Like several other developed countries, Canada will face two significant economic policy challenges in the coming decades. Both will be driven by a single force: the gradual but inexorable aging of the baby boomers, a group so much larger than any earlier or later generation that its aging dominates the trend in the age structure of the Canadian population.

One projected effect from population aging is a decline in the labour-force participation rate and thus a decline in the growth rate of material living standards. In particular, average per capita incomes are projected to rise over the next 30 years at an annual rate roughly one-half the rate at which they increased over the past 40 years. This decline in the growth rate underlines the need for Canadians to think carefully about how we can stimulate future productivity growth.

A second projected effect relates to the fiscal position of Canadian governments. On the one hand, growth in gov- ernments’ tax base will slow due to the decline in labour- force participation. At the same time, population aging will create greater demands for health care expenditures and old-age income support programs. Governments will be forced to make difficult fiscal decisions, involving restraints on expenditure growth, higher rates of taxation or greater government borrowing.

During any given year, a country’s total population will increase if the number of births plus net immigration exceeds the number of deaths. Any isolated change in the birth rate, the net immigration rate or the death rate tells us not only how the population will grow but also, depending on which rate is changing and by how much, how the aver- age age of the population will change.

In particular, changes in the birth rate have a clear effect on the population’s average age. An isolated increase in a country’s birth rate will not only increase the popula- tion growth rate but, since people are always born at age zero, it must also decrease the average age of the population. Conversely, and more importantly for Canada’s future, a decrease in the birth rate reduces the population growth rate and increases the average age of the population.

Here we focus on the changing age structure of the Canadian population and the roles played by declining fer- tility and rising life expectancy. Changes in net immigration have had only a slight effect on the age structure of Canada’s population, and so they are ignored here.

As figure 1 shows, Canada’s population growth rate has been declining significantly for the past 60 years. In the two decades immediately following the Second World War, Canada experienced a significant ”œbaby boom,” when the average fertility rate in Canada was 3.6 children per woman. In subsequent decades, however, the birth rate in Canada declined significantly. This decline in fertility was mostly due to the large increase in the participation of women in the Canadian labour force, but significant cultural and reli- gious changes in Canadian society were also contributing factors. By 2008, Canada’s fertility rate had dropped to about 1.6 children per woman.

Figure 1 also shows that Canada’s population growth rate is projected to decline gradually over the next few decades, driven mostly by further gradual declines in the fertility rate. But even if Canada’s fertility rate were to rise modestly over the near future, there would still be a need to deal with the implications of the aging of the very large baby-boom generation. No realistic increase in the future fertility rate can offset the effects of the aging baby boomers.

Over the same postwar period, there has been a gradual increase in Canadians’ life expectancy. In 1950, the average newborn Canadian child was expected to live for 71 years, while today that number is 81 years. This ris- ing life expectancy has been due part- ly to an increase in healthier lifestyles and partly to improvements in med- ical and pharmaceutical technology. The rising life expectancy of Canadians plays a key role in driving the costs of the health care system, as per capita health care costs rise very significantly with age.

With these two key demographic forces at play, it is inevitable that the average age of the Canadian popula- tion has been rising. A falling fertility rate implies that fewer young people are entering the population, and this effect alone tends to increase the aver- age Canadian’s age. Rising life expectancy implies that Canadians are growing older before they die, and this effect also tends to increase the aver- age Canadian’s age. As these two forces continue, they will drive Canada’s population aging over the next several decades.

Figure 2 shows how the proportion of the total Canadian population accounted for by seniors (65 years and over) is projected to increase over the next three decades. This share is current- ly at 14 percent and will rise steadily with the aging of the baby-boom generation. By 2050, when most baby boomers will have died (as even the youngest baby boomers will then be 85 to 90 years old), the proportion of sceniors is projected to stabilize at roughly 26 percent.

The economy’s position in the business cycle is of central importance to annual changes in Canadians’ aver- age living standards. But to know why Canadians’ average income is so far above the level experienced by their grandparents or great-grandparents 75 or 100 years ago, the business cycle is irrelevant. Instead, the leading role is played by long-term productivity growth: the ongoing improvement in our ability to produce output from labour and other productive inputs.

