How will Germany finance its ageing society?
Thursday, 12 January 2023
Hello from inside Germany,
Are you ready for a complex topic? No? I'm going to do it anyway. ;-)
Cause the topic is an important one.
Future well-being depends on it.
So the question today is how Germany should finance its social security system in the future.
Because it can hardly stay the way it is. More on that in a minute.
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First, here is how the system currently works in Germany:
There is social insurance against the major risks in life, such as unemployment, the need for care, old age and illness. This security is financed through the income from labour – as a proportion of the income. The higher the income, the more one has to pay.
Additionally, there is a basic provision called "Bürgergeld" ('citizens' money') for all those who have no income or assets and don't have social security claims. Bürgergeld – with the beginning of this year, “Arbeitslosengeld II” (unemployment benefit II) and “Sozialhilfe” (social benefit), were combined to form the new Bürgergeld – is funded by taxpayers.
Basic provision is not a problem from a financing perspective: the number of recipients has decreased over the past ten years.
The problem is social insurance.
Due to the ageing of German society, expenditures for pensions, care and medical treatment are increasing.
Employees already have to pay around 40 per cent of their income to social security.
Now a wave of retirement is about to start in Germany. Because the baby boomers born in the 1950s and 1960s will retire in the coming years.
As a result, more people will become recipients of benefits from the system, and fewer will finance it. The contribution rates for social security will therefore rise significantly.
There are four ways to deal with this development:
1. Do nothing. As a consequence, contribution rates would rise (probably to around 46 per cent in 2040), and work would become less attractive (both for employees, because net income will fall, and for employers, because labour costs will rise). The result would be less employment. However, since social insurance is financed through employment, the contribution rates would rise even more. A vicious circle would be set in motion.
2. Impose a cap on the contribution rate (e.g. 40 per cent), and finance all social security costs that go beyond through taxes. In part, we already have such a division: Every year, 100 billion euros are added to the federal budget to finance the statutory pension insurance. The disadvantage here: Such a system would be unsystematic and tend towards irresponsibility since employers and employees are no longer interested in spending discipline (they always pay the same share). In addition, taxes would have to be increased, or the mountain of debt would grow.
3. Include capital – as a production factor besides labour – in the financing of social security. From a systematic point of view, it makes little sense why only one of two production factors, namely labour, finances current social security. In this respect, capital income could and should also be used to finance social security. The problem: As systematic and financially helpful as it would be, iIt's basically impossible. Capital is fleeting. If capital were subject to excessive taxes and duties in Germany, it would look for another opportunity in the wide world of capital investments.
4. Decouple financing of social security from the production factor labour. That would be a complete departure from the current system, where social security is mainly financed through a share of earnings. If that were no longer the case, how would social security work then? What is conceivable: A basic security could be provided by the state (i.e. the taxpayer); additional social security would be bought individually. Of course, in such a system, the state would also have to ensure that insurance companies have the same risk premiums for everyone because otherwise, people with previous illnesses or hereditary diseases would not be able to afford additional insurance.
So those are the four ways that social security funding is going to change in the coming years.
Which development is likely?
Development four (decoupling from labour) is unlikely because it would mean not less but a revolution. Such a revolution is not in sight. The deterioration is too gradual, and the long-term consequences are still not very noticeable. But imagine a world where the financial results of work largely stay with the workers. How much more would people work then?
Development three (inclusion of capital) is practically impossible.
So most likely: Germany will continue to follow development one (everything stays the same) for a while and then – when pressure for rising contribution rates is increasing – will switch to development two (contribution cap).
That can work too.
This path can be successful if Germany continues to have many contributors to social insurance – through immigration into the labour market and through later retirement age. The statutory retirement age is currently 66 and will increase to 67 by 2029. There are no regulations for the time after that. But there are good reasons (people are living longer and healthier longer) why the retirement age should continue to rise thereafter. To 69 years in 2040, for example.
Today, politicians shun the debate about a higher retirement age like the devil shuns holy water. Because they assume the voters would punish an increase in age at the ballot box. But it won't be long before we can't avoid this debate. Not the voters, not the politicians.
The Strolling Economist
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