Welfare effects of fiscal policy in reforming the pension system

Motivation Model Calibration Calibration Results
Welfare eﬀects of ﬁscal policy
in reforming the pension system
Joanna Tyrowicz
(with Olivia Komada and Krzysztof Makarski)
Group for Research in APplied Economics (GRAPE)
15th
International Pension Workshop
Paris, May 2017
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Motivation
pension system reform ⇒ between and within cohort redistribution
2 / 29

Motivation
pension system reform ⇒ between and within cohort redistribution
ﬁscal policy may counteract or reinforce this adjustment
2 / 29

Literature diﬀers in terms of used ﬁscal adjustment
lump-sum tax
Heer and Irmen (2008)
contribution rates
Kumru & Thanopoulos (2011), Bruce & Turnovsky (2013), Kitao (2014)
labor tax
Keuschnigg et al. (2012), Verbic et al. (2006)
debt
Belan and Pestieau (1999), Lindbeck & Persson (2003), Kumru & Piggott (2010), Wright et al.
(2012), Song et al. (2015)
consumption tax
Fehr (2000), Keuschnigg et al. (2012), Verbic et al. (2006), Diaz-Gimenez & Diaz-Saavedra
(2009), Fehr and Kindermann (2010), Kumru and Piggott (2010), De la Croix et al. (2012), Kitao
(2015),
3 / 29

Literature diﬀers in terms of used ﬁscal adjustment
lump-sum tax
Heer and Irmen (2008)
contribution rates
Kumru & Thanopoulos (2011), Bruce & Turnovsky (2013), Kitao (2014)
labor tax
Keuschnigg et al. (2012), Verbic et al. (2006)
debt
Belan and Pestieau (1999), Lindbeck & Persson (2003), Kumru & Piggott (2010), Wright et al.
(2012), Song et al. (2015)
consumption tax
Fehr (2000), Keuschnigg et al. (2012), Verbic et al. (2006), Diaz-Gimenez & Diaz-Saavedra
(2009), Fehr and Kindermann (2010), Kumru and Piggott (2010), De la Croix et al. (2012), Kitao
(2015), Nishiyama & Smetters (2007)
3 / 29

Contribution
provide a systematic overview of the interaction between the pension
system reform and ﬁscal policy
4 / 29

Contribution
propose new ways of ﬁnancing the pensions system reform
public spending
tax progression
4 / 29

Contribution
propose new ways of ﬁnancing the pensions system reform
public spending
tax progression
is Nishiyama & Smetters (2007) result universal?
4 / 29

Our approach
OLG model with idiosyncratic productivity shocks
Procedure
Baseline: PAYG DB with aging and thus deﬁcit
Reform: PAYG DB ⇒ partially funded DC
5 / 29

Our approach
Procedure
8 fiscal policies
2 pension system adjustments: contribution or benefits
6 fiscal closures: tax on labor (with/without debt adjustment),
consumption (with/without debt adjustment), progressive income tax,
public spending
5 / 29

Our approach
Procedure
8 ﬁscal policies
public spending
government maz behave diﬀerently in baseline and reform
→ 64 combinations
5 / 29

Our approach
Procedure
8 fiscal policies
public spending
government maz behave differently in baseline and reform
→ 64 combinations
compare welfare effect and political support
5 / 29

Results preview
ﬁscal closure does matter
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Results preview
in short ...
6 / 29

Results preview
in short ...
... and long run
6 / 29

Results preview
in short ...
... and long run
welfare may by improved (in Hicks sense) ...
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Results preview
in short ...
... and long run
... and with suﬃcient political support
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Results preview
in short ...
... and long run
but for a majority of the policy options the opposite is true (welfare
improving closures have too little support or vice versa)
6 / 29

Results preview
in short ...
... and long run
but for a majority of the policy options the opposite is true (welfare
improving closures have too little support or vice versa)
Nishiyama & Smetters (2007) result is not universal
6 / 29

Outline
1 Motivation
2 Model
3 Calibration
4 Calibration
5 Results
7 / 29

Consumers I
live for j = 1, 2, ..., 16 periods
with survival probability πj,t < 1
choose labor supply endogenously until retirement at age ¯J
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Consumers I
live for j = 1, 2, ..., 16 periods
with survival probability πj,t < 1
choose labor supply endogenously until retirement at age ¯J
Utility
u(cj,t, 1 − lj,t, gt) = log(cj,t) ← private consumption
+φl log(1 − lj,t) ← leisure
+φglog(gt) ← public goods consumption
8 / 29

Consumers II
Income is composed of
9 / 29

Consumers II
net labor income wj,t = (1 − τl,t)(1 − τt)ωj,t ¯wt
after-tax capital income rtaj,t = (1 − τk) ¯rtaj,t
unintended bequests Γj,t
pension beneﬁts bj,t
9 / 29

