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

We conduct three policy experiments. The first (baseline) experiment leaves the generosity of
PAYG system in place and explores its economic and budgetary consequences. The second
scenario looks what happens if EU governments resort to debt financing of additional age related
expenditure and the last scenario analyses a partial transition to a funded system, with deficit
financing of transition costs. All three alternatives face certain trade offs between fiscal
sustainability and macroeconomic efficiency. The PAYG system does not pose a particular fiscal
sustainability problem. However ever increasing social security contributions are likely to generate
negative labour supply incentives. Along with it goes an erosion of the tax base. The debt solution
could reduce the macroeconomic costs especially in environments characterised by near Ricardian
equivalence. However, sustainability of the government budget will certainly become an issue in
this scenario. The third option is likely to yield the best long term economic and budgetary
outcome, however transition costs are potentially large, leading to high permanent but sustainable
debt burden as well.

4.1. The Baseline Scenario: Letting the PAYG System in Place

Without reforms, the share of pensions financed via the PAYG system will nearly double until
2050 from currently 9.7% to more than 17%. This is accompanied by an increase in pension
contributions in the EU from 16 to 27%. The demographic trend is leading to permanently lower
GDP (per capita) growth rates in the EU over the coming decades. Reduced labour supply is likely
to cut GDP per capita growth by one third in 2050. Notice, rising social security contributions will
reinforce the labour supply pressure. With the significant increase in social security contributions,
a further rise in structural unemployment by nearly 5% points seems possible. Though higher
savings and increased capital formation will somewhat alleviate the demographic pressure, the
current pension system does not provide sufficient investment incentives to compensate the
decline in labour input by increased productivity generated via higher capital intensity.

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