Growth, Public Finances and Immigration

Erik Haller Pedersen and Johanne Dinesen Riishøj, Economics

INTRODUCTION AND SUMMARY

The level of a society's prosperity is often measured by output per capita. In practice, however, prosperity is generated by consumption rather than production. Systematic improvement of a country's terms of trade may over time enable consumption per capita to exceed output per capita.

In a long-term historical perspective, productivity growth has been a key factor in explaining material prosperity development, while demog raphic trends and terms-of-trade improvements have played a secondary role. This will also be the case in future.

Over the last 15 years, growth in hourly productivity in Denmark has been lower than in the preceding period, and weaker than in many comparable countries. If this trend continues, Denmark will experience weaker prosperity development in the coming decades than observed over the last 40 years and consequently fall behind other countries. In a long-term perspective, offsetting significantly lower productivity growth by higher labour input will not be feasible.

Sustained improvement of a country's terms of trade contributes to prosperity on a par with productivity growth. Denmark has improved its terms of trade over the last 30-40 years. This also applies if energy is excluded. If this development can be sustained, it will to some extent compensate for low productivity growth.

While prosperity development depends primarily on productivity growth and only to a lesser extent on demographic trends, the opposite applies to fiscal sustainability. Here demography, labour participation and working hours are key factors, as they determine the size of the tax base. Moreover, in terms of its prioritisation of expenditure, the public sector is able to contribute positively to productivity growth, e.g. by focusing on education and research and development.

Immigrants and frontier workers may contribute to alleviating the pressure on the labour market and to output growth. The participation rate for these groups determines whether they contribute to prosperity development and to fiscal sustainability.

DECLINING PROSPERITY GROWTH

Welfare is a very broad term with an imprecise definition. In addition to material prosperity, the welfare of a country is determined by factors such as the mental well-being of the population, the degree of inequal ity in terms of consumption opportunities, the environment, the extent of corruption, the degree of confidence among people, etc. In a wider measure of welfare, positive value must also be attached to leisure time. Thus, to the extent that growth in output per capita is kept down due to increased leisure time, welfare will increase at a faster rate than material prosperity.

This article focuses narrowly on material prosperity measured by GDP per capita and consumption per capita. This does not mean the other factors that determine welfare are considered to be insignificant, but merely that GDP and terms of trade can be measured and compared internationally. However, this is not entirely without problems either.

The size of a country's output – measured as real GDP – is determined by labour input, e.g. measured in hours per year, and by productivity, i.e. output per hour. The higher the employment rate, the greater the output per capita, other things being equal. The demographic structure thus affects prosperity development to some extent, cf. Box 1.

As shown in Chart 1, output per capita in Denmark has developed more slowly than total output since the 1960s if we look at the popula tion as a whole. At the same time, output per hour has grown at a faster rate than output per capita. The reason is that individual employees work fewer hours per year than 40 years ago. On the other hand, labour participation has been rising over the period concerned, especially for women. This increase has, however, not quite been able to match the decline in the average number of working hours, and up to the mid-1990s the number of hours worked declined in Denmark, cf. Chart 2. Subsequently, hours worked per capita increased somewhat again in step with the rise in employment. There has also been a slight increase in the average number of working hours.

Up to the year 2050, demographic trends, cf. Chart 3, will exert down ward pressure on the employment rate as defined in Box 1. The projec tions assume that the number of hours per employee per year will re main at the 2007 level up to 2050.

For prosperity purposes, consumption per capita is more relevant than output per capita. Ongoing improvement of a country's terms of trade will allow consumption opportunities per capita to persistently exceed output per capita. Denmark has experienced continuous improvement in its terms of trade over the last 40 years. Chart 4 illustrates a situation in which the terms of trade are assumed to continue to improve at the average rate for the period from 1975 to 2007. This will contribute signi ficantly to consumption opportunities per capita and thus to material prosperity.

