This paper explores the economic and labour market effects of implementing a tax reduction targeted at older workers. The analysis is conducted with a life-cycle computable general equilibrium model calibrated on Canadian data. The analysis shows that implementing a permanent income tax reduction for workers aged 60 and over has only small macroeconomic effects because the labour supply increase of older workers is partly offset by a reduction in the labour supply at core ages. This induced effect also discourages savings and generates crowding out through private investment but has a favourable impact on lifetime economic welfare. The macroeconomic impact is much larger when the income tax reduction is temporary because workers no longer reduce their hours at core ages and there is no reduction in savings. However, since only current middle-aged and older workers benefit from the tax cut, a temporary income tax cut reduces intergenerational equity.
It is well known that the Canadian population has been ageing steadily for some time as people have been living longer and having fewer children. Compared to most other developed countries, Canada experienced a larger baby boom and a sharper decline in fertility afterward. In the next thirty years, the number of persons aged 65 and older is expected to more than double worldwide. Also, over the past decades, despite the substantial increase in longevity, the trend in early retirement has become widespread. According to Statistics Canada, the average age of retirement has declined steadily in Canada over the period 1976 to 1998 for both men and women, from around 65 for men and 64 for women during the second half of the 1970s to 61.5 years for men and 60 for women in the late 1990s (see Figure
Average effective age of retirement in canada by sex, 1976–2010. Source: Labour Force Survey, Statistics Canada.
Several studies have indicated that population ageing will lead to a significant decline in population and labour force growth, which in turn will reduce economic growth (see, e.g., [
Staubli and Zweimuller [
At the margin, the impact of the reform may seem significant. In aggregate, the economic impact is not necessary large in a country such as Canada in which the public pension system generates few work disincentives compared with other OECD countries [
According to Sheshinski [
This paper’s objective is to examine the possible impact on the Canadian economy and the participation rate of older workers of introducing a tax incentive that is similar to the policy introduced in Denmark. The analysis is conducted using a life-cycle computable general equilibrium model calibrated on the Canadian economy. The remainder of the paper is structured as follows. Section
Several papers have examined the cost of early retirement or the benefits of working longer. Table
Economic impact of a rise in the retirement age (summary of studies).
Authors | Approach/Country | Indicator | Summary of results |
---|---|---|---|
Hviding and Mérette [ |
CGE model/7 OECD countries | GDP per capita | 4-year increase in retirement age: increase of 7% by 2050 for Canada and 5.7% in the US |
Herbertson and Orszag [ |
Accounting/OECD | GDP | In 1998, 6.3% increase on average in OECD |
Rowe and Nguyen [ |
Microsimulation model (Lifepaths)/Canada | Forgone earnings | Retirement is delayed to age 65: $72,000/household with normal job loss probability |
Verma and Rix [ |
Macroeconometric model of US | GDP | LF part. rate of 65+ returns to 1950: 10% increase by 2029 |
Policy Research Initiative [ |
Microsimulation model (Lifepaths)/Canada | Avg. annual hours per person | 3-year extension of working life: 6% increase in hours by 2025 |
Fougère et al. [ |
CGE model/ Canada | GDP per capita | 1-year permanent increase in effective age of retirement: 3.2% increase in GDP per capita by 2050 |
Barrell et al. [ |
Macroeconometric model (NiGEM)/UK | GDP | 1-year permanent increase in effective age of retirement: 1% increase in GDP after 6 years |
Over the last 10 years, Denmark introduced a series of policy incentives to encourage the extension of older workers’ working lives. Denmark changed its taxation plan and its public pension system. First, Denmark changed the voluntary early retirement pension plan (VERP). Major changes included the introduction of a nontaxable premium (staggered over several years) up to 120,000 DK (about $23,000 CAN) to people staying in the labour market after age 62 and also a 10% reduction of the voluntary retirement allowance for those aged 60–62. Secondly, the minimum contribution time and the contribution rate were increased in January 2003 to ensure the lasting quality of the VERP. Admission criteria to the disability pension plan were also tightened. Finally, people aged 65+ and working more than 1,500 hours annually (about 30 hours weekly) may postpone, since July 2004, the settlement of their pension plan over a 10-year period. For instance, an individual who postpones his retirement one year would see his pension allowance increased by 7%.
