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WORKING PAPERS 2016
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Christine Ma and Chung Tran
December 2016

To what extent does population ageing limit fiscal capacity and affect fiscal sustainability? We answer this question through lens of fiscal space defined by budgetary room between the current tax revenue and the peak of Laffer curves. We use a dynamic general equilibrium, overlapping generations model calibrated to data from Japan and USA. Our findings show that the evolution of underlying demographic structures plays an important tole in shaping a country's fiscal capacity. There will be significant contractions in fiscal space in Japan and USA when the two countries enter their late stage of demographic transition in 2040. In particular, the results from the model calibrated to Japan indicates that an increase in old-age dependency ration to over 70 percent can reduce Japan's fiscal space by 36 percent. The existing design to Japan's tax system is not fiscally sustainable by 2040 when factoring in the growing fiscal cost of social security program.

 
George Kudrna and Chung Tran
December 2016

In this study, we quantify the macroeconomic and welfare effects of alternative fiscal consolidation plans in the context of a small open economy. Using a computable overlapping generations model tailored to the Australian economy, we examine immediate and gradual eliminations of the existing fiscal deficit with (i) temporary income tax hikes, (ii) temporary consumption tax hikes and (iii) temporary transfer payment cuts. The simulation results indicate that all three examined fiscal measures result in favourable long-run macroeconomic and welfare outcomes, but have adverse consequences in the short run that are particularly severe under the immediate fiscal consolidation plan. Moreover, our results show that cutting transfer payments leads to the worst welfare outcome for all generations currently alive, and especially the poor. Increasing the consumption tax rate results in smaller welfare losses, but compared to raising income taxes, the current poor households pay much larger welfare costs. Overall, the welfare trade-offs between current and future generations as well as between the rich and poor, highlight key political constraints and point to challenging policy choices for the wellbeing of future generations. 

 
Rafal Chomik
October 2016

There is a growing recognition that social security systems with a wide scope and comprehensive coverage are an essential part of sustainable development and an ambition worth pursuing vigorously. This is also the case in countries with traditionally family-oriented support frameworks such as Asia.

 
Jennifer Alonso-Garcia, Maria del Carmen Boado-Penas and Pierre Devolder
September 2016

There are three main challenges facing public pension systems. First, pension systems need to provide an adequate income for pensioners in the retirement phase. Second, participants wish a fair level of benefits in relation to the contributions paid. Last but no least, the pension system would need to be financially sustainable in the long run. In this paper, we analyse defined benefit versus defined contribution schemes in terms of adequacy, fairness and sustainability jointly. Also, risk sharing mechanisms, that involve changes in the key variables of the system, are designed to restore the financial sustainability at the same time that we study their consequences on the adequacy and fairness of the system.

 
Jennifer Alonso-García and Beatriz Rosado-Cebrián
September 2016

The recent global financial crisis has intensified the public debate on the sustainability of pay-as-you-go pension schemes. The economic risk is expanding the effects of the already existent demographic risk in most European countries. Our objective is to analyse the effect of the alarming unemployment and inactivity patterns in Spain as of 2016 on the income from contributions and pension expenditures with respect to the GDP by using the Aggregate Accounting framework. We analyse the pension expenditures for the current pattern as well as for full employment and conclude that while the economic risk outweighs the demographic risk until 2040, the main driver of expenditures lies in the ratio of pensioners to working age population in the long run. Our results raise the need to tackle the current labour market situation and confirm that the most recent reforms made in Spain don’t suffice to attain sustainability in the long run.

 
Peter McDonald
August 2016

Migration is one of the three demographic processes that contribute to changes in the size of a population, the other two being fertility and mortality. Fertility is the process by which births are added to a population and mortality is the process by which the population is reduced by deaths. Unlike fertility and mortality, migration has the additional complexity that it affects two populations at the same time: the place of origin and the place of destination.

