## _wp07247

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---

### I. INTRODUCTION — Demographic trends and fiscal pressures
- Elderly dependency ratio expected to increase from 16 percent in 2006 to 45 percent in 2050 (Eurostat central projection).
- Under alternative assumptions: dependency ratio would increase to 41 percent (young population variant) and 52 percent (old population variant).
- Central projection assumptions:
  - birth rate declines from 1.98 to 1.8;
  - life expectancy increases by more than 6 years;
  - net migration inflows of 0.4 percent of the population annually in the medium term, declining to about ¼ percent of the population in the long term.
- “Younger population” projection: birth rate increases to 2, higher net migration flow, lower increase in life expectancy than central projection.
- “Older population” projection: birth rate declines to 1.6, lower migration, higher life expectancy than central projection.
- Flat-rate pension value increased from 27 percent of gross average industrial earnings (GAIE) in 1997 to 34 percent of GAIE in 2007.
- Projections of age-related public spending (European Commission Aging Working Group methodology):
  - If pension benefits to GAIE remain at 2007 level, pension expenditure would increase by 6.5 percentage points of GDP between 2005 and 2050.
  - Health and long-term care expenditure projected to increase by 2.6 percentage points of GDP between 2005 and 2050.
  - Education expenditure projected to decline by about 1 percent of GDP over the same period.
- Without fiscal adjustment, debt dynamics under central AWG projections (holding other revenue and expenditure constant as a share of GDP) lead to unsustainable debt accumulation:
  - Fiscal surplus assumed to decline to zero by 2011.
  - Real interest rate assumed to be 3 percent (scenario variants consider real interest rate rising to 5 percent).
  - Real growth rate follows AWG assumptions (declining from about 5 percent in the near term to about 1½ percent in the long term).
  - Authorities contribute 1 percent of GNP annually to the National Pensions Reserve Fund (NPRF) every year until 2055.
  - Increase in age-related spending financed by debt issuance until 2025; after 2025 pension increases financed by NPRF withdrawals and other age-related increases financed by debt issuance; NPRF exhausted shortly after 2050 under these assumptions.
- Scenario uncertainty and sensitivity:
  - A gradual decline in public investment to the euro area average after 2020 would lower net debt accumulation (illustrated by “Lower public investment” path).
  - If real interest rate rises from 3 to 5 percent as debt grows, debt accumulation is substantially larger (“Higher interest rate” path).
  - AWG assumptions on rising labor participation and employment rates and on health cost growth (assumed to grow at same rate as wages) may be optimistic.

### I. INTRODUCTION — Policy challenge and strategy overview
- To prevent rapid debt build-up, increases in pension and health expenditure need to be offset by reduction of other public spending, substantial tax increases, and/or benefits reform.
- Two main fiscal adjustment strategies analyzed using the IMF’s Global Fiscal Model (GFM), calibrated to Ireland:
  1. Reduce public investment after 2020 + increase social security contributions (baseline).
  2. Reduce public investment after 2020 + increase retirement age + income tax base broadening + increase VAT (package).
- All scenarios assume ratio of public investment to GDP declines gradually to the euro area average after 2020 (a reduction of about 1½ percentage points of GDP).

### I. INTRODUCTION — Analytical framework
- Two-country dynamic general equilibrium macro model (Global Fiscal Model, GFM) calibrated to the Irish economy.
- Model captures aggregate demand and aggregate supply responses.
- Departures from Ricardian equivalence:
  - Consumers have finite horizons: temporary fiscal changes may affect consumption.
  - A fraction of consumers are liquidity constrained: changes in disposable income immediately change consumption.
  - Taxes are distortionary: affect labor supply and savings-investment patterns.

### I. INTRODUCTION — Debt objective in simulations
- Government aims to maintain gross debt-to-GDP ratio close to its current level (equivalent in long term to maintaining constant net debt-to-GDP once NPRF is exhausted).
- Maintaining a higher debt level is feasible but requires larger primary surpluses and fiscal measures.

