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The Decline of the Welfare State:The Decline of the Welfare State:Demography and GlobalizationDemography and Globalization

Assaf Razin and Efraim SadkaAssaf Razin and Efraim Sadka

In Cooperation with Chang Woon NamIn Cooperation with Chang Woon Nam

MIT Press (forthcoming)MIT Press (forthcoming)

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• AIMSAIMS

• The modern welfare state redistributes income The modern welfare state redistributes income from the working young to the retired old, from from the working young to the retired old, from the rich to the poor, etc.the rich to the poor, etc.

• Aging - a common contemporary phenomenon in Aging - a common contemporary phenomenon in the industrial countries - may undermine the the industrial countries - may undermine the survival of the welfare state.survival of the welfare state.

• Low-skill migration attracted to the welfare state Low-skill migration attracted to the welfare state may put additional strain on it.may put additional strain on it.

• Globalization - a widespread contemporanous Globalization - a widespread contemporanous phenomenon - generates international tax phenomenon - generates international tax competition. The consequent erosion in the tax competition. The consequent erosion in the tax base, especially on capital, is another blow to the base, especially on capital, is another blow to the finances of the welfare state.finances of the welfare state.

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• We attempt to provide an integrated We attempt to provide an integrated framework with a political-economy framework with a political-economy underpinning for the analysis of the welfare underpinning for the analysis of the welfare state. In a unfied framework, we examine how state. In a unfied framework, we examine how aging, migration and globalization affect the aging, migration and globalization affect the size and sources of financing of the modern size and sources of financing of the modern welfare state.welfare state.

• We demonstrate how demography and We demonstrate how demography and globalization team up together to downscale the globalization team up together to downscale the welfare state and change its various tax pillars.welfare state and change its various tax pillars.

• Our Analysis is positive, not normative. Our Analysis is positive, not normative.

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• 1. OVERVIEW1. OVERVIEW

• In the coming decades, the population of the In the coming decades, the population of the industrialized world is forecast to age industrialized world is forecast to age dramatically.dramatically.

• Old-age dependency is defined as the ratio of Old-age dependency is defined as the ratio of the population aged 60 and older to those the population aged 60 and older to those between ages 15 and 59.between ages 15 and 59.

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Old-Age DependencyOld-Age Dependency

2000200020502050

GermanyGermany7171

ItalyItaly7676

SpainSpain8181

EUEU35356666

JapanJapan36367070

USAUSA27274747

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• The aging of the population has far-reaching The aging of the population has far-reaching implications for national pension systems.implications for national pension systems.

• Why? Why? • Because most state pension systems are Because most state pension systems are

unfunded (pay-as-you-go systems) and, unfunded (pay-as-you-go systems) and, especially in continental Europe, the benefits especially in continental Europe, the benefits are quite generous.are quite generous.

• This will necessitate a sharp rise in taxes if This will necessitate a sharp rise in taxes if benefits are maintained largely intact. benefits are maintained largely intact.

• The O.E.C.D. predicts that France, for The O.E.C.D. predicts that France, for example, will have to spend 33 percent more as example, will have to spend 33 percent more as a share of gross domestic product than it does a share of gross domestic product than it does now.now.

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• The Economist (24th August, 2002) looks at The Economist (24th August, 2002) looks at another dimension of the financial burden, that another dimension of the financial burden, that is the public debt:is the public debt:

• "On some estimates, by 2050, government debt "On some estimates, by 2050, government debt could be equivalent to almost 100 percent of could be equivalent to almost 100 percent of national income in America, 150 percent in the national income in America, 150 percent in the EU as a whole, and over 250 percent in EU as a whole, and over 250 percent in Germany and France.“Germany and France.“

• (Recall that the Stability and Growth Pact of (Recall that the Stability and Growth Pact of the EU puts a 60 percent target ceiling on the EU puts a 60 percent target ceiling on public debt as a percentage of national public debt as a percentage of national income!)income!)

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• A forward looking approach:A forward looking approach:• Take into account not only all current liabilities Take into account not only all current liabilities

but also projected future expenditures of the but also projected future expenditures of the U.S. government and then compare them with U.S. government and then compare them with all the revenues the government can expect to all the revenues the government can expect to collect in the future. A comprehensive study collect in the future. A comprehensive study conducted recently by Jagadeesh Gokhale and conducted recently by Jagadeesh Gokhale and Kent Smetters (2003) does this, and find that Kent Smetters (2003) does this, and find that the difference (in present value) is a staggering the difference (in present value) is a staggering deficit of 44 trillion dollars, an almost deficit of 44 trillion dollars, an almost quadruple of GNP. (Major contributing factors quadruple of GNP. (Major contributing factors to this deficit are old-age social security and to this deficit are old-age social security and medicare.)medicare.)

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• Similarly, the widespread low-skill migration Similarly, the widespread low-skill migration also puts a strain on the public finances of the also puts a strain on the public finances of the welfare state. welfare state.

• Being relatively low earners, migrants are Being relatively low earners, migrants are typically net beneficiaries of the welfare state, typically net beneficiaries of the welfare state, that is, they are expected to receive benefits in that is, they are expected to receive benefits in excess of the taxes (contributions) they pay. excess of the taxes (contributions) they pay.

• For instance, a recent study, initiated by the For instance, a recent study, initiated by the U.S. National Research Council, estimates the U.S. National Research Council, estimates the overall net fiscal burden of migrants (aged 20-overall net fiscal burden of migrants (aged 20-40 years, with less than high-school education 40 years, with less than high-school education on arrival) at about $60,000-$150,000, over on arrival) at about $60,000-$150,000, over their own lifetime.their own lifetime.

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• One would naturally expect that as the share of One would naturally expect that as the share of the elderly in the population rises when the the elderly in the population rises when the population ages, their political clout would population ages, their political clout would strengthen the pro welfare-state coalition. strengthen the pro welfare-state coalition.

• Similarly, one would expect this coalition to Similarly, one would expect this coalition to gain more political power as more low-skill gain more political power as more low-skill migrants are naturalized. migrants are naturalized.

• Thus, aging and migration seem to tilt the Thus, aging and migration seem to tilt the political power balance in the direction of political power balance in the direction of boosting the welfare state, imposing a growing boosting the welfare state, imposing a growing burden on the existing workforce.burden on the existing workforce.

