Global economy: OECD study shows long-term merits of structural reform and the pitfalls of higher tariffs

The reversal of trade liberalization and a return to the average tariffs of 1990 would depress the world’s long-term living standards by about 14 percent worldwide and as much as 15 to 25 percent in the most affected countries, according to an OECD study of different long-term scenarios for the global economy until 2060.

In light of recent U.S.-led tariff increases, with corresponding tit-for-tat responses from the EU and China, and the potential for a trade war, the results of the study are timely. However, the OECD did not set out to demonstrate how harmful higher tariffs are, but rather how policy choices and market-friendly reforms today can have a significant positive effect for future living standards.

The study extrapolates the results from the OECD’s Spring 2018 Economic Outlook up to the year 2060 as a baseline scenario, under which no economic or structural reforms take place. This reference point scenario is supplemented by different projections, such as better governance and improving education in large emerging-market economies and competition-friendly product market and labor market reforms in OECD economies.

The results are not surprising, in that labor-market reforms that introduce greater flexibility and raise the employment rate not only boost living standards but also help alleviate fiscal pressures associated with an aging population.

Another scenario illustrates the potential positive impact of linking the pensionable age to life expectancy on the participation rate of older workers, and especially women. The study demonstrates the potential economic gains from raising public investment and spending more on research and development.

And, finally, a negative scenario reflects how dialing back on trade liberalization and a return to 1990 average tariff rates, would depress standards of living everywhere.

What is surprising is the extent to which the global economy changes under the various structural reforms.

According to the baseline scenario, world trend real GDP growth is going to decline from about 3.5 percent today to 2 percent in 2060, mainly because large emerging economies who continue to account for the bulk of world economic output, will see slowing growth.

Living standards, measured as GDP per capita, in the OECD countries is expected to improve by between 1.5 percent and 2 percent per annum over the coming 40 years.

And while living standards in Brazil, Russia, India, Indonesia, China and South Africa, the so-called BRIICS countries, would grow faster, their growth is forecast to decelerate from an average of 6 percent per year during the last decade to just over 2 percent by 2060, less than half of the level expected for the leading countries.

Despite the slowing growth under this scenario, the world’s economic center of gravity would still shift further to Asia. The study notes that India and China will increase their share of global output to between 20 and 25 percent of world GDP each by 2060, compared with a share of 40 percent for OECD countries.

Advanced countries will face substantial fiscal pressures from demographic change. This will force governments to raise tax revenues in relation to the size of the economy by about 6.5 percentage points of GDP to meet growing healthcare and pension needs without incurring more debt.

Room for positive change

Structural reforms, however, have the potential to offset some of the negative effects that would play out under the baseline scenario and boost living standards.

The BRIICS countries, for instance, have substantial room to improve governance and educational attainment. If both factors were to catch up with average OECD levels by 2060, living standards would increase by 30 to 50 percent.

Reforms that would make product market regulation in OECD countries as friendly to competition as in leading countries by 2030 could raise living standard by over 8 percent, as much as 15 to 20 percent in countries like Belgium, France, Italy and Spain.

Labor market reforms in the OECD would raise the aggregate employment rate by 6.5 percentage points by 2040, the study shows, mostly via higher youth and female employment.

Combined with reforms to contain healthcare cost inflation, this would alleviate future fiscal pressures, more than halving the extra revenue required to stabilize government debt.

Linking future increases in pensionable ages to life expectancy, as some countries have done, raises the aggregate employment rate of older people in the OECD by more than 5 percentage points by 2060 and living standards by about 2.5 percent by 2060.

If OECD countries boosted their research and development intensity to the level of the five leading countries, aggregate living standards would rise by 6 percent by 2060.

And increasing public investment in all OECD countries to 6 percent of GDP would improve living standards by over 4 percent by 2060.