### IV. EFFECTS OF ALTERNATIVE ADJUSTMENT STRATEGIES — Strategy 1 (Baseline: raising social security contribution rates)
- Objective: keep gross debt broadly constant.
- Required fiscal surplus: around ⅓ percent of GDP throughout the period.
- Raise social security contribution rate by about 7 percentage points in the next 15 years; maintain at that level until NPRF runs out.
- After NPRF depletion, social security rate needs to increase by about 20 points relative to its starting value (and even more if age-related spending continues to rise after 2060).
- Labor supply impact (assuming labor elasticity to after-tax wages close to the middle of existing estimates):
  - labor supply would fall by 3½ percentage points due to distortionary effects of labor taxes;
  - could decline by more toward the end of the period as working-age population shrinks.
- Aggregate demand likely remains relatively high for most of the period because after 2025 transfers to the population exceed increases in taxes as pension assets are distributed.
- Model note: social security contributions levied on workers were assumed to be increased in the simulation; similar growth effects would arise if payroll taxes on employers were increased instead.

### IV. EFFECTS OF ALTERNATIVE ADJUSTMENT STRATEGIES — Strategy 2 (Package: mixed measures, more growth-friendly)
- Package components:
  - Reduction in public investment of 1½ percentage points of GDP after 2020.
  - Increase of pension (retirement) age by 2 years, phased in gradually between 2033 and 2050 (affecting those 40 years and younger in 2007).
  - Income tax base broadening over 2021–24 (increasing revenues by about ¼ percentage points of GDP).
  - Gradual increase in VAT: raise VAT by 4 percentage points by 2020, and by another 4 percentage points after the NPRF is exhausted.
- Rationale and effects:
  - Increasing retirement age is equivalent to reducing lump-sum social security transfers, lowering required increases in distortionary taxes.
  - Income tax base broadening is less distortionary than raising marginal rates.
  - VAT is less distortionary than payroll taxes because of broader tax base (savings also taxed); shifting revenue from direct to indirect taxation is beneficial for employment and growth.
  - Package yields better employment and growth outcomes relative to relying mainly on raising social security contribution rates.
- Model results: package is more growth-friendly than baseline; results robust to variations in model assumptions (Appendix II).

### IV. EFFECTS OF ALTERNATIVE ADJUSTMENT STRATEGIES — Complementary policies to support growth
- Policies that raise productivity and labor participation mitigate growth effects of fiscal adjustment:
  - Increase flexibility of labor markets.
  - Ensure greater competition in product markets.
  - Encourage investment in education and research.
- Higher net migration (especially younger immigrants) increases GDP growth and can improve short-run fiscal position, but effects are temporary as immigrants age.

### IV. EFFECTS OF ALTERNATIVE ADJUSTMENT STRATEGIES — Prefunding of age-related liabilities
- Greater prefunding options:
  - Increase annual contribution to NPRF above 1 percent of GNP.
  - Reduce gross debt (equivalent if debt interest rate equals pension asset earnings rate).
- Benefits of prefunding:
  - Improves intergenerational equity (pay-as-you-go leads to falling ratio of benefits to contributions as elderly dependency rises).
  - Insurance against higher-than-projected age-related spending.
  - Lower public debt or higher net assets reduce crowding out and exposure to a potential rise in world interest rates as global aging occurs.
- Costs: short-run output loss due to higher initial taxes required for prefunding; long-run output higher.
- Example: maintaining fiscal surplus at current level (about 1 percent of GDP) until 2050 would result in net debt close to zero at that horizon and allow fiscal balance thereafter.
- Prefunding produces different real GDP paths relative to the package and baseline (Prefunding vs Package relative to baseline).

### V. PENSIONS BOARD PROPOSALS
- Pensions Board concern: substantial fraction of the Irish population lacks private retirement savings and relies entirely on public pension system.
- 2006 Pensions Board proposals: address the issue by either
  1. increasing generosity of the public pension system,
  2. creating a compulsory private pension system with some government involvement, or
  3. a combination of the two.
- Proposed goal cited: increase the flat rate pension from 34 percent of GAIE to 50 percent of GAIE.
- Fiscal and growth implications:
  - Increasing public pension generosity could change the system’s role from poverty prevention to ensuring a desirable level of income, with significant fiscal and growth consequences.
  - Expansion of public funding could have negative effects on fiscal position and growth greater than those analyzed under current projections.
  - Many continental European countries that aimed to provide desirable levels of income have implemented politically difficult reforms to curtail pension generosity.