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• But the theme that we put forth is quite the But the theme that we put forth is quite the opposite: opposite:

• Aging and low-skill migration generates Aging and low-skill migration generates indirectly political processes that trim rather indirectly political processes that trim rather than boost the size of the welfare state, when it than boost the size of the welfare state, when it is financed by payroll taxes.is financed by payroll taxes.

• We also provide some supportive empirical We also provide some supportive empirical evidence from the EU and the U.S. for this evidence from the EU and the U.S. for this general theme.general theme.

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• And what if the welfare state tries to rely more heavily And what if the welfare state tries to rely more heavily on capital taxes in order to finance the social benefits it on capital taxes in order to finance the social benefits it provides? provides?

• The old derive most of their income from capital The old derive most of their income from capital because they retired from work. because they retired from work.

• So, at first thought, it may seem that as the share of the So, at first thought, it may seem that as the share of the old in an aging population rises, then an attempt to rely old in an aging population rises, then an attempt to rely more heavily on capital taxes would face a stiffer more heavily on capital taxes would face a stiffer political resistance. political resistance.

• However, after a careful scrutiny of this hypothesis we However, after a careful scrutiny of this hypothesis we come to an unconventional conclusion: come to an unconventional conclusion:

• Aging plausibly tilts the political power balance in favor Aging plausibly tilts the political power balance in favor of larger capital-financed welfare state. of larger capital-financed welfare state.

• We provide also supportive empirical evidence from the We provide also supportive empirical evidence from the EU for this conclusion.EU for this conclusion.

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• Thus aging may seem to come to the rescue of the Thus aging may seem to come to the rescue of the welfare state via capital income taxation.welfare state via capital income taxation.

• Is the latter conclusion really valid? Very doubtful.Is the latter conclusion really valid? Very doubtful.• After all, aging is not the only process witnessed After all, aging is not the only process witnessed

nowadays. nowadays. • Globalization across various economies is another Globalization across various economies is another

universal phenomena to reckon with. universal phenomena to reckon with. • Can therefore high capital taxes survive Can therefore high capital taxes survive

international tax competition brought about by international tax competition brought about by such globalization? such globalization?

• Evidently, in the absence of world-wide tax Evidently, in the absence of world-wide tax coordination and enforcement, the answer is in the coordination and enforcement, the answer is in the negative.negative.

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• As put succinctly by The Economist (As put succinctly by The Economist (31st May, 199731st May, 1997):):• "Globalization is a tax problem for three reasons. "Globalization is a tax problem for three reasons.

First, firms have more freedom over where to First, firms have more freedom over where to locate... . This will make it harder for a country to locate... . This will make it harder for a country to tax [a business] much more heavily than its tax [a business] much more heavily than its competitors... . Second, globalization makes it hard competitors... . Second, globalization makes it hard to decide where a company should pay tax, to decide where a company should pay tax, regardless of where it is based... . This gives them regardless of where it is based... . This gives them [the companies] plenty of scope to reduce tax bills [the companies] plenty of scope to reduce tax bills by shifting operations around or by crafting by shifting operations around or by crafting transfer-pricing... . [Third], globalization... nibbles transfer-pricing... . [Third], globalization... nibbles away at the edges of taxes on individuals. It is away at the edges of taxes on individuals. It is harder to tax personal income because skilled harder to tax personal income because skilled professional workers are more mobile than they professional workers are more mobile than they were two decades ago."were two decades ago."

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• Indeed, the combined forces of aging, low-skill Indeed, the combined forces of aging, low-skill migration and globalization seem to be too migration and globalization seem to be too strong for the welfare state to survive in its strong for the welfare state to survive in its present size.present size.

• Indeed, most of the large industrialized Indeed, most of the large industrialized economies have embarked in recent years on a economies have embarked in recent years on a track of trimming the generosity of their track of trimming the generosity of their pension and other welfare-state programs. pension and other welfare-state programs.

• The general rules are quite straightforward: The general rules are quite straightforward: Raise retirement age and curtail benefits. Raise retirement age and curtail benefits.

• Following the report of the Greenspan Following the report of the Greenspan Committee (January, 1983), the U.S. has Committee (January, 1983), the U.S. has gradually raised the retirement age to reach 67 gradually raised the retirement age to reach 67 in the year 2027.in the year 2027.

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• Similarly, but much later France, in July 2003 Similarly, but much later France, in July 2003 decided to require public sector workers (about decided to require public sector workers (about one-fourth of the French workforce) to contribute one-fourth of the French workforce) to contribute to the state pension system for 40 years, instead of to the state pension system for 40 years, instead of 37.5 years. 37.5 years.

• Also, Germany, which already raised its Also, Germany, which already raised its retirement age from 63 to 65, is currently retirement age from 63 to 65, is currently contemplating raising it further to 67 between contemplating raising it further to 67 between 2011 and 2035. 2011 and 2035.

• With respect to curtailing benefits, this is usually With respect to curtailing benefits, this is usually accomplished by abandoning wage-indexation in accomplished by abandoning wage-indexation in favor of price-indexation. favor of price-indexation.

• Naturally, as real wages rise over time (due mostly Naturally, as real wages rise over time (due mostly to productivity increases), price-indexation is less to productivity increases), price-indexation is less generous to pensioners than wage-indexationgenerous to pensioners than wage-indexation

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• 2. AGING, MIGRATION, AND LABOR 2. AGING, MIGRATION, AND LABOR TAXATIONTAXATION

• The modern welfare state typically The modern welfare state typically redistributes income from the young to the old redistributes income from the young to the old either by cash or in-kind transfers. either by cash or in-kind transfers.

• With the aging of the population, the With the aging of the population, the proportion of voters receiving social security proportion of voters receiving social security has increased, and these pensions are by far the has increased, and these pensions are by far the largest component of transfers in all industrial largest component of transfers in all industrial economies.economies.

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• What are the main factors contributing to the What are the main factors contributing to the aging of the population?aging of the population?

• Higher life expectancy and declining fertility Higher life expectancy and declining fertility rates.rates.

• Oeppen and Vaupel (2002) pose the question Oeppen and Vaupel (2002) pose the question that lies at the heart of the aging process: "is that lies at the heart of the aging process: "is life expectancy approaching its limit?" life expectancy approaching its limit?"