The most commonly used measure of Canadians’ average material living standards is real per capita GDP " that is, the amount of output (or income) available for the average Canadian. This is measured as real GDP divided by the Canadian population (POP). Real per capita GDP is exactly equal to the product of three components. The first is the ratio of output to employment (GDP/E), a simple measure of labour productivity. The second is the ratio of employment to the size of the labour force (E/LF). The final component is the fraction of the total population that is in the labour force (LF/POP) " the labour-force participation rate. This overall relationship shows that changes in the three separate components determine the overall change in per capita output. For example, if labour productivity rises while the other two components are constant, per capita GDP must increase. Similarly, if the labour-force participation ratio declines while the other two compo- nents are constant, per capita GDP must fall.

In what follows, we focus on the first and third components because they are most relevant to the discus- sion of long-term population aging. The E/LF ratio (which is simply equal to 1 minus the unemployment rate) is quite volatile during business cycle fluctuations, but it shows no clear trend over long periods of time.

Not surprisingly, labour-force par- ticipation rates among Canadians 55 and over are well below those for Canadians between the ages of 25 and 54, as figure 3 shows for 2008 data. With the ongoing aging of Canada’s baby-boom generation, a growing proportion of the population will fall into the older age categories, thus reducing the economy’s overall labour-force participation rate. Figure 4 shows the overall labour-force partic- ipation rate from 1976 and projected until 2040, declining from over 67 per- cent of the population today to below 60 percent 30 years from now.

Using the labour-force behaviour from any typical year (such as in figure 3) as the basis for a projection many years into the future (as done in figure 4) is a common technique but one with potential problems because of the possibility of changes in indi- viduals’ behaviour. In particular, busi- ness cycle fluctuations or changes in the accumulated value of pension assets can be expected to lead to changes in labour-force participation rates. For example, after the financial crisis and associated stock market declines in 2008-09, many Canadians may have delayed their planned retirement dates until after their accu- mulated assets regain previous values. As significant as such changes might be in the short term, how- ever, they will only delay the inevitable retirement of aging Canadians. As fig- ure 4 shows, the projected decline in the aggregate labour-force participation rate will still occur, though perhaps a few years later than shown in the figure.

Consider again the three compo- nent parts of real per capita GDP. From any one year to the next, there is usu- ally an increase in labour productivity (GDP/E) of about 1 to 2 percent. Taken by itself, this productivity growth tends to increase our average income. The second component, the fraction of the labour force actually employed (E/LF), fluctuates considerably over the business cycle but is remarkably stable over longer periods of time, and thus plays almost no role in determining our long-run living standards. The labour- force participation rate (LF/POP) also fluctuates over the business cycle, but in addition it has important long-run trends driven by demographic forces, as is evident in figure 4.

It is then natural to ask, ”œWhat have been the dominant causes of growth in real per capita incomes over the past few decades?” The answer is that productivity growth and a rising labour-force participation rate have explained all of average income growth in Canada. Between 1971 and 2008, average real per capita income grew by 98 percent. Over the same period, labour productivity increased by 48 percent and the labour-force par- ticipation rate increased by 34 percent. In contrast, the E/LF component was almost exactly unchanged between 1971 and 2008. The rising labour-force participation caused by the maturing of the baby-boom generation has played a major role in raising Canadian living standards.

What does the future hold as the life cycle of the baby-boom generation drives Canada’s popula- tion aging? Other things being equal, the future decline in the labour-force participation rate shown in figure 4 will lead to a reduction in the growth rate of Canadian average incomes. Over the past 40 years, the coming of age of the baby-boom generation has tended to increase Canadian average incomes because it increased the frac- tion of the overall population that worked and thus generated income.

But the continuing aging and eventu- al retirement of this same generation will have the opposite effect in the future. The declining proportion of the population at work will offset the effects on living standards of ongoing productivity growth.

Figure 5 shows how markedly the sources of real per capita GDP growth (GDP/POP) will change from the past to the future. Between 1971 and 2008, real per capita GDP increased by about 1.9 percent annually, and this growth came only slightly more from productivity growth (GDP/E) than from the rising labour-force participa- tion rate (LF/POP). (As already stated, the changes in E/LF accounted for no part of this growth.) For the next 30 years, however, the absolute decline in the labour-force participation rate will be a significant drag on growth; with productivity growth projected to be roughly similar to that observed in the recent past, the result is that real per capita GDP will grow by only 1.0 percent annu- ally, only half its pace from the previous 40 years.

