By Il Houng Lee
Despite two decades of government efforts, including the set up of the Presidential Committee on Aging Society and Population Policy, Korea’s birth rate is still in decline. While most OECD countries face a similar aging profile, the situation is more acute in Korea. Along with ongoing policies to rekindle the birth rate, parallel efforts are needed in most countries to prepare for the expected widening of the pension gap a few decades down the road. Otherwise, the scope of taxation for redistribution purposes will become so large as to risk undermining the incentive structure of market-based systems as well as economic and social stability.
What is the scale of the ageing problem and how well are Korea and the EU prepared for it?
According to the UN medium variant scenario, the share of 65+ of the world population will increase from 6% in 1980 to 24% by 2100. Korea’s case is most drastic, rising from 4% to 44% and stands out against 11% to 32% both in Europe and the US. A numerical exercise of consumption smoothing covering 1980 through 2100 indicates, plausibly, that most countries should have started saving two decades ago and maintain their efforts through the first half of this period when their dependency ratio is still relatively low and dissave in the second half.
This contrasts with the negative net financial savings (i.e., debt) of about 33% of GDP in OECD countries and 46% in the EU members (unweighted average; 2020). Korea’s aging started later than most OECD members but will accelerate much faster. Reflecting this back-loaded aging profile, Korea’s net government financial savings stood at 41% of GDP in 2020, one of the few countries with net positive savings. However, for the same reason, its required savings as percent of GDP for the next 30 years is almost three times higher than those of the European economies. This assumes no cross-border labor mobility.
A mechanical linear extrapolation indicates that Korea’s average social spending, on account of aging alone, will rise from 10% during 2010-19 (based on OECD data) to 63% of GDP during 2075-85 (thereafter aging stabilizes). This looks extremely challenging even before considering the expected decline in government revenue. The share of social spending over government revenue (assuming constant tax burden per head) will rise from 29% of GDP to 339% of GDP during the same period. In the EU, this ratio rises from 50% to 85% of GDP and in the US from 58% to 83% of GDP. While these figures should not be taken literally, they provide a sense of the relative scope of the required adjustments.
Korea’s pension spending on the surface appears to be less drastic, rising from 2.6% of GDP in 2010-19 to 9.1% of GDP in 2075-85. These figures, however, are misleading as the starting position of its social spending to GDP is less than a third of the EU’s (unweighted) average of 9.7% or the US’ spending of 13.8%. The EU’s pension spending is estimated to rise to 18% of GDP in 2075-85, i.e., a formidable two-fold increase. As the share of working population in Korea falls by 28 percentage points of the total during the same period, irrespective of the type of pension systems (defined-benefit and/or -contribution plan), additional funding required in 2075-85 to keep the same amount of benefit per head and to get closer to the EU average will require a major undertaking. The EU’s working population falls by twelve percentage points, which compares with the global average of five percentage points and is certainly not a situation of “business as usual” either.
Which policy combinations could meaningfully contain the expected widening of the pension gap?
Government efforts in most OECD members should include revisiting their macroeconomic policies as they may have undermined private sector saving to date and start actively preparing for aging. For monetary policy, it implies expanding the mandate to cover targeting asset prices while for fiscal policy, it would entail generating structural fiscal surpluses as a means of intergenerational redistribution of income. Both policies should be implemented in parallel with existing efforts to concurrently manage macroeconomic stability.
Monetary policy should ensure that asset values increase in tandem with productive capacity. Maintaining the policy rate at the natural rate could be a good start (i.e., Ramsey rule rather than narrowly defined neutral rate). In fact, monetary policy in OECD members over the last two decades have been expansionary, which is an outcome of low price pressures under the inflation targeting framework that culminated from globalization, e.g., efficiency gains from expanding supply chains and huge addition of labor from emerging economies, especially China. Further facilitated by financial innovation, low interest rates have contributed to a rapid increase in asset prices. OECD data show the (unweighted) average value of its member countries’ financial assets held by the nonfinancial sector to have risen from 3.7 times their respective GDP in 1995 to 6.7 times by 2015. In the case of Korea, the comparable data starting in 2008 was 4.7, rising to 5.6 by 2015. Developments in physical assets, especially property prices, echo a similar picture.
Since a financial asset is not a means to its own end but a claim on goods and services, its value has to be broadly proportional to the underlying value of the capital stock it represents. The latter in turn should equal the present value of its productive capacity in terms of goods and services it can produce before full depreciation. The value of the productive capacity is “some multiple” of potential GDP as the latter is a static measure of stable output. Taking the 1990s as a benchmark period (stable savings rate with no concern for aging), this “multiple” is about 3½ times GDP. On this basis, current financial assets are worth only about 60 to 70 percent of their nominal value, i.e., their purchasing power of future goods and services. This misperception is clearly evident in national savings to GDP in most OECD economies moving sideways while their aging profile clearly dictates otherwise.
International policy coordination will also need to be fine-tuned to better reflect the relative speed of aging among countries. There are two ways to utilize savings, i.e., invest in domestic markets or invest abroad. The former will raise domestic GDP while the latter will raise GDP of the investment-recipient economy. Policy coordination should aim to allow each country to optimally allocate their cross-border savings. In this regard, since aging is taking place in most countries, but the global sum of the external current account has to be zero, their balances need to be adjusted proportionally, i.e., adjustment for multilateral consistency. This work can be built on the IMF’ external stability work.
The remaining balance, i.e., the difference between the pre- and post-adjusted amounts, has to be raised and invested internally in each country. Since the private sector is myopic, this process would require governments to maintain structural fiscal surpluses now and deficits later. The surplus should be managed independently through an earmarked fiscal fund where the use should be limited to investments in domestic productive capacity. The targeted size of such a fund can be adjusted (i) down by the amount in sovereign wealth funds and other public and private pension funds, and (ii) up by the amount of outstanding government debt. Such an effort needs to go beyond simple accrual calculations of specific pension systems and requires rethinking of the whole macroeconomic policy framework.
Once such a macroeconomic framework is put in place, investment and national savings ratios will be higher at the expense of consumption. Effective management of the fiscal fund will be critical in ensuring potential growth is not too much compromised. To the extent that future growth will be led by high tech innovation, labor-augmenting technical progress will imply higher income per worker. Governments’ use of the fiscal fund should ensure that the public sector builds up its claims on the benefits of this technical progress to avoid having to sharply raise government revenue once aging accelerates.
In conclusion, continuation of current policy combination will threaten social stability once aging accelerates. Already in the last two decades, those holding financial assets (OECD average) saw their wealth rising three times faster than the average income. Such a disproportionate increase in unearned income relative to earned income could discourage labor supply and erode confidence in the fairness of a market-based economy. Once aging is factored in, governments’ attempt to close the expected pension gap through concurrent tax collection at that time will be so large that it will seriously undermine the incentive structure of most market-based systems.