(Reprinted from HKCER Letters, Vol. 27, March-July 1994)
On Financial Viability of the Old Age Pension Scheme
Francis Lui
Introduction
In July this year, the Hong Kong government launched a consultation paper on its proposals for an Old Age Pension Scheme (OPS). Two main features of the proposed OPS are: First, all citizens at the age of 65 or above are entitled to a monthly receipt of HK$2,300 at 1994 prices. This amount will be indexed to inflation. Second, the scheme would be financed with a 3 percent payroll tax, with employers and employees each contributing 1.5 percent.
Given the very unrealistic assumptions made by the government, the scheme appears to be financially viable. However, whether this will actually turn out to be true has to be further investigated. Here we would like to use more reasonable assumptions than those adopted by the government, and project the payroll tax situation some forty years after the inception of the OPS. We can thus paint a clearer picture of how well the 3 percent payroll tax in the proposed OPS can be maintained.
Projecting Future Demographic StructureFirst of all, we have to make projections of the future population as well as its age profile, since these are essential for the problem concerned. Based on the age-specific mortality and fertility rates in 1991, provided by the government census, we can project the age-specific population for every five years after 1991. The assumption that the long-term mortality rate will stay at the 1991 level is rather conservative. Indeed, many empirical studies indicate that mortality rates of advanced countries still follow a declining trend despite their current low levels. Given the present level of economic development in Hong Kong, the future mortality rates will probably be lower than that of 1991, and the old age population will correspondingly be larger than what we estimate below. Therefore, assuming the future mortality rates to stay at the 1991 level in fact enhances the viability of the government proposal.
Regarding future total fertility rates, again we assume these to stay at the 1991 level of 1.2 to 1.3 (that is, every female is expected to bear 1.2 to 1.3 children during her lifetime). This is different from the 2.1 fertility rate that the government asked the consultancy firm to assume. Our assumption is based on the following considerations.
There are numerous economic and social factors such as unexpected income changes, women's salaries relative to those of men, etc., underlying fertility rates. Yet, when talking about the long-term trend, we have to note the famous phenomenon of "demographic transition" in population studies, which surpasses national and cultural differences. During the early stages of economic development, the mortality rate usually drops sharply while the fertility rate rises. However, as the economy develops further, the fertility rate decreases persistently until it reaches a very low level, at which point the downward trend eases. There are many theories behind this phenomenon, and this author has also undertaken joint research on the topic (see Journal of Political Economy, October 1991). It is believed that the concurrence of economic growth and of a decrease in the fertility rate is mainly due to improvement in the education level of each generation over time. Parents demand both quality and quantity of children. However, as parents become more educated, they will invest more in their children's quality (i.e., give them better education) than demanding quantity (i.e., raise more children) because they have a greater comparative advantage in doing so. Hence, generally speaking, the higher the education level of a country, the higher the amount of human capital accumulation. This will further economic growth while at the same time lowering the fertility rate.
As Hong Kong has become a developed economy, the education level of its population will continue to improve, and so its fertility rate could decrease further. Our assumption that it will on the average remain at the 1991 level is likely to be conservative. Of course, we do not rule out the possibility that the fertility rate will rise or even rise sharply in particular years. This would not be surprising. As an example, in the past year or two, a large number of pregnant women came to Hong Kong illegally from the mainland to give birth, resulting in rises in the fertility rate recorded in government statistics. However, when we analyze the problem of old age pension, what we need to consider is the long-term fertility rate rather than that of any particular year.
On the other hand, the assumption about future fertility rates made by the government has no serious theoretical basis. This issue is only briefly mentioned in the consultancy report. It remarks that, according to experiences of other countries, the fertility rate will rebound after a decline. It then assumes that the total fertility rate in Hong Kong will increase from 1.3 to 2.l and stay at that higher level. Yet, as a matter of fact, for the period 1965 to 1991, fertility rates in all advanced economies in the world (including Hong Kong) have prominently declined without exception. This happened despite the subsidization of fertility in some countries. The Hong Kong economy grew very fast in this period, and its total fertility rate dropped from 4.7 to 1.3.
The only rationale for the government assumption that the fertility rate will rebound to 2.1 is that Hong Kong will experience zero natural population growth for a very long period of time. With a 2.1 fertility rate, the number of births just offsets the number of deaths, after accounting for some infant mortality. Nonetheless, a zero natural growth merely reflects the government's wishful thinking. An economy's fertility rate is the outcome of household decisions after considering various economic and social factors. In a free society, no one will decide on the number of children based on the government's wish for zero natural growth.
It should be mentioned that even when there is population increase, the support ratio for elderly people may not necessarily improve. Population may increase as a result of a decline in the mortality rate. Also, even if the total fertility rate is low, population could still increase if a large proportion of females are in their fertile ages. If population increases are due to these two factors, the support ratio will be adversely affected. In fact, Hong Kong's population increase in recent years was mostly a result of the decline in the mortality rate, and the large proportion of young parents.
The Actual Support Ratio and the Payroll Tax RateBased on the assumptions of the age-specific mortality and fertility rates of 1991, we obtain projections of the age profiles of the population. For each year, we take people aged between 15 and 64 as one group, and people at the age of 65 and above as another. The former refers to those likely to be in the labor force and working, while the latter refers to the retired population to be supported by those at work. We determine the future actual support ratio, that is, the ratio between the working population and the retired population. Since people between 15 and 64 may not necessarily participate in the labor market, and those who do may not be able to get an appropriate job, the working population has to be calculated as the number of people between 15 and 64 times the labor force participation rate, then multiplied by one minus the unemployment rate. Here we adopt the labor force participation rate estimated by the government, and assume 2 percent unemployment, the same percentage used in the proposed OPS scheme. The actual support ratios in Hong Kong for future years can thus be easily calculated. The results are presented in the following table.
