This chapter focuses on the impact of ageing on public pension expenditures and of changes on labour markets on the accumulation of pension rights. It first analyses demographic and labour market trends and then assesses the evolution of pension spending. New pension spending projections are presented and compared with official projections. Different options for policy reforms to close the financing gap are simulated, including an increase of the statutory retirement age, pension indexation rules and tax reforms to increase financial resources of the pension system. The chapter concludes with policy recommendations to improve the financial sustainability and income adequacy of the pension system.
OECD Reviews of Pension Systems: Czech Republic
OECD Reviews of Pension Systems
2. Assessing the financial impacts of ageing
Abstract
2.1. Introduction
The Czech Republic is ageing fast as many countries in the European Union. The number of elderly people will, according to the Czech Statistical Office population data, increase by more than 50% between now and 2059. In the meantime, the working-age population will decline by 18% in 2059 compared to 2019. Therefore, the economic old-age dependency ratio will increase from 0.39 in 2019 to 0.59 in 2059. The increasing statutory retirement age has so far limited the impact of ageing on pension spending. However, ageing is expected to have important effects on age-related public spending, namely, pensions, health and long-term care expenditures.
This chapter assesses the impact of ageing on pension expenditures and of changes on labour markets on the accumulation of pension rights. In the labour market, different forces contribute to lowering the participation of some categories. In particular, labour participation of women with children is low in the Czech Republic compared to EU countries. Migration is also limited. Structural policies that increase the labour force would help raise potential economic growth and reduce the share of pension spending in GDP.
A detailed cohort model was developed to simulate and project future pension spending. It incorporates demographic developments and labour market dynamics to estimate and simulate the evolution of the pension system, in particular, the number of old-age pensioners and disability pensioners. It allows to simulate different policy options to close the financing gap of the pension system. In particular, increasing the retirement age, indexing pensions on inflation, and increasing the contributions of the self-employed are simulated.
Pension spending is projected to increase to 11.9% of GDP in 2060 from 8.2% in 2018, leading to increasing deficits of the pension system. To cope with this financial strain, reducing pension levels does not seem adequate as Czech pension levels are relatively low compared to many OECD countries. Among the different options to close the financing gap, further increasing the retirement age after 2030 in line with life expectancy gains appears to be the most efficient measure to boost growth and reduce the financing needed. However, additional measures would be needed to close the financing gap of the pension system. For instance, increasing government budget transfers could finance the redistributive component of the pension system. To finance the additional resources needed the simulations indicate that increasing profits and corporate income taxes would have less negative impacts on GDP and employment than increasing social contributions and value added tax. Increasing social contributions should be avoided, as they are already high and could start to have detrimental effects on employment. Indeed, the Czech Republic’s tax wedge is among the highest across the OECD and the average rate of employers’ social contributions is the second highest.
The structure of the rest of the chapter is as follows: in Section 2.2, the evolution of the demography and the financial impact of ageing are assessed. In Section 2.3, structural policies that could increase the size of the labour force are analysed. Section 2.4 analyses the different policy options to close the financing gap of the pension system. Finally, the last section concludes and presents policy options.
2.2. Assessing financial challenges of the pension system
2.2.1. Ageing will weigh on pension spending
The elderly population is increasing
Population ageing is accelerating in the Czech Republic albeit at a slightly slower pace than the OECD on average. The elderly population in the Czech Republic, people aged 65 and over, will increase by over 50% between 2019 and 2060 (Figure 2.1). This increase will be higher for men – about 65% – than for women – about 40% – because male life expectancy is expected to catch up with that of women.
The Czech pension system reforms since 1996 have led to a progressive increase in the statutory retirement age, which will reach 65 years in 2030 based on current legislation. The statutory retirement age is the normal age of opening rights to a pension. There are, however, few exceptions allowing for early retirement. The large increase in the population aged 65 and over, by about 47% between 2000 and 2019, only induced an 18% increase in the population at or beyond the statutory retirement age. The planned increase in the statutory retirement age will continue to contain the growth in the number of potential retirees, especially among women. The number of women at or above the statutory retirement age is expected to slightly decrease between 2020 and 2030.
Figure 2.1. Population at or above the statutory retirement age (SRA) by gender
Source: Calculations from the Czech Statistical Office data.
The working-age population is declining
In the meantime, the population aged between 19 and 64 years is expected to decline in the Czech Republic by 18% between 2019 and 2059 (Figure 2.2). However, the working-age population, defined between 19 and the statutory retirement age, with the planned increase in the statutory retirement age force will remain relatively stable until 2030, before trending down slowly until 2040 and faster afterwards. More precisely, the working-age population will increase slightly in the decade to come and peak around 2029 before declining by about 13% below the 2019 level.
