Fiscal Space under Demographic Shift

Christine Ma and Chung Tran

To what extent does population ageing limit fiscal capacity and affect fiscal sustainability? We answer this question through lens of fiscal space defined by budgetary room between the current tax revenue and the peak of Laffer curves. We use a dynamic general equilibrium, overlapping generations model calibrated to data from Japan and USA. Our findings show that the evolution of underlying demographic structures plays an important tole in shaping a country's fiscal capacity.

There will be significant contractions in fiscal space in Japan and USA when the two countries enter their late stage of demographic transition in 2040. In particular, the results from the model calibrated to Japan indicates that an increase in old-age dependency ration to over 70 percent can reduce Japan's fiscal space by 36 percent.