DECLINING PRODUCTIVITY GROWTH

Growth in hourly productivity has been declining over time. For the full period since the mid-1960s it averages 2.6 per cent a year, but since 1990 it has been only 1.6 per cent per year, see Iversen and Riishøj (2007). To get an idea of the consequences for the future prosperity development, output per capita is calculated up to 2050 based on Statistics Denmark's population forecast and the assumptions that working hours per capita are unchanged and age-related employment rates will remain at the 2005 level. As shown in Chart 4 ¹, this will result in slower prosperity growth in the coming 40 years than seen in the previous 40 years. Whereas output per capita is 2.4 times higher in 2008 than 40 years ago, based on the assumptions made it will be only 1.8 times higher than today in 40 years' time. If a potential terms-of-trade gain is included, the corresponding figures concerning consumption development are 2.6 and 2.0 times higher, respectively.

Productivity growth is the key factor in explaining the development in output per capita, whereas demographic trends have played only a sec ondary role, cf. Chart 5. This will also be the case in future.

The number of working hours is also important. If the reduction of working hours per employee continues at the same rate as in the last 40 years, this will further significantly reduce growth in output per capita. The last 10 years have seen a slight increase in working hours per em ployee in Denmark, but looking forward, the ageing of the population will have the opposite effect.

Basically, changes in the participation rate and the number of hours worked have only secondary effects on productivity growth in the calcu lation of GDP per capita, because the potential for a change in labour input is limited to a shift in level (there are only 24 hours in a day, and the participation rate can never exceed 100). On the other hand, it is as sumed that productivity will continue to grow every year up to 2050. Assuming a decline in employment of, say, 10 per cent as a result of the ageing of the population, this can be translated into a reduction of aver age annual growth in GDP per capita over 40 years of 0.25 per cent. This figure should be compared with the growth in productivity.

The dampening of productivity growth seen in Denmark is not ob served to the same extent in other countries, cf. Chart 6. Part of the ex planation is that services, including in the large public sector, account for a larger share of the economy in Denmark than in most other coun tries. Productivity growth in the service sectors is generally lower than in most other sectors, cf. Pedersen and Riishøj (2007).

An estimate shows that it is not realistic to make up for significantly lower productivity growth by increasing labour input. Let us assume that the development in hourly productivity up to 2050 will be in line with the development seen in the last 15 years, i.e. 1.6 per cent per year for the economy as a whole. For output per capita to grow by 2.5 per cent per year up to 2050, this being the historical average in the period from 1966 until today, it would require an increase in working hours to 2,100 hours per employee per year, even if the age-related employment rates are maintained at the 2005 level. This corresponds to the level in the mid-1960s and to the number of hours worked in Korea today.

Alternatively, the age-related employment rates should generally be increased by just over 20 percentage points to maintain the number of working hours per capita. Even the requirements for a combination of increased working hours and labour participation in order to match the historical prosperity development must be assessed to be unrealistic. These sensitivity calculations also show that a reduction in structural un employment of, say, 1 percentage point will not have any significant im pact on future growth in GDP per capita.

So if Denmark is to keep up with international prosperity develop ment, productivity growth has to increase. Rather than population trends, low productivity growth is the primary factor undermining our relative prosperity².

While replacing increased hourly productivity by increased labour input is only possible to a limited extent, this does not mean that em ployment and labour input are immaterial in terms of the economy. On the contrary, labour input is essential if we are to ensure fiscal sustain ability. This requires a high employment rate and a high number of working hours per employee.

GROWTH, POPULATION TRENDS AND PUBLIC FINANCES

When viewed in isolation, higher output per capita will increase the tax base, thereby facilitating the financing of a given level of government expenditure. However, a significant proportion of this expenditure is sub ject to upward regulation in line with the wage development in Denmark. This includes pensions and transfer payments. As regards public service expenditure, experience shows that there will also be a strong political desire to ensure that it follows the general prosperity development. At the same time, due to lower productivity growth in service-related sectors such as the public sector, the costs of producing public services will rise at a faster rate than the production costs in the private sector. As a result, productivity growth and thus growth in output per capita will not automatically strengthen fiscal sustainability. Presumably, demand for many public services such as healthcare will increase more rapidly than income in general, further accentuating the financing problem.

