The future of the Canada Pension Plan, financed on pay-as-you-go principles, is far from certain. Policymakers often express the opinion that as members of the baby boom generation approach retirement, the CPP will not be financially or politically sustainable in its current form because the costs of providing promised CPP benefits to this large cohort will be borne by a much smaller trailing cohort. The smaller cohorts may not be able to pay, or may choose not to honor, the levels of benefits promised by the current benefit formulas. These forecasts of demographically driven financial imbalances have encouraged debates over how to reform the existing pay-as-you-go CPP arrangement so that it will be sustainable. Proposed reforms for the CPP primarily involve reducing benefits provided and raising the taxes levied on labor income that finance the system in order to pre-fund future benefits. However, the underlying assumptions of these forecasts may be flawed, and the proposed reforms based on them may be misguided. In this paper we demonstrate in an overlapping generations framework how demographic factors not only affect the taxes required to finance the prescribed benefits, but may also affect wages. While there may be fewer workers supporting more retirees in the future, the incomes of those workers will likely rise substantially over the same time period, leaving them much better able to afford the required taxes.
Discussions of the impending crisis for the CPP focus on the increase in wage taxes necessary to pay the benefits promised under current CPP benefit formulas. A contribution rate of 3.6% prevailed from the introduction of the CPP in 1966 to 1986. Over the same period, the generosity of CPP benefits, and the extent of CPP coverage, increased. By 1993, the CPP contribution rate had risen to 5% and is expected to increase to 14.2% by 2030 (Government of Canada, 1996). This increase in taxes is troubling if real wages of workers trailing the baby boomers do not increase. However, if real wages rise in the future, then there will be a greater capacity to pay CPP benefits at the higher contribution rates. For example, Pesando (1993, p. 11) points out that if productivity "increases by just 1% per year, then by 2030 real income in Canada will be almost 50% higher than it is now, other things being equal. The capacity for the economy in 2030 to sustain the level of promised [CPP] pension benefits will be enhanced accordingly."(1) Thus, it is not clear that higher contribution rates for the smaller post-baby boom cohort to fund the currently "promised" Canada Pension Plan benefits mean that the pay-as-you-go arrangement is unsustainable, nor even that the following cohort will be worse off than the baby boom cohort.
Any conclusions we make about the future of a pay-as-you-go financed CPP depend crucially on what we believe about future productivity/real wage growth for another reason. Pay-as-you-go finance for social security arrangements like the CPP makes sense when the growth in real wages exceeds the real interest rate. The Federal/Provincial Information Paper on the CPP (Government of Canada, 1996, p. 19) explains that a reversal in this relationship over the last 30 years is the driving force behind the desire for reforming the CPP by raising contribution rates to pre-fund CPP benefits:
In the 1960s and 1970s, the growth in real wages and salaries was very high - 5.1% and 4.8%. It exceeded the real rate of interest. By the 1980s and continuing into the 1990s, this situation had reversed. Interest rates were higher than the growth of wages. Today, it would be imprudent to assume any change in that relationship for the foreseeable future. (emphasis added)
Several studies that link demographic forces and the slowdown in real wage growth and the rise of real interest rates provide a serious challenge to the belief that real interest rates will remain higher than real wage growth rates (e. …