Fiscal Space under Demographic Shift

To what extent does population ageing limit fiscal capacity and affect fiscal sustainability? We answer this question through the lens of a fiscal space defined by the budgetary room between the current tax revenue and the peak of a Laffer curve. We use a dynamic general equilibrium, overlapping generations model calibrated to data from Japan and the US. Our findings show that the evolution of underlying demographic structures plays an important role in shaping a country's fiscal capacity. There will be significant contractions in the fiscal space of Japan and the US when the two countries enter the late stage of demographic transition in 2040. In particular, the results from the model calibrated to Japan indicate that an increase in the old-age dependency ratio to over 70 percent can reduce Japan's fiscal space by 36 percent. The existing design of Japan's tax-transfer system is not fiscally sustainable by 2040 when factoring in the growing fiscal cost of the social security program.