 
Ermanno Pitacco
August 2016

This paper provides some introductory remarks to critical biometric aspects underlying risk identification and risk assessment for life annuity portfolios and pension funds. On the one hand, statistical evidence shows, in many populations, a deceleration in mortality increase at very old ages, in particular a non-exponential increase in the age-pattern of mortality. On the other hand, causes of this feature of the age-pattern of mortality constitute a rather controversial issue. Nevertheless, a deceleration in the mortality increase can analytically be explained by the (reasonable) assumption of heterogeneity with respect to mortality inside a cohort, and, in particular, in terms of non-observable risk factors, which can be represented, for each individual in the population, by his/her “frailty” level. The presence of mortality heterogeneity heavily impacts on the riskiness of a life annuity portfolio (or a pension fund), and hence should carefully be taken into account in the risk management process. In particular, appropriate parametric models can help in assessing the impact of heterogeneity among annuitants.

 
Juergen Jung, Chung Tran and Matthew Chambers
July 2016

We quantify the effects of population aging on the US healthcare system. Our analysis is based on a stochastic general equilibrium overlapping generations model of endogenous health accumulation calibrated to match pre-2010 U.S. data. We find that population aging not only leads to large increases in medical spending but also a large shift in the relative size of public vs. private insurance. Without the Affordable Care Act (ACA), aging itself leads to a 36:6 percent increase in health expenditures by 2060 and a 5 percent increase in GDP which is driven by the expansion of the healthcare sector. The group-based health insurance (GHI) market shrinks, while the individual-based health insurance (IHI) market and Medicaid expand significantly. Additional funds equivalent to roughly 4 percent of GDP are required to finance Medicare in 2060 as the elderly dependency ratio increases. The introduction of the ACA increases the fraction of insured workers to 99 percent by 2060, compared to 81 percent without the ACA. This additional increase is mainly driven by the further expansion of Medicaid and the IHI market and the stabilization of the GHI market. Interestingly, the ACA reduces aggregate health care spending by enrolling uninsured workers into Medicaid which pays lower prices for medical services. Overall, the ACA adds to the fiscal cost of population aging mainly via the Medicare and Medicaid expansion.

 
Shang Wu, Hazel Bateman and Ralph Stevens
July 2016

Whereas there is ample evidence that life-contingent income products (life annuities) have the potential to improve individual welfare, combining them with health-contingent income products (resulting in so-called life care annuities) would serve to further increase welfare for individuals who are exposed to uncertain out-of-pocket healthcare expenditure later in life. We develop a life-cycle model of annuitization, consumption, and investment decisions for a single retired individual who faces stochastic capital market returns, uncertain health status, differential mortality risks, and uncertain out-of-pocket healthcare expenditure with cost of dying. Using the calibrated model, we show that individuals who are eligible to purchase life care annuities instead of standard life annuities increase their level of annuitization by around 12 percentage points. Health status at retirement affects the extent to which the insurance feature and the pricing advantage of life care annuities contribute to this increment, with end-of-life healthcare expenditure being of particular importance. Also, life care annuities allow individuals to consume more throughout their retirement and to invest a higher proportion of their liquid wealth in the risky asset. They are willing to pay a loading up to 21% for having access to life care annuities.

