The Impact of Population Aging on the Countercyclical Fiscal Stance in Korea, with a Focus on the Automatic Stabilizer

Abstract

This paper raises questions on the impact of an aging population on the effectiveness of automatic stabilizers (automatic changes in taxes and spending during booms and recessions) in smoothing the business cycle. Population aging will increase the components of tax revenue and spending, which bear weak relationships to the business cycle. That is, the ratios of the consumption tax revenues and the spendings on age-based entitlement programs to total fiscal revenues and spendings, respectively, will grow owing to a declining share of the working-age population. This change could lead to a weakening of countercyclical automatic adjustment of the fiscal balance. The results, which are mainly derived from the spectral analysis on Korean fiscal and business cycle variables, suggest that the automatic stabilizer has worked in counter-acting output fluctuations in Korea. Also, the cross-country panel analysis of 23 major countries reveals that the level of the elderly dependency ratio (ratio of the number of people aged 65 and above to those aged 15-64), as well as the rising speed of this ratio, reduces the sizes of the automatic stabilizers in the short as well as the long run. This result suggests that population aging is an on-going threat in the Korean economy, where the elderly dependency ratio is rising rapidly. The panel analysis reveals in addition that population aging weakens the function of the automatic stabilizers by suppressing their flexible movements. This paper suggests that it would be necessary to redesign the tax and spending rules in economies facing rapid population aging so that the effectiveness of their automatic stabilizers in smoothing output fluctuations can be improved.