21 Aug 2006

Demographic Uncertainty and Fiscal Policy

Alex Armstrong / Nick Draper / Andre Nibbelink / Ed Westerhout

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European Network of Economic Policy Research Institutes (ENEPRI) Research Report No. 20 / 35 pages

It is well known by now that population ageing threatens the sustainability of fiscal policies in many countries. Although a number of policy options are available to address the problem, the uncertainty surrounding the future development of the population complicates matters.
This paper analyses the economic, intergenerational and welfare effects of several alternative taxation policies that can be used to close the fiscal sustainability gap: immediate tax smoothing, delayed tax smoothing and balanced budget policies. A distinction is made between a consumption tax and a labour income tax. In addition, the influence of demographic uncertainty on the results of these policies is analysed from a number of perspectives. Simulated population shocks show the effect of demographic volatility on macroeconomic and fiscal variables. Stochastic simulations are presented to produce probabilistic bounds for the future development of the economic outcomes and to analyse the issue of optimal fiscal policy under uncertainty.