According to Bjørn and Larsen [
The analysis uses a life-cycle OLG model of a closed economy. The economy is populated by rational households earning their income by providing their human capital to the production sector and by receiving interest on accumulated assets and transfers. The production sector hires effective labour and rents capital up to their marginal product to produce and sell a single good. The public sector is represented by a national government which levies taxes on consumption and on factors of production and issues one-period bonds to finance its spending. The model used in this paper draws on Fougère et al. [
There are 16 overlapping generations of individuals in each 4-year-time period structured in an Allais-Samuelson overlapping generations framework. In each period, a new generation enters the labour market at age 17 and the eldest dies at age 81. The population growth rate is exogenous. In what follows, the subscript
In each period, the representative agent is endowed with one unit of time which can be allocated towards learning
Representative agents maximize an intertemporal utility function with consumption and leisure as arguments subject to two accumulation conditions: wealth and human capital. Earnings are allocated between consumption and savings (domestic physical capital ownership titles and government bonds). Bonds and physical capital are considered perfect substitutes, and thus total supply of assets equals total demand. The agent preferences are represented by an isoelastic time-separable utility function similar to that in Auerbach and Kotlikoff [
Human capital evolves according to
The accumulation of assets by the representative agent is a function of savings and evolves according to:
Behavioural and public policy parameters.
Parameter | Notation | Value |
---|---|---|
Consumer preferences | ||
Intertemporal elasticity of substitution |
|
0.90 |
Intratemporal elasticity of substitution |
|
0.80 |
Production technology | ||
Production share of physical capital |
|
0.30 |
Elasticity of substitution for labour demand |
|
1.50 |
Depreciation rate of physical capital |
|
0.05 (per year) |
Interest rate |
|
0.04 (per year) |
Human capital technology | ||
Elasticity of time input |
|
0.70 |
Elasticity of public spending input |
|
0.18 |
Public policy | ||
CPP/QPP replacement rate |
|
0.20 |
RPP replacement rate |
|
0.02–0.14 |
Government expenditures/GDP | 0.37 | |
Earned income tax rate |
|
0.31 |
Capital income tax rate |
|
0.38 |
Consumption tax rate |
|
0.10 |
The optimization problem of the representative agent is to maximize its intertemporal utility (
Differentiating the utility function with respect to the lifetime budget constraint yields a reservation wage (i.e., implicit price of leisure),
The production sector is represented by a national firm which hires effective labour (
The national government issues one-period bonds to finance its spending and the interest on public debt and to satisfy the budget constraint. It levies taxes on labour income, capital income, taxable transfers, and consumption expenditures. It spends on public expenditures
The model assumes purely competitive markets and perfect foresight agents. It is also assumed that physical capital is entirely detained by local residents and that portfolio choice is subject to home bias with the rest of the world. This is consistent with Helliwell and McTitrick [
The stock of effective labour supply is the number of workers times their corresponding human capital stock and individual labour supply (i.e., hours):
Bonds and physical capital ownerships are considered perfectly substitutes. Hence, total supply of assets must equal total demand:
Table
Key features of the model calibration are representative skilled workers’ life-cycle earnings profiles and time allocated to work, leisure, and education. As presented in Annabi et al. [
The key policy simulation exercise consists of implementing an earned income (i.e., earnings) tax reduction for workers aged 60 and over as of 2006. Two basic simulation exercises are conducted. In Scenario 1, we assume that the tax policy incentive targeted at older workers is permanent, while Scenario 2 assumes that the tax policy change is temporary and effective until 2030.
