Aging population: The complex effect of fiscal leakages on the politico-economic equilibrium

The paper extends the welfare state model in an earlier paper [Razin, A., Sadka, E., Swagel, P., 2002. The aging population and the size of the welfare state. Journal of Political Economy 100, 900-918.] to include also a capital tax component in the income tax which pays the social security benefits. With a full-fledged income tax, various fiscal leakages are at play. This complicates the relationship between the size of the welfare state and aging that we analyze in a political-economy framework. The political economy equilibrium is governed by two voting pivots, one young and one old. Aging may turn the young pivot to a richer individual, who would prefer to downgrade the welfare state. But fiscal leakages can change the equilibrium relationship substantially. A fiscal leakage of revenues from the increased number of old taxpayers, of the capital tax component of the income tax to the young, may make the latter to vote for more taxes. But, on the other hand, a fiscal leakage from the young taxpayers, of the labor component of the income tax, to the increased number of old beneficiaries, may tame the appetite of the young for more taxes. As a result, the welfare system may not expand with the aging of the population. The paper also discusses the econometric problems in testing the predictions of models of this kind. OLS estimates of the coefficient of old dependency ratio are, in general, biased, because the analysis leaves out key variables associated with the identity of the median voter. The latter variables are presumed to be correlated with the error term.