Proceedings from the ECFIN Workshop "The budgetary implications of structural reforms" - Brussels, 2 December 2005

The primary balance is initially in surplus but will gradually deteriorate, and
systematic deficits will develop. The budget position changes by 4 percentage
points of GDP between now and 2040. Since the change in the demographic
dependency ratio is permanent, there is a persistent deficit.

Figure 3: Public finances - Primary and total
balance

Source: Velfærdskommissionen (2005d)

The path shown in figure 3 raises the question of whether it is consistent
with fiscal sustainability. Are current surpluses and reductions in public debt
sufficient to cope with the projected deficits?

In the following the base tax rate is used as the instrument for evaluating
the needed adjustments to ensure fiscal sustainability. This tax rate is chosen
because it is a tax rate with a very broad base (90% of all taxable persons pay
this tax, and the tax base is approximately 50% of GDP - the current rate is
5.5%) and easily interpretable. Note that in calculating the level of the base
tax in accordance with the PAYG-criterion or for the sustainable tax rate, the
consequences of tax changes are taken into account. For the base tax rate the
marginal costs of public funds in the DREAM model are 1.67.

5.1 Pay-as-you go solution

A natural starting point is to assume a pay-as-you-go financing where policy is
continuously adapted to ensure a balance between revenue and expenses, cf (6).
This ensures that the debt to GDP ratio remains constant (consolidated public
debt at 5 % of GDP in 2003).

Under PAYG financing, the consequences of the demographic changes are
financed on a period-by-period basis. This implies that capital markets are not

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