• Their answer: "Many... believe it is. The Their answer: "Many... believe it is. The evidence suggests otherwise... . For 160 years, evidence suggests otherwise... . For 160 years, life expectancy has steadily increased by a life expectancy has steadily increased by a quarter of a year per annum, an extraordinary quarter of a year per annum, an extraordinary constancy of human achievement."constancy of human achievement."

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• Fertility rates (The Fertility rates (The EconomistEconomist, , August 24August 24thth, 2002, 2002):):• "At present, West European countries are "At present, West European countries are

following what seems to be a normal following what seems to be a normal demographic path: As they became richer demographic path: As they became richer after the 1950s, so their fertility rates fell after the 1950s, so their fertility rates fell sharply. The average number of children borne sharply. The average number of children borne by each woman during her lifetime fell from by each woman during her lifetime fell from well above the "replacement rate" of 2.1 - the well above the "replacement rate" of 2.1 - the rate at which the population remains stable - to rate at which the population remains stable - to less than 1.4 now"less than 1.4 now"

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• The income redistributive feature of the The income redistributive feature of the welfare state makes it an attractive destination, welfare state makes it an attractive destination, particularly for low-skill immigrants. particularly for low-skill immigrants.

• For example, a study by Borjas (1994) indicates For example, a study by Borjas (1994) indicates that foreign-born households in the U.S. that foreign-born households in the U.S. accounted for 10% of households receiving accounted for 10% of households receiving public assistance in 1990, and for 13% of total public assistance in 1990, and for 13% of total cash assistance distributed, even though they cash assistance distributed, even though they constituted only 8% of all households in the constituted only 8% of all households in the U.S.U.S.

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• Our analysis is a positive one:Our analysis is a positive one:– We look at the political-economy We look at the political-economy

equilibrium.equilibrium.– We look at what the median voter wants.We look at what the median voter wants.

• We argue that aging and low-skill migration We argue that aging and low-skill migration have similar effects on the political-economy have similar effects on the political-economy equilibrium of the size of the welfare state equilibrium of the size of the welfare state (taxes and per-capita transfers)(taxes and per-capita transfers)

• On the one hand, an aging population or a On the one hand, an aging population or a higher share of low-skill migrants mean a higher share of low-skill migrants mean a larger pro-tax coalitionlarger pro-tax coalition

• Why?Why?

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• Because the retired and low-skill migrants are Because the retired and low-skill migrants are net beneficiaries of transfers from those who net beneficiaries of transfers from those who are employed. are employed.

• On the other hand, an aging population or a On the other hand, an aging population or a higher share of low-skill migrants put a higher higher share of low-skill migrants put a higher tax burden on the people around the median tax burden on the people around the median voter, because it becomes necessary to finance voter, because it becomes necessary to finance transfers to a larger share of the population.transfers to a larger share of the population.

• There is a “fiscal leakage” effect.There is a “fiscal leakage” effect.• A marginal tax increase that was before A marginal tax increase that was before

beneficial to the median voter may turn against beneficial to the median voter may turn against her now.her now.

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• Thus, the median voter may now want to Thus, the median voter may now want to reduce taxes: the costs of higher taxes may reduce taxes: the costs of higher taxes may outweigh the benefits and she may shift to the outweigh the benefits and she may shift to the anti-tax coalition. anti-tax coalition.

• In practice, it may well be the case that the In practice, it may well be the case that the second factor dominates and the political-second factor dominates and the political-economy equilibrium tax rate declines when the economy equilibrium tax rate declines when the population ages or the share of low-skill population ages or the share of low-skill migrants rises.migrants rises.

• This result may be re-enforced by the low This result may be re-enforced by the low voting participation rate among low-skill voting participation rate among low-skill migrants.migrants.

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• It may be useful to contrast our hypothesis with It may be useful to contrast our hypothesis with the theory of Meltzer and Richard (1981).the theory of Meltzer and Richard (1981).

• They attribute the increase in the size of the They attribute the increase in the size of the welfare state to the spread of the right to vote welfare state to the spread of the right to vote (franchise), which increased the number of (franchise), which increased the number of voters with relatively low income and thus a voters with relatively low income and thus a natural incentive to vote for higher taxes and natural incentive to vote for higher taxes and transfers. transfers.

• The increase in the number of social security The increase in the number of social security recipients has an expansionary effect similar to recipients has an expansionary effect similar to the extension of the franchise in expanding the the extension of the franchise in expanding the size of the welfare state.size of the welfare state.

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• Meltzer and Richard indeed conclude that: "In recent Meltzer and Richard indeed conclude that: "In recent years, the proportion of voters receiving social years, the proportion of voters receiving social security has increased, raising the number of voters security has increased, raising the number of voters favoring taxes on wage and salary income to finance favoring taxes on wage and salary income to finance redistribution. In our analysis the increase in social redistribution. In our analysis the increase in social security recipients has an effect similar to an extension security recipients has an effect similar to an extension of the franchise." of the franchise."

• However, our hypothesis suggests that if the median However, our hypothesis suggests that if the median voter is not among the retirees---as is probably still the voter is not among the retirees---as is probably still the case in all western countries---then the increased size case in all western countries---then the increased size of the non-working population may well lead to lower of the non-working population may well lead to lower taxes and transfers.taxes and transfers.

• This is because the extension of the franchise This is because the extension of the franchise adversely affects the median voter, as she is a net adversely affects the median voter, as she is a net contributor to the welfare system – the “fiscal contributor to the welfare system – the “fiscal leakage” effect.leakage” effect.

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• Panel data on the United States and eleven Panel data on the United States and eleven European countries over the period 1974-1992 European countries over the period 1974-1992 provide supportive empirical evidence to our provide supportive empirical evidence to our hypothesis.hypothesis.

• (The european countries are: Austria, Denmark, (The european countries are: Austria, Denmark, Finland, France, Germany, Italy, the Netherlands, Finland, France, Germany, Italy, the Netherlands, Norway, Spain, Sweden and the U.K.)Norway, Spain, Sweden and the U.K.)

• We try to estimate the determinants of the labor We try to estimate the determinants of the labor tax rate and the social transfers per capita in real tax rate and the social transfers per capita in real dollars. dollars.

