The Aging Population and the Size of the Welfare State: Is There a Puzzle?

Razin, Sadka, and Swagel (2002) unveil a puzzling fact: the welfare state appears to be shrinking even as the dependency ratio rises. While they formulate an elegant political economy model to explain the coexistence of an aging population and declining transfers, the resolution of the puzzle turns out to be much simpler. Labor tax rates and per capita transfers are negatively correlated with the dependency ratio in advanced economies only because this measure includes children as well as retirees. Both labor tax rates and per capita transfers in advanced economies are, in fact, historically positively correlated with the ratio of retirees to the working-age population and negatively correlated with the ratio of children to the working-age population. Increasing the number of retirees shifts preferences toward higher taxes and transfers by increasing the fraction of the population that receives transfers. In contrast, workers with more children prefer to spend more of their lifetime income while raising dependents, so they prefer smaller public pension systems. These results suggest that fiscal leakage from workers to retirees is not required to explain the broad trends in the transfer policies of advanced economies.