Kuhn, Michael; Prettner, Klaus

Working Paper
On the long-run growth effect of raising the retirement
age

ECON WPS, No. 10/2016

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TU Wien, Institute of Statistics and Mathematical Methods in Economics, Economics Research Unit
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Suggested Citation: Kuhn, Michael; Prettner, Klaus (2016) : On the long-run growth effect of raising
the retirement age, ECON WPS, No. 10/2016, Vienna University of Technology, Institute of Statistics
and Mathematical Methods in Economics, Research Group Economics, Vienna

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 SWM ECON
Economics

December 2016
On the long-run growth effect of
raising the retirement age

by
Michael Kuhn
and Klaus Prettner

Working Paper 10/2016

This paper can be downloaded without charge from http://www.econ.tuwien.ac.at/wps/econ_wp_2016_10.pdf
On the long-run growth effect of raising the retirement age
Michael Kuhn and Klaus Prettner

a) Wittgenstein Centre (IIASA, VID/ÖAW, WU),

Vienna Institute of Demography
Welthandelsplatz 2, Level 2
A-1020, Vienna, Austria
email: [email protected]

b) Corresponding author
University of Hohenheim
Institute of Economics
Schloss, Osthof-West,
70593 Stuttgart, Germany
email: [email protected]

Abstract

We show that the long-run economic growth effect of an increase in the retirement
age is unambiguously positive in research and development based endogenous growth
models. This contrasts recent findings based on models of learning-by-doing-spillovers,
in which an increase in the retirement age reduces physical capital accumulation and
thereby economic growth. Our results imply that models based on learning-by-doing-
spillovers, which are often used as a short-cut formulation for research and development
based growth models, do not necessarily lead to similar policy conclusions.

JEL classification: J10, J26, O30, O41.

Keywords: demographic change, pension reform, long-run economic growth, R&D-
based growth.

1
1 Introduction
We analyze the long-run growth effects of raising the retirement age in modern knowledge-
based economies as described by research and development (R&D) based growth frame-
works a la Romer (1990). We show that an increase in the retirement age unambiguously
raises economic growth because the positive growth effect of the larger workforce over-
compensates the negative growth effect of reduced savings. While it is often argued that
the results of endogenous growth models based on learning-by-doing spillovers a la Romer
(1986) are similar to those based on Romer (1990), we show that this is not the case for
an increase in the retirement age.
Our results are closely related to those of Futagami and Nakajima (2001) and Heijdra
and Mierau (2011) who find that the increase in the retirement age leads to a reduction of
capital accumulation and therefore to a reduction of economic growth in a Romer (1986)
setting. While their results are most relevant for economies in which growth is driven by
physical capital accumulation and which tend to adopt technologies from abroad (mostly
small open economies), our results imply the opposite effect in countries that actively
advance the world-wide knowledge frontier.

2 The model
2.1 Households
Consider an economy in which individuals enter the labor market as adults at time t0 and
maximize their discounted stream of lifetime utility given by
Z ∞
U = log(c)e−(ρ+µ)(t−t0 ) dt,
t0

where c is instantaneous consumption, ρ is the discount rate, and µ represents the mortality
rate that augments the discount rate. Individuals earn non-capital income w (wages and
lump-sum re-distributions of profits from intermediate goods producers) as long as they
are not retired. Suppressing time arguments and following Yaari (1965) in assuming that
there exists a fair life insurance company at which individuals insure against the risk of
dying with positive capital holdings, the flow budget constraint of individuals reads

k̇ = χw + (µ + r)k − c, (1)

where k denotes the individual capital stock and χ is an indicator function with value 1
when working and 0 when retired. Solving the intertemporal maximization problem leads
to the standard Euler equation
ċ = (r − ρ)c

stating that consumption expenditure growth is positive if and only if the interest rate
exceeds the time discount rate. Recognizing that lifetime consumption expenditures have

2
to be equal to lifetime income, the lifetime budget constraint can be written as