 
Monisankar Bishnu, Cagri S. Kumru and Arm Nakornthab
June 2016

In this paper we derive the expression for optimal inheritance tax when agents' preferences are subject to temptation and self control problem. We consider a dynamic stochastic model as in Piketty and Saez (2013) where agents are heterogeneous in terms of bequest motives and labor productivities. In such a setup we show that the optimal inheritance tax rate decreases with the level of temptation, and thus it works as an incentive mechanism that leads to more bequests and makes succumbing to temptation less attractive. In fact, when temptation is acute, a subsidy may be justified at any percentile of bequest received. This holds independent of the variation in the models used in the literature as well as the assumption of labor elasticity. The study also reveals some interesting observations. Though from the point of view of incentives, this result has the same essence as in Krusell et al. (2010) where temptation justifies a subsidy on capital, we show that unlike their other policy prescription, the long run equilibrium does not demand a constant subsidy. Thus, even under temptation and self control issue, the standard Chamley - Judd result which recommends zero capital tax in the long run is still valid. However, in a setup that is comparable to Farhi and Werning (2010), our paper shows that in the presence of temptation and self control, if dynamic efficiency holds, optimality always requires a subsidy independent of whether social welfare function puts zero or positive direct weight on the children. This is in direct contrast to Piketty and Saez (2013). A calibration using the same micro data used by Piketty and Saez (2013) shows that the drop in inheritance tax is significant in the presence of temptation and self control.

 
Hazel Bateman, Isabella Dobrescu, Ben R. Newell, Andreas Ortmann and Susan Thorp
May 2015

Short, standardized financial product disclosures should make comparisons easier, support better choices and reduce welfare losses. Using incentivized experiments, we investigate how and when prescribed fee and return information in standardized disclosures prompt efficient switches between retirement plans. Our choice data suggests members rely accurately on fee information but are reluctant to use returns information as a basis for switching plans, even when a switch is warranted. This reluctance persists even when returns have very low volatility. In addition, many of the prescribed information items are poorly understood by members. A simplified disclosure format can lead to more efficient comparisons of returns and significantly higher final account balances.

 
Heather Booth, Leonie Tickle and Jiaying Zhao
April 2016

Mortality change in Australia since 1907 is analysed in the light of Epidemiologic Transition theory. Australia began the twentieth century in the second age of the Epidemiologic Transition, the Age of Receding Pandemics. In the early decades of the twentieth century, Australia was a leader in the Transition with a life expectancy about 4 years higher than many other Western countries. By 1950, however, this advantage had been lost. Nevertheless, Australia probably moved to the third Age of Degenerative and Man-Made Diseases before 1946, which is slightly in advance of most Western countries. Transition to the fourth Age of Delayed Degenerative Diseases, is clearly marked by a downturn in about 1970 in circulatory disease mortality, concurrent with other Western countries. This interpretation of the Epidemiologic Transition in Australia is based on the analysis of trends in mortality by major cause of death and by age, elaborated through the decomposition of changes in life expectancy by age and cause of death. Differentials by sex, state/territory, type of geographic area, indigeneity and socio-economic status help to identify the leaders and laggards in the transition.

 
George Kudrna
April 2016

Population ageing, a demographic transition that will accelerate in NSW over the next few decades, is creating economic opportunities as well as significant challenges for the NSW economy and the state government. On the one hand, a growing number of seniors represent a powerful economic force in terms of their consumption spending and their housing assets. On the other, a rapidly growing proportion of the elderly in the population will put upward pressure on publicly funded age-related expenditures, particularly on health care spending. Furthermore, reduced population growth and a declining proportion of the working-age population is expected to lower employment growth and demand for housing, negatively affecting the government's main sources of tax revenues - payroll tax and property taxes. As a result, the gap between government expenditures (that are expected to grow further due to non-age related factors such as medical advances) and taxation revenues will widen in the future due to an ageing of the NSW population.

 
Juergen Jung and Chung Tran
March 2016

We quantitatively explore the welfare implications of three common approaches to providing social health insurance: (i) a mix of private and public health insurance (US-style), (ii) compulsory universal public health insurance (UPHI), and (iii) private health insurance for workers combined with government subsidies and price regulation. We use a Bewley-Grossman lifecycle model calibrated to match the lifecycle structure of earnings and health risks in the US. For all three systems we find that welfare gains triggered by a combination of improvements in risk sharing and wealth redistribution dominate welfare losses caused by tax distortions and ex-post moral hazard effects. Overall, the UPHI system outperforms the other two systems in terms of welfare gains if the coinsurance rate is properly designed. A switch from the US system to a well-designed UPHI system results in large welfare gains. However, such a radical reform faces political impediments due to opposing welfare effects across different income groups.