Figure 2.2. Projections of the working-age population
Source: Calculations from the Czech Statistical Office data.
The evolution of the dependency ratio is unfavourable to the pension system
One measure of the old-age dependency ratio is the ratio of the population at and over the retirement age to the working-age population (19 to retirement age). Another measure is the demographic old-age dependency ratios based on a fixed age boundary, e.g. of 65 years. The purely demographic measure has been sharply increasing. However, taking into account the increase in the statutory retirement age, the economic dependency ratio will remain stable until 2035, before increasing until the late 2050s. The dependency ratio is expected to increase from 0.39 in 2035 to 0.59 in 2060, i.e.by 50% (Figure 2.3).
Figure 2.3. The old-age dependency ratio is increasing
Source: Calculations from the Czech Statistical Office data.
2.2.2. Pension spending is projected to increase
Public pension expenditures as a share of GDP are expected to rise in most OECD countries (Figure 2.4). According to EU projections (European Commission, 2018), the Czech Republic is among the countries with the highest expected increase in pension spending. Projections by Guillemette (2019[1])(2019) also confirm an increase of pension spending in all countries but the United Kingdom and Greece. While EU projections are based on country-specific models, Guillemette’s estimates are based on a more aggregate approach also taking into account changes in employment and labour force due to ageing. One key assumption explaining the differences between the two approaches is the projections of the average benefit ratio (average of all pensions in payment over the average wage). In the EU projections, legislated rules of pension indexation are used, implying in most countries a limited increase in pension levels or a decrease in the benefit ratio. In Guillemette (2019[1]), it is supposed that these limited increases in pension levels or decreases of the average benefit ratio are not realistic. The baseline assumption in Guillemette (2019[1]) is to hold constant the benefit ratio for most countries including the Czech Republic, explaining higher pension spending increases in many countries. The Czech Republic’s pension spending is expected to rise from 8.2% of GDP in 2016 to 11.6% and 12.7% of GDP in 2060 by the EU (2018) and Guillemette (2019[1]), respectively.
Figure 2.4. Pension expenditures are projected to increase in almost all OECD countries
Note: 2050 for Australia, Canada, Iceland Israel, Japan, Korea, Mexico, New Zealand, Switzerland, Turkey and the United States.
Source: (Guillemette, 2019[1]; European Commission, 2018[2]); Standard & Poor’s (2016 and 2013), for Canada, Iceland Israel, Japan, Korea, Mexico, New Zealand, Switzerland, Turkey and the United States and for Australia: 2015 Intergenerational Report Australia in 2055.
In order to quantify precisely different pension reform options, a cohort model and a macroeconomic framework have been developed (see Box 2.1 and, for more details, the technical background paper: Fall (Forthcoming[3])).
The cohort model simulates the career path of a sample of representative workers from age 19 to the statutory retirement age. It takes into account participation in the labour market, employment and unemployment status and determines each year the wage of workers. It also calculates the number of contribution periods validated taking into account education and unemployment periods validated and the number of children for women. Disability status is also determined based on projections of disability probabilities using recent trends. To increase the accuracy of the status in the labour market, projections take into account the level of education by gender.
According to the simulations made with the cohort model, pension spending will remain stable around 8.4% of GDP until 2030. It will then increase progressively to peak at 11.9% of GDP in 2059 and then decline slightly until 2070 (Figure 2.5). The increase in the retirement age, which will reach 65 years in 2030, is holding back pension spending. After 2030, the increase in pension spending follows the increase in the size of the elderly population.
Figure 2.5. Projections of pension spending by schemes in percentage of GDP
Note: The figure represents the pension spending by schemes put on top of each other so that the top of the bar of the last category (survivor) indicates the level of total spending.
Source: OECD simulations, Cohort model.
Comparing official EU/Ministry of Finance projections to the cohort model shows a similar dynamic of pension spending between now and 2070 (see Table 2.1 and Table 2.2). In both projections, pension spending in terms of GDP ratios are projected to be stable over the next 10 years, before increasing. In both projections, the pension spending will increase by 3.5 percentage points of GDP by 2059, the peak year, in EU projections and by 3.3 percentage points in the cohort model. However, in the cohort model, the impact of the COVID‑19 crisis on GDP in the short run is taken into account, which increases the pension to GDP ratios in the first periods of the projections. After 2060, pension spending is projected to decrease as big cohorts born in the 1970s leave the pension system and, to a lower extent as the average validated contribution period declines.
Table 2.1. EU projections of pension expenditure
Percentage of GDP
Note: The baseline scenario is computed with the fixed ceiling on statutory retirement age. The last row represents a scenario linking the statutory retirement age to the life expectancy.
