Facing Demographic Challenges: Pension Cuts or Tax Hikes

Abstract

In this paper, we investigate two fiscal policy options to mitigate fiscal pressure arising from ageing of the Australian population: pension cuts or tax hikes. Using a computable overlapping generations model, we find that while both policy options achieve the same fiscal goal, the macroeconomic and welfare outcomes differ significantly. Future generations prefer pension cuts, whereas current generations prefer tax hikes to finance government spending commitments. Interestingly, taxing consumption or income results in opposing macroeconomic and welfare effects. Increases in the consumption tax rate have positive effects on labour supply, domestic assets and output (similar to pension cuts), but reduce the welfare of low income households most. Conversely, increases in progressive income or payroll taxes have negative effects on the economy but reduce the welfare of low income households least. Our results highlight the intra- and inter-generational conflicts of interest and political constraints when implementing any structural fiscal reforms.

Keywords: demographic transition, fiscal policy, welfare, overlapping generations