The distribution of government expenditure across age groups is high ly uneven, with the elderly accounting for by far the largest part – meas ured per capita. This makes the government budget balance highly sen sitive to the proportion of the population that is in employment, and thus contributing to output. As a consequence, fiscal sustainability is af fected by both population trends and the level of structural unemploy ment.

While in the coming decades material prosperity will depend mainly on the development in productivity and only to a lesser extent on underlying population trends, as described above, the opposite is the case for public finances. Fiscal sustainability is neither ensured by GDP growth nor in creased immigration, cf. below, but requires increased labour input by those who are already living in Denmark. Alternatively, the pressure on the tax base may be alleviated through a more direct link between public services rendered and payment for such services.

IMPORTING MORE FOREIGN LABOUR – PART OF THE SOLUTION?

In a situation where the number of persons in the prime age groups is falling, a certain influx of foreign labour may contribute to reducing the pressure on the labour market and thus the inflationary pressure on the economy. In order to fill many types of jobs in future, importing more foreign labour will be a necessity. However, if we look at the contribu tion to the future prosperity development measured as output per cap ita, immigration will be less significant – the reason being that while an additional foreign employee would indeed increase output, the social value created would have to be distributed on at least one extra person. The fraction's numerator and denominator are both increased. Conversely, if we succeed in getting a person that is passively receiving benefits to contribute to output, this would alone increase output per capita and thus have a more direct impact on prosperity development.

Just as importing foreign labour would only to a certain extent affect growth in output per capita, it is not a panacea for government budget balance support either. This issue is illustrated by calculations based on the DREAM model³.

Table 1 shows how public finances are influenced by immigration under different assumptions pertaining to immigrant behaviour, includ ing primarily participation rate and drain on public services. A positive figure indicates that public finances may be expanded and still sustain a given long-term budget balance, i.e. support the financing of the public sector. A negative figure, on the other hand, indicates that public fi nances should be tightened. The sustainability indicator, i.e. the long-term budget balance level in per cent of GDP, is not shown, as the focus is on the effect on public finances of a given change in immigration or integration.

People immigrating to Denmark over the last 15-20 years, especially in the early part of that period, have mainly come from less developed countries; they have a low participation rate and account for a relatively large drain on public welfare services. This has caused fiscal deterior ation, i.e. increased the urgency of the sustainability issue.

For immigration to substantially support the financing of the public sector, it should take the form of "super immigration". This term covers persons who immigrate only after completing their education, who im mediately enter the labour market at a participation rate of 100 and pay taxes like the Danes, who do not bring their families, and who leave Denmark before reaching retirement age. These are rather far-reaching requirements, but to a large extent the conditions are met by the influx of foreign labour in recent years, especially that from Eastern Europe. In practice, however, workers from e.g. Eastern Europe pay far less income tax than Danish workers in similar jobs, because they are granted separ ation allowance.

There are great financial benefits in better integration – and the re sulting higher labour participation – of the immigrants and descendants who are already in Denmark. Perfect integration, whereby immigrants and descendants resemble the population at large with regard to labour participation and drain on public services, would go a long way towards reducing the sustainability problem. Initiatives to increase the participa tion rate in general would have a similar effect.

LITERATURE

Feyrer, James (2005), Demographics and Productivity, Dartmouth College, Working Paper, no. 02-10.

Iversen, Per Flink and Johanne Dinesen Riishøj (2007), Development in Productivity in Denmark, Danmarks Nationalbank, Monetary Review, 4th Quarter.

Pedersen, Erik Haller and Johanne Dinesen Riishøj (2008), Denmark's Wage Competitiveness, Danmarks Nationalbank, Monetary Review, 2nd Quarter.