For the next few decades, Canadians and their governments will need to think carefully about how the rate of pro- ductivity growth can be increased. Growth in their future living standards will depend much more on productivity growth than it has in the past.

But it is worth recognizing the role of government in creating a beneficial environment in which firms and work- ers can take actions to have reasonably predictable results. There will always be uncertainties in a modern market economy, and today’s firms and work- ers recognize that. But government policy should avoid adding to these uncertainties. In this vein, explicit commitments to the rule of law, con- tract enforcement, the right of private property, low and stable inflation, and predictable and straightforward tax and regulatory regimes can help to produce an environment conducive to productivity-enhancing investments by firms and workers.

As Bank of Canada Governor Mark Carney recently observed, Canadian governments have performed well in this regard since the mid-1990s, including the maintenance of low and stable inflation, significant reductions in government indebtedness, reduc- tions in personal and corporate income tax rates, the elimination of many tariffs on intermediate inputs, and much else. Yet Canada’s produc- tivity performance has still been lack- lustre in the past decade and has lagged that of several other developed economies. At some point, govern- ments can only do so much and the responsibility falls on the private sec- tor to take the lead in improving pro- ductivity growth. After all, it is the workers and firm owners who will ulti- mately gain from these actions.

Aside from producing a beneficial economic environment, government policies can be designed in a more tar- geted way and can be aimed directly at promoting the accumulation of human and physical capital, support- ing the development of new technolo- gies and encouraging greater competition in the marketplace, either through more streamlined regulation or more openness to international trade. Whichever specific policies are pursued to improve productivity growth, it is important to keep in mind that all policies involve opportu- nity costs, and most involve direct fis- cal costs to governments. As a result, a careful analysis of costs and benefits is required before advocating any specific policy. Mention of the fiscal cost brings us to the second policy chal- lenge driven by population aging: the fiscal adjustments that Canadian gov- ernments will require as a conse- quence.

Quite apart from the issue of pro- ductivity, the aging of the Canadian population will force Canadian gov- ernments to face a significant two-part fiscal challenge. First, the aging of the population will lead to a slowing of governments’ tax base. Second, key Canadian government spending pro- grams will become more costly as the population ages: in particular, pro- grams providing health care and income support for the elderly. Confronting this fiscal challenge will likely create political tensions between provincial and federal governments and will force governments at all levels to make some difficult fiscal decisions.

Canadian governments levy all kinds of taxes, including personal and corporate income taxes, the federal goods and services tax (GST), provincial sales taxes, municipal property taxes and various excise taxes such as those that apply to the sale of gasoline, cigarettes and liquor. Since the rev- enues raised by the most important Canadian taxes tend to fluctuate with income and spending, we can view national income (GDP) as a good approximation of the governments’ overall tax base.

We have already seen that an important effect of Canada’s population aging will be a significant decline in the labour-force partici- pation rate over the next 30 years, with the important consequence that real per capita GDP will grow more slowly than it did over the past four decades. The implications for govern- ment tax revenue are clear: in the absence of changes to the govern- ments’ various tax rates, the slowing of the growth in per capita income will lead to a slowing of Canadian govern- ments’ per capita tax revenues. From figure 5, one can project that the annu- al growth rate of per capita income for the next 30 years will be lower by about one percentage point than it was over the past few decades; the implication is that, for unchanged tax rates, the annual growth rate of governments’ per capita tax revenues will also fall by about one percentage point.

Average health care spending per person rises significantly with age. In general, older people suffer more from illnesses than do the young. They also require more hospi- talization and recover more slowly from accidents of various kinds than do younger people. Using data from 2007, figure 6 shows how per capita health care spending varies by age category, with the amount of public spending for people aged 75 and over several times larger than the spending for those under the age of 55.

The aging of the baby-boom gen- eration implies that, for the next 30 years or so, there will be a steadily increasing fraction of the Canadian population over the age of 65 (look back to figure 2). Government spend- ing on health care will also increase over this period, since a greater share of the population will be in the high- er-cost age categories shown in figure 6. The projected increase in overall public spending on health care between 2020 and 2040, measured in percentage points of GDP, is shown in figure 7. Over this period, public spending on health care is projected to increase by roughly three percentage points of GDP.

