Demographic Uncertainty and Labour Market Imperfections in a Small Open Economy Juha Kilponen Bank of Finland Helvi Kinnunen Bank of Finland Antti Ripatti Bank of Finland This version June 16, 2006 Abstract This paper extends Gertlers (1999) tractable overlapping generations model by allowing for imperfect labour markets and distortionary taxation. Further- more, we allow for stochastic variation in demographic structure. The model is then used to study demographic change in a small open economy of Finland. The simulations highlight a key role played by labour market imperfections in determining a scal burden of ageing in dened benet pensions systems. Higher labour market imperfections lead into considerably stronger responses of labour supply and taxes on ageing. Thus, imperfections magnify the prob- lem associated with scal sustainability in ageing society. Stochastic simulations suggest that lengthening of working time has rather minor impact on alleviat- ing the scal burden of ageing: Only a small fraction of stochastic variation in endogenously determined contribution rate is explained by the stochastic vari- ation in the length of working time. Variation in fertility rate is clearly much more important. 1 Introduction According to demographic trends, the old-age dependency ratio will almost double in Finland during the next 30 years. This generates a formidable burden on the pension system and long term scal balance. Several calculations detecting direct costs of ageing on scal balance indicate that pension expenditures share to GDP could raise roughly by 5 percentage points if the current pension system would prevail 1 . This would mean that contribution rates would need to rise several percentage points in order to fund the system. Demographic aging will also lead to an increased expenditure on social welfare and health care. Some estimates show that social services to elderly population would double during the next 30 years. To the extent that these services remain publicly funded and e¢ ciency gains remain moderate, the growth in the proportion of elderly people will further increase the tax burden of the working-age population and the public sectors share of the national economy. In addition, in Finland, additional tax burden on labour would be particularly detrimental for economic growth, given that tax burden on labour is already now at a very high level in An earlier version of this paper was presented at the European Central Bank in December 2005 and at the Annual Meeting of the Finnish Economists in February 2006. We are indebted for many valuable comments from the participants and in particular, our discussant Mika Kuismanen at the ECB. Usual disclaimer applies. Corresponding author: juha.kilponen@bof. 1 See for instance Lassila (2005) 1