The economics of an ageing population

The economics of an ageing population

Managing the balance between an economy's income and expenditure has always been a challenge for governments around the world. Throw demographic change into the mix, and we have serious cause for disquiet.

Commentary 23rd Mar 2015

Managing the balance between an economy's income and expenditure has always been a challenge for governments around the world. Throw demographic change into the mix, and we have serious cause for disquiet.

Not too long ago, the more common problem was how to support a growing proportion of dependent children in the population brought on by high population growth rates. Children need to be fed, sheltered, clothed and educated – all of which cost large amounts of resources to provide – and so the policy norm then was to institute measures to discourage families from having many children; these ranged from contraception, education and family planning, to the most drastic ones, such as China's mandatory one-child policy.

These days, the issue has shifted to the other end of the age scale. With the relative size of the workforce declining over time, the question now has become how can the economy support the needs of its dependent, elderly population.

Economics of aging population

How does an ageing population affect the economy? One impact is a reduction in per capita output. Per capita output is calculated by taking total production in the economy and dividing that by the country's population. This gives an average amount of income that each member of the population potentially has access to, to meet his or her needs and achieve a particular standard of living.

If the pool of active, productive workers in the economy is continually shrinking in favour of a larger and larger set of retired, older individuals, then each has to be happy with a smaller and smaller share of the cake, so to speak.

What this means in practice is that households, on average, will have fewer resources to meet consumption needs. In the early stages, the typical household might have to compromise on the quality of what it consumes. Later on, when the ageing population problem becomes more acute, the typical household might have to stop consumption of some goods and services altogether.

This implies lower standards of living, on average. It implies significant losses of welfare for a lot of people. And when that happens, it will be a significant step backward that negates the significant advances in welfare improvements that we have achieved in the past 20 or 30 years.

A second way an ageing population affects the economy is through the national savings. Assuming current policies stay the same, the national saving rate is expected to fall in the next 40 years for two main reasons.

First, the increase in the proportion of elderly in the population means a relative increase in the numbers who draw down assets, thereby reducing total private saving. Second, major government transfer programs – social security and the health programs (the Pharmaceutical Benefit Scheme and medical care) – are expected to blow out over time in favour of the elderly. It is true that a large chunk of current government consumption goes disproportionately to the young through expenditure on public education.

However, with Australia's birth rate hovering about 2.0 (replacement rate), the share of public education cost to total budget is not expected to rise much more. Official statistics, in fact, show that in 1997, Australia's public education spending budget was just about half that of Australia's total social security and health transfers budget, and that this difference in budget shares has since become more pronounced.

Clearly, with an ageing population, there will be fewer resources in the future to allocate over an increasingly dependent population. So, what can we do about that?

One choice would be to do nothing now, and raise taxes in the future to cover budget deficits as they occur. Some have strongly argued in favour of this position, noting that in 40 years Australia's average household incomes will be substantially higher than they are today due to continuing economic growth.

In short, they say that a richer society will be able to afford higher taxes. But while society might indeed be richer in the future, it might be prudent to think whether we really want to condemn our children to higher taxes. It is, in fact, a condemnation, as we are talking about huge tax rate hikes. The Australian Treasury has modelled this – a minimum tax increase of about 5 per cent of gross domestic product (GDP), translates to an increase in personal income tax collections of more than 40 per cent.

With younger people today barely able to afford their own homes, the higher cost of university education, and very tight labour markets, with very high rates of rates underemployment, a 40 per cent tax hike might not be the sort of legacy we will want to leave to our children.

Alternatively, we could elect to could run deficits and hence increase debt. This option avoids some of the hard decisions now, but is clearly not a sustainable or a responsible solution, as it is another way of merely passing the problem on to our children's children. Interest payments on debt would grow at an ever-increasing rate, thereby reducing the money available to pay for pensions and healthcare.

Eventually, our descendants have to start to pay off the debt, further reducing the scope for government provision of essential services. Viewed long term, this option would simply leave a legacy of economic disadvantage to our children's children, and is not one any responsible Australian should be prepared to contemplate.

Another alternative approach would be to cut future government expenditure by about 5 per cent of GDP. Without doubt, we will need to be very careful about government spending priorities in the future. But, again, the dimensions of such spending cuts are enormous.

To illustrate, the sorts of expenditure cuts required to achieve a 5 per cent reduction of GDP could include: the entire amount allocated to health, or more than half the current social security and welfare budget Clearly, neither of these options could ever be seriously contemplated.