Source: European Commission (2018).
Table 2.2. Pension spending simulated by the cohort model
Percentage of GDP
Source: OECD simulation, Baseline of the cohort model.
Box 2.1. A simulation framework to project the spending of the Czech pension system
The simulation framework has two components, a macroeconomic model to project the evolution of GDP up to 2070 and a cohort model to project the different schemes of the pension system.
A long-term general equilibrium model is developed including the evolution of the labour force. The model takes into account the impacts of long-term factors on unemployment and GDP, especially demography, productivity and structural factors.
The cohort model simulates the career path of a representative sample of the working-age population and their path in retirement. It is calibrated to match the main features of the labour market and of the pension system. In particular, wage careers are precisely simulated. The cohort model allows to simulate precisely the rules of the pension system, to incorporate non-linearity in the rules (on contributions and wages) and to produce the distributional impacts of reforms.
More precisely, the model simulates for each generation 2000 nationals and 94 immigrant persons, split equally between women and men, and aged each year from 19 to 64 years (94230 individuals in total). Each individual is weighted in the model to reflect the mortality profile. These individuals live from the age of 19 to 99 in the model, subject to expected mortality. The model simulates the system from 1986 to 2070.
Figure 2.6. The cohort model’s structure
Source: Fall (Forthcoming[3]), “A simulation Framework to project pension spending: the Czech Pension System”, OECD Economics Department Working paper.
The model simulates the career of individuals from the age of 19 to 69, with one observation per year, for labour market participation, unemployment, disability status, self-employment status and wage. Wages are drawn randomly with their level depending on age, gender, disability status and education.
The different sources of validation of contribution periods include contributed periods for employees and self-employed, education periods and maternity and parental leaves for women.
Survivor and disability schemes are simulated based on projections of estimates of current probabilities to be disabled or a widower/widow.
The retirement decision is based on the length of contributions, which is a by-product of the career. Individuals are assumed to retire as soon as the mandatory contribution period and the retirement age are reached, reflecting that only a tiny fraction of each cohort actually choses to work longer. The level of pension is determined according to actual rules.
Figure 2.6 illustrates the structure of the cohort model and the different steps of the simulation. There are four main steps. The first step draws the main characteristics of individuals entering the labour force, including their level of education. The second step simulates the career path by determining each year participation to the labour market, type of activity (employee or self-employed), employment status and wages. The third step determines the number of contribution periods validated. The last step applies the retirement decision rule and establishes the pension status and level.
As for any projection and simulation, there are assumptions and methodological choices that may affect the results at the margin. Overall, the projections are robust but may deviate from other projections due to differences in methodology and assumptions. For instance, our random drawing strategy creates some variance in the distribution of variables like wages, participation and unemployment thus affecting the number of contribution periods validated. Also, we use a yearly modelling strategy which may minimise infra-year retirement decision. Moreover, due to lack of information, some elements like periods validated for family care and military careers are not included, however, that is comparable to EU projections. Moreover, the COVID-19 crisis may have long run effects on potential output which are not taken into account.
2.2.3. There is little room to increase pension contributions
The Czech pension system needs additional resources to cope with the impact of ageing. The financing of the public pension scheme is wage-based social contributions transiting through the government budget. There is no clear separation between the government budget and the pension scheme account. Therefore, the space for reforming the financing of the pension scheme to cope with the spending pressure due to ageing might imply changes in government financing.
The structure of government revenues is unbalanced, with a heavy reliance on social security contributions. While government tax revenues were 35% of GDP in 2018, social security contributions were almost 15% of GDP (Figure 2.7). In terms of collected social security contributions, the Czech Republic ranks among the highest countries across the OECD. At the same time, personal income tax revenues are low (Figure 2.7, Panel B).
Figure 2.7. An unbalanced structure of government revenues
Source: OECD (2019), Revenue Statistics database.
Value added tax (VAT) revenues are above the OECD average, but the revenues on goods and services are more similar to the OECD average (Figure 2.8), indicating that the Czech Republic raises relatively fewer excise duties (possibly on fuels and environmentally related taxes). This revenue structure relies heavily on payroll-based taxes compared to many OECD countries where a shift toward a broader tax base has been initiated on the back of lowering wage costs.
Figure 2.8. An unbalanced structure of government revenues (continued)
Source: OECD (2019), Revenue Statistics database.
