NATIONAL CENTER FOR POLICY ANALYSIS

Measuring the Unfunded Obligations of European Countries

Policy Report No. 319 by Jagadeesh Gokhale, PhD

Europe is undergoing two major transitions. On the demographic front, many European countries are undergoing rapid population aging as their Baby Boom generations enter retirement, senior citizens live longer and fertility rates remain well below the population replacement level. On the economic front, 15 European countries have adopted the euro as a common currency, eliminating the ability to use monetary policy to achieve country-specific economic goals. Both transitions will place tremendous, conflicting pressures on the domestic national budgets of European countries.

Executive Summary

These countries remain politically committed to maintaining fiscal discipline, but large portions of their government budgets are funded on a pay-as-you-go basis. That means that no real resources are set aside and invested each year by government or individuals to prefund future expenditures on such programs. Spending on promised retirement and health-care benefits for the elderly will increase. But there will be fewer workers to pay benefits as the bills come due, and the growth of income from which to extract taxes to support these programs will slow. As a result, all European countries have large unfunded liabilities — the difference between the projected cost of continuing current government programs and net expected tax revenues. In general:

■ The average EU country would need to have more than four times (434 percent) its current annual gross domestic product (GDP) in the bank today, earning interest at the government’s borrowing rate, in order to fund current policies indefinitely.

■ At the low end, Spain would need to have almost two and one-half times (244.3 percent) its annual GDP invested.

■ At the high end, Poland would need to have 15 times its GDP invested in real assets, forever!

No EU government has made the necessary investment. As an alternative, the next-best option is for these countries immediately to gradually but significantly increase saving and investment. In particular, the average EU country could fund its projected budget shortfall through the middle of this century if it put aside 8.3 percent of its GDP each and every year. Despite this adjustment, a budget shortfall is likely to emerge after 2050, requiring additional fiscal reforms.

What will happen if EU countries do not set aside these funds? Unless they reform their health and social welfare programs, they will have to meet these unfunded obligations by increasing tax burdens as the larger benefit obligations come due. Although spending averages 40 percent of GDP today:

■ By 2020, the average EU country will need to raise the tax rate to 55 percent of national income to pay promised benefits.

■ By 2035, a tax rate of 57 percent will be required.

■ By 2050, the average EU country will need more than 60 percent of its GDP to fulfill its obligations.

In some countries, the projected shortfalls are lower than the average. In other countries, they are higher. This is the result of several factors. For instance, life expectancy at birth (in 2004) ranges from a low of 71.2 years in Latvia to a high of 80.7 in Sweden, indicating higher age-related costs in older EU countries than in newer, Eastern countries. Another demographic factor is fertility, which is below the rate of 2.1 births per woman required to maintain populations. However, fertility rates in the EU range from a low of 1.18 in the Czech Republic to a high of just 1.93 in Ireland — indicating that the Czech Republic is closer to a population implosion. Partly as a result of these demographic differences, economic growth rates also differ widely, from a contracting economy in Malta, with a –1.6 percent rate of growth in GDP per capita (averaged over the period from 1996 to 2005), to a 5.7 percent growth rate in Estonia.

In comparison, the United States’ shortfall for Social Security and Medicare alone has been somewhat smaller than the EU average, at 6.5 percent of future GDP. But as a result of the expansion of the Medicare program to cover prescription drugs, the U.S. fiscal imbalance is now 8.2 percent of future GDP. Putting this in perspective, to close its fiscal imbalance:

■ The United States would need to save and invest an amount equal to 8.2 percent of its GDP beginning now and continuing every year forever to pay expected future benefits without future tax increases.

■ This could be accomplished by more than doubling the current 15.3 percent payroll tax on employers and employees, immediately and forever.

■ Alternatively, the federal government could immediately stop spending nearly four out of every five dollars on programs other than Social Security and Medicare — eliminating most discretionary spending on such programs as education, national defense, environmental protection and welfare — forever. Each year that the United States does not take action to reduce the projected shortfall, it grows by more than $1.5 trillion, after adjusting for inflation.

About the Author

Jagadeesh Gokhale is a senior fellow with the Cato Institute in Washington, D.C. His research focuses on U.S. fiscal policy, entitlement reforms, intergenerational redistribution, national saving, and labor productivity and compensation. He works with Cato’s Project on Social Security Choice to develop reforms for programs such as Social Security and Medicare. Dr. Gokhale served in 2002 as a consultant to the U.S. Department of the Treasury and in 2003 as a visiting scholar with the American Enterprise Institute (AEI). Earlier, he was senior economic adviser to the Federal Reserve Bank of Cleveland. His most recent book, Fiscal and Generational Imbalances: New Budget Measures for New Budget Priorities, coauthored with Kent Smetters, drew widespread attention when it was published by AEI. He has also authored numerous papers in such economic journals as the American Economic Review, Journal of Economic Perspectives and the Quarterly Journal of Economics. Gokhale holds a Doctor of Philosophy degree in economics from Boston University.

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