Additionally, where to apply those cuts is always contentious. Health? Education? Social welfare? Police? How about defence? Foreign aid? Or public infrastructure? Successive Australian governments have already taken significant steps to try to moderate growth in health and income support expenditure, as well as streamline the budgets for each of the other areas of responsibility.

All that seems never enough though, as this option is but a rolling one. Time and again, this option requires us to revisit and re-evaluate each agency's portfolio and make deeper cuts where we can. As we can all relate, deeper cuts hurt more.

And the unpalatable feature about all these "much-needed" budget cuts that Prime Minister Tony Abbott and Treasurer Joe Hockey would like the Senate to approve is that the greater burden of disadvantage will belong to low socioeconomic households. Without doubt, these cuts will serve only to push more towards greater poverty and to aggravate already high inequality levels. Is this the kind of Australia we are aspiring to be?

Fortunately, we do have a fourth option and it is a brighter, more positive one. I believe the approach for Australia, looking into the future, is to look for ways to increase the size of the economy so that we all have higher incomes and are better able to meet the costs associated with our ageing population.

This is standard economic prescription, but it is nonetheless full of wisdom and good thought. Increasing the size of the economy means that we should aim for consistent, sustained economic growth and the key to that is higher labour productivity. Productivity pertains to how much one worker can produce in one hour – if the output of goods and services produced will rise relative to the population, national income or gross domestic product will rise. Many thus regard labour productivity as the key factor in determining a nation's standard of living.

This demands the question, how can we raise productivity? Labour productivity can increase with capital deepening – that is, providing workers with more and higher quality equipment in their work to enable them to produce more units of output per hour of their time.

We also need to invest in education and training, as better-trained and better-educated workers tend to be more productive. In fact, employment of more advanced and more capital-intensive production techniques returns the highest level of productivity if it is combined with the employment of more educated or more highly skilled workers who are able to use them more effectively.

The bottom line, therefore, is not that we are doomed to a lower standard of living in the next 40 years if we continue to "spend, spend, spend", but that we need to pick up the challenge of pursuing higher growth rates by investing in both our human and physical capital.

Of these two, investment in human capital is prime. Investment in education and training provides high returns to both the individual and the economy. It also optimises any investments we make on machines and equipment we use.

On this point, two seemingly contradictory newspaper headlines confronted many of us recently. The first inferred from the recently released intergenerational report and predicting doom for the economy because "Australians are living longer and the economy has less and less workers available to support an ageing population". The second quoted numbers from the Australian Bureau of Statistics to highlight fragility in the current jobs market: "A reserve army of 293,900 part-time workers are looking for and available to work more hours but can't get them."

Upon reading these, a smart young fellow asked me: "How can these both exist in the same economy?" After some discussion, we found the answer lay in the apparent mismatch of demand and supply in the labour market. In particular, what the workers are offering out there – their skills and what they can do for employers – is clearly not the skills and tasks required in the jobs that are being offered.

This issue simply highlights my argument about investment in education. We need to invest in our human capital so that their training, skills and expertise match those required in our economy's areas of economic growth.

With younger people today barely able to afford their own homes, the higher cost of university education, and very tight labour markets, with very high rates of rates underemployment, a 40 per cent tax hike might not be the sort of legacy we will want to leave to our children.

Dr Rebecca Valenzuela

Department of Economics

And this brings me to my last point. Through all this, the government has a critical role in ensuring that Australia is constantly building comparative advantage to ensure we are constantly growing as an economy, operating efficiently domestically and maintaining competitiveness in the international economy.

Our economic foundation for this, I believe, would be in areas of our natural advantage – as may be dictated by our natural endowments of land, our vast seas, our location, geography and weather, particularly our rich endowment of natural solar power that can be harnessed into marketable energy.

We can also harness the natural talents and characteristics of our population into higher levels of innovativeness and creativity. Given the right incentive, we can stir our young towards loftier economic and social goals, to instill hard work and greater ambitions at both the personal and community levels. All these will augur well with the long term welfare of our nation as a whole.

To find our niche growth areas requires sustained investments in scientific and technological research, and investment in our independent thinkers, Such would include those in academia but not only. There are many others in the wider community, whose life experiences and technical expertise can be tapped or solicited or consulted for the purpose.

And the 65-plus group will be a rich pool of talent to draw on for this. These suggestions will certainly require a leader to look beyond political timelines and party loyalties. But looking into the future, it is imperative that Australian leaders and political parties as a whole rise above party politics and lead us bravely into a bright and promising future, ageing population notwithstanding.

Dr Rebecca Valenzuela works in the Department of Economics at Monash Business School.

This article has appeared in The Age and Monash News.

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