The Political Economy of Social Security Advanced Political Economics Fall 2011 Riccardo Puglisi

Why does most Redistribution take place through Pensions? Main Component of the Welfare State What do Pensions Systems do? Provide Income to the Elderly Why do different countries feature different welfare states? Main Questions

Pension Systems and 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)

 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 Main Feature 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

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

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)?

Political Responses: Young and Old  Generational Differences: Young and Old  Elderly are pension recipients, they always support Pension systems  However, Old are not a Majority  Important Question: Why do some Young and Middle Age Workers Agree to Transfer Resources to the Current Retirees?  Since Pension Systems are a Saving Device Two Elements are needed: 1.Social Norm or Contract Among Successive Generations 2.Economic Convenience to Follow the Contract

Economic Convenience of a Pension System  We assume that a Social Norm or Contract exists: Agents expect their decisions on the Pension Systems to carry on into the future  Which Features may induce an Economic Convenience to Support the Pension System for some Young and Middle Age Voters?  Dynamic Inefficiency or Good Performance of a PAYG Pension System [Imrohoroglu, Imrohoroglu and Jones ET 99]  Reduced Time Horizon or “Middle Age” Median Voter [Browning EI 75, Cooley & Soares JPE 99]  Redistribution Within Generations [Tabellini SJE 00]  General Equilibrium Effects on Savings and Wages [Cooley & Soares JPE 99, Boldrin & Rustichini RED 00]

 3 periods OLG: Young, Adult, Old  Demographic:  population growth rate  Young and Adult Work and Pay Taxes  Old Retire and Receive a Pension Transfer  Young and Adult are Heterogeneous in their working ability (e)  Time constraint: A Simple Model 1 + e = l + n Effective disposable time Leisure Work

e Distribution of Ability elel eueu eMeM E ( e ) = 0 Poor Rich G (e M ) = 1/2 Median Ability e M < 0 Median < Average A Simple Economy e  [e l, e u ] e l 0 e ˜ G (e) E (e) = 0 Average Ability

A Simple Economic Model  Selfish Preferences:  Budget Constraint

A Simple Economic Model  Social Security System Budget Constraint:  Economic Decisions

A Simple Economic Model  Labor supply Individual AverageAbility  Social Security System Budget Constraint:

 Assume Commitment or Voting once-and-for-all voting (constant  )  Old: Voters’ Preferences

 Adult:  Young: Voters’ Preferences

 COST: Every Young pays a Pension Contribution:  n t  COST: Every Adult pays a Pension Contribution:  n t+1  BENEFIT: Every Old receives a Pension Transfer: p  Assume Dynamic efficiency: Pension system provides on average a lower rate of return than alternative saving mechanisms  Internal rate of return, 1+i= (1+g)(1+  )<(1+R) Economic Convenience of Pension System to Voters  Average Young does not support the Pension system

 Although pensions system provides on average a lower rate of return than alternative saving mechanisms…..  ………………some individuals face a Reduced Time Horizon  Adults have already paid some contributions, which represent a sunk cost.  Past Contributions will not be returned to the worker, but as pensions  Middle Age Individuals only consider Current and Future Contributions and Benefits Economic Convenience of Pension System to Voters

 Internal Rate of Return for an Adult Worker: i W : Economic Convenience: Reduced Time Horizon  Average Adult may support the Pension system

 Although pensions system provides on average a lower rate of return than alternative saving mechanisms…..  ………………some (poor) individuals face a higher return, due to the existence of an element of Redistribution Within Generation  Idea: Agents obtain different returns from the pension system, according to their income:  High Income agents pay large contributions and receive a flat pension benefits: their return is below average  Low Income agents pay lower contributions and receive a flat pension benefits: their return is above average Economic Convenience: Redistribution

 Pension Budget Constraint:  Internal Rate of Return, i w : Economic Convenience: Redistribution  Consider a two periods model with Workers and Retirees.  Low-Income Young may support the Pension system

Political Equilibrium  Individual voting:  Old choose the highest tax rate (top of the Laffer curve)  The vote of Young and Adults depend on their ability  For a given ability (e), Adults choose a higher rate than Young  Preferences are single-peaked  Median voter’s theorem applies  The equilibrium tax rate is the one voted by the agent with Median working ability

 Adult:  Young:  Find equivalent voter: e A and e Y such that  A =  Y. Comparing Votes

Old Low  High  Adults Young Voting on Social Security

Empirical Implications  Pensions decreasing in R  Aging of the population has two opposite effects:  Raises the dependency ratio  Increases the median voter age (or reduces her income)  An increase in income inequality increases Pension spending

 Pension systems affect saving decisions: larger pension transfers lead to lower savings and hence to less capital accumulation  Less Capital implies Lower Wages and Higher Returns on Capital  Idea: More pensions lead to Less Capital. Redistribution:  Capitalists enjoy higher returns on their capital  Workers receive lower wages Additional Element of Economic Convenience: general equilibrium effect

 Simplified Version of Boldrin & Rustichini (RED 00)  2 periods OLG: Young & Old  Homogeneous agents (no ability types)  Production economy with savings and capital accumulation  Demographic:  population growth rate (stochastic)  Log-linear utility : Simple general equilibrium model  Individual Budget Constraint

Simple general equilibrium model  Economic Decisions  Equilibrium Conditions

 Median voter is a young agent  Assume commitment, consider steady state and set initial stock of capital equal to its steady state level.  Indirect Utility: Political equilibrium

 General equilibrium effect:

 In a democracy, voters may only determine current policy-makers and policies. Future policies are determined by future voters (or policy-makers)  Consider the existence of some Economic Convenience: why do some Young or Middle Agents agree to incur a current cost against an uncertain future benefit?  Idea: They expect their current voting behavior to affect future voter’s behavior. How they vote today is relevant for tomorrow’s policy Social Norms or Contracts

 Young Voters’ Expectations: If we pay a pension to the current retirees, we will receive a pension in our old age.  What is their Voting Strategy?  If a pension transfer, financed by a tax rate , has always been paid in the past, Vote for   If, at some point in the past, the pension transfer has not been paid, and thus p , Vote for   Is this Voting Strategy the best a young voter can do?  Is not she better off not paying the current tax rate? Social Norm: How does it work?

 A pension transfer has always been paid in the past.  Agent votes for  Lifetime income:  Agent votes for  Lifetime income:   Because of the Economic Convenience, Agents vote for  Voting Strategy: Results

 A pension transfer has not been paid in the past.  Agent votes for  Lifetime income:  Agent votes for  Lifetime income:   To avoid to incur in a current cost attached to no future benefits, Agents vote for  Voting Strategy: Results