Also, to maintain budget balance, we assume that the government finances the work incentive by an earned income tax adjustment (i.e., an increase) for taxpayers who are under age 60. The earned income tax increase is very small because it is distributed amongst a large number of workers under age 60. The scenarios are compared with a reference scenario which factors in the effect of population ageing. That is, the age structure of the population in the model replicates historical and projected values of the old-age dependency ratio. As shown in Figure
Simulated projected population ageing.
The objective of the paper is to examine whether reducing earned income taxes for workers aged 60 has a significant impact on aggregate labour supply. In the model, a decrease in earned income tax for older workers increases their incentives to work by raising the implicit price of leisure (see (
To understand the labour market effects of a permanent 10 percent employment income tax reduction over the life cycle, Figure
Difference in weekly working hours of 1982 and 2006 high-skilled cohorts, permanent 10% earned income tax reduction. (Difference compared with the reference scenario.)
The results show that workers aged 60 and over increase their time allocated to work. For the 1982 cohort, gains are a little more than 0.6 hour on average per week while the 2006 cohort gains are close to 1.0 hour per week. However, those gains are somewhat offset by reduced labour supply from middle-aged workers. Since the tax policy change is permanent, both cohorts choose to allocate more time to leisure activities when young as they anticipate it will be more profitable to work more when they reach the age of 60 (a substitution effect). The effect is less marked for the 1982 cohort than the 2006 cohort, since the 1982 cohort workers have less time to adjust their worked hours following the introduction of the work incentive (they already have 20 years of career when the incentive is introduced in 2006). The impact for medium and low-skilled workers (not represented in the graphic) is similar to the impact for high-skilled workers for both cohorts.
Table
Impact of a 10% permanent reduction in earned income taxes for workers aged 60 and over on key macroeconomic indicators (percentage point difference relative to reference scenario).
2010 | 2014 | 2022 | 2030 | 2042 | 2050 | |
---|---|---|---|---|---|---|
Real GDP per capita | 0.08 | 0.05 | 0.05 | 0.05 | 0.08 | 0.10 |
Labour supply/capita | 0.13 | 0.12 | 0.15 | 0.18 | 0.25 | 0.30 |
National savings | −0.29 | 0.07 | −0.10 | −0.14 | −0.29 | −0.25 |
Capital stock/capita | −0.05 | −0.13 | −0.19 | −0.32 | −0.42 | −0.47 |
Capital/labour ratio | −0.19 | −0.28 | −0.38 | −0.57 | −0.79 | −0.93 |
Real wages | −0.05 | −0.08 | −0.11 | −0.15 | −0.20 | −0.24 |
Earned income tax rate | −0.13 | −0.13 | −0.13 | −0.13 | −0.13 | −0.14 |
The aggregate labour supply increase also contributes to a modest reduction in real wage rates but increases the labour income tax base for the government. Thus, the earned income tax rate can be slightly reduced in aggregate to maintain budget balance, despite the tax reduction for older workers (redistribution of the tax burden).
Similar to Auerbach and Kotlikoff [
Impact of a 10% permanent reduction in earned income taxes for workers aged 60 and over on economic welfare and leisure over the life cycle per cohort.
Table
Simulated impact of a permanent 10% to 40% tax reduction for workers aged 60+ (percentage point difference relative to the benchmark scenario).
Labour supply per capita | National savings | Capital stock per capita | Real GDP per capita | |||||
---|---|---|---|---|---|---|---|---|
2030 | 2050 | 2030 | 2050 | 2030 | 2050 | 2030 | 2050 | |
10% | 0.18 | 0.30 | −0.14 | −0.25 | −0.32 | −0.47 | 0.05 | 0.10 |
20% | 0.36 | 0.57 | −0.39 | −0.48 | −0.55 | −0.93 | 0.12 | 0.19 |
30% | 0.54 | 0.85 | −0.62 | −0.75 | −0.81 | −1.41 | 0.19 | 0.27 |
40% | 0.71 | 1.11 | −0.86 | −1.02 | −1.09 | −1.91 | 0.24 | 0.34 |
Results also show that a more generous incentive raises economic welfare more because of increased leisure activities of middle-aged workers (not shown here). In short, a greater tax reduction increases economic welfare, but the decrease in savings and accumulated physical capital is also larger and reduces the gains in real GDP per capita.
