Insights ¦ Working paper 22: A new UK overlapping generations model

Key Take Aways

1. The UK OLG (Overlapping Generations) model captures detailed household behaviour over time, including saving, consumption, and labour supply decisions across life stages, providing a robust tool for long-term macroeconomic and fiscal analysis.

2. Developed jointly by the OBR and HM Treasury, the model complements existing forecasting tools by explicitly considering demographic shifts, policy impacts, and shocks affecting different age groups differently.

3. The model’s micro-founded, general equilibrium framework enables analysis of how policy or shocks influence household decisions, macro aggregates, and the government’s fiscal sustainability.

4. It incorporates stochastic income shocks, generating within-generation inequalities and more realistic savings behaviours, including life-cycle and precautionary savings.

5. Calibration to UK-specific data, including demographics, income, wealth, tax, and welfare systems, ensures relevance and accuracy for national policy assessments.

6. The model operates flexibly as either a closed or open economy, affecting interest rate determination and the international capital position of the UK.

7. Sensitivity analyses demonstrate the model’s ability to evaluate long-term impacts of policies such as income tax changes, pension eligibility shifts, and demographic trends.

8. In scenarios like a 1% rise in income tax or an increase in life expectancy, the model shows household labour supply, savings, and macroeconomic variables respond differently across age groups, influencing potential output and fiscal balances.

9. By explicitly modelling public pension systems and welfare transfers, the model assesses how ageing, policy reforms, or demographic changes affect government spending and revenue paths.

10. The model’s structure emphasises long-term stabilisation targets, such as debt-to-GDP ratios, with fiscal adjustments captured through residual budget components, supporting sustainability analyses.

11. Its design allows for future extensions—adding heterogeneity, international trade, or sectoral linkages—making it adaptable for evolving analytical needs.

12. UK OLG offers a transparent, data-calibrated approach that aligns household decisions with macroeconomic and fiscal outcomes, aiding policymakers and financial services professionals in understanding long-term economic dynamics.

Key Statistics

• UK OLG is calibrated to match recent UK economic data, including a baseline GDP per capita of £35,100 (fiscal year 2028-29).

• The model assumes UK population growth at 0.75% annually and productivity growth at 1.2%.

• The targeted government debt-to-GDP ratio is set at 100%, with residual fiscal balancing components around 6.25% of GDP.

• External calibration shows private assets to GDP at roughly 376%, with actual data around 443%.

• Income taxes are modelled with three thresholds at £12,570, £50,270, and £125,140, with marginal rates of 0%, 4%, and 5%, respectively.

• The capital share in production is set at one-third (33%), aligned with UK economic assumptions.

• Income shocks have persistence (ρz=0.9) and standard deviations calibrated to match income distribution, including high-income tails.

• Welfare payments during old age, mainly state pensions, are scaled based on age-specific profiles, with total transfers about 10.5% of GDP in long-run equilibrium.

• Asset holdings are calibrated to match UK wealth survey data, with the ratio of private assets to GDP around 376% in the model.

• The model’s simulations show a 0.1% decline in GDP when the basic income tax rate increases by 1 percentage point, with hours worked decreasing by 0.2% among older households.

Key Discussion Points

• The UK OLG model enhances fiscal policy analysis by explicitly incorporating individual life-cycle optimisation and demographic heterogeneity.

• Its ability to simulate shocks, policies, and demographic trends offers valuable insights into long-term macroeconomic stability and public finances.

• The model captures intra-generational inequalities through income shocks, which influence saving behaviours and wealth accumulation.

• It performs calibration to UK-specific data, ensuring relevance for policy impact assessment, especially on pension systems and welfare spending.

• Flexibility in operating as either a closed or open economy helps analyse international capital flows and their effects on interest rates and growth.

• Sensitivity analyses highlight how a 1% change in income tax or pension age can influence household labour supply, savings, and government fiscal balances.

• Household responses are age-dependent, with older individuals more sensitive to welfare and pension reforms, affecting aggregate labour supply and output.

• The model’s simplicity in production and international trade can be extended to include more sectoral or global dynamics for sector-specific policies.

• Future adaptations could improve modelling of wealth inequality, inheritance policies, and asset types like housing for a more comprehensive view.

• The model underscores the importance of demographic trends, such as life expectancy increases, on public spending and fiscal sustainability.

• Its capacity to simulate long-term effects makes it a core instrument for policy analysis, complementing existing macroeconomic models used by the OBR.

• Limitations include simplified production sectors and basic bequest modelling, which can be refined in future research to improve policy precision.

Document Description

This article introduces a new UK overlapping generations model developed to assess long-term macroeconomic and fiscal impacts of shocks, policies, and demographic changes. Built by the Office for Budget Responsibility and HM Treasury, it emphasises micro-founded household decision-making, demographic heterogeneity, and general equilibrium interactions. The article details the model’s structure, calibration to UK data, and demonstrates its use through various scenario analyses related to taxation, welfare, and demographics, offering valuable insights for policymakers and stakeholders in financial services seeking long-term strategic perspectives.