This paper extends Gertler's (1999) tractable overlapping generations model with life-cycle features by allowing for distortionary taxation, demographic transition, and stochastic variation in demographic structure. The model is used to study demographic change in the small open economy of Finland. Simulations highlight the key role played by labour market responses to ageing. When the responses of labour supply, wages, and hence private consumption, to higher taxation are consistently accounted for, efficiency losses induced by demographic change can be considerable. Stochastic simulations suggest that lengthening of working time has only a modest alleviating effect on the fiscal burden of ageing. This is based on the observation that only a small fraction of stochastic variation in an endogenously determined contribution rate is explained by stochastic variation in the length of working time. Variation in life expectancy is clearly much more important. The paper develops a tractable dynamic general equilibrium macroeconomic model that allows for demographic transition. The model features dynamic optimization of a small open economy with an internationally given real interest rate and a non-stochastic balanced growth path determined by labour-saving technological development and population growth. Optimal consumption and labour supply decisions are based on Gertler's (1999) tractable overlapping generation model, extended for distortionary taxes and time-varying retirement and death probabilities. Pensions are conditioned on aggregate wage level and demographic trend, and the model features a partially funded pension system. The funded part of the pension system is considered contractual saving (assets accumulated by the pension fund) and the PAYG part as a transfer from workers to pensioners. These transfers are financed by collecting pension contributions from firms and workers. The results of simulations highlight the key role played by feedback effects from taxation in the assessment of economic costs of ageing. When the responses of labour supply, real wages, and hence private consumption, to higher taxation are consistently accounted for, the economy settles at a level of taxation clearly above that generally estimated in mechanical sustainability calculations. Even if the effective retirement age were to increase as expected, the burden from pension payments alone would cause the tax rate to rise to a level above that witnessed in the worst years of Finland's recession of the mid-1990s. Results from stochastic simulations support this view, by showing that a lengthening of working time has only a minor alleviating impact on the fiscal burden of ageing: Only a small fraction of the stochastic variation in an endogenously determined income tax rate is explained by the stochastic variation in the length of working time. Finally, if the pension replacement rate falls, as seems likely under the current pension regime, there would be a much smaller increase in taxation in response to rising dependency ratio. The average decline in the level of pensions relative to wage developments, however, raises a concern that the falling purchasing power of pensions relative to wage developments will exert pressure on other social security schemes. The current pension scheme, which appears to be financially sustainable, may thus in practice generate costs toThis paper extends Gertler's (1999) tractable overlapping generations model with life-cycle features by allowing for distortionary taxation, demographic transition, and stochastic variation in demographic structure. The model is used to study demographic change in the small open economy of Finland. Simulations highlight the key role played by labour market responses to ageing. When the responses of labour supply, wages, and hence private consumption, to higher taxation are consistently accounted for, efficiency losses induced by demographic change can be considerable. Stochastic simulations suggest that lengthening of working time has only a modest alleviating effect on the fiscal burden of ageing. This is based on the observation that only a small fraction of stochastic variation in an endogenously determined contribution rate is explained by stochastic variation in the length of working time. Variation in life expectancy is clearly much more important. The paper develops a tractable dynamic general equilibrium macroeconomic model that allows for demographic transition. The model features dynamic optimization of a small open economy with an internationally given real interest rate and a non-stochastic balanced growth path determined by labour-saving technological development and population growth. Optimal consumption and labour supply decisions are based on Gertler's (1999) tractable overlapping generation model, extended for distortionary taxes and time-varying retirement and death probabilities. Pensions are conditioned on aggregate wage level and demographic trend, and the model features a partially funded pension system. The funded part of the pension system is considered contractual saving (assets accumulated by the pension fund) and the PAYG part as a transfer from workers to pensioners. These transfers are financed by collecting pension contributions from firms and workers. The results of simulations highlight the key role played by feedback effects from taxation in the assessment of economic costs of ageing. When the responses of labour supply, real wages, and hence private consumption, to higher taxation are consistently accounted for, the economy settles at a level of taxation clearly above that generally estimated in mechanical sustainability calculations. Even if the effective retirement age were to increase as expected, the burden from pension payments alone would cause the tax rate to rise to a level above that witnessed in the worst years of Finland's recession of the mid-1990s. Results from stochastic simulations support this view, by showing that a lengthening of working time has only a minor alleviating impact on the fiscal burden of ageing: Only a small fraction of the stochastic variation in an endogenously determined income tax rate is explained by the stochastic variation in the length of working time. Finally, if the pension replacement rate falls, as seems likely under the current pension regime, there would be a much smaller increase in taxation in response to rising dependency ratio. The average decline in the level of pensions relative to wage developments, however, raises a concern that the falling purchasing power of pensions relative to wage developments will exert pressure on other social security schemes. The current pension scheme, which appears to be financially sustainable, may thus in practice generate costs to