Notice, however, that population aging is not the only force driving the increase in expenditures in figure 7. Two other factors, taken together, are estimated to account for slightly over half of the overall increase. First, as real per capita incomes continue to increase, it is estimated that the demand for health care will also rise, perhaps even more than in propor- tion to the increase in income. The second additional factor driving greater expenditure on health care comes from the continuing develop- ment of new medical technologies. In some cases, new medical technologies allow doctors to do existing procedures in lower-cost ways. But in many cases, new technologies and drug treatments allow doctors to do things that they could not do before at any cost. In other words, an important source of rising health care expendi- tures is that technological advances give us new ways to spend money on health care that were simply not available in the past.

The aging of the Canadian popu- lation will also lead to increased demands for public spending on old age benefits. Programs such as Old Age Security (OAS) and guaranteed income supplement (GIS) provide direct income assistance to the elderly, espe- cially those with incomes below a specified threshold. As baby boomers continue to age and more of them enter their golden years, there will inevitably be greater demands on these existing programs. Between 2020 and 2040, spending on such programs is projected to increase by approximately half of one percentage point of GDP.

Overall, the effect of population aging is expected to significantly increase demands on public expenditure. (It will also lead to decreases in the growth of spending on programs designed for the young, but this reduc- tion is predicted to be far smaller than the combined increases for health care and elderly benefits, and so it is ignored here.) Rising spending on health care and elderly benefits is expected to add roughly 3.5 percent- age points of GDP to annual government spending between 2020 and 2040. Such an increase in today’s econo- my would be equivalent to approximately $56 billion, over 10 percent of federal plus provincial government spending. The increased demands for health care spending will surely create signif- icant fiscal pressures between the fed- eral and provincial governments, for the simple reason that the lion’s share of the increased spending will come directly from the provincial budgets. At the same time, however, no law or institutional arrangement will gener- ate an automatic transfer of taxing power toward the provinces. Thus, as population aging drives the increase in age-related spending, provinces will demand greater financial trans- fers from the federal government. Based on past experience, these heightened demands will create sig- nificant political tensions, the resolu- tion of which will depend on the personalities and the political land- scape in place at the time.

Provincial governments will increase their demands from Ottawa because it is easier and more popular than the alternative methods of financing the rising health care expen- ditures: reducing other spending pro- grams or increasing taxes. If the federal government can be convinced to increase transfer payments, the provinces can avoid making these dif- ficult and unpopular fiscal decisions.

As population aging adds to the demands for greater age-related spending, however, someone will need to make some difficult fiscal choices " they simply cannot be avoided. Greater financial transfers to the provinces would make life easier for provincial governments, but the burden would then be squarely on the federal government to make the tough fiscal decisions. And in general terms the federal government has no more fiscal levers at its disposal than does any provincial gov- ernment. With a limited fiscal capacity of its own, the federal government would only be able to make larger transfers to the provinces if it could either restrain its other spending or increase taxes, or some combi- nation of the two. From the perspective of the country as a whole, it is more useful to focus on the overall need for fiscal adjustment " apart from the difficult issue of how the adjustment will be apportioned between the various lev- els of government.

Perhaps the obvious place to begin the discussion of fiscal adjustment is whether and to what extent the growth of health care spending can be reduced. Presumably, however, the goal will be to restrain the growth of health care spending while maintain- ing or even improving the quality of delivered health care services. Once this discussion begins in earnest, it is inevitable that we will start asking about possible changes to the existing delivery mechanism, perhaps includ- ing an increased role for the private sector in Canada’s mostly public health care system. Such a discussion will be uncomfortable for many Canadians. We briefly flirted with these issues in the mid-1990s when the federal government reduced its trans- fers to the provinces, thus putting sig- nificant financial pressures on the health care systems " the provinces’ largest and fastest-growing budget item. But a quick fiscal turnaround is aided by a fast-growing economy allowed us to avoid a protracted and unpleasant discussion. The coming demographic forces are strong and sus- tained, however, and Canadians will likely return to this debate in a more serious way. We should all brace our- selves. As former Bank of Canada Governor David Dodge has said recently, Canadians need to have an ”œadult conversation” about how we finance our future health care system.