Z∞ tZ
0 +R
−(µ+r)(t−t0 )
e c(t0 , t)dt = e−(µ+r)(t−t0 ) w(t0 , t)dt,
t0 t0

where the working life span is denoted by R such that the age at retirement is given by
t0 + R. Assuming that t0 is constant, an increase in R is tantamount to an increase in the
retirement age.
Denoting the aggregate capital stock by K and aggregate consumption expenditures
by C we have the following aggregation rules (see for example Blanchard, 1985; Heijdra
and van der Ploeg, 2002):
Z t
K(t) ≡ k(t0 , t)N (t0 , t)dt0 , (2)
−∞
Z t
C(t) ≡ c(t0 , t)N (t0 , t)dt0 , (3)
−∞

where N (t0 , t) denotes the size of the cohort entering the labor market at time t0 as of
date t, while k(t0 , t) and c(t0 , t) are the capital holdings and consumption levels of its
members, respectively. To capture the Romer (1990) case of a stationary population, we
assume that the birth rate equals the death rate such that the flow of labor market entrants
Rt
is N (t, t) = µN (t), where N (t) = −∞ N (t0 , t)dt0 ≡ N represents the adult population
Rt
size and L(t) = t−R N (t0 , t)dt0 is the labor force. Note that each adult cohort is of
size µN eµ(t0 −t) at a certain date t > t0 . Taking into account this demographic structure
leads to the following dynamic equations for the aggregate capital stock and for aggregate
consumption, respectively,

K̇ = rK + W − C, (4)
Ċ K
= r − ρ − µ(ρ + µ) , (5)
C C

where W refers to aggregate non-capital income. The economy-wide resource constraint

states that everything that is produced but not consumed is invested in physical capital
such that the goods market clearing condition is

K̇ = Y − C, (6)

with Y referring to the economy’s GDP.

3
2.2 Firms
The final goods sector produces the consumption aggregate with labor and machines ac-
cording to Z A
Y = L1−α
Y xαi di, (7)
0

where LY refers to labor used in final goods production, A is the technological frontier, xi
is the amount of a certain specific machine i used in final goods production, and α ∈ (0, 1)
is the elasticity of final output with respect to machines. Perfect competition implies that
the wage rate, wY , and the prices of machines, pi , are given by

Y
wY = (1 − α) , (8)
LY
pi = αL1−α
Y xi
α−1
. (9)

Each intermediate firm produces one of the differentiated machines such that there
is monopolistic competition in the vein of Dixit and Stiglitz (1977). After a firm has
purchased a blueprint, it has access to the linear production technology ki = xi . Thus,
operating profits can be written as

πi = pi ki − rki = αL1−α α
Y ki − rki . (10)

Profit maximization of firms yields prices of machines as pi = r/α, where 1/α is the
markup over marginal cost. The aggregate capital stock is equal to the amount of all
intermediates produced, i.e., K = Ax, such that equation (7) becomes Y = (ALY )1−α K α .
Consequently, production per capital unit can be written as a function of the interest rate
and the elasticity of final output with respect to machines such that r = αp = α2 Y /K ⇒
Y /K = r/α2 .
The R&D sector employs scientists to discover new blueprints. Depending on the
productivity of scientists, λ, the stock of blueprints evolves according to

Ȧ = λALA , (11)

where LA denotes the employment level of scientists. Research firms maximize their profits
πA = pA λAφ LA − wA LA , with pA representing the price of a blueprint, by choosing the
employment level, LA . The first-order condition pins down wages in the research sector
as wA = pA λA . Due to perfect labor mobility, wages of workers in the final goods sector
and wages of scientists equalize and we get the equilibrium condition

Y
wA = pA λA = (1 − α) = wY . (12)
LY

Firms in the R&D sector charge prices for blueprints that are equal to the present value
of operating profits in the intermediate goods sector because there is always a poten-

4
 R∞
tial entrant who is willing to outbid a lower price. Consequently, pA = t e−R(τ ) π dτ,
Rτ
where the discount rate is the market interest rate: R(τ ) = t r(s) ds. Via the Leibniz
rule and the fact that prices of blueprints do not change along a balanced growth path
(BGP), we obtain pA = π/r, i.e., prices of blueprints are equal to the discounted stream
of operating profits for intermediate goods producers. Next, by using Equation (10), we
derive operating profits as π = (1 − α)αY /A such that the price of blueprints becomes
pA = (1 − α)αY /(rA). Using the labor market clearing condition L = LA + LY , we can
determine the amount of labor employed in the final goods sector and in the R&D sector
by using Equation (12) as

r r
LY = , LA = L − . (13)
αλ αλ

Inserting (13) into (11) leads to the evolution of technology as

 
rA
Ȧ = max λAL − , 0 . (14)
α

2.3 Results
Along a BGP, we know that Ȧ/A = Ċ/C = K̇/K = g. Collecting equations (5), (6),
Rt
(14), recalling that labor supply is given by L(t) = t−R N (t0 , t) dt0 , and utilizing the
definition C/K ≡ ξ, we can derive the following three-dimensional system describing our
model economy along the BGP

r
g = − ξ, (15)
α2
1
g = r − ρ − µ(ρ + µ) , (16)
ξ
Z t
r
g = λ N (t0 , t) dt0 − , (17)
t−R α

where the endogenous variables are r, g, and ξ. At this stage we can state our main result.

