An ageing population means the government needs to spend more (on pensions and health care) it will also receive lower income tax.
If the government does nothing it will experience a rise in the structural budget deficit. This has many problems
1) Resource crowding out. government borrow from private sector so private sector have less to spend and invest. Furthermore the private sector is usually more efficient than government
2) Financial Crowding out. To Borrow more money the government may need to increase interest rates, to make sure people buy enough debt. The problem is that this will put upward pressure on general interest rates and causes lower spending and growth in the economy.
3) Increase the national debt and annual interest payments. Italy already borrows over 100% of GDP. The effect is that a high% of GDP goes on servicing the debt, which will only increase over time.
4) It will require higher taxes or lower spending for future generations.
Policies to deal with an Ageing Population
Option ONE: Make people work longer.
From an economic point of view this is beneficial, this leads to more tax revenue and more spending. The main problem with this policy, is that it will be highly unpopular, especially from people who are nearing retirement age. People may say the government is going back on its word to provide pensions at a certain age. In the UK, the government has pledged to increase retirement age to 67, but this will not come in for a long time and therefore does not tackle the short term debt.
Option TWO: Increase income tax.
If the government increase income tax, they will increase revenue to pay for the higher pension bill. However, higher income tax may lead to lower work incentives. It may discourage people from living in a certain country. Because income tax is low in the UK, a higher rate may not reduce incentives that much; however, there is a high opportunity cost of taxing for pensions. Pension spending does not increase productivity in the economy.
Option THREE: Means tested pensions.
This means pensions are targeted just to those on low incomes, and those who do not have a private pension. This helps to reduce inequality and reduce the total cost of pensions.
However, it creates a very big incentive for people not to save and avoid getting a private pension. This is because if you did save, you would receive little from the government. Therefore, in the long run it may make the situation worse
Encourage private pensions.
Governments could make it obligatory for firms to provide a private pension. Alternatively, they could give more generous tax breaks for private pensions. This is good for reducing the governments pension burden. The concern is that some people may not have sufficient private pension provision when they retire. Therefore, there is still a need for means tested pensions.