Population aging and fiscal sustainability: Nonlinear evidence from Europe

Abstract

This study investigates the effects of population aging on fiscal sustainability for 14 European countries from 1970 to 2014. With a novel nonlinear econometric method, we estimate the dynamic transition of the marginal response of the primary surplus (MRPS) to public debt driven by the demographic shift. We find that the dynamics of the MRPS are highly nonlinear and exhibit opposite patterns between countries with major fiscal crises and those without such crises. The “non-crisis” countries have raised their MRPS to positive values despite population aging, thereby satisfying the conditions sufficient for fiscal solvency. By contrast, the “crisis” countries have let their MRPS decline to negative values and violated the solvency conditions, as the population aged. To account for the contrasting patterns of the MRPS, we estimate the effects of the elderly’s population share on the public expenditures for pension and health care in the cointegration and error-correction models. We find that population aging tends to increase such expenditures, but this effect is much stronger in the crisis countries. This result suggests that their policies for improving fiscal sustainability have been relatively ineffective, which can explain the diminishing MRPS in the crisis countries.