Facing Demographic Challenges: Pension Cuts or Tax Hikes

In this paper, we investigate two fiscal policy options to mitigate fiscal pressure arising from an ageing of Australian population: pension cuts or tax hikes. Using a computable overlapping generations model, we find that while the two policy options achieve the same fiscal goal, the macroeconomic and welfare outcomes differ significantly. Future generations prefer pension cuts, whereas current generations prefer tax hikes to finance age-related government spending commitments. Interestingly, taxing consumption or income results in opposing effects on macroeconomic aggregates and welfare across different skill types of households. Increases in the consumption tax rate have positive effects on labour supply, domestic assets and output per capita (similarly to pension cuts), but reduce the welfare of low income households most. Conversely, increases in progressive income or payroll taxes have negative effects on most macroeconomic aggregates but reduce the welfare of low income households least. Our results highlight the intra- and inter-generational conflicts of interest and political constraints when implementing any structural fiscal reforms.