by Yvan Guillemette, OECD Economics Department

Every 2-3 years, the OECD Economics Department publishes a set of country-level economic scenarios to 2060 to quantify some of the most important long-term macroeconomic trends and policy challenges facing the global economy. The latest update includes the standard ‘business-as-usual’ scenario, in which no major reforms to government programmes are undertaken and progress on energy efficiency and energy decarbonisation continues along recent trends. For the first time, the update also describes a stylised scenario in which OECD and non-OECD G20 economies successfully transition to low-carbon energy in a way broadly consistent with a net-zero target for greenhouse gas emissions by 2050. While this represents a negative supply shock to all economies, the upshot of the analysis is that fiscal and structural reforms could fully offset the output costs associated with mitigation efforts over the first 10 years of the energy transition.

In the baseline scenario, global CO₂ emissions from energy use remain around current levels, a trajectory incompatible with the UN Paris Agreement’s ambition of limiting warming to 1.5°C. This failure occurs despite trend annual real GDP growth for the combined OECD+G20 area gradually declining from around 3% pre-COVID to 1.7% by 2060, mainly due to falling working-age population growth and a deceleration of trend labour efficiency growth in emerging-market economies. China and India continue to account for most of global growth, with India’s contribution surpassing China’s in the late-2030s.

Figure 1. The baseline scenario in a snapshot

Note: ‘G20 advanced’ includes Australia, Canada, Germany, France, the United Kingdom, Italy, Japan, Korea and the United States. ‘G20 emerging’ includes Argentina, Brazil, China, India, Indonesia, Mexico, Russia, Saudi Arabia, Türkiye and South Africa. The OECD+G20 aggregate includes all OECD and non-OECD G20 countries.

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In per capita terms, growth in the OECD area remains stable, around 1½ per cent per annum, below historical norms. Real GDP per capita growth is projected to slow in most of the G20 emerging-market economies, except those where recent performance has been relatively weak (including Argentina, Brazil and South Africa).

In the energy transition scenario, all countries accelerate their CO₂ mitigation efforts as of 2026, eliminating coal as an energy source by 2050 and lowering oil and gas shares in total energy supply to 5% and 10%, respectively. Abstracting from gains due to avoidance of environmental damages, this acceleration of the energy transition leads to a reallocation of resources that impact GDP negatively. Global growth slows by 0.2 pp per annum initially relative to the baseline scenario, and by 0.6 pp toward the end of the transition period. The slowdown is more modest in the OECD area, but sharper in the G20 emerging-market area given higher carbon intensity.

An increase in carbon taxation sufficient to bring about the transition could bring in around 3¼ per cent of GDP in additional government revenue in the OECD area over the 2026-2030 period. In the basic energy transition scenario, this extra revenue is channelled back to households as a direct transfer. However, an alternative scenario assesses a tax shift strategy in which revenue from higher carbon pricing is used to lower the tax burden on labour (labour tax wedges). Dynamics are important here because revenue from carbon pricing first rises, but later declines along with CO₂ emissions, implying that tax wedges could be lowered, but would eventually have to rise again. Nevertheless, because higher carbon pricing is politically awkward to implement, the tax shift strategy could facilitate the phasing in of higher carbon taxes, allowing at least the initial part of the energy transition to benefit from the greater efficiency of a price-induced transition.

Via positive effects on employment, this tax shift strategy is shown to fully offset the decline in output otherwise associated with the first 10 years of the energy transition, leaving living standards in 2035 higher than in the baseline scenario in the OECD area and most individual countries. At peak impact around 2035, the euro area and OECD aggregate employment rates are around 1½ pp higher than without the tax shift.

Figure 2. Shifting tax burden from labour to carbon offsets most transition costs to 2035
Level of potential output in 2035, % difference between scenarios (see legend and note)

Note: Blue bars show the % difference in the level of output in 2035 in an energy transition scenario with carbon revenue rebated as lump sums versus the baseline scenario. Orange bars show the % difference in the level of output in 2035 in an energy transition scenario with carbon revenue used to lower tax wedges versus when it is rebated as lump sums. Diamonds show the % difference in the level of output in 2035 in an energy transition scenario with carbon revenue used to lower tax wedges versus the baseline scenario, which corresponds to the sum of blue and orange bars. Chile, Colombia, Costa Rica, Mexico, Norway and Türkiye are not shown as these countries do not have a fiscal block in the OECD Global Long-Term Model.

