Demographic change, human capital and welfare

Projected demographic changes in the U.S. will reduce the share of the working-age population. Analyses based on standard OLG models predict that these changes will increase the capital–labor ratio. Hence, rates of return to capital decrease and wages increase, which has adverse welfare consequences for current cohorts who will be retired when the rate of return is low. This paper argues that adding endogenous human capital accumulation to the standard model dampens these forces. We find that this adjustment channel is quantitatively important. The standard model with exogenous human capital predicts welfare losses up to 12.5%12.5% (5.6%5.6%) of lifetime consumption, when contribution (replacement) rates to the pension system are kept constant. These numbers reduce to approximately 8.7%8.7% (4.4%4.4%) when human capital can endogenously adjust.

► We study the aggregate and welfare consequences of demographic change.
► We extend an otherwise standard quantitative model by endogenous human capital adjustments.
► We show that our quantitative conclusions are significantly altered when human capital can adjust.
► For example, welfare losses induced by demographic change would be 27–44% higher when human capital cannot adjust.