The Aging Population and the Size of the Welfare State

This paper develops an overlapping generations model of Social Security and human capital formation in which–somewhat against the conventional wisdom–an increase in the dependency ratio can lead to a reduced tax burden or less generous social transfers. A higher dependency ratio resulting from the aging of the population therefore reduces the extent of redistribution. Data on 12 European countries over the period 1974 to 1992 are consistent with the implications of this model: a higher dependency ratio leads to a lower tax rate on labor income, with the effects statistically significant even after controlling for income inequality as suggested by the standard theory of the tax burden, per capita GDP growth, the international exposure of the economy, and the share of government jobs out of total employment. Similarly, a higher dependency ratio leads to lower per capita transfers, again after controlling for these socio-economic factors.