The extent of demographic changes in Europe is much more drastic than in the United States. This paper studies the effects of population aging on the interactions between economic growth and living standards in Europe with labor market and pension reform, behavioral adaptations, and international capital flows. Our analysis is based on an overlapping generations model with behavioral reactions to reform which is extended to the multi-country situation typical for Europe. While the negative effects of population aging on growth in Europe can in principle be compensated by reforms and economic adaptation mechanisms, they may be partially offset by behavioral reactions.

We quantitatively characterize the optimal mix of progressive income taxes and education subsidies in a model with endogenous human capital formation, borrowing constraints, income risk and incomplete financial markets. In addition to the distortions of labor supply, progressive taxes weaken the incentives to acquire education. The latter distortion can potentially be mitigated by an education subsidy. We find that the welfare-maximizing fiscal policy is indeed characterized by a substantially progressive labor income tax code and a positive subsidy for college education. Both the degree of tax progressivity and the education subsidy are larger than in the current US status quo.