The tax wedge is among the highest across the OECD and the average rate of employers’ social contributions is the second highest (Figure 2.9). The tax wedge is the sum of personal income tax and employee and employer social security contributions together with any payroll tax less cash transfers, expressed as a percentage of labour costs for a single person on average earnings. It expresses the average wage-based contributions and the fiscal burden supported by workers. Up to now, this has not been detrimental to labour market performance, in particular to employment, only because the average wage is low compared to other EU countries. Indeed, the Czech Republic has built its comparative advantage by holding wages low to attract foreign direct investment, in particular in manufacturing industries. However, as wage convergence towards OECD and EU averages is continuing and given the recent acceleration of wage growth, the high level of wage taxation could become burdensome. With higher wages, the tax wedge could lower the wage comparative advantage, in particular in the manufacturing industry. It could also affect the structure of employment as firms will be incentivise to substitute labour for capital.
Figure 2.9. The fiscal burden on labour could be lowered
Note: Single person without child earning 100% of average earnings.
Source: OECD (2019), “Taxing Wages: Comparative tables”, OECD Tax Statistics (database).
Given the high level of tax wedge and social contributions, there is little room to increase social security contribution rates in the current settings. The pension contribution rate is high at 28% of the payroll. One aspect of the pension system is to mix contributory and non-contributory benefits blurring the accounting of the pension system. Separating the pension system’s accounts from government accounts would increase transparency and clarify the financing of the different benefits. For instance family-related elements of the pension system represent around 5% of old-age pension spending and should be financed from government budget transfers to the pension system (Table 2.3). Indeed, the rationale behind the financing of family-related elements of the pension system by pension contributions is not straightforward. Family policy, which benefits the whole society, should/could be financed by a broader base including all types of revenues, and not only wages.
Table 2.3. Share of family and disability benefits in pension spending
Source: Simulations from the cohort model.
2.3. Policies to expand the working-age population
2.3.1. Increasing female labour participation
Increasing the labour force participation will raise potential GDP and alleviate the weight of pension expenditures on public finances over time. Labour market participation has been increasing in theyears before the COVID‑19 crisis as the economy was booming and experiencing shortages in the labour market. The employment rate in the Czech Republic is above the OECD average. Nevertheless, the employment rates of the young (15‑29‑year olds), older persons, people with disabilities and mothers of young children still record significant gaps to those of prime age men (OECD, Forthcoming[4]).
In particular, while the employment rate between men and childless women differs only slightly, female labour force participation drops once women have children (Figure 2.10). The difference between the employment rate of women aged 25‑49 without children and women with children under the age of six in 2016 exceeds 30 percentage points (Figure 2.11). This places the Czech Republic among the three EU countries (together with the Slovak Republic and Hungary) with the most significant consequences of childbirth on mothers’ employment. The break in the employment history of mothers further translates into both gender gaps in the overall employment rate and low earnings.
Figure 2.10. Age-employment profile by sex, 2018
Source: OECD Employment database.
Figure 2.11. Employment gap of women with children
Note: Mothers with young children refer to working-age mothers with at least one child aged 0 to 14 years.
Source: OECD (2018), Good Jobs for All in a Changing World of Work: The OECD Jobs Strategy, https://doi.org/10.1787/9789264308817-en.
The long break in young mothers’ employment is partly due to parental leave rules, which do not incentivise resuming work. Spending on maternity and parental leave is the highest among OECD countries, reflecting a public policy preference for home care over formal childcare. Spending on cash benefits are at around 2.4% of GDP among the highest in the OECD, while spending on childcare servicesrepresents only 0.5% of GDP (OECD, 2018[5]). Despite recent efforts to increase access to childcare facilities, childcare supply remains limited. Rebalancing the generous cash benefits for childcare toward more childcare facilities would help women with children participate in the labour market while reducing the incentives to stay at home.
In addition, long parental leaves might reduce women’s participation to the labour market. The maximum length of entitlement for parental allowance is until the child is aged up to three years. Childbirth and long maternity/parental leave affect the career opportunities of women. Re-entering the labour market after taking parental leave seems to be especially difficult. Returning to work is partly hindered by inflexible work arrangements, and about 60% of women with children up to six years became unemployed immediately after their parental leave. In 2016, only 9.8% of working women in the 20‑64 age group worked part-time, most of them mothers with children of up to six years (OECD, 2018[5]; Forthcoming[4]). Increasing the flexibility of jobs by providing and enforcing existing rights for part-time work, flexible teleworking arrangements and shared jobs can support the re-entering of skilled females into the market.
2.3.2. Trying to raise fertility rates further
The fertility rate has been increasing since the low point in 1999 at 1.13 child per women. In 2018, the number of children per women was about 1.71 (Figure 2.12). According to official projections, the fertility rate will converge to 1.74 in the long-run, assuming that fertility among young women will continue rising at the rate observed during the last eight years for another eight years before stabilising. However, assuming for instance that the upward fertility trend lasts for 15 years would lead to a long-term fertility rate of 1.83. Such levels are far from being unrealistic as they match the most fertile countries in the EU (Table 2.4).
