What is the future of the public pension system in Europe?

Gayle Allard. Professor. Instituto de Empresa

4 May 2006

Europe’s public pension system is in dire straits--the victim of changing demographics and high unemployment. If Europe fails to boost its personal saving rate, retirement pensions for future generations will be in jeopardy.

One of the most pressing economic challenges facing Europe today is ensuring the future of its public pension system. The current system is unsustainable as a result of both population and employment trends. Indeed, the pending crisis is of such magnitude that all reforms affecting the viability of the public pension system must be taken into consideration, including, of course, the Spanish government’s recently announced reform.

How did the public pension system in Europe become caught up in such a crisis? The answer is simple: The flow of money into the system is failing to keep up with what is paid out. Several factors contribute to this phenomenon. Demographic changes and high unemployment are stemming the growth in the number of taxpayers. Early retirement, an aging population and rising life expectancy have boosted the total number of pensioners. In contrast, the number of people contributing to the system has increased at a far slower rate. In Europe, on average, there are three taxpayers for every pensioner. In 30 years, this ratio is expected to be three taxpayers to every two pensioners.

Another fundamental problem exists: There doesn’t seem to be a clear relationship between what is earned, saved and invested during a typical European’s working life and the income he or she receives upon retirement. When people aren’t able to perceive a direct correlation between effort and benefit, convincing them to save more becomes increasingly difficult. A low national savings rate is always a drawback for the well being of any economy.

So then, what are some of the solutions that could save the European pension system from collapse? A few steps have already been taken in Spain, including the measures enshrined in the Toledo Agreement. Unfortunately, these measures have only served to delay the crisis, but will have little long-term effect. A tax increase is not the answer because taxes are already very high in Europe, and greater fiscal pressure is only likely to fuel worker frustration. Immigration could alleviate the situation temporarily given that the majority of immigrants are young and enter into the pool of taxpayers (this, of course, is true only if they are legal immigrants). However, within a few years these same immigrant workers will be lining up to collect their own pensions as well.

The most basic change seems to offer the greatest hope for resolving the public pension debacle. To avoid drastic cutbacks in the pensions themselves, it seems to make sense for individuals to assume more responsibility for their own future plans. If people establish their own personal pension funds--thereby contributing their own private savings to supplement the public pension system--they not only guarantee a larger pension for themselves upon retirement, they also perceive the direct correlation between what they save and what they receive. The key lies in finding a way to encourage private savings, particularly the type of long-term savings earmarked for retirement funds.

Given the need to raise personal savings, the income-tax reform recently proposed by the government appears to point in exactly the opposite direction. Instead of lowering taxes, the reform envisions increasing taxes on long-term savings, from 15% to 18%. Similarly, it reduces the deduction allowed for pension contributions by private individuals over the age of 52 (in some cases the reduction has been as much as 50%), while imposing limits on the annual tax relief allowed for this type of contribution.

The reform does have one positive feature: It increases the tax deductions allowed for children. Compared to other European countries, Spain allows for only minimal tax reductions for families with children, underscoring the pressing need for this change. However, other reforms must continue to target large families if the government wants to correct current population trends.

In policy-making, and particularly in tax policy, the temptation to focus on the short term is great. However, a crisis is pending, and with 33% of the population expected to reach retirement age over the next few years, policy must be geared towards finding long-term solutions. Guaranteeing the future of the pension system and ensuring a decent retirement for the elderly is an economic issue that is easily manipulated by politicians. However, if there is not a gradual and orderly transition towards a system based on greater personal savings, the consequences may prove disastrous for a sizeable portion of the population in coming years. Any tax reform must be aimed at achieving a smooth transition over the long term.

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