• These determinants are:These determinants are:

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• the share of government jobs; the share of government jobs; • the dependency ratio; the dependency ratio; • trade openness; trade openness; • per capita GDP growth,;per capita GDP growth,;• a measure of income skewness (rich/middle a measure of income skewness (rich/middle

income share);income share);• unemployment rate;unemployment rate;• the share of immigrants in the population;the share of immigrants in the population;• the share of medium plus high education the share of medium plus high education

immigrants in the population.immigrants in the population.

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Table 1: Determinants of Tax Rate on Labor income (t) Table 1: Determinants of Tax Rate on Labor income (t) and Social Transfers (T) (146 observations)and Social Transfers (T) (146 observations)

tTGovernment jobs/total employment0.699

)5.52(5.825

)4.14(

Dependency ratio-1.254-)7.53(

-2.941-)1.59(

Trade openness-0.026-)0.99(

-1.682-)5.87(

Per capita GDP growth0.042)0.72(

-0.078-)0.12(

Rich/middle income share-0.022-)0.47(

-1.181-)2.24(

Unemployment rate0.259)3.07(

-0.514-)1.62(

Immigrants/population-9.723-)4.45(

-42.945-)1.77(

Medium + high education immigrants/population

16.679)8.37(

119.375)2.71(

All specifications include country fixed effects (coefficients not shown). The t statistics are in parentheses

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• (1) Share of governments jobs:(1) Share of governments jobs:– Positive and significant effect on both Positive and significant effect on both tt and T. and T.

• (“Big” government is a “big” government.)(“Big” government is a “big” government.)

• (2) Trade openness (globalization):(2) Trade openness (globalization):– Safety-net hypothesis (Rodrik, 1998: “Why Do More Open Safety-net hypothesis (Rodrik, 1998: “Why Do More Open

Economies Have Bigger Governments?”): positive effect on Economies Have Bigger Governments?”): positive effect on tt and T. and T.

– Our results: negative, but insignificant, effect on Our results: negative, but insignificant, effect on tt; negative ; negative and significant effect on T.and significant effect on T.

– We conjecture here that because trade openness goes hand-We conjecture here that because trade openness goes hand-in-hand with capital account openness, then the trade in-hand with capital account openness, then the trade openness coefficient may actually capture the effect of openness coefficient may actually capture the effect of capital account openness. Globalization which stimulates capital account openness. Globalization which stimulates tax competition among governments with respect to capital tax competition among governments with respect to capital income leads to low capital income tax rates and revenues, income leads to low capital income tax rates and revenues, thereby forcing a decline in the per capita transfers. thereby forcing a decline in the per capita transfers.

– (We shall return to this issue later.) (We shall return to this issue later.)

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• (3) Per capita GDP growth:(3) Per capita GDP growth:– When fiscal policy is counter-cyclical, we expect the When fiscal policy is counter-cyclical, we expect the

effect on effect on tt to be positive and the effect on T to be to be positive and the effect on T to be negative.negative.

– But no such significant effects were found.But no such significant effects were found.

• (4) The measure of the skewness of the income (4) The measure of the skewness of the income distribution:distribution:– The literature suggests that as rich/middle income The literature suggests that as rich/middle income

share rise, then both share rise, then both tt and T should rise. and T should rise.

– No significant effect was found on No significant effect was found on tt..

– An opposite (negative) and significant effect was An opposite (negative) and significant effect was found on T.found on T.

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• (5) The unemployment rate:(5) The unemployment rate:– Insignificant effect on T.Insignificant effect on T.

– Positive and significant effect on Positive and significant effect on tt, as expected., as expected.

– But this may reflect an effect in the other direction But this may reflect an effect in the other direction (as suggested by Daveri and Tabellini, 2000): high (as suggested by Daveri and Tabellini, 2000): high labor taxes leading to high unemployment in labor taxes leading to high unemployment in Europe.Europe.

• (6) Dependency Ratio:(6) Dependency Ratio:– As our hypothesis suggests, the effect on the labor As our hypothesis suggests, the effect on the labor

tax rate (tax rate (tt) is negative and significant.) is negative and significant.

– The effect on the social transfers is negative too, but The effect on the social transfers is negative too, but significant only at the 15% confidence level.significant only at the 15% confidence level.

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• (7) Migration: The effect is as predicted by our (7) Migration: The effect is as predicted by our hypothesis:hypothesis:– Total migration has negative and very Total migration has negative and very

significant effect on significant effect on t.t. – Medium and high skill migration has a Medium and high skill migration has a

positive and very strong effect on positive and very strong effect on tt..– Therefore, low-skill migration has a negative Therefore, low-skill migration has a negative

and very significant effect on and very significant effect on tt..– The effects of total, medium and high-skill The effects of total, medium and high-skill

and low-skill migration on T are similar to and low-skill migration on T are similar to those on those on tt, though they are statistically less , though they are statistically less significant.significant.

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• Two reservations:Two reservations:• (a) On the plus side:(a) On the plus side:– If taxes affect migration, this would likely If taxes affect migration, this would likely

strengthenstrengthen our results. This is because higher our results. This is because higher taxes (and social transfers) would be expected to taxes (and social transfers) would be expected to attract low-skill migration. Despite this positive attract low-skill migration. Despite this positive effect of taxes on low-skill migration, we found effect of taxes on low-skill migration, we found in the data negative effect of low-skill migration in the data negative effect of low-skill migration on taxes. This means that our negative “fiscal on taxes. This means that our negative “fiscal leakage” effect of low-skill migration on taxes is leakage” effect of low-skill migration on taxes is even more pronounced than what appears in the even more pronounced than what appears in the data.data.

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• (b) On the negative side:(b) On the negative side:– It is also possible that countries with more It is also possible that countries with more

elaborate welfare systems will choose to tighten elaborate welfare systems will choose to tighten their migration quotas, especially with respect to their migration quotas, especially with respect to unskilled migrants. This can offer an alternative unskilled migrants. This can offer an alternative explanation for the negative correlation between explanation for the negative correlation between the tax rate and migration share that we find in the the tax rate and migration share that we find in the data.data.

• To sum up this partTo sum up this part::• We explored in this chapter how the demand for We explored in this chapter how the demand for

redistribution by the decisive voter is affected by redistribution by the decisive voter is affected by the growing demands on the welfare state's public the growing demands on the welfare state's public finances implied by aging population and low-skill finances implied by aging population and low-skill migration.migration.