An increase in fertility rate, in the next five years, would bring more people in working-ages before the projected peak in ageing spending in 2059. Current government family policies, though focusing on cash benefits, have the potential to boost maternity. However, facilitating access to childcare services would encourage, in particular, high-skilled women to give birth as in EU countries like France.
Figure 2.12. The fertility rate is increasing
Source: The Czech Statistical Office.
Table 2.4. Total fertility rates in 2018 in selected European countries
Source: Eurostat.
2.3.3. Facilitating migration
Migrants affect pension prospects mainly through their impact on both the workforce and the number of pensioners. To compensate for labour shortages in the context of an ageing society, policies can attract skilled labour into the Czech Republic. However, attracting foreign workers from outside the EU faces several challenges, including language barriers and current migration policies. By 2015, most newly arrived migrants were from Eastern Europe, i.e. from the Slovak Republic, Ukraine and Russia. In November 2015, a special migration procedure was introduced for high-skilled workers from Ukraine. This project “Special Procedures for Highly Qualified Workers from Ukraine” gave participants priority access to embassies when applying for the Employee Card. The number of beneficiaries was augmented regularly in recent years to cope with shortages in the labour market.
Migration policies should be reconsidered to attract workers from countries other than Ukraine and Eastern Europe. Programmes were put in place to attract workers from Mongolia and the Philippines. Easy accessible information about educational degree verification, work opportunities and the availability of language courses could raise awareness among skilled workers to consider the Czech Republic as a destination. Already, in 13 out of 14 regions of the Czech Republic regional centres for support of the integration of immigrants to co-ordinate the efforts of local authorities, NGOs and other stakeholders have been set up to provide among other things language courses, information, advice, cultural events, welcome and orientation courses. These efforts should be scaled up to facilitate the integration of workers and their families.
2.3.4. Coping with labour market developments
Industry’s contribution to GDP in the Czech Republic is one of the largest across OECD countries (32% of GDP). The country has benefitted in recent years from the booming manufacturing sector, which has reduced unemployment to record lows and driven high wage growth. Looking forward, technological change presents risks that could affect the manufacturing sector and therefore the structure of jobs, level of employment and accumulation of pension rights. Technological change can also lift incomes and create new types of jobs.
Realising the opportunities from automation, digitalisation and robotisation will require overcoming their challenges
New technologies also generate large number of jobs. Automation, digitalisation and robotisation are essential for ongoing productivity change. However, they can destroy many jobs, in particular in the industrial sector. The OECD estimates that the share of jobs at high risk of automation (i.e. those with a probability of being automated of at least 70%) is around 14% on average across the OECD (OECD, 2019[6]) (Figure 2.13). The Czech Republic ranks slightly above the OECD average with 15.5% of jobs at high risk of automation. Nevertheless, those who lose their jobs out of automation may not be the beneficiaries of newly created jobs if not prepared or re-skilled adequately. Keeping those people in employment is essential for the accumulation of pension rights and for maintaining participation rates.
Figure 2.13. Jobs at risk of automation in OECD countries
Note: Jobs are at high risk of automation if the likelihood of their job being automated is at least 70%. Jobs at risk of significant change are those with the likelihood of their job being automated estimated at between 50 and 70%. Data for Belgium correspond to Flanders and data for the United Kingdom to England and Northern Ireland.
Source: OECD Employment Outlook 2019.
Moreover, countries with relatively low labour costs have witnessed a slower process of automation and for that reason, do not display a similar pattern of job polarisation as more industrialised countries (OECD, 2019[6]). As a relatively low-wage country, the Czech Republic so far has not experienced important investment in labour replacing technologies. Nevertheless, as wages converge to the EU average, there is a risk of further development of automation and job destruction, leading to higher unemployment and lower accumulation of pension rights.
Moreover, the Czech labour market is shifting towards higher-skilled employment. Since transitioning from central planning, the service sector has expanded and manufacturing has become tightly integrated into global value chains, changing the skills needed in the labour market (OECD, 2014[7])). Sectors such as manufacturing, IT and business services will continue expanding, creating new jobs. Employment projections from CEDEFOP (2017) suggest that the need for high-skilled workers will increase, whereas the demand will decrease in low and middle-skilled employment. Antal et al. (2015[8]) who showed that low-skilled jobs are at the greatest risk find similar results. By contrast, the demand for highly skilled workers, especially those with a technical education, is found to increase. Providing workers with the right skill set and training to adapt to a changing environment will also increase the resilience towards automation.