 
Axel Borsch-Supan and Christopher Quinn
February 2016

The paper motivates and describes the tax treatment of German retirement benefits and pensions after the 2005 reform initiated by the German Federal Constitutional Court. The main question is whether this reform has produced a “level playing field” among the many instruments generating retirement income in Germany.

The paper briefly outlines rational principles for the taxation of retirement benefits and pensions and compares these with current practice in Germany and abroad.

 
Carl Emmerson and Paul Johnson
February 2016

Private pension saving is hugely important in the UK and traditionally the taxation of pensions has been relatively stable and rather generous, beyond the treatment offered by an expenditure tax regime. Recently, though, there have been substantial changes. Annual and lifetime allowances have been cut dramatically, largely as a way of increasing tax revenues. At the same time the requirement to annuitise pension wealth has been abolished, making pension saving look much more similar to other forms of saving. Meanwhile the tax treatment of other important forms of saving has been made more generous. The motivation for many of the reforms enacted has been largely one of increasing tax revenues. They have been encouraged by a misunderstanding of the purpose, and cost, of the current system. They have not dealt with elements which are over-generous whilst limiting opportunities for receiving a “neutral” treatment on savings. We have now reached a position of great uncertainty about the future tax treatment of pensions.

 
Bernd Genser and Robert Holzmann
February 2016

Pension policy reforms across the world in recent decades are a reaction to the changing demographic and socioeconomic environment. While pension scheme redesign has received much attention, the tax treatment of contributions, returns, and benefits of retirement savings remains mostly unattended and the taxation of internationally portable pensions is terra incognita for economists. This paper focuses on the huge differences in old-age pension taxation within and across OECD countries and highlights fiscal equity and efficiency issues that emerge in a world of internationally mobile workers and pensioners. It highlights that pension taxation differs widely not only across countries but also across pension pillars within a country, creating savings and mobility distortions and fiscal equity problems at individual and country level. The paper offers explanations for this heterogeneity and proposes a switch from deferred taxation towards front-loaded taxation of retirement savings to meet the demographic challenges of a globalized world. Three policy options presented differ in the way taxes are paid, but all of them are claimed superior to single-country measures taken to uphold deferred pension taxation or to rely on renegotiations of bilateral double taxation treaties.

 
Jukka Lassila and Tarmo Valkonen
February 2016

We study transitions from EET tax regime to TEE regime in a defined-benefit pension scheme with a numerical overlapping generations model, using stochastic mortality projections as inputs. In a traditional pension scheme with no automatic longevity rules, such as a link between life expectancy and pensions or retirement age, the tax regime shift can be used to improve public finances, when longevity increases. Diminished private saving and weaker labour supply incentives are among the downsides. Especially the latter makes the reform welfare-reducing, if the improvement in state finances is not used to relieve taxation of labour.

 
Christian Keuschnigg
February 2016

The gains in life expectancy are expected to double the dependency ratio and increase population by 10% in Switzerland until 2050. To quantify the effects on pensions, taxes and social contributions, we use an overlapping generations model with five margins of labor supply: labor market participation, hours worked, job search, retirement, and on-the-job training. A passive fiscal strategy would be very costly. A comprehensive reform, including an increase in the effective retirement age to 68 years, may limit the tax increases to 4 percentage points of value added tax and reduce the decline of per capita income to less than 6%.

 
Torben M. Andersen
February 2016

How should pensions be taxed? In many cases pension savings are usually taxed more leniently than other forms of savings. What is the rationale for this? And are those concerns best targeted via taxation or mandatory pension savings? These issues are discussed with outset in the experience of the Scandinavian countries (Denmark and Sweden). These countries are also interesting because they have implemented a dual income taxation scheme; i.e. they pursue an ETT-taxation regime vis a vis pensions. It is argued that the incentive structure related to pension
savings and retirement can not be seen independently from how private pensions (and savings more generally) affect public pensions via meanstesting. The effective rates of taxation may thus differ significantly from the nominal rates. For Denmark and Sweden it is shown that the effective tax rates on pension savings can be rather high, and for low/medium income close to 100%.