### VI. CONCLUSIONS AND POLICY RECOMMENDATIONS — Main findings
- Substantial fiscal measures required to prevent debt build-up as age-related spending rises.
- Relying mainly on increased social security contributions would necessitate a very large increase in contribution rates with negative impacts on labor supply.
- A package including an increase in retirement age is a more growth-friendly strategy.

### VI. CONCLUSIONS AND POLICY RECOMMENDATIONS — Policy recommendations and options
- Consider a package of measures: moderate reduction in public investment after 2020, increase retirement age, income tax base broadening, and increases in VAT rather than sole reliance on payroll/social security tax hikes.
- Targeting a small fiscal surplus (as opposed to balance) in the medium term would reduce the magnitude of required long-term adjustment.
- Increase the annual contribution to the NPRF to safeguard fiscal saving and consider greater prefunding.
- Regular publication of a sustainability report detailing long-term fiscal projections, risks, and possible measures to address aging-related fiscal effects could improve public debate and reduce short-term bias.
- Additional notes:
  - The suggested package is illustrative; other options could include higher increases in retirement age and changes in other indirect taxes (property taxes for example).
  - Raising taxes on returns to capital is not included in the suggested package because capital is more internationally mobile and such taxes could lower investment and trigger capital outflows.

### Appendix I — Parameterization of the Global Fiscal Model (calibration to Ireland)
- Model parameterized to reflect key macroeconomic features of Ireland.
- Ratios of consumption, investment, government spending, wage income, and income from capital relative to GDP are set to their values in 2006.
- Key fiscal variables calibrated to Ireland’s fiscal structure:
  - revenue-to-GDP ratios from taxation of corporate, labor, and personal income and from consumption tax,
  - government debt,
  - current government spending.
- The size of the Irish economy relative to the world economy implies Irish policies would have only a minimal impact on the global rate of interest.

### Appendix I — Key behavioral parameters and baseline assumptions
- Structural and behavioral parameters based on microeconomic evidence; include:
  - real rigidities in investment,
  - markups for firms and workers,
  - elasticity of labor supply to after-tax wages,
  - elasticity of substitution between labor and capital,
  - elasticity of intertemporal substitution,
  - rate of time preference.
- Baseline and alternative simulations examine changes in key parameters:
  - The wedge between the rate of time preference and the yield on government bonds:
    - Baseline value: 10 percent (corresponding to a planning horizon of 10 years).
    - Alternative: 1 percent (corresponding to a planning horizon of 100 years).
  - The fraction of liquidity-constrained consumers:
    - Baseline: 40 percent of consumers are liquidity constrained; these consumers have no wealth and consume one-fourth of aggregate consumption.
    - Alternative: 10 percent of individuals are liquidity constrained.
  - Sensitivity of labor supply to the real after-tax wage (Frisch elasticity):
    - Baseline value: -0.1 (suggests relatively elastic labor supply).
    - Alternative: -0.01 (almost completely inelastic labor supply).
  - Elasticity of intertemporal substitution:
    - Baseline value: -0.33 (describes sensitivity of consumption to changes in the real interest rate).
    - Alternative: -0.25 (consistent with the lower end of microeconomic estimates).

### Appendix I — Other main model features
- Consumption and production are characterized by constant elasticity of substitution functions.
- Firms and workers have some market power; prices and wages are above perfectly competitive levels.
- Model includes traded and nontraded goods, allowing for a bias toward domestic goods in private or government consumption.
- Two factors of production: capital and labor used to produce traded and nontraded goods; capital and labor move freely between sectors but are not mobile internationally.
- Investment is driven by Tobin’s Q with adjustment costs; firms respond sluggishly to differences between the discounted value of future profits and the market value of the capital stock.
- Wages and prices are fully flexible; monetary policy is ineffective.
- Two kinds of financial assets: government debt (traded internationally) and equity (held domestically).
  - In the standard GFM, international trade in government debt implies equalization of nominal interest rates across countries as capital markets are fully integrated.
  - Alternatively, the model can include a risk premium that depends on the level of public debt.

