Sustainability of Finland’s public finances

The standard measure of the sustainability gap is the so-called S2 indicator. It determines the immediate and permanent fiscal adjustment required to stabilise public debt in spite of growth in age-related expenditure. Technically calculation of the S2 indicator is subject to an infinite time horizon, although in practice the examination of age-related expenditure is restricted to 40–60 years ahead.

At the Bank of Finland, fiscal sustainability is assessed with a model framework which draws on the short-term cyclical forecast for 2018–2021 as well as the medium- and long-term forecasts for the macroeconomy and the public finances. In the medium-term macroeconomic forecast for 2022–2025, the economy is assessed to move closer to a balanced growth path, in which total output will grow at its potential rate and economic growth will not be based on the accumulation of debt. Inflation will approach 2% and real earnings will rise at a rate close to productivity growth. The fiscal balance will be weakened already in the coming years by higher spending on healthcare and long-term care, in addition to higher pension expenditure. However, the primary budget position[1] is almost on balance in 2025, the base year of the calculation.

The long-term forecast estimates GDP growth and its components – employment and productivity – in 2026–2040. The actual assessment of the sustainability gap, which examines how the fiscal position responds to demographic change and its effects on age-related expenditure, is also based on this period and the subsequent years until 2065. Thus, the sustainability gap indicator calculated by the Bank of Finland determines the permanent adjustment required in 2025 for stabilising the general government debt-to-GDP ratio.

In the years following the long-term forecast horizon, i.e. 2041–2065, age group-specific labour force participation rates and labour productivity are assumed to remain at the 2040 level. This will lead to slightly slower GDP growth from 2040 onwards than estimated in the previous sustainability calculation, since the most recent population projection points to a decline in the working-age population. Real wages will rise in the sustainability calculation at the rate of productivity growth. Inflation will stabilise to 2% already in the medium term.

Fiscal sustainability is also affected by interest rate assumptions. Both general government property income (i.e. rent, interest and dividends), which is mainly income received by the pension funds, and interest payments on public debt are dependent on the assumed interest rate path and the long-term equilibrium interest rate. The Bank of Finland’s sustainability calculation assumes that the current low level of interest rates will have risen by the mid-2030s: the nominal interest rate on public debt will reach 5%, and the return on property income assets will be 5.5%.

Pension funds’ investment portfolios are assumed to be divided equally between interest-bearing (bond) and equity investments.[3] The real rate of return on equity is assumed to be 4% immediately from the first calculation year onwards. The real interest rate, in turn, is assumed to rise to 3%, but only later, by 2035. This pertains to both the interest rate on public debt and pension funds’ bond investments. Thus, the long-term average return for pension funds is assumed to be 3.5%, in real terms.

Statistics Finland’s population projection published in November 2018 assumes that the birth rate will remain unchanged, at its current low level. This means that the number of working-age persons will be markedly lower than in the previous projection. Namely, there would be 200,000 less persons of working age in 2050 in Finland than estimated in the previous population projection. If the labour force participation rate is assumed to remain unchanged, the decrease in the working-age population will also mean a decrease in the number of employed. Weaker employment, in turn, will put a strain on economic growth in the long term.

Chart 1

Total age-related expenditure, including unemployment spending, relative to GDP, will grow by an estimated 2.8 percentage points in 2016–2065 (Table 1).

Table 1. Age-related expenditure, % relative to GDP. 2016–2065

However, age-related expenditure will not grow evenly over time (Chart 2). In 2020–2030, age-related spending will grow already by 1.5 percentage points. During this period, pension, healthcare and long-term care expenditure will grow simultaneously. Pension expenditure growth will peak in the 2030s. From the perspective of central and local government budgets, the expenditure challenges will increase throughout the period under review, since healthcare and long-term care spending will still grow for many years in the 2060s.

Chart 2

Another method for assessing the impact of interest rates is to assume that the general interest rate level exceeds the baseline, which would affect not only the real interest rate on public debt but also the real return on pension fund investments. If the real interest rate and the return on equity were both to exceed the baseline scenario by 1 percentage point, the sustainability gap would be 0.6 percentage points smaller. Better pension fund returns would reduce the pressures to raise pension contributions, which would leave room for increases in central and local government taxation in the event of a weakening of the fiscal balance, as the total tax ratio is assumed to remain unchanged. This would also compensate for larger interest payments on public debt.