Increases in the retirement age and labour demand for youth

Tito Boeri, Pietro Garibaldi, Espen Moen

The Eurozone's sustained rise in youth unemployment since 2008 threatens to create a 'lost generation'. This column presents evidence that this is, in part, an unintended consequence of pension reforms in southern Europe that locked in older workers. In future, reforms that create flexible retirement ages alongside variable pension levels could minimise the impact on youth unemployment without increasing the state's long-term pension liabilities.

Most European countries have experienced a dramatic increase in youth unemployment since the beginning of the Great Recession in April 2008. For the Eurozone as a whole, employment for people aged between 15 and 24 fell by almost 17% in six years. In southern Europe, the smallest decline was 34% in Italy, and the largest was 57% in Spain. Other age groups suffered less: 3% for the Eurozone as a whole and, for all older age groups in all countries, between one-third and one-sixth of the employment decline for young workers.

In the Eurozone as a whole, employment for people in the 55-65 age group increased by approximately 10%. Demographic factors do not account for these changes. Both employment levels and employment rates moved in opposite directions for young and senior workers (Figure 1).

The strong increase of youth unemployment was predicted by the research on contractual dualism (Saint-Paul 1993, Boeri 2011). This predicts that youth unemployment will respond more strongly to cyclical fluctuations in countries with strict employment protection in permanent contracts and ‘fire-at-will’ for temporary contract workers (Boeri et al 2015). Boeri and Garibaldi (2007) predicted that immediate declines in youth unemployment after two-tier labour market reforms, even under slow growth scenarios, would be followed by youth disemployment when macroeconomic conditions deteriorate. Research on contractual dualism, however, does not explain why employment rates have diverged for young and old.

Figure 1. Employment rate for young and old workers in the EU15

Portugal in 2007, Spain in 2011, Greece in various stages between 2010 and 2016, and Italy in 2011 all increased the retirement age during the recession. So is the decline in youth employment related to changes in the retirement rules? Research on retirement is typically focused on the supply side. As a result, it ignores trade-offs between young and old workers on the demand side. Vestad (2013) used administrative data to estimate the impact of an early retirement programme on youth employment in Norway, but there is little other research on this topic.

The economics of pension reform and labour demand

The economics of a pension reform and labour demand is more subtle than a simple exogenous shift in labour supply. Most of the individuals involved are already employed and cannot be easily fired. Under a pension reform forcing firms to retain older workers, there are two effects at work.

First, there is a negative scale effect, due to decreasing returns to scale. The reform forces some of the older workers to stay employed rather than retire. This tends to increase output, but with decreasing marginal returns to scale in production, the marginal product of young workers falls and so does youth hiring.

Second, there is an effect that depends on the degree of complementarity between young and old workers: the stronger the complementarity, the more likely that the reform could positively affect youth employment.

Which one of the two effects – the scale or the substitution effect – prevails is ultimately an empirical matter.

Italy and the Monti Fornero reform

Italy provides an excellent case study of whether unexpected increases in retirement age can have adverse effects on youth employment. In the middle of a recession, labour markets are typically driven by the demand side. In Italy, employment rates for the 15-24 and 55-64 age groups were almost the same in 2005 (Figure 2). Ten years afterwards, the employment rate for the 55-64 age group was 45%, while the youth employment rate was approximately 12%. In this period, the normal retirement age increased, and the minimum contribution requirement for access to early retirement tightened. In December 2011, the Monti Fornero reform increased the retirement age by up to five years for some categories of workers. We use this policy experiment to estimate the impact of increases in retirement age on youth labour demand.

Figure 2. Employment rate for young and old workers in Italy

We had access to a dataset on Italian firms before and after the reform compiled by the Italian social security administration (INPS). We looked at whether a sudden and unexpected increase in the contributory and age requirements for retirement, which forced firms to keep workers previously entitled to pensions to stay in the payroll, affected labour demand for young workers. We identified the population hit by the changes in retirement rules in each firm, and looked at the dynamics of net hiring in the same firms.

The results are clear. Before and after the reform, firms that were more exposed to the mandatory increase in the retirement age significantly reduced youth hiring compared to those who were less exposed to the reforms. We cannot rule out that the latter firms may have increased their hiring as a result of the reform, due to general equilibrium effects. Nevertheless, we argue that the reform was likely to reduce the labour market prospects of young workers.

We estimate that five workers locked in for one year mean the firm hires approximately one less young person. Firms with more than 15 employees lost 160,000 youth jobs in this period. Of these, 36,000 can be attributed to the reform. We performed robustness checks including rolling regressions across the size distribution, propensity score matching, and a falsification test on the pre-reform years.

Policy implications

Cautiously, we make two points.

Reducing the generosity of pensions in the middle of the European sovereign debt crisis was probably inevitable, despite the severe recession that southern European economies experienced. But this tightening could have been done by reducing pensions for workers who were retiring before the normal retirement age. This would have allowed firms to encourage the least productive older workers to retire. With hindsight (as well as the evidence above), much more should have been done by European policymakers to help and sustain young workers who were about to enter the labour market. The equilibrium for young and old workers in the southern European labour market was not what these policies set out to achieve. We risk a lost generation in Europe.

Also, the retirement age should be as flexible as possible. As far as Italy is concerned, the long-run defined contribution system is viable and sustainable. A system like this, though, has a prolonged transition phase. During the medium-run adjustment to the new system, policy should seriously attempt to increase actuarially neutral flexibility in retirement. From the perspective of broader fiscal coordination, our results suggest that short-sighted fiscal rules that force sudden increases in retirement age during major downturns may backfire. They may cause a prolonged and almost total freeze on new hires, particularly when older workers are locked in by the increase in the retirement age.

Fiscal rules should better focus on fiscal sustainability in the long run. A 2005 reform of the Stability and Growth Pact attempted this, but in words, not in practice. It stated that a short-run deterioration in the budget deficit could be tolerated if, at the same time, a government reduces its long-run liabilities. In practice, however, this principle can only be enforced by explicitly including in the pact any efforts that reduce the hidden liabilities associated with social security entitlements, the most important long-run liabilities in our ageing societies.

This means that a citizen could be given some freedom to retire when he or she wants, provided the size of the pension reflects age and life expectancy. More pensions could be paid under downturns without affecting long-term liabilities, because the additional pensions for early retirees would be lower than those paid to people who retiring later. Therefore this system could be budget-neutral and operate as an automatic stabiliser. A pact that allows for sustainable flexibility in retirement would also help countries facing the huge demographic shock that is associated with the current refugee crisis.

References

Boeri, T. (2011) "Institutional reform and dualism", Handbook of Labor Economics 4b ed. D. Card and O. Ashenfelter. Elsevier.

Boeri, T. and Garibaldi P. (2007) “Two Tier Reforms of Employment Protection: a Honeymoon Effect?" The Economic Journal 117 (521), F357-F385

Boeri, T., Garibaldi, P. and E. R. Moen (2015) “Graded security from theory to practice”, VoxEU.org, 12 June.

Boeri, T. Garibaldi, P. and E. R. Moen (2016) “A Clash of Generations? “Increase in Retirement Age and Labor Demand for Youth”, CEPR Discussion Paper 11422 and WorkInps Paper 1.

Saint Paul, G. (1993) “On the Political Economy of Labor Market Flexibility", NBER Macroeconomic Annual 151-192

Vestad, O. L. (2013) “Early Retirement and Youth Employment in Norway", Statistic Norway.