### Appendix I — Calibration sources
- Structural parameters calibrated using evidence from Laxton and Pesenti (2003) and Batini, N’Diaye, and Rebucci (2005).

### Appendix II — Sensitivity Analysis — summary of key results
- Results for growth effects of the package versus the baseline are relatively robust to variation in model assumptions.
- Notable sensitivities:
  - If labor supply is inelastic, there will be little difference between the two strategies because raising social security contributions will not cause significant changes in labor supply.
  - Lower intertemporal elasticity of substitution increases the importance of consumption smoothing; payroll taxes distort labor-leisure choice by less, modestly reducing the beneficial effects of the adjustment package.
  - A longer planning horizon and/or fewer rule-of-thumb consumers make the model more Ricardian and reduce crowding-out effects associated with higher debt; however, since net debt changes broadly by the same amount in the two strategies, changing the horizon does not affect significantly the relative benefits.
- Table A1 (Deviation of real GDP from baseline in NPV terms) — Package results:
  - Baseline parameter values 2/9.3
  - Longer planning horizon 3/10.4
  - Fewer rule-of-thumb consumers 4/9.2
  - Less elastic labor supply 5/2.1
  - Lower intertemporal elasticity of substitution 6/5.3
- Additional note:
  - The small improvement of the performance of the package with a longer planning horizon comes from the accumulation of assets in the economy (as the marginal propensity to consume of optimizing consumers declines), which makes the VAT less distortionary as a larger share of the tax falls on wealth.

*Source: IMF working paper content unit _wp07247 (References and chapter text provided).*

### References..............................................................................................................

### I. INTRODUCTION

### Demographic trends and fiscal pressures
- Elderly dependency ratio expected to increase from 16 percent in 2006 to 45 percent in 2050 (Eurostat central projection).
- Under alternative assumptions: dependency ratio would increase to 41 percent (young population variant) and 52 percent (old population variant).
- Central projection assumptions: birth rate declines from 1.98 to 1.8; life expectancy increases by more than 6 years; net migration inflows of 0.4 percent of the population annually in the medium term, declining to about ¼ percent of the population in the long term.
- “Younger population” projection: birth rate increases to 2, higher net migration flow, lower increase in life expectancy than central projection.
- “Older population” projection: birth rate declines to 1.6, lower migration, higher life expectancy than central projection.
- Flat-rate pension value increased from 27 percent of gross average industrial earnings (GAIE) in 1997 to 34 percent of GAIE in 2007.
- Stability Report projection (assuming pension benefits to GAIE remain at 2007 level): pension expenditure would increase by 6.5 percentage points of GDP between 2005 and 2050.
- Health and long-term care expenditure projected to increase by 2.6 percentage points of GDP between 2005 and 2050.
- Education expenditure projected to decline by about 1 percent of GDP over the same period.
- European Commission Aging Working Group methodology used for projections (EC Special Report No 1, 2006).
- Without fiscal adjustment, debt dynamics under central AWG projections (holding other revenue and expenditure constant as a share of GDP) lead to unsustainable debt accumulation:
  - Fiscal surplus assumed to decline to zero by 2011.
  - Real interest rate assumed to be 3 percent (scenario variants consider real interest rate rising to 5 percent).
  - Real growth rate follows AWG assumptions (declining from about 5 percent in the near term to about 1½ percent in the long term).
  - Authorities contribute 1 percent of GNP annually to the National Pensions Reserve Fund (NPRF) every year until 2055.
  - Increase in age-related spending financed by debt issuance until 2025; after 2025 pension increases financed by NPRF withdrawals and other age-related increases financed by debt issuance; NPRF exhausted shortly after 2050 under these assumptions.
- Scenario uncertainty and sensitivity:
  - A gradual decline in public investment to the euro area average after 2020 would lower net debt accumulation (illustrated by “Lower public investment” path).
  - If real interest rate rises from 3 to 5 percent as debt grows, debt accumulation is substantially larger (“Higher interest rate” path).
  - AWG assumptions on rising labor participation and employment rates and on health cost growth (assumed to grow at same rate as wages) may be optimistic.

