEP. The anges of foecas evisions seem quie elevan, when compaed o he adjusmens in demogaphic foecass by Saisics Finland beween 2002 and Using peiodically updaed populaion pojecions as an inpu in a fowadlooking economic model poduces esuls ha, we hink, have song links o decisions ha ae consideed o acually made in he eal wold. Each updae in he official populaion pojecions changes ou concepion of he fuue. All public policies and pivae behaviou coningen o he concepion of he fuue ae subjec o change. Inoducing foecass embedded in sochasic populaion pojecions allows us o analyze policies ha ae based on foecass. Thee is an obvious way fowad hee. Analyze all elevan policy ules, and compae esuls. This is vey edious, and difficul. Thee ae many paamees ha could be changed and should be analyzed. In ou ahe simple policy ules such paamees ae he heshold values and lengh of he peiod hey ae calculaed fom, and ohe specificaions elaed o hem. The size of he iggeed policy measues should also be sudied. Fo pedagogical puposes, ough examples may suffice. Fo quaniaive policy guidelines, much moe wok is needed. This ype of analysis poduces a vas amoun of simulaion esuls so vas ha choosing wha o pesen is an essenial pa of any sudy. The economic model oupu consiss of sylized naional accouns fo each peiod, added by household behavio by 5-yea bih cohos, hee educaional goups and a maximum age of 00 yeas. 50 yeas wih a 5-yea uni peiod and a 50-yea hoizon of foecass means ha he baseline consiss of 00 naional accouns fo each of he 200 populaion pahs used, in oal 20,000 naional accouns. 73

182 Jukka Lassila, Tamo Valkonen and Juha M. Alho Refeences Alho, J. M. Cuijsen, H. Keilman, N. (2008): Empiically-based specificaion of foecas unceainy. In Unceain Demogaphics and Fiscal Susainabiliy. Ed. by Alho, J M e al. Cambidge Univesiy Pess. Alho, J. M. Jensen, S. E. H. Lassila, J. Lazuka, R. Mokūnienė, A. Valkonen, T. (2002): The Economic Effecs of Populaion Ageing and Demogaphic Unceainy in Lihuania. Reseach Repo P R of he Euopean Union s Phae ACE Pogam. Alho, J. M. Jensen, S. E. H. Lassila, J. Valkonen, T. (2005): Conolling he Effecs of Demogaphic Risks: The Role of Pension Indexaion Schemes. The Jounal of Pension Economics and Finance, 4(2), Alho, J. M. Jensen, S. E. H. - Lassila, J. (eds.) (2008): Unceain Demogaphics and Fiscal Susainabiliy. Cambidge Univesiy Pess. Alho, J. M. Spence, B. D. (2005): Saisical Demogaphy and Foecasing. New Yok: Spinge. Alho, J. M. Vanne, R. (2006): On Pedicive Disibuions of Public Ne Liabiliies. Inenaional Jounal of Foecasing, 22(4), Alho, J. M. (20): Foecasing demogaphic foecass. ETLA, manuscip. Auebach, A. J. Kolikoff, L. J. (987): Dynamic Fiscal Policy. Cambidge, Cambidge Univesiy Pess. Auebach, A. J. Lee, R. D. (2006): Noional Defined Conibuion Pension Sysems in a Sochasic Conex: Design and Sabiliy. NBER Woking Papes No Blanchad, O. J. Chouaqui, J-C. Hagemann, R. P. Sao, N. (990): The susainabiliy of fiscal policy: New answes o an old quesion. OECD Economic Sudies No. 5. Boads of Tusees (2003): Annual Repo of he Boads of Tusees of he Fedeal Hospial Insuance Tus and Fedeal Supplemenay Medical Insuance Tus Funds. Available a hp://cms.hhs.gov/publicaions/useesepo/2003/.pdf CBO (200): Unceainy in Social Secuiy s Long-Tem Finances: A Sochasic Analysis. Congessional Budge Office, Technical Repo, Decembe 200. Available a 74

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185 VATT JULKAISUT / VATT PUBLICATIONS VATT JULKAISUT SARJASSA AIEMMIN ILMESTYNEET JULKAISUT 4. Veous, alouspoliiikka ja kansanalous Taxaion, Economic Policy and he Economy. Vesa Kanniainen Seppo Kai (oim.). Helsinki Suomi 0 vuoa Euoopan unionissa Taloudellise vaikuukse. Jaakko Kiande Ani Romppanen (oim.). Helsinki Suomi 2025 Kesävän kasvun haasee. Reino Hjeppe Juha Honkaukia (oim.). Helsinki Kasvumallin muuos ja veopoliiikan haasee. Reino Hjeppe Seppo Kai Jaakko Kiande (oim.). Helsinki Finance and Incenives of he Healh Cae Sysem. Poceedings of he 50 h Annivesay Symposium of he Yjö Jahnsson Foundaion. Ani Suvano Hannu Vaiainen (Eds.). Helsinki Hyvinvoinipalvelujen uoavuus: Tuloksia opinien vaela. Aki Kangashaju (oim.). Helsinki Vaikuavaa ukimusa mien avioiniukimus palvelee pääökseneon apeia? Seija Ilmakunnas Teuvo Junka Roope Uusialo (oim.). Helsinki Hyvinvoinipalveluja enisä ehokkaammin. Uudisusen mahdollisuuksia ja keinoja. Seija Ilmakunnas (oim.). Helsinki Teveyskeskusen ehokkuua ja uoavuua seliävä ekijä. Juho Aalonen Maija-Liisa Jäviö Kalevi Luoma (oim.). Helsinki Essays on globalizaion Policies in ade, developmen, esouces and climae change. Leena Kekelä. Helsinki Essays on Migaion. Mai Savimäki. Helsinki Essays on income inequaliy, povey and he evoluion of op income shaes. Maja Riihelä. Helsinki Essays on he efficiency of schools and suden achievemen. Tanja Kijavainen. Helsinki Veouksen ja sosiaaliuvan uudisaminen miksi ja mihin suunaan? Essi Eeola Seppo Kai Jaakko Pehkonen (oim.). Helsinki Talouden akenee Seija Ilmakunnas Oui Köge Timo Rauhanen (oim.). Helsinki Local public seco in ansiion: A Nodic pespecive. Ani Moisio (Ed.). Helsinki Encouagemen and discouagemen. Essays on axaion and govenmen expendiue. Tuomas Kosonen. Helsinki 20.

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