Use of stepwise population projections in fiscal policy analysis in Finland

NIESR Seminar, November 30, 2015

Jukka Lassila (ETLA)joint work with Tarmo Valkonen (ETLA)and Juha Alho (University of Helsinki)

“Sustainability is basically about good housekeeping.

• It is essentially about whether, based on the policy currently on books, a government is headed towards excessive debt accumulation.” (Blanchard et al. 1990).

Auerbach and Hassett (2001)

• ”…how and when to deal with long-term fiscal imbalances that are at once very significant and very uncertain,…”

• ”…stylized models in search of more general conclusions regarding the nature of optimal policy responses.” (OLG with 2-period lives)

• Here: Finnish public institutions, OLG with 16-period lives, searching for ways to describe and discuss.

• Based on Lassila – Valkonen – Alho, Int. J. of Forecasting 2014

Alho: Forecasting demographic forecasts Int. J. of Forecasting 2014

• “We assume that an approximation to the predictive distribution of the future population is available in terms of simulated population counts.

• The required conditional expectations are then obtained by averaging the future evolution of a set of sample paths that come from the neighborhood of a target path.

• This is formally equivalent to n-nearest neighbor kernel regression.”

The model• Open-economy Auerbach – Kotlikoff type general

equilibrium model• Overlapping generations, life-cycle optimization,

endogenous labour supply

• Forward-looking firms, maximizing share value • Perfect foresight, except for demographics where

forecasts are believed in

• A new demographic forecast every period

Demography-related features in the model

• Earnings-related pensions (DB, with longevity adjustment)

• and their funding (partial)• National pensions, means-tested on earnings-

related pensions• Health and LTC costs, depending both on age

and proximity to death• Public education costs and some transfers• Aggregation: How many people in what age

doing what (working or not, consuming, saving, paying taxes, getting transfers etc.)

An interpretation of policy currently on books (Baseline policy)

• Mandatory pension contributions adapt to pension expenditure

• Health and long-term care costs are financed partly by municipal taxes, which adapt.

• Part of health and LTC is financed by state aid to municipalities. State tax rates are held constant, so changes in expenditure and tax bases go into public debt.

Base policy + a forecast-based rule

• if public debt/GDP is forecasted to exceed 60 % within 20 years,

• then the VAT rate is increased permanently by two percentage points.

Conclusions• Analysis of fiscal sustainability relies heavily on

demographic projections. These are changed at regular or irregular intervals. Such changes are often large.

• The introduction of forecasts that are embedded in stochastic population projections allowed us to analyze policies that are based on forecasts.

• Forecasts seem to contain information so that ageing policies can respond in advance. Uncertainty should not imply inaction.