Introduction

It is well known that changes in the age structure of the population can have dramatic consequences for public finances. For example, under a pay-as-you-go (PAYG) scheme, changing demographics may lead to substantial swings in either taxes or welfare services. If neither of these outcomes is politically acceptable, the issue arises as to how a welfare system can be maintained which is not only fiscally sustainable, but which also offers a fair distribution profile across different generations.

To address this challenge, several countries are now operating a medium-term fiscal strategy of public debt reduction. This should help countries avoid substantial cuts in existing welfare arrangements, yet without having to raise taxes when the projected increase in the demographic dependency ratio becomes more severe. By developing the capacity to absorb demographic changes with stable taxes, a country would not only enjoy the efficiency gains associated with tax-smoothing (Barro, 1979), but also be better protected against adverse intergenerational distribution effects.

Provided that the underlying shock – in this case a rise in the demographic dependency burden – is of a non-permanent kind, a saving (or pre-funding) strategy can be seen as a sensible way of smoothing a fiscal adjustment. Therefore, the question of whether the projected increase in the demographic dependency burden constitutes a temporary or a permanent shock is an important one.