Consumers II
net labor income wj,t = (1 − τl,t)(1 − τt)ωj,t ¯wt
after-tax capital income rtaj,t = (1 − τk) ¯rtaj,t
unintended bequests Γj,t
pension beneﬁts bj,t
and used to ﬁnance
consumption (1 + τc,t)cj,t
savings aj+1,t+1 − (1 + rt) aj,t
lump sum tax Υt
9 / 29

Consumers III
Ex ante homogeneous
with initial assets a1,t = 0 and productivity ω1,t = 1
Productivity changes randomly over time
ωj,t = eηj,t where ηj,t follows AR(1) process
approximated by Markov chain with Π(ηj,t|ηj−1,t−1)
States can be summarized by ψj,t = (aj,t, ηj,t, fj,t),
where aj,t denotes private assets, ηj,t productivity and fj,t pension assets
Solve the following optimization problem
V (ψj,t) = max
cj,t,lj,t,aj+1,t+1
u(cj,t, lj,t, gt) + δ
πj+1,t+1
πj,t
E V (ψj+1,t+1) | ψj,t
BC : aj+1,t+1 + (1 + τc,t)cj,t + Υt = wj,tlj,t + bj,t + (1 + rt) aj,t + Γj,t
10 / 29

Producers
Perfectly competitive representative ﬁrm
Standard Cobb-Douglas production function
Yt = Kα
t (ztLt)1−α
,
Proﬁt maximization implies
wt = (1 − α)Kα
t zt(ztLt)−α
rt = αKα−1
(ztLt)1−α
− d
where d is the capital depreciation rate
11 / 29

Government
Collects taxes
Tt = τl,t(1 − τt) ¯wtLt + τk,trtAt + τc,tCt + Υt
J
j=1
Nj,t
Finances spending on public goods and service Gt = gt
J
j=1 Nj,t,
balance pension system subsidyt
and services debt ∆Dt = (1 + rt)Dt−1 − Dt
Tt = Gt + subsidyt + ∆Dt
12 / 29

Pension system
Baseline scenario PAYG DB
equal beneﬁt for whole cohort (insurance motive)
b ¯J,t = ρ · wavg,t
13 / 29

Pension system
indexed by payroll growth rate (labor ↑ ⇒ beneﬁts ↑)
bj,t = (1 + rI
t )bj−1,t−1∀j > ¯J
13 / 29

Pension system
indexed by payroll growth rate (labor ↑ ⇒ beneﬁts ↑)
bj,t = (1 + rI
t )bj−1,t−1∀j > ¯J
longevity ↑ ⇒ deﬁcit occurs
subsidyt =
J
j= ¯J
Nj,tbj,t − τtwt
¯J−1
j=1
Nj,tLt,
13 / 29

Pension system - reform: partially funded DC
contributions go into PAYG and funded pillar: τt = τI
t + τII
t
14 / 29

t + τII
t
individual pension accounts fj,t = {fI
j,t, fII
j,t } ⇒ no insurance
fI
j,t = (1 + rI
t )fI
j−1,t−1 + τI
t wj,tlj,t
fII
j,t = (1 + ¯rt)fII
j−1,t−1 + τII
t wj,tlj,t
beneﬁts are actuarially fair
b ¯J,t =
accrued ‘savings’
life expectancyt
+
accrued savings
life expectancyt
14 / 29

t + τII
t
individual pension accounts fj,t = {fI
j,t, fII
j,t } ⇒ no insurance
fI
j,t = (1 + rI
t )fI
j−1,t−1 + τI
t wj,tlj,t
fII
j,t = (1 + ¯rt)fII
j−1,t−1 + τII
t wj,tlj,t
beneﬁts are actuarially fair
b ¯J,t =
accrued ‘savings’
life expectancyt
+
accrued savings
life expectancyt
indexed by payroll growth rate and capital rate respectively
bI
j,t = (1 + rI
t )bI
j−1,t−1 and bII
j,t = (1 + ¯rt)bII
j−1,t−1 ∀j > ¯J,
14 / 29

64 policy options
8 ways of financing transition cost in baseline and reform scenario:
Fiscal closures within the pension system
contribution τt
tax on benefits τb,t
Fiscal closures financing the pension system deficit
consumption tax closure τc,t
labor tax τl,t
tax progressivity closure τH
l,tI
public debt + consumption tax Dt + τc,t
public debt + labor tax Dt + τl,t
public spending closure gt
15 / 29

Calibration to replicate 2015 US economy
Taxes {τc, τl, τk} match revenue as % of GDP {9.2%, 3.8%, 3.6%}
Depreciation rate d matches investment rate 25%
Replacement rate ρ matches beneﬁts as % of GDP 5.2%
Contribution rate balances pension system
Retirement age ¯J = 65
Preference for leisure φl matches average hours 33%
Preference for public consumption φg optimal p.c value
Discounting rate δ matches interest rate 4%
16 / 29

Calibration of demographics
Demographics from UN data
number of 20-year-olds mortality rates
17 / 29

