The effect of early retirement schemes on youth employment Updated

There is no upper limit of jobs in an economy

The assumption that there is an upper limit on the number of jobs in an economy—the “lump-of-labor fallacy”—has no theoretical justification; nor is there empirical evidence to support such a view. In fact, as economies become more complex and grow due to specialization, additional jobs are being created. Technological progress, while rendering some occupations obsolete, constantly creates demand for new occupations. Research shows that having older people active and productive actually benefits all age groups and spurs the creation of more jobs. A 2012 analysis of Current Population Survey data tested for changes in employment among US workers under the age of 55 when those aged 55 and older worked in greater numbers [3]. The study found no evidence that younger workers lost work; in fact, it found the opposite: greater employment, reduced unemployment, and higher wages.

Another example of this effect is seen in the expansion of the employment of women during the second half of the 20th century in OECD countries: women did not replace men in the workforce; on the contrary, the transition to two-earner families increased disposable income, created new demand, and prompted firms to hire more workers. (It could be argued that in the very short term the number of jobs was fixed, because it takes time for this virtuous cycle to operate. However, it is known from a vast literature that there is an impressive amount of simultaneous job creation and job destruction, which stresses that even in the very short term the number of jobs is not limited.)

Are young workers substitutes for older workers?

If firms faced higher labor costs following an increase in the retirement age (e.g. because seniority decreases the profitability of older workers), they could substitute younger workers for older workers. Economic theory suggests that any substitution of one type of worker with another is governed by the similarity of the skills they possess. Empirical evidence, however, suggests that even workers of similar skills who differ by as little as five years in age are already imperfect substitutes, suggesting that firms would have, at most, a limited ability to substitute young workers for older ones [4]. As a consequence, the hiring behavior of firms in response to the cost of older workers indicates that substitution between young and old workers is limited. Even when the cost of employing older workers is significantly increased, the substitution of older with younger workers is moderate in scope [5].

Skill-based technical change might further decrease the substitutability between workers of different age cohorts. Technical change constantly adjusts the demand for skills. Although many jobs can now be more cheaply undertaken by computers, the demand for higher levels of skills (e.g. software engineers) has increased. However, learning new skills is costly and older workers may not invest in acquiring new skills if their remaining working life is too short to recoup the costs. In contrast, younger workers will more readily learn new skills because the period over which they can recover their costs is longer. Studies of US data indicate that the sector-specific rate of technological progress leads to more unemployment and the early retirement of older workers [6]. With older workers more likely to exit the labor market under these circumstances, rapid technological change makes the possibility of substituting younger workers for older ones even less likely.

The substitutability of younger and older workers might also depend on institutions such as the retirement system. In general, social systems can be characterized by their differences with respect to equity (i.e. regulations intended to lower economic and social inequality) and efficiency (i.e. regulations intended to optimize employment rates) [7]. The literature commonly uses a classification based on employment rates and poverty rates and describes countries as belonging to the “Nordic” model (high employment, low inequality), the “Anglo-Saxon” model (high employment, high inequality), the “Continental European” model (low employment, low inequality), and the “Mediterranean” model (low employment, high inequality). Because social models differ in their focus on employment and inequality, it is reasonable to expect to find a lower rate of substitutability between young and old workers in countries classified as Nordic than in, for instance, Anglo-Saxon countries. Empirical evidence does not indicate that different social models lead to greatly different rates of substitution between younger and older workers. An analysis of data for 22 OECD countries finds rather that workers of different age cohorts are complements, regardless of the dominant social model [8].

A detailed analysis of US data for 1977–2011 establishes a positive association between the employment rates of younger and older workers [8]. Furthermore, the analysis shows that not only are the employment rates positively correlated, but the wages of young workers are also positively correlated with higher employment for older workers. Recent evidence from Japan shows a negative effect of increasing the retirement age on the wages of older workers [9].

The positive correlations of employment rates and wages of young and old workers could be caused by a positive shock common to both age groups. However, careful econometric analysis indicates that this is not the case. Several robustness checks—for example, using different definitions of age groups and controlling for state population—confirm these findings. The most likely causes of the positive association of younger and older workers’ employment and wages are the additional demand created by employed older workers and, in countries where pensions are financed by taxes, a reduction of the tax burden due to a lower number of inactive people. (There may also be additional benefits as moderate employment in older age has been found to be associated with better physical and mental health.)

Unfortunately, evidence of the substitutability of younger workers for older workers is limited for non-OECD countries. Data from China, published in 2012, however, suggest that the employment rates of young workers are positively associated with the employment rates of older workers [10].

