Political Economics Riccardo Puglisi Lecture 6 Content: An Overview of the Pension Systems Distinguish Features Economic and Political Explanation A Simple Model of Pensions

Pension Systems and the Welfare State  What do Pensions Systems do? Provide Income to the Elderly  Main Component of the Welfare State Social Spending by Age Group (1980) Age Group Country and over Canada France Germany Italy Japan Sweden UK US Source: World Bank (1994)

Pay As You Go (PAYG) Systems: contributions by current workers are immediately used to pay pensions to current retirees. …but some (partially) funded systems exist in UK, Sweden Complete Coverage (but of diffent type) of all workers, their families and of elderly poor (social pension transfers) Financing through social security contribution rate on labor income (paid by workers and firms). Italy: 32.7%; Spain: 28.3%; Germany 19.5%; France 14.75% %. Pension Benefits (Defined Benefits, DB) depend on (i) number of years of contributions and (ii) reference wage. Redistribution: equal, flat pensions or proportional to labor income (or contributions). Pension Systems: Main Characteristics

Pension Indexation: to inflation (Italia, Francia), wages or demographic and economic factors (Germany post 2006) Eligibility: Years of Contribution and seniority Retirement Age Official: 65 for men (60 in France) and 60 for females Effective: much lower (58 in Italy e France in 2000) e in decreasing! Pension Systems: Main Characteristics

Pension Systems Design Features

Retirement and Longevity

Population Aging

 Pension Systems are mainly Pay-As-You-Go (or Unfunded) and Redistribute Across (and Within) Generations  The Size of the Program Increases with Economic Growth  Pension Systems are Financed with Special Payroll Taxes  Pension Systems Induce Early Retirement  Official Retirement Age has not Increased with Life Expectancy and Health Historical Features of Pension Systems

 The Government Determines the Pension Benefit Formula  Benefits Increase with Lifetime Earnings: Bismarckian and Beveridgean Systems  Benefits do not Depend on Asset Income  Benefits are Paid as Life Annuity  Hard to Borrow against Future Benefits Main Feature of Pension Systems: Benefits

 Individuals are Shortsighted  Lack of Information Why Should the Government Intervene? Equity Moral Hazard  Initial Economic Growth: Share the Pie with the Elderly  Few Reliable Saving Instruments  Ex: US after the Great Depression, France and Italy after WWII  Absence of Private Insurance Markets (Life Annuity) due to Adverse Selection Problems

Failures of Government Intervention  Financial Sustainability: Current Pension Benefits are Too Large and may not be Financially Sustainable in the Long Run  Employment: High Payroll Taxes (not closely tied to pension benefits) Discourage Employment  Early Retirement: Pension Systems Induce Early Retirement thereby Decreasing the Employment Rate among the Elderly  Economic Growth: High Tax Burden and Early Retirement may Reduce Accumulation in Physical and Human Capital

Pension Systems: Unanswered Questions  Equity Reasons may Justify the Initial Government Intervention to Set-up a PAYG Pension System:  US after the great Depression (stock market crash)  Italy and France after the WWII (Inflation)  Lack of Private Insurance Markets (Adverse Selection) Explains the Continuation of these Programs as a Substitute for Family Insurance.  However, how to Explain:  Their Enormous Extension over the last three decades  Their Different Characteristics among Similar Economies  The Existence of Growth-Reducing Features

Pension Systems: Unanswered Questions Pension Fund Assets as Percentage of GDP,

Pension Systems: Unanswered Questions Simulated Real Rate of return to private occupational Pension Funds in eight industrial Countries

Pension Systems: Unanswered Questions Effective retirement age in some OECD Countries

Pensions: Political Economics Approach  We abstract from Equity and Asymmetric Information and Concentrate on the Redistribution  Pension Systems as a Saving Mechanism with Redistribution  Why do a Majority of Young and Middle Age Workers Agree to Transfer Resources to a Minority composed of the Current Elderly (Retirees)?  Social Norm or Contract Among Successive Generations  Economic Convenience to Follow the Contract

 Intertemporal, two Periods Model  Two Types of Agents: Young and Old  Demographic Aspects: L t = (1+n) L t-1  Young Work, Consume and Save for Future Consumption. Young Economic Decision: Saving  Young Budget Constraint:  Old Retire and Consume. No Economic Decision: they Consume all their Income  Old Budget Constraint: An Economic Model with Pensions

 Agents’ Utility Function  Economic Decision: Young Agents’ Economic Decision

….some simple algebra

Thus, Saving Decrease if  Pensions Increase  Tax Rates Increase  Rate of Returns Decrease  Net Income Decreases Saving Decisions

 Workers L t, Retirees L t-1 where L t = (1+n) L t-1  Pension Tax Revenue: L t  t w t,  Pension Benefits: L t-1 p t,  Pension Budget Constraint: Pension System’s Budget Constraint