Ensuring non-standard workers also accumulate pension rights
Career length is an important factor for pension entitlements and, short and interrupted careers usually lead to lower pension levels. Pension entitlements are not equally sensitive to incomplete careers across the OECD, however. Non-standard forms of employment encompass all forms of work that deviate from the “standard” of full-time, open-ended contracts with a single employer (OECD, 2019[6]). They include, therefore, workers with temporary jobs, part-time contracts, and those who are self-employed. Many forms of non-standard work are associated with reduced (or no) access to employer and social benefits, and with lower accumulation of pension rights.
The Czech Republic has not experienced so far an important development of these non-standard forms of work, except for self-employment (OECD, 2019[6]). While temporary employment has increased in half of the OECD countries, it remained stable in the Czech Republic at around 10% between 2000 and 2017. Part-time work is also very low in the Czech Republic, but that may not be seen as a positive indicator as part-time work is often associated with higher labour participation of women with children and old-aged workers. The low development of these non-standard forms of work is associated to the high share of industry in the economy, which in general provides standard forms of employment. The development of non-standard forms of work in many OECD countries is correlated with the expansion of the service sectors and new form of jobs (OECD, 2019[6]).
Part-time workers in the Czech Republic are covered by the general social protection scheme, as are workers in standard employment. The social security contribution rate is identical at 28% for all types of employment contracts, be they part-time or full-time. A low minimum level of earnings equal to 8% of the average wage is imposed for pension entitlements. Given the share of the basic pension component in the total pension, the incidence of these non-standard forms of work on pension levels is limited in the Czech Republic.
Self-employment is high
After the democratic revolution, the number of self-employed workers increased substantially, encouraged by attractive tax and social contributions treatment. The Czech Republic had around 1 million self-employed workers in the mid‑90s. The number of self-employed workers has been stable, but their share in total employment increased by 2 percentage points between 2000 and 2017, to 17%.
The Czech pension scheme is relatively generous for the self-employed. There is an important redistribution within the pension system from employees to the self-employed. Theoretical pensions of the self-employed relative to employees reach around 80% in the Czech Republic (see Figure 1.27 in Chapter 1). The justification of such policy is not clear. In addition, given the development of new forms of work such as platform-related jobs, the number of own account/self-employed workers may increase substantially. This calls for reforming the contribution base of the self-employed (Chapter 1).
2.4. Pension reforms are needed to ensure financial sustainability
Different options of policy reform exist to cope with the impact of ageing on public finances. In particular, increasing the retirement age reduces the number of age cohorts in retirement while augmenting the labour force. Indexing pensions in payment on price inflation would reduce spending while preserving the purchasing power of retirees, but it would raise the income gap between retirees and workers. Increasing contribution rates and taxes make workers carry a large burden of financing the impact of ageing. Specific changes to the pension rules can also be made that would affect the level of the first payment by changing for instance the assessment base, the uprating of past wages or the accrual rate (see Chapters 1 and 3 or the proposals of the Fair Commission on Pensions).
The choice between these options is a policy decision that ultimately reflects the degree of fairness and redistribution desired. The simulation exercise focuses on the main parameters to give an overview of the different routes that could be taken to close the financing gap driven by ageing. Due to the planned increase in retirement age until 2030, pension spending will remain stable in the next decade and will start to increase slowly before accelerating from 2040. This dynamics of pension spending allows to introduce reforms that will progressively affect spending and/or revenues.
2.4.1. Increasing the retirement age
The current planned increase in the statutory retirement age to 65 in 2030 is prolonged to 67 after 2030. The simulation takes into account the impact of the increase in the retirement age on the active population and on GDP. However, no changes in labour productivity is introduced.
In the increasing retirement age scenario, the projected spending would be stable until 2040 before rebounding and reaching a peak in the late 2050s, albeit at a lower level compared to the baseline: in 2050, pension spending would be lower by 1.1 percentage points of GDP. In 2059, the peak year of pension spending, the reform would lower spending by 0.6 percentage point (Figure 2.14). The impact of increasing the retirement age on spending is higher between 2035 and 2060, it diminishes over time as big cohorts of retirees born in the 1970s leave the pension system.
Figure 2.14. Projection of pension spending with increasing retirement age to 67
Source: OECD simulation, Cohort model.
These projections include the increase in pension levels induced by higher retirement ages. Under the assumptions that employment and participation rates are translated fully to higher retirement ages, individuals will on average accrue more contribution periods and pension rights. The pension replacement rate, defined as the ratio of newly granted pensions on average wage, would increase on average by 3 percentage points over the projection period (Figure 2.15). Therefore, increasing the retirement age improves the adequacy of the pension system. Also, increasing the retirement age will increase the revenues of the pension system as more people contribute and for longer. Overall, increasing the retirement age will thus reduce the deficit of the pension system (see Fall (Forthcoming[3])).