As indicated earlier, when the earned income tax reduction is permanent, younger cohorts choose to reduce their work effort at core ages as they find it more profitable to work more at older ages (they adjust their time allocation decision over their lifetime). Accordingly, the reduction in work effort during core ages lowers the overall impact on total labour supply. In this context, since the rise in the elderly dependency ratio due to ageing is projected to accelerate during the 2010–2030 period and to slow thereafter, it may be argued that the tax cut should be temporary rather than permanent and be implemented during the period when ageing is expected to be most severe. Moreover, a temporary tax cut during the 2010–2030 period would mainly benefit core-age and older individuals. It would have little influence on younger cohorts because they are not expected to receive the benefit at older age.
Figure
Difference in weekly working hours of 1982 and 2006 high-skilled cohorts, temporary 10% earned income tax reduction. (Difference compared with the reference scenario.)
Table
Impact of a 10% temporary reduction in earned income taxes for workers aged 60 and over on key macroeconomic indicators (percentage point difference relative to reference scenario).
2010 | 2014 | 2022 | 2030 | 2042 | 2050 | |
---|---|---|---|---|---|---|
Real GDP per capita | 0.08 | 0.08 | 0.12 | 0.20 | 0.10 | 0.07 |
Labour supply/capita | 0.12 | 0.14 | 0.16 | 0.24 | 0.07 | 0.05 |
National savings | −0.19 | 0.17 | 0.19 | 0.21 | 0.03 | 0.15 |
Capital stock/capita | −0.03 | −0.07 | 0.01 | 0.08 | 0.17 | 0.16 |
Capital/labour ratio | −0.16 | −0.24 | −0.19 | −0.21 | 0.09 | 0.11 |
Real wages | −0.05 | −0.07 | −0.05 | −0.06 | 0.02 | 0.03 |
Earned income tax rate | −0.13 | −0.14 | −0.14 | −0.15 | −0.02 | −0.01 |
There are two key factors at play here that change the results from Scenario 1. First, since the employment income tax cut is temporary, younger cohorts do not reduce their work hours at core ages. Therefore, the total labour supply effect is larger because the increase in older workers’ labour supply is partly compensated by very little reduction in younger worker’s labour supply. Second, there is no reduction in savings from younger cohorts because they do not plan to work longer. In aggregate, national savings increase rather than decrease and there is no crowding out coming from private investment. Therefore, the negative impact on the physical capital stock per capita and the capital-labour ratio is much smaller and the net real GDP impact remains positive after 2030.
The policy shock generates some marginal reduction in intergenerational equity although the macroeconomic impact of a temporary earned income tax cut is more favourable for real GDP than a permanent tax cut. Figure
Impact of a 10% temporary reduction in earned income taxes for workers aged 60 and over on economic welfare and leisure over the life cycle per cohort.
Just like in Section
Simulated impact of a temporary 10% to 40% tax reduction for workers aged 60+ (percentage point difference relative to the benchmark scenario).