Additional scenarios show that deploying the extra revenue into a combination of higher R&D expenditure and support for childcare would have similar effects. Other structural reforms, such as product market liberalisation and improvements in governance could also help to offset the output costs of CO₂ mitigation.

Reference

Guillemette, Y. and J. Chateau (2023), “Long-term scenarios update: incorporating the energy transition”, OECD Economic Policy Papers, No. 33, OECD Publishing, Paris, https://doi.org/10.1787/153ab87c-en

By David Crowe, Jörg Haas, Valentine Millot, Łukasz Rawdanowicz and Sébastien Turban, OECD Economics Department

Population ageing is one of the biggest challenges to public finances (Rawdanowicz et al., 2021). It is expected to necessitate a sizeable increase in public spending on pensions and health care. Such spending pressures could be mitigated by structural reforms or cost reductions, but in their absence large increases in tax revenue would be needed to stabilise public debt (Rouzet et al., 2019; Guillemette and Turner, 2021).

In contrast to the existing literature which focuses on government spending, in our latest paper (Crowe et al., 2022), we shed light on the consequences of population ageing for government revenue in OECD countries. We do this in a framework consistent with the OECD long‑term model (LTM) (Chalaux and Guillemette, 2019; Guillemette and Turner, 2021). We show that if the labour and capital income shares in GDP remain constant and pension income increases in relation to GDP, the tax revenue-to-GDP ratio is likely to increase slightly via higher revenues derived from the taxation of pension income and of associated consumption. However, this will not be enough to cover the total increase in government spending due to population ageing.

In view of these results, countries still would have to reduce spending or raise taxes and implement structural reforms to boost labour force participation and growth, if they do not want public debt to increase. Policy options will be constrained by countries’ current levels of overall taxes and debt, and political economy considerations. Countries with high tax revenue and debt may need to favour spending reductions. In contrast, countries with low taxation and debt may envisage raising taxes and increasing borrowing. In practice, a combination of these strategies, which reflects a country’s social preferences, could be desirable to limit negative effects associated with each option.

The modelling framework

Building on the recent analysis of the consequences of ageing populations on government spending and long‑term GDP in the LTM (Guillemette and Turner, 2021), we analyse implications for government revenue. In the baseline scenario, the labour share in GDP remains constant, consistent with the Cobb‑Douglas production function employed in the LTM.

Our model’s general approach is to project shares of the main income components in GDP, which constitute the main income tax bases, and apply calibrated effective tax rates (ETRs), which are assumed to remain constant, to obtain projected government revenue from income taxes and social security contributions (SSCs). The resulting disposable income of households is used to project household consumption (based on constant calibrated saving rates) and then consumption taxes, again based on a constant calibrated ETR.

The proposed framework, while admittedly stylised, has the advantage of ensuring accounting consistency between the assumed split of nominal GDP into labour and capital income shares (the primary allocation of income), taxes and social benefits – including pensions (which are part of the secondary distribution of income) – and household consumption (uses of disposable income). Thus, the model can indicate the orders of magnitude of the impact of selected aspects of population ageing on budget balances.

Given the model’s assumptions, population ageing affects tax revenue mainly via income taxes and SSCs on pensions and via taxes on consumption out of pension income.

The results

The increase in government tax revenues resulting from higher aggregate pension income projected in the model is significant in relation to the size of the pension spending pressures, but by far not enough to solve the fiscal challenge. On average, the additional revenue covers around a quarter of the expected increase in government spending on public pensions; the latter accounts for less than 40% of the total increase in public spending due to population ageing (see figure).

In most countries, more than half of the extra tax revenue is generated from indirect taxes due to growing consumption out of pension income and thus growing consumption tax revenue. In these countries, the coverage ratio correlates positively with the ETR for consumption taxes.