### Policy challenge and strategy overview
- To prevent rapid debt build-up, increases in pension and health expenditure need to be offset by reduction of other public spending, substantial tax increases, and/or benefits reform.
- Two main fiscal adjustment strategies are analyzed using the IMF’s Global Fiscal Model (GFM), calibrated to Ireland:
  1. Reduce public investment after 2020 + increase social security contributions (baseline).
  2. Reduce public investment after 2020 + increase retirement age + income tax base broadening + increase VAT (package).
- All scenarios assume ratio of public investment to GDP declines gradually to the euro area average after 2020 (a reduction of about 1½ percentage points of GDP).

### Analytical framework (model features and departures from Ricardian equivalence)
- Two-country dynamic general equilibrium macro model (Global Fiscal Model, GFM) calibrated to the Irish economy.
- Aggregate demand and aggregate supply responses both captured.
- Departures from Ricardian equivalence:
  - Consumers have finite horizons: temporary fiscal changes may affect consumption.
  - A fraction of consumers are liquidity constrained: changes in disposable income immediately change consumption.
  - Taxes are distortionary: affect labor supply and savings-investment patterns.

### Debt objective in simulations
- Government aims to maintain gross debt-to-GDP ratio close to its current level (equivalent in long term to maintaining constant net debt-to-GDP once NPRF is exhausted).
- Maintaining a higher debt level is feasible but requires larger primary surpluses and fiscal measures.

### IV. EFFECTS OF ALTERNATIVE ADJUSTMENT STRATEGIES

### Strategy 1 — Baseline: raising social security contribution rates
- Objective: keep gross debt broadly constant.
- Required fiscal surplus: around ⅓ percent of GDP throughout the period.
- Raise social security contribution rate by about 7 percentage points in the next 15 years; maintain at that level until NPRF runs out.
- After NPRF depletion, social security rate needs to increase by about 20 points relative to its starting value (and even more if age-related spending continues to rise after 2060).
- Labor supply impact (assuming labor elasticity to after-tax wages close to the middle of existing estimates): labor supply would fall by 3½ percentage points due to distortionary effects of labor taxes; could decline by more toward the end of the period as working-age population shrinks.
- Aggregate demand likely remains relatively high for most of the period because after 2025 transfers to the population exceed increases in taxes as pension assets are distributed.
- Model notes: social security contributions levied on workers were assumed to be increased in the simulation; similar growth effects would arise if payroll taxes on employers were increased instead.

### Strategy 2 — Package: mixed measures (more growth-friendly)
- Components:
  - Reduction in public investment of 1½ percentage points of GDP after 2020.
  - Increase of pension (retirement) age by 2 years, phased in gradually between 2033 and 2050 (affecting those 40 years and younger in 2007).
  - Income tax base broadening over 2021–24 (increasing revenues by about ¼ percentage points of GDP).
  - Gradual increase in VAT: raise VAT by 4 percentage points by 2020, and by another 4 percentage points after the NPRF is exhausted.
- Rationale and effects:
  - Increasing retirement age is equivalent to reducing lump-sum social security transfers, lowering required increases in distortionary taxes.
  - Income tax base broadening is less distortionary than raising marginal rates.
  - VAT is less distortionary than payroll taxes because of broader tax base (savings also taxed); shifting revenue from direct to indirect taxation is beneficial for employment and growth.
  - Package yields better employment and growth outcomes relative to relying mainly on raising social security contribution rates.
- Model results: package is more growth-friendly than baseline; results robust to variations in model assumptions (Appendix II).

### Complementary policies to support growth
- Policies that raise productivity and labor participation mitigate growth effects of fiscal adjustment:
  - Increase flexibility of labor markets.
  - Ensure greater competition in product markets.
  - Encourage investment in education and research.
- Higher net migration (especially younger immigrants) increases GDP growth and can improve short-run fiscal position, but effects are temporary as immigrants age.