Labour supply per capita | National savings | Capital stock per capita | Real GDP per capita | |||||
---|---|---|---|---|---|---|---|---|
2030 | 2050 | 2030 | 2050 | 2030 | 2050 | 2030 | 2050 | |
10% | 0.24 | 0.05 | 0.21 | 0.15 | 0.08 | 0.16 | 0.20 | 0.07 |
20% | 0.46 | 0.09 | 0.42 | 0.31 | 0.16 | 0.31 | 0.39 | 0.15 |
30% | 0.68 | 0.14 | 0.61 | 0.47 | 0.24 | 0.46 | 0.56 | 0.22 |
40% | 0.88 | 0.19 | 0.80 | 0.65 | 0.30 | 0.60 | 0.73 | 0.30 |
To verify the robustness of the results, several sensitivity tests have been performed. For the type of shock performed here, the results can be sensitive to two key parameters. The first is the intratemporal elasticity of substitution, which measures the degree to which workers are willing to substitute consumption for leisure or inclined to change their working hours when the return to work varies. The second key parameter is the intertemporal elasticity of substitution, which measures the degree to which workers are willing to substitute current consumption with future consumption, which depends on changes in the return to savings. As a third sensitivity analysis, we have also simulated permanent and temporary tax incentives that are financed through a lump-sum tax instead of an earned income tax. The lump-sum tax paid by each representative individual is proportional to its demographic weight in the whole population.
Table
Impact of a 10% permanent and temporary reduction in earned income taxes for workers aged 60 and over with a lower intratemporal elasticity of substitution key macroeconomic indicators*.
Macroeconomic indicators | Permanent | Temporary | ||||
---|---|---|---|---|---|---|
2010 | 2030 | 2050 | 2010 | 2030 | 2050 | |
Real GDP per capita | 0.05 (−0.03) | 0.05 (0.00) | 0.05 (−0.05) | 0.08 (0.00) | 0.17 (−0.03) | 0.08 (0.01) |
Labour supply/capita | 0.10 (−0.03) | 0.17 (−0.01) | 0.25 (−0.05) | 0.13 (0.01) | 0.22 (−0.02) | 0.06 (0.01) |
National savings | −0.27 (0.02) | −0.15 (−0.01) | −0.24 (0.01) | −0.20 (0.01) | 0.36 (0.15) | 0.18 (0.03) |
Capital stock/capita | −0.06 (−0.01) | −0.30 (0.02) | −0.55 (−0.08) | −0.03 (0.00) | 0.00 (−0.08) | 0.14 (−0.02) |
Capital/labour ratio | −0.16 (0.03) | −0.54 (0.03) | −0.95 (−0.02) | −0.17 (−0.01) | −0.29 (−0.08) | 0.08 (−0.03) |
Real wages | −0.05 (0.00) | −0.14 (0.01) | −0.24 (0.00) | −0.05 (0.00) | −0.08 (−0.02) | 0.02 (−0.01) |
Earned income tax rate | −0.14 (−0.01) | −0.14 (−0.01) | −0.13 (0.00) | −0.15 (−0.02) | −0.16 (−0.01) | −0.01 (0.00) |
*Percentage point difference against the reference scenario. Values in brackets are differences compared with the first scenario. See Tables
Table
Impact of a 10% permanent and temporary reduction in earned income taxes for workers aged 60 and over when the intertemporal rate of substitution increased, key macroeconomic indicators*.
Macroeconomic indicators | Permanent | Temporary | ||||
---|---|---|---|---|---|---|
2010 | 2030 | 2050 | 2010 | 2030 | 2050 | |
Real GDP per capita | 0.06 (−0.02) | 0.06 (0.01) | 0.10 (0.00) | 0.09 (0.01) | 0.19 (0.01) | 0.07 (0.00) |
Labour supply/capita | 0.11 (−0.02) | 0.18 (0.00) | 0.29 (0.01) | 0.13 (0.01) | 0.24 (0.00) | 0.04 (−0.01) |
National savings | −0.25 (0.04) | −0.20 (−0.06) | −0.23 (0.02) | −0.19 (0.00) | 0.25 (0.04) | 0.16 (0.01) |
Capital stock/capita | −0.06 (−0.01) | −0.29 (0.03) | −0.47 (0.00) | −0.03 (0.00) | 0.05 (−0.03) | 0.15 (−0.01) |
Capital/labour ratio | −0.18 (0.01) | −0.54 (0.03) | −0.92 (0.01) | −0.18 (−0.02) | −0.25 (−0.04) | 0.11 (0.00) |
Real wages | −0.05 (0.00) | −0.14 (0.01) | −0.24 (0.00) | −0.05 (0.00) | −0.07 (−0.01) | 0.03 (0.00) |
Earned income tax rate | −0.13 (0.00) | −0.13 (0.00) | −0.14 (0.00) | −0.13 (0.00) | −0.15 (0.00) | −0.01 (0.00) |
*Percentage point difference against the reference scenario. Values in brackets are differences compared to the first scenario. See Tables
Finally, Table
Impact of a 10% permanent and temporary reduction in earned income taxes for workers aged 60 funded through a lump-sum tax, key macroeconomic indicators*.
