A paper contributing to OECD Fiscal Federalism Studies published on 27 October 2020 looks at the fiscal challenges across levels of government resulting from an ageing population.

Personal Tax Revenue and an Ageing Population

Some tax systems may allow countries to be less vulnerable to the fiscal problems resulting from a decline in the numbers of people in work. If pensioners pay personal income tax and social security contributions for health, either as a percentage of the pension or as a lump sum, the system may be less vulnerable to the fiscal challenges of an aging population.

Also if the tax system allows a tax deduction for pension contributions and then taxes pension income the pension costs can be smoothed out. However, as pension income is generally lower than the income earned during the working life, personal income tax on pension income will tend to be paid at a lower marginal rate than the rate at which contributions were deductible. The tax deferral would therefore result in a lower value of tax revenue received from the pension income.

Analysis shows significant falls in tax revenue received when the population is ageing. This fall is however less steep if wages rise as a result of the drop in labour supply caused by ageing.

Revenue from Other Taxes

Population ageing also impacts indirect tax revenues because consumption peaks at middle age and is lower for older people. Tax revenue from recurrent taxes on immovable property and from corporate income tax are likely to be less affected by population ageing, although an ageing population could lead to a drop in investment that could affect corporate tax revenue. Population ageing could also lead to lower house prices and lower tax revenue from property taxes.

Sub-Central Levels of Government

For sub-central governments (regional, provincial and local governments) expenditure generally amounts to around 12% of GDP in the OECD and is around a third of general government expenditure. Generally in OECD countries, sub-central governments are partly or wholly responsible for expenditure on education, healthcare and social protection. Pensions are however normally a central government responsibility.

Expenditure related to old age reaches around 50% of sub-central government expenditure in Germany Austria, Denmark, Poland, Italy, Portugal and Spain but is significantly lower in other OECD countries. The paper notes that by the year 2050 local old age expenditure is likely to reach a level around 80% higher than current levels, but with large differences between countries.

The taxes raised by sub-central governments differ from those raised by central government with more reliance on recurrent taxes on immovable property, although some authorities use local income taxes. The vulnerability of tax revenue to an ageing population is based upon the tax mix of the regional or local authority and to the extent to which those local taxes will be affected by population ageing.

In some countries tax sharing with central government is an important source of revenue for local governments, especially in relation to revenue from personal or corporate income tax or value added tax. The tax sharing agreements are based on formulae which do not systematically take into account demographic factors and may therefore require adjustment.

Whole of Government Approach

The study suggests that to make their tax and spending systems more resilient when populations are ageing countries must adopt tax and spending reforms that take into account a whole-of-government perspective that can focus on the correct tax mix, appropriate methods for local government funding and suitable patterns of spending.