 
George Kudrna
February 2016

This report summarises the results obtained by Kudrna (2015) for the effects of hypothetical changes in the existing taper rate of the Age Pension income test. Using an overlapping generations (OLG) model stylised to the Australian economy, Kudrna examined the implications of changing the income taper for lifecycle labour supply, consumption and savings of households, for key macroeconomic and fiscal aggregates and for household welfare. 

 
Zixi Li, Adam W. Shao and Michael Sherris
February 2016

Multiple state functional disability models do not generally include systematic trend and uncertainty. We develop and estimate a multi-state latent factor intensity model with transition and recovery rates depending on a stochastic frailty factor to capture trend and uncertainty. We estimate the model parameters using U.S. Health and Retirement Study (HRS) data between 1998 and 2012 with Monte Carlo maximum likelihood estimation method. The model shows significant reductions in disability and mortality rates during this period and allows us to quantify uncertainty in transition rates arising from the stochastic frailty factor. Recovery rates are very sensitive to the stochastic frailty. There is an increase in expected future lifetimes as well as an increase in future healthy life expectancy. The proportion of lifetime spent in disability on average remains stable with no strong support in the data for either morbidity compression or expansion. The model has widespread application in costing of government funded aged care and pricing and risk management of LTC insurance products.

 
Cagri Kumru and Arm Nakornthab
February 2016

We study the interaction between estate taxation and annuity demand both analytically and quantitatively. Our quantitative model is rich enough to capture the important features of the economy such as business investment, borrowing constraints, estate transmission, and wealth inequality. Having entrepreneurs in the model is essential to generate a realistic wealth distribution and analyze non-entrepreneurs (workers) and entrepreneurs' annuity demands separately. The simple analytical model gives the direction of the relationship between estate tax rates and annuity demand: lower estate tax rates result in lower annuity demands. The quantitative model shows that annuity demand is indeed sensitive to the changes in the estate tax system. Removing the estate tax rate reduces the annuity demand substantially when the government's budget is balanced with an increase in the proportional income tax rate. If we adjust the consumption tax rate or the government spending to balance the budget, the annuity ownership rate increases slightly compared to that of the benchmark case. Removing the exemption level generates the most striking result: the annuity ownership rate increases from 5.45% to 24.1%. This result indicates that if all individuals face the estate tax, the annuity ownership rate increases dramatically.

 
Rafal Chomik and John Piggott
February 2016

This paper offers a discussion of adequacy of retirement benefits. We have the Australian context in mind, but introduce extensive international comparisons to provide perspective. We cover possible benchmarks against which to set benefits, how these might change depending on household structure, the actual levels at which different countries set basic and minimum pension levels, related taxation policy, and the policies and rationale for benefit indexation. We focus primarily on adequacy in the context of poverty alleviation, but also investigate the idea of defining the adequacy of income replacement. This includes a discussion of design features that increase the likelihood that the retirement system will provide adequate income replacement and the measures that can guide our assessment of the outcomes. 

 
Rafal Chomik and John Piggott
February 2016

This note looks at the treatment of wealth in the income and assets tests that comprise the Age Pension means test. We demonstrate how the tests interact, the extent to which different assets are treated equally and whether the income and assets tests interact effectively across the asset distribution. Policymakers have equalised treatment of some asset classes but have been reluctant to go further. Recent reforms have made the means test more aggressive with respect to assessable assets. This recognises the value of not only asset income but the underlying capital value. We show how a similar outcome can be achieved by implementing a comprehensive income test alongside deemed income rates that increase with assets.