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• We uncovered similar effects of both aging We uncovered similar effects of both aging population and low-skill migration on the population and low-skill migration on the political-economy equilibrium tax rates and political-economy equilibrium tax rates and transfers.transfers.

• On the one hand, an aging population or a higher On the one hand, an aging population or a higher share of low-skill migrants mean a larger pro-tax share of low-skill migrants mean a larger pro-tax coalition, because the retired and low-skill coalition, because the retired and low-skill migrants are net beneficiaries of transfers from migrants are net beneficiaries of transfers from those who are employed. those who are employed.

• On the other hand, an aging population or a On the other hand, an aging population or a higher share of low-skill migrants put a higher tax higher share of low-skill migrants put a higher tax burden on the people around the median voter, burden on the people around the median voter, because it is necessary to finance transfers to a because it is necessary to finance transfers to a larger share of the population (a “larger share of the population (a “fiscal leakagefiscal leakage” ” effect). effect).

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• People for whom the costs of higher taxes People for whom the costs of higher taxes outweigh benefits shift to the anti-tax coalition. outweigh benefits shift to the anti-tax coalition.

• Hence, it may well be the case that the second Hence, it may well be the case that the second factor dominates and the political-economy factor dominates and the political-economy equilibrium tax rate declines when the equilibrium tax rate declines when the dependency ratio or the share of low-skill dependency ratio or the share of low-skill migrants rise. migrants rise.

• This hypotheses is supported by empirical This hypotheses is supported by empirical evidence.evidence.

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• 3. AGING AND PRIVATIZATION OF 3. AGING AND PRIVATIZATION OF OLD-AGE SOCIAL SECURITYOLD-AGE SOCIAL SECURITY

• We showed earlier how aging can tilt the We showed earlier how aging can tilt the political power balance toward downscaling the political power balance toward downscaling the welfare state. welfare state.

• One of the well-publicized proposals on how to One of the well-publicized proposals on how to reduce the size of the welfare state is to shift reduce the size of the welfare state is to shift from national pensions to individual retirement from national pensions to individual retirement accounts, that is: to privatize old-age social accounts, that is: to privatize old-age social security.security.

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• Indeed the economic viability of national old-Indeed the economic viability of national old-age security systems has been increasingly age security systems has been increasingly deteriorating.deteriorating.

• The demographic picture is particularly The demographic picture is particularly gloomy for Europe.gloomy for Europe.

• As vividly put by The Economist (3rd August, As vividly put by The Economist (3rd August, 2002, p. 23):2002, p. 23):– "As its people grow fewer, Europe's state "As its people grow fewer, Europe's state

pensions systems will go deeper into the red. pensions systems will go deeper into the red. Germany and Italy are trying to push the Germany and Italy are trying to push the private-sector alternative. It is not easy...".private-sector alternative. It is not easy...".

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• More concretely, for Germany:More concretely, for Germany:• "Seven-tenths of German pensions come from a "Seven-tenths of German pensions come from a

state scheme with roots in Bismarck's day. It is state scheme with roots in Bismarck's day. It is financed mainly by a levy on wages, 19.1% this financed mainly by a levy on wages, 19.1% this year, half paid by workers and half by employers. year, half paid by workers and half by employers. But, as all over Europe, the demographics are But, as all over Europe, the demographics are grim. Today, there are 2.8 Germans aged 20-59 to grim. Today, there are 2.8 Germans aged 20-59 to support each pensioner. By 2030 there could be support each pensioner. By 2030 there could be half as many. And the state can't just fork out half as many. And the state can't just fork out money to fill the gap". money to fill the gap".

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• And similarly, in Italy (op. cit):And similarly, in Italy (op. cit):• "The government's strategy is to get private "The government's strategy is to get private

pension schemes and funds, now embryonic, pension schemes and funds, now embryonic, working properly first. Then, it hopes, it will be working properly first. Then, it hopes, it will be politically able to tackle the financing of the politically able to tackle the financing of the pay-as-you-go state system. But Italy cannot pay-as-you-go state system. But Italy cannot afford to wait. Its state's spending on pensions afford to wait. Its state's spending on pensions is more than 14% of GDP, almost double the is more than 14% of GDP, almost double the European Union average. Every year, payouts European Union average. Every year, payouts far exceed contributions by workers and far exceed contributions by workers and employers".employers".

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• Indeed, the aging of the population raises the Indeed, the aging of the population raises the burden of financing the existing pay-as-you-go, burden of financing the existing pay-as-you-go, national pension (old-age security) systems, national pension (old-age security) systems, because there is a relatively falling number of because there is a relatively falling number of workers, that have to bear the cost of paying workers, that have to bear the cost of paying pensions to a relatively rising number of pensions to a relatively rising number of retirees. retirees.

• Against this backdrop, there arose proposals to Against this backdrop, there arose proposals to privatize social security, as a solution to the privatize social security, as a solution to the economic sustainability of the existing systems. economic sustainability of the existing systems.

• This, by and large, means a shift from the This, by and large, means a shift from the current pay-as-you-go systems to individual current pay-as-you-go systems to individual retirement accounts (or fully-funded systems). retirement accounts (or fully-funded systems).

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• A supposedly added benefit to such a shift is A supposedly added benefit to such a shift is the better return on the contributions to the better return on the contributions to individual accounts than to a pay-as-you-go individual accounts than to a pay-as-you-go national pension systems. national pension systems.

• If privatized pensions can offer better rates of If privatized pensions can offer better rates of return than national pensions, transition from return than national pensions, transition from the latter to the former may be smooth. the latter to the former may be smooth.

• However, a careful scrutiny of the pensions' However, a careful scrutiny of the pensions' rate-of-return argument reveals that it is rate-of-return argument reveals that it is flawed, as neatly demonstrated by Paul flawed, as neatly demonstrated by Paul Krugman (2002).Krugman (2002).

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• We imagine an overlapping-generations model We imagine an overlapping-generations model with just one young (working) person and one with just one young (working) person and one old (retired) person in each period - each old (retired) person in each period - each individual lives for two periods. individual lives for two periods.

• Suppose there is a pay-as-you-go, national Suppose there is a pay-as-you-go, national pension system by which the worker pension system by which the worker contributes one dollar to finance the pension contributes one dollar to finance the pension benefit of one dollar paid to the retiree. benefit of one dollar paid to the retiree.