Table
Year Actual Support Ratio
1991 5.57 1996 4.65 2001 4.09 2006 3.85 2011 3.67 2016 2.95 2021 2.25 2026 1.67 2031 1.34 2036 1.22 2041 1.18 2046 1.16 2051 1.14 2056 1.14 2061 1.12 2066 1.11 2071 1.14 2076 1.16 2081 1.17 2086 1.17 2091 1.16 2096 1.15
The OPS proposed by the government recommends that elderly people receive a monthly amount of $2,300 at 1994 prices. This level of entitlement benefits represents 19.4 percent of the average 1994 salary in Hong Kong. If the benefits of the elderly people in the future were to be maintained at the same percentage of the average salary, the payroll tax for the working population can be obtained by the formula:Payroll tax rate = 19.4 percent / actual support ratio
For instance, the actual support ratio for 1996 is 4.65, that is, there will be 4.65 working people for one retired person. The payroll tax (aside from other kinds of government subsidies) will therefore have to be equal to 19.4/4.65 = 4.17 percent. If the OPS is scheduled to begin in 1996, then by the year 2036, forty years after its inception, the payroll tax will have to be increased to 19.4/1.22 = 15.9 percent as a result of the drop in the actual support ratio. This level of contribution is much higher than the 3 percent proposed by the government.
Immigration and EmigrationThe above calculations are based on the assumption that the future population evolves from the demographic structure in 1991; population changes due to immigration and emigration are not included. Unlike fertility and mortality rates that have long-term trends and are therefore easier to predict, the number of immigrants and emigrants in the future can hardly be estimated with much accuracy. However, we can still perform simple calculations to discover the implications of the proposed OPS for immigration. Suppose that the payroll tax for the working population remains at 3 percent and the old still obtain entitlement benefits amounting to 19.4 percent of the average salary. In this case, each retired person will on average require one third of 19.4 -- or 6.5 -- working people for support. According to our projection of future population based on the 1991 demographics discussed above, there will be about 1,650,000 retired people by 2036. This has not taken into account those immigrants who arrive before 2036 but will retire by then. (The government-projected number of retired people is larger because immigrants are included.) The number of working people needed to support this enormous quantity of retired people will be 6.5 times 1,650,000, or 10,725,000. Since not everybody between 15 and 64 will be at work, we should take into account the labor force participation and unemployment rates assumed by the government. This will put the number of people between 15 and 64 required for the proposed OPS at 16,703,000 in the year 2036. Ignoring immigrants and emigrants, Hong Kong will have only 3,150,000 people between 15 and 64 in that year. So Hong Kong must have a net inflow of 13,553,000 young migrants in the coming forty years in order to maintain a 3 percent payroll tax. Should there be emigrants from Hong Kong, more immigrants will be needed. Such large scale immigration will certainly exert great downward pressure on wages, which is very much to the disadvantage of laborers.
The conclusion is that, based on future demographic changes in Hong Kong, if there are no immigrants joining the labor market to help support the retired, the payroll tax will have to be increased to 15.9 percent forty years later. If we intend to maintain a 3 percent payroll tax, then an incredibly large number of immigrants will be needed to work in Hong Kong. Also, we have to assume that these immigrants will not enjoy the benefits offered by the OPS when they retire. Otherwise, the scheme will again become financially unviable. Of course, aside from these two extremes, we can choose any combination in between. For instance, if the number of emigrants and immigrants happen to be the same as what the government optimistically projects (20,000 emigrants, and 80,000 to 90,000 immigrants annually), the required payroll tax in 2036 will be roughly 12 percent. To maintain a lower payroll tax, the number of immigrants needed will be larger; if we do not want a huge number of immigrants, then the payroll tax has to be increased accordingly.
Political and Financial ViabilityThroughout the above discussion, we have assumed the future entitlement benefits to maintain at a level equal to 19.4 percent of the average salary. In other words, it is pegged to average salary and not to inflation, as proposed by the government. As a matter of fact, the government proposal is extremely unfair and politically untenable in the long term. Under the proposed OPS, every retired person is entitled to $2,300 per month, which, after adjustment for inflation, has only constant purchasing power. This level of benefit is equal to 19.4 percent of the present average salary. If real salaries increase by 2 percent annually, then a 25-year-old person who works and contributes for 40 years will have entitlement benefits equal to only 8.8 percent of the average salary when he retires at 65, far below the present level of 19.4 percent. Yet, the real amount of his contributions increases with his salary year by year. As a result, the public pressure for entitlement benefits to be pegged to the average salary rather than to inflation will surely be immense. The faster the salary grows, the larger the discrepancy between the government-proposed entitlement benefits and the average salary, and the more irresistible the political pressure to change the OPS. If the government chooses to peg the entitlement benefits to the average salary for political reasons some time after the implementation of the scheme, the scheme will soon run into financial difficulties. By that time, the choice would be between having a substantial number of immigrants and increasing the payroll tax.
In a nutshell, pegging benefits to inflation is financially viable but politically unfeasible and unfair; on the other hand, pegging benefits to the average salary is politically feasible but financially unviable. A scheme thus flawed is not worth implementing.
Dr. Francis Lui is an Associate Professor and Acting Head of the Department of Economics at The Hong Kong University of Science and Technology.
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