Macroeconomic indicators | Permanent | Temporary | ||||
---|---|---|---|---|---|---|
2010 | 2030 | 2050 | 2010 | 2030 | 2050 | |
Real GDP per capita | 0.17 (0.09) | 0.19 (0.14) | 0.21 (0.11) | 0.18 (0.10) | 0.36 (0.16) | 0.09 (0.02) |
Labour supply/capita | 0.27 (0.14) | 0.34 (0.16) | 0.42 (0.12) | 0.27 (0.15) | 0.41 (0.17) | 0.06 (0.01) |
National savings | −0.24 (−0.05) | 0.16 (0.31) | −0.23 (0.02) | −0.27 (−0.08) | 0.18 (−0.03) | 0.15 (0.00) |
Capital stock/capita | −0.03 (−0.02) | −0.17 (0.15) | −0.41 (0.06) | −0.06 (−0.03) | 0.20 (0.12) | 0.21 (0.05) |
Capital/labour ratio | −0.33 (−0.17) | −0.32 (−0.11) | −0.01 (−0.10) | −0.35 (−0.19) | −0.30 (−0.09) | 0.09 (0.03) |
Real wages | −0.10 (−0.05) | −0.11 (−0.03) | −0.14 (−0.03) | −0.10 (−0.05) | −0.04 (−0.02) | 0.04 (0.01) |
*Percentage point difference against the reference scenario. Values in brackets are differences compared to the scenarios in which the tax reduction is financed through increases in the earned income tax rate for worker under the age of 60.
Although many studies have demonstrated that the economic and fiscal benefits of working longer are potentially large, the analysis shown here demonstrates that it would be difficult to achieve a significant increase in older workers’ labour supply through policy incentives, such as implementing tax reductions for older workers. Another interesting finding is that the magnitude of the impact could significantly vary depending on whether individuals perceive the tax policy reduction as permanent or temporary.
In our analysis, we assume that over the life cycle, economic agents use all available information in a rational way to maximise their life-time utility and adjust their time allocation between education, work, and leisure. In this context, implementing a permanent tax cut targeted at older workers would have little economic impact since younger workers would modify their time allocation over their working lives, choosing to work and save less when young and to work more when old. In this circumstance, it would be more economically beneficial to implement a tax cut that would be perceived as temporary by younger workers rather than permanent. There are both winners and losers with this policy, since only current middle-aged and older workers would expect to benefit from the tax cut, thus creating some reduction in intergenerational equity.
Finally, the results reinforce the idea that there is no magic bullet or single policy option to consider if we want to have a significant influence on older workers’ labour supply. Several other complementary policies need to be considered, such as stimulating productivity as well as incentives for other possible targeted groups or more marginally attached workers.
The authors wish to thank Gilles Bérubé, Jeff Carr, James Davies, Louis Grignon, and two anonymous referees for useful comments on earlier versions of this paper and Nabil Annabi for technical advices. All remaining errors are the authors’. The views expressed in this paper are solely those of the authors and do not necessarily reflect the views of HRSDC nor those of the Government of Canada.