Demographic change and income distribution

Abstract

This paper examines the interactions between demographic change and income distribution, especially in the context of government. Starting from a simple, descriptive life-cycle model of individual income, this paper established an explicit link between the age composition of a population and the personal distribution of incomes. Demographic effects on income inequality are derived. Next, 2 income maintenance programs are introduced: a redistributive tax-transfer scheme and a pay-as-you-go financed state pension system. The resulting government budget constraints entail interrelations between fiscal and demographic variables, causing an additional, indirect demographic impact on the distribution. This is shown not only to change, but in some cases even to reverse the distributional incidence of demographic trends. The superimposition of different age structures on populations of otherwise identical characteristics is non-neutral with respect to income distribution: disregarding state interventions, population aging increases income inequality. This result may no longer generally hold if redistribution policies are taken into account. The paper provides an example of how indirect demographic effects may lead to a reversal of sign. In the absence of any government program, a higher ratio of pensioners to active workers raises income inequality. In the presence of a redistributive tax-transfer scheme and pay-as-you-go financed state pension system, a higher dependency ratio decreases income dispersion. The restoration of government budget equilibrium induces unintended distributional effects which put the incidence of demographic shifts in a different light. Varying important aging indicator with realistic forecast bounds leads to inequality fluctuations up to 35%. This illustrates the quantitative scale and hence the political importance of demographically caused inequality distortions.