Sense and nonsense about the aging of the population

Earlier this week, the federal minister responsible for overseeing Canada's public pension and old age security programs, Diane Finley, suggested that the aging of the population and the future cost of social programs targeted to retirees and seniors will lead to massive increases in taxes, crippling debt and a huge debt burden on future generations.  To remedy the situation, Minister Finley is proposing to raise the eligibility age to Canada's old age security program as a way to reduce future costs and preserve the "sustainability" of federal budget costs.

The rationale for the proposed program changes is based on the fact that the ratio of working-age people to seniors is projected to decline in the next decades or, as Minister Finley puts it, "as we go forward, we’re going to have three times the expense in Old Age Security as we do now, but we’re only going to have half the population to pay for it".

But is it really correct to say that the government is headed for a demographic shift that will jeopardize the sustainability of the federal budget in years to come?  I am not convinced. And here's two reasons why I think the problem of population aging is currently overblown.*

The ratio of workers to seniors

First of all, it's important to understand that the so-called "ratio of workers to seniors" is, by itself, a fairly uninformative concept for analyzing the issue of population aging.  The reason for this is simple: the ratio of workers to seniors tends to distort the true burden associated with the aging of the population.  Focusing on the ratio of workers to seniors, as most commentators and policymakers are currently doing, obscures the fact that seniors are, and will remain, a relatively small share of the total population.  Also, it's important to keep in mind that the working population must also "support" itself and the youth, in addition to supporting the senior population.

Instead, a more useful concept for analyzing the impact of population growth on the economy is the ratio of the total population to working-age population.  By using this ratio, one gets a much better sense of the real impact of population growth on the economy and, as a result, on future government budget outcomes.

Figure 1, Source: OCA, 2010

Figure 2, Source: OCA, 2010

Figure 1 provides a good snapshot of the increase in population projected (broken down for each age category) between 2011 and 2030 in Canada (see Figure 2 for the period 2011-2050).**  As shown in Figure 3 below, if the focus is solely on the population over age 65, the picture looks worrisome: over the next two decades (2011 to 2030) the number of people 65 and older will rise 78% relative to those 20 and 64.  When adding those under 20 to those 65 and older, the dependency ratio rises by 36% over the next two decades.  And when the entire population is considered relative to the working-age population, we note that the ratio rises from 159% to 180%, a much more manageable 13% increase over the next two decades (note: 13% of 159 is 21).

In other words, the actual "burden" of aging based on current projections consists of an additional 13% more people per working-age person.  This is much smaller than the 78% that is currently being mentioned by commentators and politicians.

Figure 3, Source: OCA, 2010 and author's calculations

Figure 4, Source: OCA, 2010 and author's calculations

Now, some people may argue that this amount is still quite high and, as a result, the government should nonetheless intervene to reduce future outlays to seniors.  This brings me to the second reason why I'm skeptical about the argument that population aging will have deleterious effects on the economy and public sector budgets: productivity growth. 

Productivity growth

Discussions about the aging of the population rarely, if ever, highlight the critical role that productivity growth plays in enabling the economy to afford the cost of programs destined to retirees and seniors.  Yet, the role that productivity growth plays is actually very important because as people become more productive at work, more income is generated to support those who aren't in the labour force such as the youth and seniors. 

In fact, if we look at the average rate of productivity between 1981 and 2011 for Canada, we find that productivity grew at a rate of approximately 1.3 percent per year (Martel et al., 2011).  This productivity gain greatly contributed to helping the Canadian economy shoulder the increased burden of aging during previous decades.  In 1981, the ratio of workers to seniors was approximately six to one whereas today it is approximately four to one. In 2030, it is expected to be below three to one (Statistics Canada, 2011).  Therefore, assuming that the average rate of productivity will remain at this level until 2031, we find that productivity will have nearly doubled between 1981 and 2031.***

Thus, once you consider the impact of productivity growth, the picture doesn't look so bleak anymore:  three workers in 2031 are expected to produce approximately the same level of output that six workers produced in 1981, fifty years earlier.  In other words, because of productivity growth, the worker in 2031 will generate almost twice as much output per hour as the worker from 1981.

A simple rule of thumb is that population aging remains "sustainable" as long as productivity rises faster than population.  Therefore, assuming an average productivity of 1.3% per year between now and 2031 (the same level as for the period from 1981 to today), we find that productivity will grow 28% whereas population will grow by 13%, as shown in Figure 3.  This is a noticeable difference that would enable Canada's economy to shoulder the burden of population aging while also increasing the population's standard of living.  Comparing this amount to the projected increase in population of 13%, we see that productivity growth will more than make up for the future increase in population.

Now, it is possible that future gains from productivity may not be entirely reflected in increased income for workers (via rising real wages).  Productivity gains may end up being disproportionally absorbed by businesses through increased profits.  However, it is important to understand that this problem is an entirely different one from that of the sustainability or solvency of public pensions and retirement programs.

In the event that future productivity gains get absorbed disproportionally into business profits, the remedy would be for government to ensure that a fair share of the gains from productivity be diverted toward real wage growth for workers.  Certainly, such a scenario would not warrant making drastic changes to the federal government's old age security program by raising the program's eligibility age from 65 to 67, as Minister Finley is proposing to do.

To conclude, I am not saying that taxes will not need to be raised by some amount to cover the future cost of public pensions and other retirement benefits.  The point here is that increased costs to taxpayers and workers should not be overly onerous.  The resources will be there to support the senior population in the future since productivity growth should more than make up for the 13% growth in the total population that working-age people will have to support in the coming decades.

The FRB blog invites your comments. Please share your thoughts below.

* This analysis is based on the excellent article by Spriggs and Price (2005).
** All figures are based on OCA, 2010, p. 96 and author's calculations. See Figure 5 below.
*** An average rate of productivity of 1.3 percent between 2011 and 2031 is a conservative assumption. Some economists are suggesting that Canada's future rate of productivity will rise in the coming decades. See Arlene Kish's IHS Global Insight dated October 2011, as well as the October 2011 edition of the Bank of Canada's Monetary Policy Report, (p. 19) regarding the expected increase in productivity the next few years. Note: a quick and easy way to approximate the number of years it takes for a variable growing at a constant rate to double is to use the "Rule-of-70" or dividing 70 by the chosen growth rate.

Figure 5, Current population and projections,
Source: OCA, 2010 (in thousands) and author's calculations

Hoc dicatur meum filium Vincent, cui futurum quasi electa ut sol. Ut non factus hostiam logica. 



References

OCA (Office of the Chief Actuary), The 25th Actuarial Report on the Canada Pension Plan, November 2010

OCA (Office of the Chief Actuary), The 10th Actuarial Report Supplementing the Actuarial Report on the Old Age Security Program, August 2011

Martel, L. et al., Projected trends to 2031 for the Canadian Labour Force, Statistics Canada, August 2011

Spriggs, W. and Lee Price, Productivity Growth and Social Security's Future, Economic Policy Institute Issue Brief #208, May 2005.

Statistics Canada, Revisions to Canada and United States Annual Estimates of Labour Productivity in the Business Sector 2006-2009, March 2011 (Table 4)