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Ageing population - will public finances cope?

Jorma Tuukkanen, Financial Counsellor, Ministry of Finance

Jorma Tuukkanen

Jorma Tuukkanen, Ministry of Finance

Economic development of the last few decades has been characterised by

  • Favourable development of the demographic structure and labour force, which has been a crucial economic growth factor.
  • Relatively rapid growth of productivity, which has been another crucial economic growth factor.
  • Comparatively high rates of saving and investment, allowing rapid adoption of new technology and growth of productivity.
  • A welfare state, with funding based on economic growth at an average rate of a good 3 percent.

In terms of financing of the welfare state, Finland is undergoing a transition into a new phase due to changes in the age structure of the population. The working age population will start to decrease as early as 2010, when the first large age group – those born in 1945 – reaches age 65. Since the famine years of the 1860s, the working-age population has not declined in Finland, except during the war years and a couple of the most active years of emigration to Sweden. As the labour force shrinks, growth of production hinges solely on increased productivity. Consequently, economic growth is estimated to slow down permanently to about 1.5 percent per annum, while over the last hundred years we have become accustomed to an average annual growth rate of a good three percent. The change is very notable.

Finland’s population is ageing more rapidly than in any other EU country, and the old age dependency ratio will be the highest of all EU countries in 2025. The rapid greying is not only due to the baby boomers reaching pension age, but also reflects a long-standing megatrend – longer life expectancy. Since 1970, the life expectancy of Finns aged 65 has increased by 6½ years for women and by 5½ years for men. Based on the statistics, there would seem to be no sign of a slow-down in the rise of life expectancy, rather the opposite. Between the years 2000 and 2005, men’s life expectancy increased by 1.4 years and women’s by 1.3 years.

At the same time as economic growth slows down, pressures on public expenditure will increase. The greatest challenge will be financing of pensions and care services for the elderly. These costs are estimated to grow by the year 2040 by a total of 6-7 percentage points in relation to total production. Savings in expenditure due to shrinking young age groups are likely to be slight. The ageing population will put the funding of the welfare state to a severe test.

Finland is ageing at world record rate, but is also prepared for the financial and spending pressures this will cause.

  1. Central government debt has been reduced through prudent fiscal policy.
  2. Provisions for growth of pension expenditures have been made by partial funding.
  3. Pension systems have been reformed in a more sustainable direction in terms of financing.
  4. The financial basis of public finances has been reinforced through economic policy that fosters growth and employment.

Finland’s starting situation is good compared to many other countries. In 2005, Finland’s general government net lending was 2.5 percent and public debt 41 percent in relation to gross national product. Furthermore, pension funds` financial assets were larger than the public debt.

Through prudent fiscal policy, we have reduced the central government debt and interest costs in good time. This way, we have made room for foreseeable growth of pension and welfare services expenditure. Partial funding of pension schemes in turn has alleviated the pressure of rising pension contributions. The market value of pension reserves has doubled in seven years. At the end of September 2006, pension funds totalled 108.5 billion euros, or 65 percent in relation to gross domestic product.

In addition, pension systems have been reformed on several occasions. The most recent comprehensive reform was implemented in stages from the beginning of 2005. The reform reinforces sustainability of pension system financing, e.g. by adapting pensions to changes in life expectancy and by using ‘pension bonuses’ as incentives for ageing workers to stay in the labour market for longer than previously. As a result, we have seen a distinct rise in the employment rate of these worker groups. However, we must admit that we are still a long way off the target employment rate of 75 percent.

Private sector employment pension institutions’ opportunities for investment risk taking will increase from the beginning of 2007. The aim is to raise the long-term real yield on pension funds` assets to a challenging 4 percent per annum.

The unemployment benefit system has also been reformed with a view to improving employment rates and sustainability of public finances. To increase available manpower, we have raised the lower age limit of the unemployment path to retirement and removed incentive traps by reforming taxation and social security systems. The preconditions for economic growth have also been bolstered through investing in skills. As a whole, Finland has done a great deal and at the right time for sound public finances. For example, the EU classifies Finland’s public sector finances as among the most sustainable in the EU countries.

Our preparations for the ageing challenge have been ‘nearly sufficient’. On the basis of expenditure scenarios up to 2050, Finland’s general government finances have been projected to have a sustainability gap of approximately 1.5% in relation to GDP. This means that either taxation should be increased or growth of expenditure slowed down by the corresponding amount to prevent borrowing from turning to an uncontrollable rise in the long term. Nevertheless, there is no cause for panic, as narrowing the sustainability gap is feasible.

Due to international tax competition, however, it is not expedient to finance this shortfall through increased taxation, as Finland’s tax rates are already high by international standards. In any event, tightening the tax screw would not be a desirable alternative, because it would further slow down economic growth and therefore impede financing of public expenditure. Thus, there is little scope for manoeuvre with regard to taxation; the pressure rather points to its reduction. Neither is debt financing an option, as it is precluded by the EU Stability and Growth Pact, which restricts excessive public borrowing. In any event, it is not pragmatic to build the future of any economy on debt.

The only sustainable ways of financing the growth of public expenditure brought about by the ageing population are:

  • slowing down the growth rate of public expenditure, e.g. by more efficient production of public services
  • ensuring good rates of employment and economic growth, i.e. the tax base of public finances; a well-run economic policy is the best welfare policy.

In addition, it is important that occupational pension funds make a good return. The minimum requirement of return on pension funds is that, after administrative costs, it should be higher than the average interest rate on government debt.

After the recession of the early 1990s, Finland has taken good care of its public affairs. Narrowing the sustainability gap in the public finances is within reach during the next governmental term, before the labour force starts to decline and economic growth slows down. There would seem to be no scope for significant tax cuts.