Later retirement ages increase employment of young workers

Further empirical evidence on the substitutability of younger and older workers comes from studies that analyze “natural experiments”—that is, reforms that change the conditions for one group of workers but not for others [11]. These “quasi-experimental” situations allow the identification of causal effects from policy changes that could otherwise be biased. Evidence from Germany, where several reforms to the pension system have led to significant changes in the employment rate for older workers, provides strong support for the view that workers of different ages are complements rather than substitutes. Following one such reform in 1972, the employment rate for older workers dropped by seven percentage points by 1976. During the same period, the employment rate for younger workers declined by about two percentage points. In 1992, a pension reform changed the incentives for older workers to remain in employment longer, which led to a roughly 15 percentage point increase in the employment of older workers. At the same time, the youth unemployment rate declined slightly. Similar evidence can be observed following more recent reforms.

Moreover, Germany is not unique in this regard. Similar evidence is available for Denmark and France, where the employment of younger workers also tends to rise and fall together with the employment of older workers. Denmark introduced its Post-Employment Wage Program, an early retirement scheme, in 1979. This program led to a 35% decrease in the labor force participation rate for men aged 61–65. Before the reform, the unemployment rate of young workers had been relatively stable, while the employment rate was slightly increasing. After the reform, the employment rate of young workers dropped by about four percentage points.

In France, the employment rates of young workers dropped after pension system reforms that led to lower rates of labor market participation for older workers over the period 1971–1993. Subsequent reforms reversed this trend, leading to an increase in labor force participation for older workers between 1993 and 2005. This increase in the percentage of older workers in the labor force was accompanied by a corresponding increase in the employment rate of younger workers.

Cross-country comparisons, using panel data regressions, provide additional evidence. While these regressions permit the comparison of labor markets across countries, they typically do not exploit a quasi-experimental framework such as the analyses presented above. However, they do serve to establish whether the relationship between the employment of younger and older workers is significant or not, and whether this association is negative or positive. A positive association would be evidence against the trade-off between early retirement and the employment of young workers, and vice versa.

Empirical evidence from 12 countries—Belgium, Canada, Denmark, France, Germany, Italy, Japan, the Netherlands, Spain, Sweden, the UK, and the US—indicates that the employment rates of older and younger workers move together, rather than in opposite directions. The six countries with the greatest increases in the employment of older workers have seen the largest increases in youth employment. (They have also seen the greatest decreases in youth unemployment.) Different specifications and a series of robustness checks confirm these results.

Evidence from Italian firm-level data, however, suggests that when firms retain more older workers they hire fewer younger workers [12]. In Italy, the pension reform of 2011 is estimated to have reduced the employment of young workers by about 2.3%. The size of a negative effect on youth employment may reflect the declining real GDP of the observation period and a longer time series does indeed result in a smaller, but still negative, effect. Rather than dramatically worsening young workers’ job prospects, however, the greatest impact is instead on the layoffs of old and middle-aged workers, who are closer substitutes for those near retirement. Recent research using Norwegian data also finds that firms hire fewer younger workers when they retain older workers longer [13].

In summary, analyses of the impact of recent pension reforms in several countries on the effective retirement age of older workers and on the employment rate for younger workers typically arrive at the same conclusion: the employment rates of younger and older workers correlate positively. While some evidence exists that a higher pension age might cause an individual firm to postpone the hiring of younger workers, especially when employment protection for older workers is strong, the aggregate indicates no real evidence of a trade-off between jobs for younger and older workers. In addition, there is limited evidence that increasing the employment of older workers causes fewer jobs for younger workers, and vice versa.

The impact of increased pension contributions

While the early retirement of older workers does not lead to an increase in employment for younger workers, it does distort the returns for human capital accumulation and therefore leads to lower economic growth. Theoretically, early retirement shortens people's working life and reduces the incentive to accumulate human capital.

In addition, as life expectancies increase, early retirement may create a larger tax burden for future generations of workers. As contributions to the pension system are made over a shorter working life and consumed over a longer time spent in retirement, a lower retirement age may result in a lower level of benefit payments (assuming no increase in contributions from current workers). In order to maintain the level of retirement benefits, workers may be forced to make higher contributions or to take out private pension insurance.

Recent evidence suggests that an aging labor force can reduce the ability of firms to innovate as workers stay in their jobs longer [14]. This lack of job and worker reallocation has long-term negative effects on overall growth. Moreover, with older workers more likely to occupy high-skill jobs, delayed retirement may force young workers into occupational downgrading (taking a job below their skill level) or part-time work to find employment.