We analyze the political stability of welfare enhancing privatization of the social security. We consider an economy populated by overlapping generations, who vote on abolishing the funded system and replacing it with the pay-as-you-go scheme, i.e. “unprivatizing” the pension system. We show that even if abolishing the system reduces overall welfare, the distribution of benefits across cohorts along the transition path implies that some ways of “unprivatizing” social security are always politically favored

1. Motivation Model Motivation Results
Political (In)Stability of Social Security Reform
Krzysztof Makarski Joanna Tyrowicz
with help from Marcin Bielecki, Oliwia Komada and Magda Malec
Economic Institute, National Bank of Poland
Faculty of Economics, University of Warsaw
Warsaw School of Economics
Royal Economic Society - 2016 - Brighton
1 / 24

2. Motivation Model Motivation Results
Literature review
A wave of reforms: Holzman and Stiglitz (2001), Bonoli and Shikinawa (2006),
Gruber and Wise (2009)
2 / 24

3. Motivation Model Motivation Results
Literature review
A wave of reforms: Holzman and Stiglitz (2001), Bonoli and Shikinawa (2006),
Gruber and Wise (2009)
Reform = introduce some notion of funding into the system
2 / 24

4. Motivation Model Motivation Results
Literature review
A wave of reforms: Holzman and Stiglitz (2001), Bonoli and Shikinawa (2006),
Gruber and Wise (2009)
Reform = introduce some notion of funding into the system
Political economy of pension systems: will the reform be implemented
Cooley and Soares (1999), Galasso and Profeta (2002), subsequent literature
reviewed by de Waque (2005)
extant literature on whether or not privatization is in fact welfare enhancing:
Conesa and Kruger (1999), Nishiyama and Smetters (2007), Fehr (2009)
2 / 24

5. Motivation Model Motivation Results
Motivation
3 / 24

6. Motivation Model Motivation Results
Literature review - continued
Despite general welfare gains...
... most of these reforms got reversed: Jarrett (2011); Schwarz et al. (2014)
(At least) Some of the reversals are welfare deteriorating: Hagemejer et al
(2015)
4 / 24

7. Motivation Model Motivation Results
Goals and expectations
Goal
Suppose there already is a reform, with stable gains in the long-run:
does it eventually become politically stable?
5 / 24

8. Motivation Model Motivation Results
Goals and expectations
Goal
Suppose there already is a reform, with stable gains in the long-run:
does it eventually become politically stable?
Expectations
With passing of the initially old cohorts, welfare gains become majoritarian
Understand/explain the reversing of reforms
5 / 24

9. Motivation Model Motivation Results
Outline
1 Motivation
2 Model
3 Motivation
4 Results
6 / 24

10. Motivation Model Motivation Results
Agents
”born” at age 20 (j = 1) and live up to 100 years (J = 80)
subject to time and cohort dependent survival probability π
choose labor supply l endogenously until exogenous retirement age ¯J (forced to
retire)
7 / 24

11. Motivation Model Motivation Results
Agents
”born” at age 20 (j = 1) and live up to 100 years (J = 80)
subject to time and cohort dependent survival probability π
choose labor supply l endogenously until exogenous retirement age ¯J (forced to
retire)
optimize remaining lifetime utility derived from leisure 1 − l and consumption c
Uj,t =
J−j
s=0
δs πj+s,t+s
πj,t
u(cj+s,t+s, lj+s,t+s)
with
u(c, l) = log(cφ
(1 − l)1−φ
)
7 / 24

12. Motivation Model Motivation Results
Agents
receive market clearing wage for labor
receive market clearing interest rate on private savings
receive pension income + unintentional bequests
pay taxes
8 / 24

13. Motivation Model Motivation Results
Agents
receive market clearing wage for labor
receive market clearing interest rate on private savings
receive pension income + unintentional bequests
pay taxes
Subject to the budget constraint
(1 + τc
t )cj,t + sj,t = (1 − τl
t )(1 − τι
)wj,tlj,t ← labor income
+ (1 + (1 − τk
t )rt)sj−1,t−1 ← capital income
+ (1 − τl
t )pι
j,t ← pension income
+ bj,t ← bequests
− Υt ← lump-sum tax
8 / 24

14. Motivation Model Motivation Results
Firms
Perfectly competitive representative firm
Standard Cobb-Douglas production function
Yt = Kα
t (ztLt)1−α
Profit maximization implies
wt = zt(1 − α)kα
t
rt = αkα−1
t − d
9 / 24

15. Motivation Model Motivation Results
Government
collects taxes on earnings, interest and consumption (sum up to T)
spends a fixed share of GDP on government consumption G
collects social security contributions and pays out pensions
of the DB and NDC systems
subsidyt = τι
¯J−1
j=1
wj,tlj,t −
J
j= ¯J
pj,tNj,t
services debt D and targets a fixed long-run debt/GDP ratio
lump sum tax Υ adjusts to satisfy the government budget constraint in steady
state
consumption tax τC adjusts to satisfy the long-term debt/GDP target
Gt + subsidyt + (1 + rt)Dt−1 = Tt + Dt + Υt
J
j=1
Nj,t
10 / 24