The general smaller importance of direct taxes stems from the fact that ETRs for current taxes and SSCs on pensions are usually low and below the respective ETRs on labour income. Lower ETRs on pensions are due to favourable treatment, exemptions from taxation, and the progressivity of personal income taxation (as average pension income is usually below average wage income). Still, the coverage ratio is large in several countries where ETRs related to current taxes paid by households on social benefits are particularly high (e.g. Denmark, Finland, Luxembourg, the Netherlands, Sweden and Switzerland).

Tax revenue from growing aggregate pension income will likely increase

Per cent of GDP, change between 2023 and 2060

Robustness checks

Given the stylised nature of the model, the results should be treated as indicative of potential magnitudes rather than precise projections. While the results are robust to alternative constant ETRs calibrations, there are other aspects of the model that could affect the results. They are discussed in the paper. Here we mention only two:

• First, the alternative assumption of a modest decline in labour income shares does not change net fiscal pressures significantly. Lower labour shares reduce labour-related revenue but increase tax revenue from gross profits of companies and self-employed income (all relative to GDP). The net effect on the tax‑to‑GDP ratio is expected to be negative since the taxation of capital income tends to be lower than that of labour income. However, as the LTM specifies pensions relative to the average wage, a fall in the labour share also reduces the increase in public spending on pensions relative to GDP. On net, fiscal pressures are expected to be slightly higher in the scenario with a modest decline in the labour share compared with the baseline scenario in two‑thirds of the analysed countries, and marginally lower in the remaining countries.
• Second, while saving rates in the model are assumed to be constant over time, they are likely to differ across age cohorts (which can be related to income level and type) and result in a time-varying aggregate saving rate given expected changes in population and income structures. For instance, the saving rate can fall for people transitioning from employment to retirement if they maintain similar consumption level and their pension income is lower than previous wage income. However, savings may not be affected if older people receive higher capital income. Similarly, if the consumption of older people declines proportionally or more than income during retirement, their saving rate could remain unchanged or increase. Available Eurostat household surveys suggest that saving rates tend to decrease with age in several EU countries, but the opposite is true in other countries. Other studies show that on average, the elderly does not decumulate wealth in the United States (Auclert et al., 2021) and in Europe (Horioka and Ventura, 2022). Maintaining wealth could be explained by precautionary or bequest motives, but reasons for cross-country differences in age-specific saving rates are not clear. Thus, although assuming the same saving rate for all age cohorts may not be a realistic assumption, the alternative is not obvious. If the saving rate for the older population would be lower than for the working‑age population, consumption tax revenue would be somewhat larger than in the case of a uniform saving rate. However, sensitivity tests indicate that this assumption does not affect the model simulation results significantly.

References:

Auclert, A. et al. (2021), Demographics, Wealth, and Global Imbalances in the Twenty-First Century, National Bureau of Economic Research, Cambridge, MA, https://doi.org/10.3386/w29161.

Chalaux, T. and Y. Guillemette (2019), “The OECD potential output estimation methodology”, OECD Economics Department Working Papers, No. 1563, OECD Publishing, Paris, https://dx.doi.org/10.1787/4357c723-en.

Crowe et al. (2022), “Population ageing and government revenue: Expected trends and policy considerations to boost revenue”, OECD Economics Department Working Papers, No 1737, OECD Publishing, Paris, https://doi.org/10.1787/9ce9e8e3-en.

Guillemette, Y. and D. Turner (2021), “The Long Game: Fiscal Outlooks to 2060 Underline Need for Structural Reforms”, OECD Economics Department Policy Papers, https://doi.org/10.1787/a112307e-en.

Horioka, C. and L. Ventura (2022), Do the Retired Elderly in Europe Decumulate Their Wealth? The Importance of Bequest Motives, Precautionary Saving, Public Pensions, and Homeownership, National Bureau of Economic Research, Cambridge, MA, https://doi.org/10.3386/w30470.

Rawdanowicz, Ł. et al. (2021), “Constraints and demands on public finances: Considerations of resilient fiscal policy”, OECD Economics Department Working Papers, No. 1694, OECD Publishing, Paris, https://dx.doi.org/10.1787/602500be-en.

Rouzet, D. et al. (2019), “Fiscal challenges and inclusive growth in ageing societies”, OECD Economic Policy Papers, No. 27, OECD Publishing, Paris, https://dx.doi.org/10.1787/c553d8d2-en.