• Each young person contributes one dollar, Each young person contributes one dollar, when young and working, and receives one when young and working, and receives one dollar upon retirement. dollar upon retirement.

• The young person earns zero return on her The young person earns zero return on her contribution to the national pay-as-you-go, old-contribution to the national pay-as-you-go, old-age security system. age security system.

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• If, instead, the young person were to invest her If, instead, the young person were to invest her one dollar in an individual account, she would one dollar in an individual account, she would have earned the real market rate of return of, say, have earned the real market rate of return of, say, 100%, allowing her a pension of two dollars at 100%, allowing her a pension of two dollars at retirement.retirement.

• Is the young person better off with this transition Is the young person better off with this transition from pay-as-you-go systems to individual from pay-as-you-go systems to individual retirement accounts? retirement accounts?

• Not if the government still wishes to honor the Not if the government still wishes to honor the existing "social contract" (or political norm) to existing "social contract" (or political norm) to pay a pension benefit of one dollar to the old at pay a pension benefit of one dollar to the old at the time of the transition. the time of the transition.

• In order to meet this liability, the government can In order to meet this liability, the government can issue a debt of one dollar. issue a debt of one dollar.

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• The interest to be paid by the government on The interest to be paid by the government on this debt at the market rate of 100% will be one this debt at the market rate of 100% will be one dollar in each period, starting from the next dollar in each period, starting from the next period ad infinitum. period ad infinitum.

• Hence, the young person will be levied a tax of Hence, the young person will be levied a tax of one dollar in the next period when old, to one dollar in the next period when old, to finance the interest payment. finance the interest payment.

• Thus, her net-of-tax balance in the individual Thus, her net-of-tax balance in the individual account will only be one dollar, implying a zero account will only be one dollar, implying a zero net-of-tax return in the individual account; the net-of-tax return in the individual account; the same return as in the national, pay-as-you-go same return as in the national, pay-as-you-go system. system.

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• And what if the individual invests the one dollar in And what if the individual invests the one dollar in the equity market and gets a better return than the equity market and gets a better return than the 100% which the government pays on its debt? the 100% which the government pays on its debt?

• If the capital markets are efficient, the higher If the capital markets are efficient, the higher equity return (relative to the government bond equity return (relative to the government bond rate) reflects nothing else but a risk premium. rate) reflects nothing else but a risk premium.

• Therefore, equity investment offers no gain in Therefore, equity investment offers no gain in risk-adjusted return over government bonds. risk-adjusted return over government bonds.

• And if markets are inefficient, then the And if markets are inefficient, then the government can, as a general policy, issue debt in government can, as a general policy, issue debt in order to invest in the equity market, irrespective order to invest in the equity market, irrespective of the issue of replacing social security by of the issue of replacing social security by individual retirement accounts.individual retirement accounts.

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• Nevertheless, the increased fragility of national Nevertheless, the increased fragility of national pay-as-you-go pension systems, caused by the pay-as-you-go pension systems, caused by the aging of the population, raises indeed doubts aging of the population, raises indeed doubts among the young whether they will receive the among the young whether they will receive the same benefit as the old get now.same benefit as the old get now.

• The young start to question whether the next The young start to question whether the next generations will continue to honor the implicit generations will continue to honor the implicit intergenerationalintergenerational social contract, or the social contract, or the political norm, according to which, "I pay now political norm, according to which, "I pay now for the pension benefits of the old, and the next for the pension benefits of the old, and the next young generation pays for my pension benefits, young generation pays for my pension benefits, when I get old".when I get old".

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• These doubts are not unfounded, for after all there These doubts are not unfounded, for after all there will indeed be more pensioners per each young will indeed be more pensioners per each young worker of the next generation, and hence each one worker of the next generation, and hence each one of the young workers will have to pay more in of the young workers will have to pay more in order to honor the implicit social contract. order to honor the implicit social contract.

• Recall that the young are still the majority. Recall that the young are still the majority. Therefore, the political power balance may indeed Therefore, the political power balance may indeed shift towards scaling down the pay-as-you-go shift towards scaling down the pay-as-you-go system.system.

• This encourages the establishment of This encourages the establishment of supplemental individual retirement accounts.supplemental individual retirement accounts.

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• Such accounts are, by their very nature, fully Such accounts are, by their very nature, fully funded, so that they are not affected by the funded, so that they are not affected by the aging of the population.aging of the population.

• Instead of paying social security taxes without Instead of paying social security taxes without being sure about how much pension they will being sure about how much pension they will get upon retirement, the young may prefer to get upon retirement, the young may prefer to channel their money into their own individual channel their money into their own individual accounts. accounts.

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• 4. AGING AND CAPITAL INCOME 4. AGING AND CAPITAL INCOME TAXATIONTAXATION

• So far we developed the hypothesis that So far we developed the hypothesis that contemporary phenomena such as aging and contemporary phenomena such as aging and low-skill migration generate political processes low-skill migration generate political processes that must eventually downscale the welfare that must eventually downscale the welfare state. state.

• Our model welfare state is financed primarily Our model welfare state is financed primarily by labor income taxes, as is typically the case in by labor income taxes, as is typically the case in reality. reality.

• Let us now turn briefly to ask whether capital Let us now turn briefly to ask whether capital income taxation can come to the rescue of the income taxation can come to the rescue of the welfare state, as an alternative to labor tax.welfare state, as an alternative to labor tax.

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• In every life-cycle saving framework the In every life-cycle saving framework the burden of a tax on capital income falls most burden of a tax on capital income falls most heavily on the shoulders of the elderly, whose heavily on the shoulders of the elderly, whose income is primarily derived from capital. income is primarily derived from capital.

• The current young become capital-income The current young become capital-income taxpayers only later, when they grow older and taxpayers only later, when they grow older and accumulate savings.accumulate savings.

• Thus, as population ages, the anti-tax (old) Thus, as population ages, the anti-tax (old) coalition increases its political power.coalition increases its political power.

• However, at any point in time, the young still However, at any point in time, the young still constitute the majority.constitute the majority.

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• As population ages, there is more capital income As population ages, there is more capital income that can be taxed.that can be taxed.

• Therefore, the (young) median voter may be lured Therefore, the (young) median voter may be lured into taxing capital income more heavily.into taxing capital income more heavily.

