The Dynamic Fiscal Effects of Demographic Shift: The Case of Australia

In this paper we develop a small open economy, overlapping generations (OLG) model that incorporates non-stationary demographic transition paths to study the dynamic fiscal effects of demographic shift in Australia. Our main results are summarised as follows. First, the demographic shifts towards population ageing lead to a change in the tax base from labor income to capital/asset income and consumption. The effect on income tax revenue is non-linear along the transition paths. Second, the changes in demographic structure cause substantial increases in old-age related spending programs including health, aged care and pensions. Significant adjustments in other government expenditures and taxes will be required to finance the larger old-age related benefits in the future. In particular, the government will have to either cut other expenditures by around 32 percent or increase consumption taxes by 28 percent by 2050 to finance these benefits. Third, the increase in survival rates, rather than the decline in fertility rates, is the main driving factor behind these fiscal costs. Fourth, increases in fertility and immigration are not an effective solution to such budget challenges.