Introduction

As with many other industrialized countries, the ageing population of the Netherlands is expected to render current fiscal policies unsustainable in the coming decades (Van Ewijk et al., 2006). The sizeable changes in the ratio of retired persons to workers will increase demographically sensitive public expenditures beyond the ability of current revenue arrangements to cope. Adequate remedies may take a variety of forms like tax rate or contribution increases, spending reductions or institutional reforms.

Uncertainty in the scale and direction of future demographic developments presents an added problem to policy-makers because the magnitude of the required adjustments is not fully known. Possible strategies for dealing with this uncertainty include delaying policy reforms until the uncertainty is resolved or making adjustments based on the assumption that demography will develop according to the most likely scenario. In this chapter, however, we show that a government faced with demographic uncertainty whose interest is in maximizing the expected welfare of society should pursue a precautionary fiscal policy. A precautionary policy in this case involves front-loading taxes: that is, setting tax rates such that they are expected to decrease over time.

It is a well-known result in the public finance literature that a policy that smoothes tax rates over time minimizes the excess burden from distortionary taxation (Barro, 1979). This result holds if the government has perfect foresight about future revenue requirements.