Long-term sustainability of public finances in the EU

Faced with an ageing population, the European Commission examines the risks and challenges facing Member States and the European Union, in order to ensure the long-term sustainability of public finances.

ACT

Communication of 12 October 2006 from the Commission to the Council and the European Parliament: The long-term sustainability of public finances in the EU [COM(2006) 574 final - not published in the Official Journal].

SUMMARY

In this Communication, the European Commission examines the risks facing Member States regarding the long-term sustainability of public finances. The main challenge seems to be the impact of an ageing population on public finances. In the light of this challenge, public debt needs to be quickly reduced, employment rates increased, and pensions, health care and long-term care systems reformed as appropriate.

A low birth rate and a high life expectancy: an ageing population

The size and the age structure of Europe's population is set to change in the future, due to low birth rates, continuous increases in life expectancy and the retirement of the "baby-boom" generation. Future population ageing will bring major economic, budgetary and social challenges due to the impact on growth and public expenditure (c.f.: " The impact of ageing on public expenditure: projections for the Member States (2004-2050 ").

As a result, it will be difficult for Member States to maintain sound and sustainable public finances in the long-term. This is of particular importance in the context of Economic and Monetary Union since high deficit and increasing levels of debt within a Member State can have an adverse effect on macroeconomic conditions in other Member States. It is therefore important to rectify budgetary imbalances and take coherent action in time, before population ageing brings about a rise in public spending.

Taking action before it is too late

In the long term, population ageing will have consequences for the public purse, notably in the form of a significant increase in expenditure on pensions, health care and long-term care. Structural reform is needed to curb this expenditure and promote growth by raising employment rates and retirement ages.

In the absence of reform measures and budgetary consolidation, the Commission's analysis reveals that a considerable sustainability gap (in other words, the gap between the 2005 budgetary position and a sustainable position) of approximately 3.5 % of GDP is emerging in both the EU and the euro area. Unless steps are taken to fill this gap, the average government debt/GDP ratio within the EU is projected to remain above 60 % over the coming decades and, in the run-up to 2020, is set to start rising considerably, reaching almost 200 % of GDP in 2050.

In order to illustrate the impact of an improvement of the budgetary position on the long-term sustainability of public funds, the Commission has analysed an alternative scenario: if Member States were to reach their medium-term budgetary objectives in 2010, sustainability gaps in the EU and the euro area would be around 1.5 % of GDP. If this happened, the debt/GDP ratio in 2050 would probably be around 80 % compared to 200 % if the budgetary position were to remain unchanged.

The long-term sustainability of public finances: a risk assessment

In order to indicate the relative importance of the risks to the long-term sustainability of public finances, the European Commission and the Council of the European Union have introduced a classification system consisting of three levels: low, medium and high risk.

The 25 Member States at the time (Bulgaria and Romania joined the EU in January 2007) can be classified as follows:

High-risk countries: the Czech Republic, Greece, Cyprus, Hungary, Portugal and Slovenia. High risk is characterised by a very significant rise in long-term age-related expenditure. Some of these countries also have large deficits and in some cases a high level of debt;
Medium-risk countries: Belgium, Germany, Spain, France, Ireland, Italy, Luxembourg, Malta, Slovakia and the United Kingdom. These countries can be sub-divided into two groups:

-countries with a significant cost of ageing for public funds and where measures might be needed to curb these costs, but which currently have relatively strong budgetary positions (Spain, Ireland, Luxembourg);

-countries that need to consolidate, to differing degrees, their public finances in the medium term, but for which the cost of ageing is less of a concern, usually as a result of reforms made to their pension systems (Slovakia, Italy, Germany, France, the United Kingdom and Malta).

Belgium shows some characteristics of both subgroups and needs to maintain a comfortable budget balance to reduce the very high level of debt and to offset the high increase in age-related expenditure.

Low-risk countries: Denmark, Estonia, Latvia, Lithuania, the Netherlands, Austria, Poland, Finland and Sweden. These countries have come furthest in coping with ageing populations; this has meant a strong budgetary position (large surpluses, lower debt and/or accumulated assets) and/or comprehensive pension reforms, sometimes including a shift towards private pension schemes. However, this does not mean that in these countries long-term sustainability is risk-free. In fact, the situation in Estonia, Latvia, Lithuania, Austria, Poland and Sweden is dependent on the successful implementation of pension scheme reforms, which have reduced the long-term budgetary impact of ageing, and on the budgetary position being maintained or in some cases strengthened. The projected cost of ageing, notably with regard to pensions, is relatively high in Denmark, the Netherlands and Finland and these countries may need to consider structural reforms to modify the projected long-term budgetary trends at some point, if the current strong budgetary position is not maintained over the long term.

Ensuring sustainable public finances: a major challenge for the EU

The economic and budgetary challenge that comes with an ageing population involves:

a rapid reduction in debt: Member States need to achieve and sustain sound budgetary positions and reduce public debt before population ageing unfolds and results in an increase in public expenditure;
raising employment rates and productivity: there is a need to raise employment rates, especially amongst women and older workers and appropriate measures should be envisaged to raise labour supply and utilisation;
reform of pension, healthcare and long-term care systems: Member States should envisage appropriate reforms of their social systems to ensure their financial viability.

This three-pronged strategy, aimed at rising to the economic and budgetary challenge of an ageing population, is an integral part of the Lisbon Strategy.

See also