### Prefunding of age-related liabilities
- Greater prefunding options:
  - Increase annual contribution to NPRF above 1 percent of GNP.
  - Reduce gross debt (equivalent if debt interest rate equals pension asset earnings rate).
- Benefits of prefunding:
  - Improves intergenerational equity (pay-as-you-go leads to falling ratio of benefits to contributions as elderly dependency rises).
  - Insurance against higher-than-projected age-related spending.
  - Lower public debt or higher net assets reduce crowding out and exposure to a potential rise in world interest rates as global aging occurs.
- Costs: short-run output loss due to higher initial taxes required for prefunding; long-run output higher.
- Example: maintaining fiscal surplus at current level (about 1 percent of GDP) until 2050 would result in net debt close to zero at that horizon and allow fiscal balance thereafter.
- Comparative growth results: prefunding produces different real GDP paths relative to the package and baseline (chart shows Prefunding vs Package relative to baseline).

### V. PENSIONS BOARD PROPOSALS
- Pensions Board concern: substantial fraction of the Irish population lacks private retirement savings and relies entirely on public pension system.
- 2006 Pensions Board proposals: address the issue by either
  1. increasing generosity of the public pension system,
  2. creating a compulsory private pension system with some government involvement, or
  3. a combination of the two.
- Proposed goal cited: increase the flat rate pension from 34 percent of GAIE to 50 percent of GAIE.
- Fiscal and growth implications:
  - Increasing public pension generosity could change the system’s role from poverty prevention to ensuring a desirable level of income, with significant fiscal and growth consequences.
  - Expansion of public funding could have negative effects on fiscal position and growth greater than those analyzed under current projections.
  - Many continental European countries that aimed to provide desirable levels of income have implemented politically difficult reforms to curtail pension generosity.

### VI. CONCLUSIONS AND POLICY RECOMMENDATIONS
- Main findings:
  - Substantial fiscal measures required to prevent debt build-up as age-related spending rises.
  - Relying mainly on increased social security contributions would necessitate a very large increase in contribution rates with negative impacts on labor supply.
  - A package including an increase in retirement age is a more growth-friendly strategy.
- Policy recommendations and options:
  - Consider a package of measures: moderate reduction in public investment after 2020, increase retirement age, income tax base broadening, and increases in VAT rather than sole reliance on payroll/social security tax hikes.
  - Targeting a small fiscal surplus (as opposed to balance) in the medium term would reduce the magnitude of required long-term adjustment.
  - Increase the annual contribution to the NPRF to safeguard fiscal saving and consider greater prefunding.
  - Regular publication of a sustainability report detailing long-term fiscal projections, risks, and possible measures to address aging-related fiscal effects could improve public debate and reduce short-term bias.
- Additional notes:
  - The suggested package is illustrative; other options could include higher increases in retirement age and changes in other indirect taxes (property taxes for example).
  - Raising taxes on returns to capital is not included in the suggested package because capital is more internationally mobile and such taxes could lower investment and trigger capital outflows.

*Source: IMF working paper content unit _wp07247 (References and chapter text provided).*

### Appendix I.

### Appendix I. Parameterization of the Global Fiscal Model

### Calibration to Ireland
- The model is parameterized to reflect key macroeconomic features of Ireland.
- Ratios of consumption, investment, government spending, wage income, and income from capital relative to GDP are set to their values in 2006.
- Key fiscal variables calibrated to Ireland’s fiscal structure:
  - revenue-to-GDP ratios from taxation of corporate, labor, and personal income and from consumption tax,
  - government debt,
  - current government spending.
- The size of the Irish economy relative to the world economy implies Irish policies would have only a minimal impact on the global rate of interest.