• Our empirical evidence suggests that the second Our empirical evidence suggests that the second factor dominates: aging lead to heavier taxes on factor dominates: aging lead to heavier taxes on capital income.capital income.

• Table 2 presents estimation results (from OLS Table 2 presents estimation results (from OLS estimation; 2SLS and 3SLS with capital and labor estimation; 2SLS and 3SLS with capital and labor are also carried out – not reported).are also carried out – not reported).

• (1) The share of old in the population has indeed a (1) The share of old in the population has indeed a positive and significant effect. positive and significant effect.

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• (2) We include two measures of exposure to the (2) We include two measures of exposure to the international flows of capital, to take into account international flows of capital, to take into account the impact of capital mobility on governments' the impact of capital mobility on governments' setting of tax rates through international tax setting of tax rates through international tax competition. competition.

• These measures are: The ratio of the gross stock These measures are: The ratio of the gross stock (inflows and outflows) of international portfolio (inflows and outflows) of international portfolio investment to GDP, and the ratio of the stock of investment to GDP, and the ratio of the stock of international direct investment to GDP.international direct investment to GDP.

• The effect of FDI is positive and significant (Note The effect of FDI is positive and significant (Note that FDI may get a preferential tax treatment; or – that FDI may get a preferential tax treatment; or – a support to Rodrik’s hypothesis).a support to Rodrik’s hypothesis).

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• The effect of portfolio investment is negative The effect of portfolio investment is negative and significant. This may indicate reverse and significant. This may indicate reverse causality: less taxes attract more foreign causality: less taxes attract more foreign investment.investment.

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Table 2: Determinants of Capital Tax RateTable 2: Determinants of Capital Tax Rate(169 observations)(169 observations)

All specifications include country fixed effects (coefficient not shown).All specifications include country fixed effects (coefficient not shown).

T-statistics are in parentheses.T-statistics are in parentheses.

VariableTax rate on capital

Old/population2.033)2.23(

FDI stock0.199)1.90(

Portfolio stock-0.335-)3.84(

Trade openness-0.026-)0.38(

Govt. job share0.876)3.26(

GDP growth-0.711-)4.18(

Incme skewness-0.152-)3.04(

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• (3) Trade openness: insignificant effect.(3) Trade openness: insignificant effect.• (4) Government job share: the breadth of (4) Government job share: the breadth of

government involvement in the economy leads to government involvement in the economy leads to higher taxes.higher taxes.

• (5) GDP growth: negative and significant, so that (5) GDP growth: negative and significant, so that there is no evidence of a counter cyclical role for there is no evidence of a counter cyclical role for capital taxes.capital taxes.

• There could be reverse causality: less taxes There could be reverse causality: less taxes promote GDP growth.promote GDP growth.

• (6) Income skewness (the ratio of the income of the (6) Income skewness (the ratio of the income of the top quintile to the total of the three middle top quintile to the total of the three middle quintiles): negative and significant. quintiles): negative and significant.

• This is somewhat puzzling result.This is somewhat puzzling result.• One explanation may be that the very rich finance One explanation may be that the very rich finance

more intensively anti-tax lobbying activity.more intensively anti-tax lobbying activity.

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• 5. CAPITAL TAXATION: THE SHADOW OF 5. CAPITAL TAXATION: THE SHADOW OF INTERNATIONAL TAX COMPETITIONINTERNATIONAL TAX COMPETITION

• We saw that aging generates political forces that tend to We saw that aging generates political forces that tend to curtail the size of the welfare state, in case the social curtail the size of the welfare state, in case the social transfers it provides are financed by labor taxes. transfers it provides are financed by labor taxes.

• We also pointed out that aging may generate political We also pointed out that aging may generate political forces that tend to boost capital income taxation. forces that tend to boost capital income taxation.

• The question naturally arises whether capital tax can The question naturally arises whether capital tax can indeed replace labor tax and thereby come to the rescue indeed replace labor tax and thereby come to the rescue of the aging welfare state. of the aging welfare state.

• We will show how capital-market globalization exerts We will show how capital-market globalization exerts downward pressure on the size of the welfare state, downward pressure on the size of the welfare state, through international tax competition. through international tax competition.

• Therefore, in the end, the downsizing of an aging welfare Therefore, in the end, the downsizing of an aging welfare state is unavoidable.state is unavoidable.

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• The forces of globalization and open capital markets The forces of globalization and open capital markets can be illustrated by the simple home-foreign country can be illustrated by the simple home-foreign country parable.parable.

• In this framework, the median-voter in the home In this framework, the median-voter in the home country (or a bonevolent government) would like to country (or a bonevolent government) would like to enhance efficiency of the allocation of capital between enhance efficiency of the allocation of capital between home and abroad.home and abroad.

• This would require:This would require:

(1) (1) MPMPkk = (1-t = (1-t**nn)r)r**

Where:Where:

MPMPkk – marginal product of capital at home; – marginal product of capital at home;

rr** - Interest rate in the foreign country;- Interest rate in the foreign country; tt**

nn – Non-residents tax levied by the foreign country – Non-residents tax levied by the foreign country (on capital income of the home country residents (on capital income of the home country residents which originates in the foreign country).which originates in the foreign country).

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• For this to happen, the home country must follow For this to happen, the home country must follow the following international taxation rule:the following international taxation rule:

• (2) (2) ttff = t = tdd (1- t (1- t**nn)),,

where:where:

ttdd – Tax levied by the home country on domestic- – Tax levied by the home country on domestic-source capital income;source capital income;

ttff - Additional (to - Additional (to tt**nn) tax levied by the home ) tax levied by the home

country government on foreign source capital country government on foreign source capital income.income.

• Condition (2) means that the home country Condition (2) means that the home country imposes the same tax rate imposes the same tax rate ttdd on foreign-source on foreign-source income from capital as on domestic-source income income from capital as on domestic-source income from capital, except that a deduction is allowed for from capital, except that a deduction is allowed for foreign taxes paid (and levied at source):foreign taxes paid (and levied at source):

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• One dollar earned abroad is subject to a tax at source One dollar earned abroad is subject to a tax at source at the rate at the rate tt**

n n ,, the after-foreign-tax income, which is 1 - the after-foreign-tax income, which is 1 - tt**

nn, is then taxed by the home country at the rate , is then taxed by the home country at the rate ttdd..• A critical issue of taxation, in the era of globalization of A critical issue of taxation, in the era of globalization of

the capital markets, is the ability of national the capital markets, is the ability of national governments to tax their residents on foreign-source governments to tax their residents on foreign-source capital income. capital income.