Calibration of demographics
Demographics from UN data
number of 20-year-olds mortality rates
Idiosyncratic productivity shock based on Kruger and Ludwig (2013):
Persistence η = 0.95
Variance ση = 0.375
17 / 29

Baseline
The eﬀects of demographics
adjustment in pension parameters adjustment in ﬁscal parameters
18 / 29

Reform
Gradually replace PAYG DB with
a partially funded deﬁne contribution (DC)
19 / 29

Welfare eﬀect - ﬁnal steady state
Fiscal closure
Baseline
τ τb τc τl prog. debtτc debtτl gt
Reform
τ 0.70
pensions (τb) 0.53
τc 0.39
τl 0.25
progression 0.29
debtτc 0.39
debtτl 0.25
gt 0.08
20 / 29

Welfare eﬀect - ﬁnal steady state
Fiscal closure
Baseline
Reform
τ 0.70 0.53 0.53 0.52 0.52 0.53 0.52 0.55
pensions (τb) 0.70 0.53 0.53 0.52 0.52 0.53 0.52 0.55
τc 0.63 0.48 0.39 0.39 0.39 0.39 0.39 0.42
τl 0.55 0.42 0.25 0.25 0.25 0.25 0.25 0.28
progression 0.57 0.44 0.29 0.28 0.29 0.29 0.28 0.42
debtτc 0.63 0.48 0.39 0.39 0.39 0.39 0.39 0.42
debtτl 0.55 0.42 0.25 0.25 0.25 0.25 0.25 0.28
gt 0.48 0.38 0.48 0.45 0.48 0.48 0.45 0.08
20 / 29

Welfare eﬀect - aggregate
Fiscal closure
Baseline
Reform
τ 0.08
pensions (τb) 0.11
τc -0.07
τl -0.37
progression -0.33
debtτc -0.09
debtτl -0.14
gt -0.34
21 / 29

Welfare eﬀect - aggregate
Fiscal closure
Baseline
Reform
τ 0.08 0.13 -0.04 -0.03 -0.02 -0.04 0.12 0.02
pensions (τb) 0.06 0.11 -0.06 -0.05 -0.04 -0.06 0.10 -0.00
τc 0.09 0.15 -0.07 -0.06 -0.05 -0.07 0.09 -0.00
τl -0.12 -0.04 -0.38 -0.37 -0.36 -0.38 -0.25 -0.32
progression -0.07 0.02 -0.35 -0.34 -0.33 -0.35 -0.23 -0.03
debtτc 0.07 0.13 -0.09 -0.07 -0.07 -0.09 0.07 -0.02
debtτl 0.05 0.10 -0.26 -0.26 -0.25 -0.27 -0.14 -0.21
gt -0.05 0.06 -0.41 -0.39 -0.38 -0.41 -0.25 -0.34
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Welfare eﬀects
τ τb
progression gt
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Welfare eﬀects
τc τl
debtτc debtτl
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Political support
Political majority
(% of cohorts approving at the time of the reform - 50%)
Fiscal closure
Baseline
Reform
τ 8
pensions (τb) -50
τc -5
τl -5.2
progression -5
debtτc 6
debtτl 3
gt -13
24 / 29

Political support
Political majority
(% of cohorts approving at the time of the reform - 50%)
Fiscal closure
Baseline
Reform
τ 8 16 8 16 16 8 16 8
pensions (τb) -50 -50 -50 -50 -50 -50 -50 -50
τc -13 6 -5 3 6 -5 6 -5
τl -5 -2 -13 -5.2 -5 -13 -5 -13
progression -5 6 -13 -5 -5 -13 -5 6
debtτc 6 6 6 6 6 6 6 6
debtτl 2 6 -17 3 3 3 3 -5
gt -13 6 -13 -5 -5 -13 3 -13
24 / 29

Key insights
ﬁscal closure can change the evaluation of the reform
ﬁscal closure matters for political support
may improve welfare and be politically favored at the same time
25 / 29

Key insights
ﬁscal closure can change the evaluation of the reform
ﬁscal closure matters for political support
may improve welfare and be politically favored at the same time
labor supply major source of adjustment
25 / 29

Nishiyama & Smetters, 2007: stochastic vs deterministic?
large role for the insurance motive per se
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large role for the insurance motive per se
but there are closures with positive outcomes despite stochastic setup
26 / 29

τ τc τl
τb debtτc debtτl
gt
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Conclusions
Fiscal closures matter a lot (unnoticed in earlier literature)
Insurance motive large but not decisive for evaluation of (partial)
privatization
Adjustment in pensions yields highest welfare, but is never politically
favored
Debt closures generally yield some welfare gain and are able to obtain
political support
28 / 29

Questions or suggestions?
Thank you!
w: grape.org.pl
t: grape org
f: grape.org
e: j.tyrowicz@grape.org.pl
29 / 29

Welfare effects of fiscal policy in reforming the pension system

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