16. Motivation Model Motivation Results
Pension system
Initial steady state: defined benefit
Exogenous contribution rate τ and an exogenous replacement rate ρ
pDB
¯J,t = ρ · wage in last working year
indexed by 25% of total payroll growth
11 / 24

17. Motivation Model Motivation Results
Pension system
Initial steady state: defined benefit
Exogenous contribution rate τ and an exogenous replacement rate ρ
pDB
¯J,t = ρ · wage in last working year
indexed by 25% of total payroll growth
Reform: partially funded defined contribution
Exogenous contribution rate τ and actuarially fair individual accounts
pDC
¯J,t =
accumulated sum of contributions ¯J,t
expected remaining lifetime ¯J,t
In PAYG: Contributions and pensions are indexed by 25% of total payroll growth
In funded part: return on capital, tax free
11 / 24

18. Motivation Model Motivation Results
What do we actually do? Two exercises
Exercise 1 - democracy from the scratch
Compensate cohorts living at t = 0 for whatever their loss due to funding
Allow all living people to vote
Use a fiscal rule: coordinated reductions in taxes and debt if reform reversed
Final steady state: debt share same as t = 0, gradual convergence
12 / 24

19. Motivation Model Motivation Results
What do we actually do? Two exercises
Exercise 1 - democracy from the scratch
Compensate cohorts living at t = 0 for whatever their loss due to funding
Allow all living people to vote
Use a fiscal rule: coordinated reductions in taxes and debt if reform reversed
Final steady state: debt share same as t = 0, gradual convergence
Exercise 2 - pension responsibility for fiscal responsibility
Reform at t = 0 is not compensated for (enlightened central planner)
Allow all living people to vote
Use all resources captured from funded pillar to reduce debt, only then allow
lower taxes
Final steady state: debt share at 30pp less than t = 0, gradual convergence
12 / 24

20. Motivation Model Motivation Results
Motivation
“Democracy” vs. “trading responsibilities”
13 / 24

21. Motivation Model Motivation Results
Political economy
What happens within each voting round?
Policy 1 - shift of contributions: funded ⇒ PAYG
Policy 2 - shift of pensions: annuity ⇒ benefit
Policy 3 - a combination of the two
14 / 24

22. Motivation Model Motivation Results
Political economy
What happens within each voting round?
Policy 1 - shift of contributions: funded ⇒ PAYG
Policy 2 - shift of pensions: annuity ⇒ benefit
Policy 3 - a combination of the two
We run these votes in subsequent years
If consumption equivalent positive, a cohort is in favor
If a policy gains majority, it is put in place
Order of voting:
Policy 1 vs status quo → winner vs Policy 2 → winner vs Policy 3
(Dhami and al Nowaihi (2010): transitivity of preferences)
14 / 24

23. Motivation Model Motivation Results
Voting results: reforms are never stable
Figure: Political support for reversing the reform
“Democracy” vs. “trading responsibilities”
15 / 24

24. Motivation Model Motivation Results
Even though reversals deteriorate welfare in the long run
Figure: Welfare effects of shifting contributions (Policy 1)
“Democracy” vs. “trading responsibilities”
16 / 24

25. Motivation Model Motivation Results
Even though reversals deteriorate welfare in the long run
Figure: Welfare effects of shifting pensions (Policy 2)
“Democracy” vs. “trading responsibilities”
17 / 24

26. Motivation Model Motivation Results
Even though reversals deteriorate welfare in the long run (Policy 4)
Figure: Welfare effects of combined policies (shifting both contributions and pensions)
“Democracy” vs. “trading responsibilities”
18 / 24

27. Motivation Model Motivation Results
Shift of pensions becomes inviable quite fast
Because it reduces pensions too much relative to delayed gains.
Winning scenarios
Voting year Winning policy
with democracy with trading resp.
2012 P3 P0
2022 P3 P3
2032 3 1
2042 1 1
2052 1 1
2062 1 1
2072 1 1
2082 1 1
2152 1 1
19 / 24

28. Motivation Model Motivation Results
Why are reforms never stable? Lower pension benefits distant
Figure: Pension benefits for voting in 2022
“Democracy” vs. “trading responsibilities”
20 / 24

29. Motivation Model Motivation Results
... taxes lower immediately...
Figure: Taxes for voting in 2022
“Democracy” vs. “trading responsibilities”
21 / 24

30. Motivation Model Motivation Results
... ultimately, due to lower debt.
Figure: Pension benefits for voting in 2022
“Democracy” vs. “trading responsibilities”
22 / 24

31. Motivation Model Motivation Results
Conclusions
We simulate subsequent voting rounds on potential pension reform reversals
to find out when does the initial reform become politically stable
The voting scenarios contain policies deteriorating welfare in the long run
We find that
funded system is never politically stable vis-a-vis to PAYG system
annuity becomes preferred to benefit
how internally consistent is that?
Our model does not need political risk, business cycles, etc.
Pension reform reversion is preferred if it reduces taxes for the living cohorts
23 / 24

32. Motivation Model Motivation Results
Thank you for your attention!
24 / 24