• An editorial in the New York Times (May 26th, 2001) An editorial in the New York Times (May 26th, 2001) underscores the severity of this issue:underscores the severity of this issue:

• "From Antigua in the Caribbean to Nauru in the South "From Antigua in the Caribbean to Nauru in the South Pacific, offshore tax havens leach billions of dollars Pacific, offshore tax havens leach billions of dollars every year in tax revenues from countries around the every year in tax revenues from countries around the world... . The Internal Revenue Service estimates that world... . The Internal Revenue Service estimates that Caribbean tax havens alone drain away at least $70 Caribbean tax havens alone drain away at least $70 billion per annum in personal income tax revenue. The billion per annum in personal income tax revenue. The OECD suspects the total worldwide to be in the OECD suspects the total worldwide to be in the hundreds of billions of dollars…”hundreds of billions of dollars…”

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• It is fairly safe to argue that tax havens, and the It is fairly safe to argue that tax havens, and the inadequacy of cooperation among national tax inadequacy of cooperation among national tax authorities in the OECD countries in authorities in the OECD countries in information exchanges, put binding ceilings on information exchanges, put binding ceilings on how much foreign-source capital income can be how much foreign-source capital income can be taxed. taxed.

• What then are the implications for the taxes on What then are the implications for the taxes on domestic-source capital income?domestic-source capital income?

• Consider the extreme situation where the home Consider the extreme situation where the home country cannot effectively enforce any tax on country cannot effectively enforce any tax on foreign-source capital income of its residents. foreign-source capital income of its residents. That is, suppose that That is, suppose that ttff = 0.= 0.

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• Then we can see from the tax rule applying to Then we can see from the tax rule applying to foreign-source capital income, equation (2), foreign-source capital income, equation (2), that the tax rate on domestic-source capital that the tax rate on domestic-source capital income, income, ttdd , would be set to zero too. , would be set to zero too.

• Thus, the capital income tax vanishes Thus, the capital income tax vanishes altogether. altogether.

• And even if some enforcement of taxation on And even if some enforcement of taxation on foreign-source capital income is feasible so that foreign-source capital income is feasible so that ttff does not vanish altogether, it is still true that does not vanish altogether, it is still true that a low a low ttff generates a low generates a low ttd d . .

• Indeed a poor enforcement of international Indeed a poor enforcement of international taxes would generate political processes that taxes would generate political processes that curtail any burden of capital income taxation.curtail any burden of capital income taxation.

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• The unwillingness of foreign tax authorities to The unwillingness of foreign tax authorities to cooperate with the home tax authority in helping to cooperate with the home tax authority in helping to enforce capital taxation on the capital income of enforce capital taxation on the capital income of residents of the home country originating abroad residents of the home country originating abroad usually stems from their desire to lure capital to their usually stems from their desire to lure capital to their countries. countries.

• This is what is meant by tax competition. This is what is meant by tax competition. • They further compete with the home country by They further compete with the home country by

lowering the source tax (lowering the source tax (tt**nn) they levy on the capital ) they levy on the capital

income of the residents of the home country. income of the residents of the home country. • Then we can see from equation (1) that MPThen we can see from equation (1) that MPkk must rise must rise

too. too. • With a diminishing marginal product, this happens With a diminishing marginal product, this happens

when the stock of domestic capital falls and more when the stock of domestic capital falls and more capital flows abroad.capital flows abroad.

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• Hence, the tax base for the domestic-source Hence, the tax base for the domestic-source capital income shrinks. capital income shrinks.

• Thus, a welfare state that relies on capital taxes Thus, a welfare state that relies on capital taxes is akin to a house built on sand.is akin to a house built on sand.

• We can supplement this hypothesis with some We can supplement this hypothesis with some empirical evidence from the EU.empirical evidence from the EU.

• The event of the creation of a single market in The event of the creation of a single market in Europe creates a rare natural experiment for Europe creates a rare natural experiment for the effects of capital market openness on the effects of capital market openness on capital income taxation. capital income taxation.

• We highlight the effects of this event on the We highlight the effects of this event on the corporate sector in the EU.corporate sector in the EU.

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• The statutory tax rates have indeed declined The statutory tax rates have indeed declined since the 1970s by from 11 percentage points since the 1970s by from 11 percentage points (Germany) to 26 percentage points (Ireland). (Germany) to 26 percentage points (Ireland).

• However, the meaningful tax rates from an However, the meaningful tax rates from an economic point of view are the effective tax economic point of view are the effective tax rates which may substantially differ from the rates which may substantially differ from the statutory rates. statutory rates.

• We therefore calculate effective tax rates on We therefore calculate effective tax rates on corporate income for fourteen EU countries for corporate income for fourteen EU countries for the period 1974-2000.the period 1974-2000.

• The countries are Austria, Belgium, Denmark, The countries are Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, Luxembourg, the Netherlands, Portugal, Spain, Sweden, and the United Kingdom.Sweden, and the United Kingdom.

660%

10%

20%

30%

40%

50%

60%

70%

74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00

year

%

Finland:

Sweden:

Germany:

Austria:

UK:

Belgium

Denmark:

France:

Italy:

Luxembourg:

Spain:

Portugal:

Netherlands:

Ireland:

Effective Marginal Tax Rates on Corporate Income

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• One can clearly detect a downward breakpoint One can clearly detect a downward breakpoint at the end of the 1980s in the wake of the single at the end of the 1980s in the wake of the single market event. market event.

• Overall, the mean EU effective corporate tax Overall, the mean EU effective corporate tax rate went down from 42% in 1975 to 32% in rate went down from 42% in 1975 to 32% in 2000.2000.

• Globalization seems to be a catalyst to a major Globalization seems to be a catalyst to a major cut in the taxes on corporate income.cut in the taxes on corporate income.

• To conclude: To conclude: • The combined forces of aging, low-skill The combined forces of aging, low-skill

migration, and globalization seem to be too migration, and globalization seem to be too strong for the welfare state to survive in its strong for the welfare state to survive in its present size.present size.