political (in)stability of pension system reforms

Motivation Model Motivation Results

Political (In)Stability of Social Security Reform

Krzysztof Makarski Joanna Tyrowiczwith help from Marcin Bielecki, Oliwia Komada and Magda Malec

Economic Institute, National Bank of PolandFaculty of Economics, University of Warsaw

Warsaw School of Economics

Royal Economic Society - 2016 - Brighton

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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 systemPolitical economy of pension systems: will the reform be implemented

Cooley and Soares (1999), Galasso and Profeta (2002), subsequent literaturereviewed 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)

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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 implementedCooley and Soares (1999), Galasso and Profeta (2002), subsequent literaturereviewed 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)

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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 systemPolitical economy of pension systems: will the reform be implemented

Cooley and Soares (1999), Galasso and Profeta (2002), subsequent literaturereviewed 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)

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Motivation Model Motivation Results

Motivation

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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)

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Motivation Model Motivation Results

Goals and expectations

GoalSuppose 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 majoritarianUnderstand/explain the reversing of reforms

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Motivation Model Motivation Results

Goals and expectations

GoalSuppose 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 majoritarianUnderstand/explain the reversing of reforms

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Motivation Model Motivation Results

Outline

1 Motivation

2 Model

3 Motivation

4 Results

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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 πchoose labor supply l endogenously until exogenous retirement age J̄ (forced toretire)

optimize remaining lifetime utility derived from leisure 1− l and consumption c

Uj,t =J−j∑s=0

[δsπj+s,t+sπj,t

u(cj+s,t+s, lj+s,t+s)]

with

u(c, l) = log(cφ(1− l)1−φ)

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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 πchoose labor supply l endogenously until exogenous retirement age J̄ (forced toretire)

optimize remaining lifetime utility derived from leisure 1− l and consumption c

Uj,t =J−j∑s=0

[δsπj+s,t+sπj,t

u(cj+s,t+s, lj+s,t+s)]

with

u(c, l) = log(cφ(1− l)1−φ)

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Motivation Model Motivation Results

Agents

receive market clearing wage for laborreceive market clearing interest rate on private savingsreceive pension income + unintentional bequestspay taxes

Subject to the budget constraint

(1 + τ ct )cj,t + sj,t = (1− τ lt )(1− τ ι)wj,tlj,t ← labor income

+ (1 + (1− τkt )rt)sj−1,t−1 ← capital income

+ (1− τ lt )pιj,t ← pension income+ bj,t ← bequests−Υt ← lump-sum tax

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Motivation Model Motivation Results

Agents

receive market clearing wage for laborreceive market clearing interest rate on private savingsreceive pension income + unintentional bequestspay taxes

Subject to the budget constraint

(1 + τ ct )cj,t + sj,t = (1− τ lt )(1− τ ι)wj,tlj,t ← labor income

+ (1 + (1− τkt )rt)sj−1,t−1 ← capital income

+ (1− τ lt )pιj,t ← pension income+ bj,t ← bequests−Υt ← lump-sum tax

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Motivation Model Motivation Results

Firms

Perfectly competitive representative firmStandard Cobb-Douglas production function

Yt = Kαt (ztLt)1−α

Profit maximization implies

wt = zt(1− α)kαtrt = αkα−1

t − d

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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 Gcollects social security contributions and pays out pensionsof the DB and NDC systems

subsidyt = τ ιJ̄−1∑j=1

wj,tlj,t −J∑j=J̄

pj,tNj,t

services debt D and targets a fixed long-run debt/GDP ratiolump sum tax Υ adjusts to satisfy the government budget constraint in steadystateconsumption 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

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Motivation Model Motivation Results

Pension system

Initial steady state: defined benefit

Exogenous contribution rate τ and an exogenous replacement rate ρ

pDBJ̄,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

pDCJ̄,t =accumulated sum of contributionsJ̄,t

expected remaining lifetimeJ̄,t

In PAYG: Contributions and pensions are indexed by 25% of total payroll growthIn funded part: return on capital, tax free

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Motivation Model Motivation Results

Pension system

Initial steady state: defined benefit

Exogenous contribution rate τ and an exogenous replacement rate ρ

pDBJ̄,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

pDCJ̄,t =accumulated sum of contributionsJ̄,t

expected remaining lifetimeJ̄,t

In PAYG: Contributions and pensions are indexed by 25% of total payroll growthIn funded part: return on capital, tax free

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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 fundingAllow all living people to voteUse a fiscal rule: coordinated reductions in taxes and debt if reform reversedFinal 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 voteUse all resources captured from funded pillar to reduce debt, only then allowlower taxesFinal steady state: debt share at 30pp less than t = 0, gradual convergence

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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 fundingAllow all living people to voteUse a fiscal rule: coordinated reductions in taxes and debt if reform reversedFinal 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 voteUse all resources captured from funded pillar to reduce debt, only then allowlower taxesFinal steady state: debt share at 30pp less than t = 0, gradual convergence

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Motivation Model Motivation Results

Motivation

“Democracy” vs. “trading responsibilities”

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Motivation Model Motivation Results

Political economy

What happens within each voting round?

Policy 1 - shift of contributions: funded ⇒ PAYGPolicy 2 - shift of pensions: annuity ⇒ benefitPolicy 3 - a combination of the two

We run these votes in subsequent yearsIf consumption equivalent positive, a cohort is in favorIf a policy gains majority, it is put in placeOrder of voting:Policy 1 vs status quo → winner vs Policy 2 → winner vs Policy 3(Dhami and al Nowaihi (2010): transitivity of preferences)

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Motivation Model Motivation Results

Political economy

What happens within each voting round?

Policy 1 - shift of contributions: funded ⇒ PAYGPolicy 2 - shift of pensions: annuity ⇒ benefitPolicy 3 - a combination of the two

We run these votes in subsequent yearsIf consumption equivalent positive, a cohort is in favorIf a policy gains majority, it is put in placeOrder of voting:Policy 1 vs status quo → winner vs Policy 2 → winner vs Policy 3(Dhami and al Nowaihi (2010): transitivity of preferences)

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Motivation Model Motivation Results

Voting results: reforms are never stable

Figure: Political support for reversing the reform

“Democracy” vs. “trading responsibilities”

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Even though reversals deteriorate welfare in the long run

Figure: Welfare effects of shifting contributions (Policy 1)

“Democracy” vs. “trading responsibilities”

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Even though reversals deteriorate welfare in the long run

Figure: Welfare effects of shifting pensions (Policy 2)

“Democracy” vs. “trading responsibilities”

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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”

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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 policywith democracy with trading resp.

2012 P3 P02022 P3 P32032 3 12042 1 12052 1 12062 1 12072 1 12082 1 12152 1 1

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Motivation Model Motivation Results

Why are reforms never stable? Lower pension benefits distant

Figure: Pension benefits for voting in 2022

“Democracy” vs. “trading responsibilities”

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... taxes lower immediately...

Figure: Taxes for voting in 2022

“Democracy” vs. “trading responsibilities”

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... ultimately, due to lower debt.

Figure: Pension benefits for voting in 2022

“Democracy” vs. “trading responsibilities”

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Conclusions

We simulate subsequent voting rounds on potential pension reform reversalsto find out when does the initial reform become politically stableThe voting scenarios contain policies deteriorating welfare in the long runWe find that

funded system is never politically stable vis-a-vis to PAYG systemannuity becomes preferred to benefithow 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

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Motivation Model Motivation Results

Thank you for your attention!

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