Proposition 1. In an overlapping generations version of the endogenous growth frame-

work of Romer (1990) that takes retirement into account, an increase in the retirement
age (a rise in R) leads to an increase in the interest rate (r) and to an increase in the
long-run economic growth rate (g).
Rt
dt0 = N 1 − e−µR , we rewrite the system (15)-(17) as


Proof. Noting that t−R N (t0 , t)

r
W (ξ, g, r) := − ξ − g = 0, (18)
α2
1
X (ξ, g, r) := r − ρ − µ(ρ + µ) − g = 0, (19)
ξ
r
Y (ξ, g, r) := λN 1 − e−µR − − g = 0.


(20)
α

5
Applying the implicit function theorem and Cramer’s rule, we obtain the following com-
parative statics

λµN e−µR α2 ξ 2 + µ(µ + ρ)

 
dg
= > 0,
dR (1 + α) [αξ 2 + µ(µ + ρ)]
α2 λµN e−µR µ(µ + ρ) + ξ 2
 
dr
= > 0.
dR (1 + α) [αξ 2 + µ(µ + ρ)]

Hence, in contrast to Futagami and Nakajima (2001) and Heijdra and Mierau (2011),
who base their analysis on a Romer (1986) framework, an increase in the retirement age
unambiguously raises economic growth in a Romer (1990) setting. The intuition for this
result is that a rise in the retirement age implies an increase in the labor force and therefore
it raises the number of scientists that are available for the production of blueprints in the
R&D sector. While there is also a reduction in individual savings due to the longer
working-life (as in the other papers cited above), the associated negative growth effect is
overcompensated by the positive effect of the larger labor force.

Remark 1. The impact of an increase in the retirement age would follow a similar mech-
anism as the one described here if we were using a semi-endogenous growth model a la
Jones (1995) without the strong scale effect as baseline framework. However, the growth
effect itself would be transient and vanish in the long run, i.e., increasing the retirement
age would have a positive level effect on per capita GDP but no long-run growth effect.

3 Conclusions
Using an R&D-based growth model of the Romer (1990) type we showed that a rise in the
retirement age implies faster long-run economic growth. This contrasts with recent findings
based on the framework of Romer (1986) in which an increase in the retirement age reduces
physical capital accumulation and thereby economic growth. Our result illustrates that
Ak-type of growth models do not necessarily lead to similar policy conclusions as models
of R&D-based economic growth.

References
Blanchard, O. J. (1985). Debt, deficits and finite horizons. Journal of Political Economy,
Vol. 93(No. 2):223–247.

Dixit, A. K. and Stiglitz, J. E. (1977). Monopolistic competition and optimum product

diversity. American Economic Review, Vol. 67(No. 3):297–308.

Futagami, K. and Nakajima, T. (2001). Population aging and economic growth. Journal
of Macroeconomics, Vol. 23(No. 1):31–44.

6
Heijdra, B. J. and Mierau, J. O. (2011). The Individual Life Cycle and Economic Growth:
An Essay on Demographic Macroeconomics. De Economist, Vol. 159(No. 1):63–87.

Heijdra, B. J. and van der Ploeg, F. (2002). Foundations of Modern Macroeconomics.

Oxford University Press. Oxford.

Jones, C. I. (1995). R&D-based models of economic growth. Journal of Political Economy,

Vol. 103(No. 4):759–783.

Romer, P. (1986). Increasing returns and long-run growth. Journal of Political Economy,
Vol. 94(No. 5):1002–1037.

Romer, P. (1990). Endogenous technological change. Journal of Political Economy, Vol.

98(No. 5):71–102.

Yaari, M. E. (1965). Uncertain lifetime, life insurance and the theory of the consumer.
The Review of Economic Studies, Vol. 32(No. 2):137–150.

7
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