Introduction
Demographic pressure in the EU is putting the long run sustainability of government budgets on
the fiscal policy agenda. The PAYG pension system which currently is the dominant source of
intergenerational income transfer will increasingly come under stress. Currently ten workers
finance two and a half retirees, in 2050, ten workers will have to finance five retirees with their
pension contributions. This has serious consequences for the government budget in coming
decades if no reforms are undertaken. As shown previously, leaving the generosity of the PAYG
system unaffected would require an increase in pension contribution rates from currently about
16% to about 27%8 in 2050, taken as given the demographic trends currently projected for the EU.
Given the still high levels of unemployment in the EU and the fact that non wage labour costs are
partly blamed for low employment rates in Europe, letting the current pension system in place
does not seem to be an attractive policy option. There are two radically alternative fiscal strategies
of financing additional pension expenditures if one wants to avoid ever increasing pension
contributions. A first alternative could be seen in a switch to debt financing of additional ageing
related pension expenditure requirements and freezing the replacement rate at current levels. An
alternative strategy would be to partially move to a funded system, with a government guarantee of
accrued pension rights for current pensioners and certain well defined age cohorts within the pool
of current workers. It will be assumed that the transition costs are financed via an increase in
government debt.
Obviously, the first option is not a true long run solution but rather a strategy of postponing
reforms, since it will eventually lead to exploding debt levels. Nevertheless it is interesting to show
the debt dynamics implied by that strategy. The second option would certainly be preferable from
a debt sustainability point of view, however, the short to medium term budgetary costs, in terms of
deficits, are likely to be larger, because of immediate and large transition costs due to a fraction of
accrued pension rights guaranteed by the government. However, unlike with the first option, the
transition costs would be temporary. The duration would be limited by the age cohorts who are
chosen to be eligible for government transfers. Nevertheless, given the voting power of age
cohorts older than 40 years in Europe, it is likely that any transition to a funded system in Europe
would be accompanied by a fairly generous compensation of current retirees and older workers.
This paper compares these two stylised strategies to each other and to a baseline PAYG scenario
where the current generosity of the pension system is retained, financed by increasing pension
contributions. In particular it asks the following questions. What are the macroeconomic and fiscal
consequences of retaining the generosity of the present PAYG system? What would be the
macroeconomic impact of the two strategies for stabilising social security contributions? And what
would be the level of debt the EU would end up in 2050 under the two alternative strategies?
The quantitative analysis is conducted with a five region version of the ‘QUEST model’, where we
distinguish between EU15, US, Japan and the rest of the World divided into fast and slow ageing
regions (FA, SA). We regard the international dimension as useful since ageing and pension
reforms are generally associated with changes in national savings and have implications for
international capital flows. This model is an extension of DG ECFINs macro model, allowing for a
disaggregated household sector, split into worker and pensioner households along the lines
suggested by Gertler (1999). The paper is structured as follows. Section 1 presents the model,
8 See, The EU Economy Review 2001 Review, Reforms of Pension Systems in the EU - An Analysis of the Policy Options, pp.171-222.
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