Reforms of the pension system imply substantial redistribution between cohorts and within cohorts. They also implicitly affect the scope of risk sharing in the society. Making pensions linked to individual incomes, increases efficiency, but reduces the insurance motive implicit in Beveridgean systems. The existing view in the literature argues that the insurance motive dominates the efficiency gains when evaluating the welfare effects. We show that this result is not universal: there exist ways to increase efficiency or compensate the loss of insurance assuring welfare gains from the pension system reform even in the economy with uninsurable idiosyncratic income shocks. The fiscal closure, which necessarily accompanies the changes in the pension system, may boost efficiency and/or make up for lower insurance in the pension system. Indeed, fiscal closures inherently interact with the effects of the pension system reform, counteracting or reinforcing the original effects. By analyzing a variety of fiscal closures, we reconcile our result with the earlier literature. We also study the political economy context and show that political support is feasible depending on the fiscal closure.

1. Welfareeffectsoffiscalpolicy
inreformingthepensionsystem
Krzysztof Makarski Joanna Tyrowicz Oliwia Komada
FAME | GRAPE, NBP FAME | GRAPE, IZA, IAAEU FAME | GRAPE
Warsaw School of Economics University of Warsaw Warsaw School of Economics
Motivation
A consensus: with income shocks, privatized pen-
sions reduce welfare because of insufficient insur-
ance. True?
Literature full of various fiscal closures, each with
welfare effects on its own. Effect on conclusions?
Literature “forgets” about public debt and capi-
tal taxation. These are intersting and relevant
from the policy perspective!
What do we do?
Construct an otherwise standard OLG model, with specific focus on the role of fiscal policy in determining
welfare effects of pension reform.
• Provide a systematic overview of the interactions between the pension reform and fiscal closures
• Introduce to the literature new closures, that are theoretically relevant: labor tax progression
(can substitute for the insurance motive) and capital income tax (pension privatization typically
exempts part of capital gains from taxation).
• Challenge the consensus: measure the size of insurance motive, as separate from efficiency gain,
i.e. quantify the two channels through which pension privatization influences the economy.
Result 1: reform can improve welfare & be politically favored
% of consumption in the reform scenario you give up to ensure that the reform takes place
Fiscal closure Baseline
τk dτk prog. τ τb τc dτc τl dτl
Reform
τk 0.57 0.56 1.01 0.59 0.50 0.65 0.65 0.65 0.66
dτk 0.54 0.54 0.99 0.56 0.47 0.63 0.63 0.63 0.64
prog. -0.45 -0.45 0.02 -0.13 -0.07 -0.35 -0.35 -0.36 -0.34
τ -0.13 -0.12 0.35 0.09 0.14 -0.03 -0.02 -0.03 -0.01
τb -0.15 -0.14 0.33 0.07 0.13 -0.05 -0.04 -0.05 -0.03
τc -0.14 -0.14 0.33 0.11 0.17 -0.04 -0.03 -0.05 -0.03
dτc -0.16 -0.16 0.31 0.09 0.15 -0.07 -0.06 -0.07 -0.05
τl -0.46 -0.46 0.01 -0.11 -0.03 -0.36 -0.35 -0.37 -0.35
dτl -0.45 -0.45 0.01 -0.1 -0.02 -0.36 -0.35 -0.36 -0.35
• τk is always good (efficiency) AND progression (almost) always better then τl in the reform (insurance)
• consequences of (temporarily) allowing public debt: small welfare ↓ and huge political support ↑
Result 2: insurance is small & efficiency is large
capital tax τk progression
capital tax:
the highest welfare gain
due to efficiency
progression:
the smallest welfare loss due
to insurance
The model
Consumers face uncertain life span (up to 20 peri-
ods = 100 years), with unintended bequests. Earn-
ings subject to idiosyncratic shocks, uninsur-
able. Consumers work until retirement age, con-
tributing to the social security and paying taxes (on
labor income, capital income and consumption).
They smoothen consumption throughout lifetime
and have no bequest motive.
Competitive producers with a standard CD pro-
duction function
Government collects taxes, finances government
expenditure and services the debt. Government
also balances pension system ⇐ fiscal closure
Pension system
Baseline scenario: PAYG DB
→ within cohort redistrbution: b ¯J,t = ρ · wavg,t
(insurance)
→ contributions ˜tax (disincentive for the labor )
→ longevity causes deficit ⇐ fiscal closure
Reform scenario: (partially) funded DC
→ contributions: τt = τP AY G
t + τF
t
→ individual pension accounts (no insurance)
b ¯J,t = accrued ‘savings’
life expectancyt
+ accrued savings
life expectancyt
→ contributions viewed as future benefits (incen-
tives to increase labor supply)
Expectation: privatization generates a transitory
deficit ⇐ fiscal closure, but system is balanced
in the long run.
Question: will there be enough of a gain in the
long run, to compensate the transition cohorts?
Conclusions: fiscal closure DOES matter
Fiscal closures redistribute, i.e. attenuate or amplify the effects of the reform, hence affect the welfare
and hence affect efficiency.
• Loss of insurance is important but not decisive for evaluation of (partial) privatization.
• Preferred policy options when privatizing pensions: combine debt (allows to smoothen the costs of
the transition) with capital income taxation.
Acknowledgements
Authors are grateful to Roel Beetsma, Monika Buetler, Lukasz Drozd, Borys Grochulski, Hans Fehr, Tim Kehoe, Fabian Kindermann, Finn Kydland, Duke Love, Jaromir Nosal,
Franck Portier, Jose Victor Rios Rull, Ward Romp, Jacek Suda and Carlos E. Zarazaga for fruitful discussions and useful comments. The paper benefited greatly from the
comments of the participants of SNDE in New York (2014), Netspar Pension Days in Leiden (2016), International Pension Workshop (2017), ICMAIF in Rethymnon (2017),
XXII Workshop on Dynamic Macroeconomics in Vigo (2017). The support of National Center for Science (grant UMO-2014/13/B/HS4/03264) is gratefully acknowledged.