Figure 2.15. The pension replacement rate increases with retirement age
Source: OECD simulation, Cohort model.
2.4.2. Indexing pensions with inflation
Another reform option is to change the indexation of pensions. In the current legal framework, pensions are indexed with inflation and half of real-wage growth. An alternative scenario would consist in indexing pensions with inflation, preserving only their purchasing power. Overall pension spending is significantly lower when the real-wage indexation component is removed. At the peak in 2059, pension spending would be 0.9 percentage point of GDP lower than in the baseline (Figure 2.16). This impact is comparable to that from increasing the retirement age.
However, in recent years, pension indexation has been more generous than the indexation rule. Guillemette (2019[1]) projections based on estimates of past pension indexation behaviour found that pension spending would reach 12.7% of GDP in 2060 in the Czech Republic. When assuming that old-age pensions are fully indexed on nominal wages in the future, pension spending would reach 13.1% of GDP in 2060 in the cohort model. These simulations underline that indexation is an important tool for pension finances.
Figure 2.16. Indexation of pensions with inflation will reduce expenditures
Source: OECD simulation, Cohort model.
2.4.3. Increasing fiscal resources for the pension system
The macroeconomic framework allows simulating increases in taxes on labour, corporate income and value added tax (VAT). One can compare the effectiveness of these policy options by computing the effects of raising each tax separately so that additional revenues collected (ex ante) would represent 1% of GDP. Tax increases have negative effects on the macroeconomic aggregates, which tend to decrease all types of public revenues (Table 2.5). There are negative effects of increasing any tax. For a tax increase targeting 1% of GDP of additional revenues ex ante, the net additional revenues is only between 0.4% to 0.5% of GDP ex post, while wages and employment both decline by 2%, which represents a 4% drop in labour earnings as a whole.
Increasing the value-added tax (VAT) appears to be the less efficient scenario as a large share of household income, and thus consumption depends on labour earnings. At the same time, VAT is levied on investment goods, and thus, a higher VAT increases the cost of capital, so that it is at the same time depressing supply and demand.
Comparable increases of corporate taxes or social contributions are likely to bear the same effect overall on GDP and public revenue collection. However, the negative effect of increasing taxes on corporate earnings on employment is lower than the effect of increasing social contributions.
Because the model functions at the margin, it is linear and one can add the columns of Table 2.5 to analyse the mix of fiscal measures. For instance, shifting part of social contributions to additional taxes on corporate income or other capital income would allow for a given level of public revenue to reduce the pressure on labour tax and thus to boost employment.
Increasing the progressivity of income taxes or differentiating the corporate taxation with size are other options that could be considered. However, high tax collection through progressivity raises distortions and efficiency issues, and therefore needs to be carefully designed. The evaluation of the impact of such reform is beyond the scope of this pension study.
Table 2.5. Long-run impact of tax increases on GDP and tax revenues
Note: The table presents the long-term effects of an increase in three types of taxes so that additional revenues before the economy adjust would represent one GDP point. For the corporate tax, such a policy would imply to increase the effective tax rate by 2.2 percentage points (from 5.5%). The long run GDP level would fall by 1.7% compared to where it would have been without the policy, while employment would decrease by 0.8% compared to the baseline scenario and the unemployment rate would increase by 0.6pp – going from 3% to 3.6%. Real wage growth would decrease by 0.9% from the baseline scenario. After the economy would have adjusted to the new measure, the total public revenues collected would be 0.5 percentage points of GDP higher compared to what would have occurred in the absence of tax increase.
Source: Simulations from the macroeconomic framework (Fall, Forthcoming[3]).
2.4.4. Increasing social contributions of the self-employed
A macroeconomic assessment of increasing the social contributions of the self-employed indicates that it is likely to reduce employment and have negative effects on GDP as well (Table 2.6). Increasing social contributions for the self-employed, by expanding their tax base, would have, however, less damaging effects than raising the social contribution rates for all workers. However, a thorough assessment of the effects of changing the taxation of the self-employed requires individual data, and is beyond the scope of this study. For a given gross labour income, the self-employed are indeed less taxed, as they can deduct a large share of their income as costs from their tax base. As a result, their effective social contribution rate is much lower than that of employees.
