Demographics and the Welfare State—From One Crisis to the Next?

ABSTRACT Recent demographic projections point to lower fertility rates, and in most countries below the reproduction level. This is widely perceived to add further burdens to already strained public finances due to increasing longevity and aging populations. The public finance implications of changes in fertility are analyzed considering intergenerational linkages arising via age dependencies in expenditures due to childcare and education for the young, and healthcare and pensions for the old, being largely financed by taxes levied on the working‐age population. Evidence is shown that support to both the young and the old is quantitatively important in most countries, and this makes the response of public finances to fertility generally ambiguous. A decline in fertility triggers a dynamic process as the youth dependency falls on impact followed by a later increase in the old‐age dependency ratio. The former improves and the latter deteriorates public finances, and hence an important budget dynamics is released, and the long‐run budget effects are in general ambiguous. It is shown how the structure of the intergenerational compact matters for these responses, and hence the effects are generally country specific. A quantitative analysis for Denmark shows that lower fertility improves fiscal sustainability.