Alma mater of economic well being

Most advanced and emerging market economies according to IMF studies will face a momentous transition towards ageing and shrinking populations. This is expected to have profound implications for economics, financial markets, social stability, and geopolitics.

Without action, public pension and health systems will not be sustainable over the long-term. Our grandchildren would face unsustainable public debt and sharp tax increases that could stifle growth and reduce their economic well-being.

So we need to re-frame the debate about demographics. But it requires the right policies, political resolve, and strong leadership.

The fiscal policy responses and technological innovation are especially important parts of the solution.

Global per capita income is up

For one thing, increased investment in human capital has had a large positive effect on economic well-being. Average incomes in emerging market economies, such as China and India, have risen much faster than those in richer countries. Since the 1990s, the growth momentum has spread to more than 70 developing countries.

As a result, global inequality that is, income inequality between countries has fallen steadily over the past decades. And global income per capita has nearly quadrupled since the end of the Second World War.

Global poverty has also come down sharply. People living at or below the poverty line of $1.90 per day account for 13 percent of the world’s population, down from 44 percent in 1981. China alone has lifted more than 750 million people out of poverty over the past three decades.

The bottom line: emerging and developing countries have been catching up with advanced economies in facilitating longer and more prosperous lives for their citizens.

First, the impact on growth. For obvious reasons, older workers participate less in the labor market, and a country with an aging and shrinking population will therefore see lower growth over the medium term.

Fewer workers also means less need to equip them with capital. And countries may become reluctant to upgrade their capital stock. Why build more infrastructure for fewer people?

Our research suggests that the combination of aging and shrinking will reduce potential growth in advanced economies by about 0.2 percentage points in the medium term and by twice as much in emerging economies. This may not look so bad, but it would be a severe blow to those countries that are already facing very low growth and high debt.

Second, the impact on financial markets. Many see population aging as a significant drag on asset prices. Some even hypothesize that retiring baby boomers may trigger stock market disruptions, because they may liquidate their equity holdings to finance their retirement

This may or may not be true, but what we definitely know is that governments, pension funds, and individuals seriously underestimate the prospect of people living much longer than anticipated.

IMF analysis suggests that, if everyone lived three years longer than expected, pension-related costs could increase by 50 percent in both advanced and emerging economies. This would heavily affect private and public sector balance sheets and could also undermine financial stability.

Third, the impact on fiscal health. Again, IMF staff research shows that, in advanced economies alone, age-related spending is projected to jump from 16½ percent of GDP to 25 percent by the end of this century unless policy action is taken. How can this challenge be met?

• Through borrowing? If governments were to finance the entire increase in age-related expenditure that way, public debt would explode from an average of 100 percent of GDP now to 400 percent by the end of the century.
• Through higher taxes? In our hypothetical example, this would mean lifting VAT rates by roughly 20 percentage points, or increasing social security taxes by about 25 percentage points.
• Through drastic entitlement reforms? By our calculations, this would mean slashing pensions and health benefits on average by about a third.

There is a wide variety of country experiences, but broadly speaking, emerging markets and advanced economies face similar challenges. Without action, China€™s spending on pensions and health care is projected to increase by 13 percentage points of GDP by the end of this century, compared to 15 percentage points in the United States.

So, what can policymakers do to tackle these daunting fiscal challenges?

2. Fiscal policy the first line of defense

This is the point in the lecture where Groucho Marx would jump up and ask: Why should I care about future generations? What have they ever done for me?

Of course, we do not need a comedian to remind us that voters and politicians rarely look beyond the next election, let alone the next 85 years.

The question is: It’s there a quick fix, a silver bullet? The answer is: yes€¦and no.

Common sense tells us that simply increasing the fertility rate could help. Many countries have tried to do just that with baby bonuses, family allowances, tax incentives, parental leave, subsidized child care, and flexible work schedules.

What is the result? Well, these measures have boosted the labor force participation of mothers which is great news in and of itself but they seem to have little or no effect on the number of births. So, bribing people to have children does not seem to work at least in the aggregate.

One important game changer is better tax systems and more efficient public expenditure.

On the tax side, this means broadening the base for value-added taxes, improving taxation of multinational corporations, and strengthening tax compliance to ensure that everybody pays their fair share.

On the spending side, there must be better management of public investment. Our research shows that the most efficient public investors get twice the growth bang for their buck than the least efficient.

And, of course, energy pricing is key not only for the public purse, but for the planet. This means more emphasis on energy taxation and less reliance on energy subsidies.

We estimate that global energy subsidies amounted to $5.3 trillion last year, or 6.5 percent of GDP. This staggering number needs to come down so these resources can be better used. Doing it now, when energy prices are low, makes it that much easier.

Innovation is key

Powerhouses like MIT have been leading the way for decades, including through partnerships with major corporations.

Governments also need to play their part by removing barriers to competition, cutting red tape, and investing more in education and Research and Development (R&D). This would unleash entrepreneurial energy and help attract private investment in ideas that are new, surprising, and useful.

In addition to supporting universities and research networks, governments typically provide subsidies for private-sector R&D. More investment in R&D means bigger benefits for the wider economy.

New IMF research shows that, if advanced economies were able to ramp up private R&D by 40 percent, on average, they could increase their GDP by 5 percent in the long term.

Innovation is also critical outside the advanced economies. For example, China is today€™s number one in the world in terms patent applications. And more and more multinationals outsource parts of their R&D to countries like Brazil and India.

To be fair, most developing countries still rely considerably on the imitation and absorption of technologies from advanced economies.

This is why we should encourage greater sharing of technology between the advanced economies and their emerging peers including through foreign direct investment, trade reforms, investment in education, and a better enforcement of intellectual property rights.

If this were to happen, it would be another global game-changer