1 Introduction
The medium to long run developments of public finances is in focus in many
countries due to changing demographics. Increasing dependency ratios imply
that systematic fiscal deficits may develop, and this raises questions concerning
both the sustainability of public finances and thus current policies as well as the
timing and scaling of reforms.
For short run evaluations of the fiscal position it is important to have a fore-
cast of medium to long run developments, since the former need not be a good
indicator for the latter. For EMU countries the GSP stipulates norms for the
fiscal position. Originally these were formulated in terms of the current budget
and debt position (the 3% deficit-to-gdp and 60% debt-to-gdp norms) with an
objective of ensuring that the structural deficit is in balance or surplus. In a
recent reinterpretation (ECOFIN council (2005)) it is stressed that the evalua-
tion of the budget position should take the medium to long run developments
into account. In particular the influence of demographic changes should be con-
sidered. Moreover, it is stressed that the evaluation of the short run position
should be seen in perspective of eventual structural reforms leading to more
sustainable public finances.
Often fiscal policies are evaluated by considering the structural budget bal-
ance and questioning whether this is consistent with stabilization of a given
debt level. Although readily applicable this approach has some shortcomings.
First, in a forward looking perspective the primary balance may change sig-
nificantly even for a given structural unemployment rate e.g. due to changing
demographics. Second, the approach is not easy to apply in evaluating the ef-
fects of reforms. Finally, the issue of fiscal sustainability is more complex than
just stabilization of debt levels.
While it is sensible to consider the medium to long run developments in
public finances in order to evaluate the fiscal stance and the need for reforms, it
also raises a number of questions. A key question is concerned with reliability
and credibility. What is needed is a realistic projection of the development in
public finances rather than desired paths. The latter are easy to formulate but
do not provide very useful guidelines for an evaluation of the sustainability of
current policies. This is in particular important since a main task is to provide
indicators on the need and scale of structural reforms as an input to policy
discussions.
Structural issues are involved in the discussion of possible policy reforms and
to this end an explicitly formulated intertemporal general equilibrium model is a
useful tool. The framework thus allows for indicators of the fiscal sustainability
problem but also for assessment of reforms which may either be phased in over
several years or have effects which unfold over a sequence of years. Clearly the
specific results depend on the precise modelling assumption which needs to be
carefully considered in each separate case. A forward looking approach is needed
to take into account expected future developments affecting public finances.
In this paper we present a forward looking approach using an OLG model
for assessing the sustainability of public finances and thus of current policies.