Public Finance - Introductory Pensions systems Public Finance - Introductory

Pensions: stylized facts In most countries the largest source of public spending → often between 14% e il 17% Upward trend because of Demographics Misuse of early pensions instead of unemployment insurance/assistance Several types of pensions Old age : when beyond a certain age (Early) Retirement : when beyond a certain # of years of work Disability : for ind who cannot earn an income because of accident/illness Survivors : for relatives of deceased workers Social : for ind non self sufficient Family : for families with dependent children 1-2 social insurance → previdence 3-6 → assistance Sociale, di guerra, invalidi civili, non udenti, non vedenti: assistenza (relaz gen 07) Public Finance - Introductory

Rationales for government intervention Efficiency Asymmetric info (weak) Intergenerational insurance Negative externality Equity Merit good Solidarity between generations Public Finance - Introductory

Public Finance - Introductory Evolution XIX century: mutual assistance within working categories XX century: progressive extension of mandatory insurance Growth of SS spending due to extension of provisions Since the 1980s many countries face a ‘pension debt’ → difference between entitled provisions and PV of future SS contributions → pension crises 3 causes of pension debt Financing mechanism of SS institutions Macroeconomic situation Demografics Public Finance - Introductory

Public Finance - Introductory U.S. historical data Public Finance - Introductory

Public Finance - Introductory The record braker Ida Mae Fuller First recipient of monthly Social Security Benefits Retired Nov. 4, 1939 and died in 1975, aged 100 Collected US$20,897 SS benefits having paid a tax of US$24.85 Public Finance - Introductory

Expenditures in SS - % of GDP – OECD 2006 Public Finance - Introductory

Sustainability of pensions in France – COR alternative scenarios Public Finance - Introductory

Causes of pensions crises In most countries, pension schemes were originally fully funded (capitalization) USA was an exception due to Great Depression → PAYG a fundamental element of Roosevelt’s New Deal High inflation of the 1970s reduced the real value of pension savings → switch to pay as you go PAYG Beginning with the 1980s increase of life expectancy and reduction of participation to workforce reduced the amount of contributions → pension debt Public Finance - Introductory

Definition of amount of pensions 2 ways of calculating the amount of the pension Retribution: pension correlated with salary (average or of the last X years) Contribution: pension correlated with contributions actually set aside In most countries until the 1990s predominance of retribution schemes → Pension debt → Differences of treament between categories of workers → Confusion between previdence and assistance Progressive switch to contribution systems with reforms during the 1990s Public Finance - Introductory

Public Finance - Introductory Financing Repartition (pay-as-you-go, or PAYG) Fully funded (capitalization) Non fully-funded: mix of the two previous systems (typical of countries undergoing pension reforms) Public Finance - Introductory

Public Finance - Introductory Pay-as-you-go Revenues of contributions at time t finance pensions at t → Today’s workers pay pensions of today’s retirees Equilibrium requires contributions=outlays at every time Public Finance - Introductory

Public Finance - Introductory Capitalization Also called ‘fully-funded’ because it is their main feature Today’s contributions invested in capital markets Upon retirement pension is equal to total amount of contributions plus total amount of capital gains/losses Equilibrium requires contributions=social security tax+rates of return=investiments+matured interest Public Finance - Introductory

Public Finance - Introductory Fully Funded Plan Period 1 Period 2 Period 3 Period 4 The Greatest Generation Work Retire Dead Still Dead contribute benefits Each generation’s benefits based on deposits it made during working life plus accumulated interest The Baby Boom Generation Retire Childhood Work Dead contribute benefits Unborn Childhood Work Retire Generation X contribute benefits Public Finance - Introductory

Pay As You Go (or Unfunded) System Pay As You Go (or Unfunded) System Period 1 Period 2 Period 3 Period 4 Each generation’s benefits come from tax payments made by current workers contribute benefits The Greatest Generation Work Retire Dead Still Dead contribute benefits The Baby Boom Generation Work Retire Childhood Dead contribute benefits Unborn Childhood Work Retire Generation X benefits Public Finance - Introductory

Partially Funded System Partially Funded System Period 1 Period 2 Period 3 Period 4 contribute benefits Baby Boomers and Gen X are also contributing to their own retirement The Greatest Generation Work Retire Dead Still Dead contribute benefits The Baby Boom Generation Work Retire Childhood Dead contribute benefits Unborn Childhood Work Retire Generation X benefits Public Finance - Introductory

Comparison between capitalization and PAYG PAYG generates intergenerational transfers Capitalization generates intertemporal reallocation If interest rate equal to productivity growth rate+rate of change of workforce → they are equivalent Public Finance - Introductory

Pensions and redistribution - 1 The more a pension scheme is … PAYG Retributive …the greater its redistributive potential The larger the outlays, the greater the redistribution Redistribution fluxes between generations (young and old) → intergenerational pact Under fully funded system → inter-temporal redistribution, no intergenerational pact Public Finance - Introductory

Pensions and redistribution - 2 In PAYG systems redistribution depends on equilibrium SS tax rate → ratio contributions/wage can avoid pension debt Type of redistribution (“intergenerational pact”) depends on 3 features of the system, i.e., whether it is in fixed amount: Substitution rate between pension and retribution Ratio between total pensions/total salaries Ratio between pension pro capite and net (of contributions ) wage Public Finance - Introductory

1. Fixed rate of substitution Pension is a fixed % of last year’s salary (or of the average of the last years) If population decreases → financial equilibrium requires higher SS tax rate Redistribution from young to old (lower net wage) If productivity rises → financial equilibrium requires lower SS tax rate Redistribution from old to young (higher net wage) Public Finance - Introductory

2. Fixed ratio total pensions/total salaries If equilibrium is kept at the aggregate level (total of contributions paid by all workers=total of pensions paid to all retirees) If population growth slows down → reduces today’s pensions (and viceversa) If productivity growth increases → increases today’s pensions and today’s net salaries (and viceversa) Public Finance - Introductory

3. Fixed ratio pension/net wage If equilibrium is at the level of single pension and single net wage If population growth slows down → it raises the equilibrium SS tax rate and reduces both the net wage and today’s pensions Same for productivity growth slowdown In general “…the devil lies in the details” In many countries (Italy, France) important fluxes of redistribution among categories of workers Pension jungle This is what current reform in France is surely goinjg to produce Public Finance - Introductory