Whatever realistic restraint can be placed on the growth of age- related spending, it is important to keep in mind that the underlying demographic forces are so strong that they will still cause this spending to rise more quickly in the future than it has in the past. Canadian govern- ments will therefore need to respond to this rising demand for spending. As is always the case, the simple arith- metic of government budgets implies that there are only two broad fiscal choices available.

First, if governments can ade- quately reduce the growth rate of non-age-related spending, they can make room in their budgets for the coming increases in age-related spending without the need for higher taxes. But such restraint is always diffi- cult for governments to accomplish, despite what they sometimes claim on the politi- cal campaign trail. Powerful and often vocal political forces are entrenched within those groups that benefit from any existing government program, and many governments ini- tially committed to restraint have later been compelled to stand down in the face of pub- lic outcry. Slowing the growth of a spending program is tough enough; cutting or eliminating programs alto- gether is even more difficult. As Milton Friedman once famously said, ”œNothing is so permanent as a temporary government program.” Past experi- ence in Canada and elsewhere, how- ever, has proven that cutting spending is possible, despite the inevitable hurdles and controversy. Committed political leadership and effective communications are required.

The second broad fiscal option is to accommodate the rising demands for health care spending by raising taxes. In this way, Canadians can sim- ply be asked to pay for the greater services they will be receiving. Apart from the general unpopularity of higher taxes, an important choice would then need to be made concern- ing which taxes would be raised and by how much. Unfortunately, there is typically a misalignment between the efficiency of a tax and its popularity, so that any tax increase will generate either significant economic or politi- cal costs. For example, most econo- mists would agree that increasing a broad-based consumption tax like the GST would be the best way to raise taxes because it would have the small- est negative effect on growth. But given the GST’s status as the most vil- ified tax in recent Canadian history, it would surely be the least popular tax increase one could imagine imple- menting. In contrast, many Canadians would argue that if taxes must be increased, corporations should be asked to pay more; yet economists know very well that higher corporate taxes are an almost certain route toward reduced economic growth and that the burden of such taxes ultimately falls on workers. Finding the right balance between the economic costs and political costs requires considerable finesse on the part of the government, a balancing act that would be aided with clearly stated objectives and careful but hon- est communications.

Being forced to choose between these broad fiscal options will be unpleasant for future Canadian gov- ernments, but some combination of these choices will be inevitable. Any attempt to avoid these unpleasant fis- cal realities would only result in increased government borrowing, made necessary by the acceleration of spending occurring simultaneously with the slowdown of the tax base. But such an increase in government debt is not a genuine long-term solu- tion; it can only delay the inevitable fiscal adjustment, as any debt incurred now must ultimately be repaid with future resources " financed through either higher taxes or lower spending.

Over the past 50 or so years, Canadians have built an impres- sive ”œmachine” of government. This machine reaches into our pockets and collects resources in various ways, by taxing personal income, corporate profits, expenditures and property val- ues. The same machine uses this rev- enue to finance the delivery of goods and services that Canadians presum- ably value " the justice system, national parks, public education, health care, national defence, roads and highways, and much more. Naturally we can and should debate the efficiency of this machine, and should constantly be exploring ways to improve its effectiveness. We should also continue to question whether its scale is best suited to the needs and aspirations of Canadians, and whether it is providing the optimal mix of goods and services.

The key point is not about such debates. Rather, the key point is that this government machine built over the past half-century was constructed during a time when the demographic forces were very advantageous: a young and fast-growing population. The implications were rapidly advanc- ing living standards and the ability to easily fund many government pro- grams. But as the oldest baby boomers reach 65 next year, and these demographic forces move into reverse for roughly 30 years, there will be a need to adjust this machine of government. The adjustment can occur primarily on the spending side or primarily on the rev- enue side " or indeed can occur on both. But some adjustment will be necessary. None of this is an argument specifically for a ”œsmaller” machine or a ”œlarger” one; it is only that whatever level of spending the machine provides must be balanced by the level of taxes it collects. And the coming demographic changes imply that achieving this balance in the future will only be possible if Canadian governments make deliber- ate and significant policy adjustments. Ignoring this fact is a sure route to the future problems that come from high levels of government indebtedness.

Only time will tell how our gov- ernments choose to confront the pro- ductivity and fiscal challenges created by population aging. But they need to begin thinking about them very soon.