### Key behavioral parameters and baseline assumptions
- Structural and behavioral parameters are based on microeconomic evidence.
- Parameters include:
  - real rigidities in investment,
  - markups for firms and workers,
  - elasticity of labor supply to after-tax wages,
  - elasticity of substitution between labor and capital,
  - elasticity of intertemporal substitution,
  - rate of time preference.
- Baseline and alternative simulations examine changes in the following key parameters:
  - The wedge between the rate of time preference and the yield on government bonds:
    - Baseline value: 10 percent (corresponding to a planning horizon of 10 years).
    - Alternative: 1 percent (corresponding to a planning horizon of 100 years).
  - The fraction of liquidity-constrained consumers:
    - Baseline: 40 percent of consumers are liquidity constrained; these consumers have no wealth and consume one-fourth of aggregate consumption.
    - Alternative: 10 percent of individuals are liquidity constrained.
  - Sensitivity of labor supply to the real after-tax wage (Frisch elasticity):
    - Baseline value: -0.1 (suggests relatively elastic labor supply).
    - Alternative: -0.01 (almost completely inelastic labor supply).
  - Elasticity of intertemporal substitution:
    - Baseline value: -0.33 (describes sensitivity of consumption to changes in the real interest rate).
    - Alternative: -0.25 (consistent with the lower end of microeconomic estimates).

### Other main model features
- Consumption and production are characterized by constant elasticity of substitution functions.
- Firms and workers have some market power; prices and wages are above perfectly competitive levels.
- Model includes traded and nontraded goods, allowing for a bias toward domestic goods in private or government consumption.
- Two factors of production: capital and labor used to produce traded and nontraded goods; capital and labor move freely between sectors but are not mobile internationally.
- Investment is driven by Tobin’s Q with adjustment costs; firms respond sluggishly to differences between the discounted value of future profits and the market value of the capital stock.
- Wages and prices are fully flexible; monetary policy is ineffective.
- Two kinds of financial assets: government debt (traded internationally) and equity (held domestically).
  - In the standard GFM, international trade in government debt implies equalization of nominal interest rates across countries as capital markets are fully integrated.
  - Alternatively, the model can include a risk premium that depends on the level of public debt.

### Calibration sources
- Structural parameters calibrated using evidence from Laxton and Pesenti (2003) and Batini, N’Diaye, and Rebucci (2005).

### Appendix II. Sensitivity Analysis — summary of key results
- The results for the growth effects of the package of measures versus the baseline are relatively robust to variation in model assumptions.
- Notable sensitivities:
  - If labor supply is inelastic, there will be little difference between the two strategies because raising social security contributions will not cause significant changes in labor supply.
  - Lower intertemporal elasticity of substitution increases the importance of consumption smoothing; payroll taxes distort labor-leisure choice by less, modestly reducing the beneficial effects of the adjustment package.
  - A longer planning horizon and/or fewer rule-of-thumb consumers make the model more Ricardian and reduce crowding-out effects associated with higher debt; however, since net debt changes broadly by the same amount in the two strategies, changing the horizon does not affect significantly the relative benefits.
- Table A1 (Deviation of real GDP from baseline in NPV terms) — Package results:
  - Baseline parameter values 2/9.3
  - Longer planning horizon 3/10.4
  - Fewer rule-of-thumb consumers 4/9.2
  - Less elastic labor supply 5/2.1
  - Lower intertemporal elasticity of substitution 6/5.3
- Notes and parameter definitions related to Table A1:
  - 1/ Baseline increases social security contributions on workers and employers; sum of discounted deviations of real GDP from adjusting through a package or prefunding relative to the baseline; discount rate equal to market interest rate as determined in the model simulations.
  - 2/ Planning horizon: 10 years; fraction of rule-of-thumb consumers equal to 40 percent; moderately elastic labor supply (eta = 0.90); and intertemporal elasticity of substitution equal to 1/3.
  - 3/ Planning horizon equal to 100 years.
  - 4/ Rule-of-thumb consumers equal to 10 percent.
  - 5/ Inelastic labor supply (eta = 0.99).
  - 6/ Intertemporal elasticity of substitution equal to 0.25.
- Additional note:
  - The small improvement of the performance of the package with a longer planning horizon comes from the accumulation of assets in the economy (as the marginal propensity to consume of optimizing consumers declines), which makes the VAT less distortionary as a larger share of the tax falls on wealth.

*Source: GFM simulations.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2007/_wp07247.pdf_