2.4.5. Relaxing the mandatory contribution period
The mandatory 35 years of validated contribution period or 30 years of contributed period to be eligible for a pension will start to be binding in the late 2050s. The simulations show that on average around 10% of a cohort could reach the statutory retirement age without fulfilling the contribution period requirement (Fall, Forthcoming[3]). Though this is a projection and is subject to variations of career paths depending on the future of the labour market, it gives an indication on the degree of strictness of the contribution period requirement. An alternative is to allow the possibility to retire at the statutory retirement age but with a pension proportionated to the validated contribution period. Relaxing the mandatory contribution period, once the statutory retirement age is set at 65, will increase spending by slightly less than 0.2 percentage point of GDP while revenues will only marginally be affected.
Table 2.6. The impacts of the different policy options
Note: 1) The net effective impact on the deficit is slightly lower if the changes in spending to GDP ratio is taken into account.
Source: Calculations from the cohort model and the macroeconomic framework (Fall, Forthcoming[3]).
2.5. Policy options
2.5.1. A need to reform the pension system
The number of old-age people is projected to increase by about 50% between now and 2070. In the meantime, the working-age population, aged 19 to 64 is expected to decline in the Czech Republic by 18% in 2059 compared to 2019. The old-age dependency ratio, defined by using the retirement age as the age boundary, is expected to increase by 50% between 2035 and 2060. However, given the planned increase in the statutory retirement age by 2030, the dependency ratio will remain stable up to 2035.
As confirmed by the simulations, pension spending is projected to increase by 3.3 percentage points by 2060 at 11.9% of GDP. This trajectory calls for a phased-in reform of the pension system to increase its revenues or reduce its spending. Among the different options to help close the financing gap, increasing the retirement age in line with life expectancy gains appears the most efficient component that will need to be completed by other measures. It also has the potential to boost growth.
2.5.2. Rebalancing financing sources and increasing government budget transfers
The financing sources of the public pension system presents some limits. Firstly, by contrast to most OECD countries, it is currently solely wage-based social contributions covering contributory and non-contributory benefits. This leads to an unbalanced structure of government revenues, which heavily rely on social security contributions. While general government tax revenues amounted to 35% of GDP in 2018, social security contributions were almost 15% of GDP. Secondly, there is no clear separation between the government budget and the pension scheme account. This limits the transparency and accountability of the pension system. The non-contributory components of the pension scheme, in particular family benefits, weigh on pension expenditures financed through wage contributions. There should thus be an effective separation of the pension scheme’s account and the government budget. This would allow to clarify the transfers from government budget to cover family and other benefits decided by the government. The simulations indicate that increasing corporate or capital income taxes might be the most indicated instruments to finance increased government transfers to the pension system to compensate for family benefits for instance.
2.5.3. Mandatory contribution period
The Czech Republic is an outlier by requiring that either 30 years are contributed or 35 years are validated to be eligible to an old-age pension, unless one retires up to five years after the statutory retirement age. So far, such a long required period has not been binding because of high-recorded employment for old generations and generous validation of non-contributed periods (education, unemployment and parental leave). However, the tightening of the validation of contribution periods, as for example the exclusion of years spent in secondary and tertiary education (from 2010), as well as labour market trends will raise the share of older people not fulfilling the mandatory contribution period. Pensions could be proportionate to the validated contribution period out of the required contribution period for a full pension. Therefore, those who reach the statutory retirement age without 35 years validated or 30 years contributed but do not want or are not able to wait five more years to retire would still have a reduced pension.
2.5.4. Preparing to labour market changes
Changes in the occupational structure driven by digitalisation and automation require a holistic policy framework to contain the risk of increasing inequality and lower pension rights. The social security system needs to adapt to new forms of employment and ensure adequate coverage for workers on non-standard work contracts. For instance, contribution rules of the self-employed should be better aligned with rules for dependent workers. Long-term strategies need to be complemented by short- and medium-term solutions focusing on skill upgrading of the existing workforce. As shifting the skill composition of the labour force through young entrants takes time, the current labour force should be provided with adequate training options to adapt to new skill demands. Vocational education should be further developed to play a significant role in overcoming skill mismatches through the involvement of employers to supply workers with the needed skill set.
2.5.5. Key recommendations
Phase in a reform of the pension system to cope with the expected increase in pension spending by increasing progressively the retirement age in line with life expectancy gains.
Separate budget and pension accounts and increase government budget transfers to the pension system to finance redistributive components of the pension system.
Reduce the length of the contribution period to be eligible to old-age pensions at the statutory retirement age and/or introduce a proportional pension to the validated contribution period out of the required contribution period for a full pension.
Further develop reskilling, vocational training and flexible systems to ease transitions from job-to-job and between sectors.
References
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[3] Fall, F. (Forthcoming), A simulation Framework to project pension spending: the Czech Pension System, OECD Economics Department Working paper.
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