Transcript Pensions

Pension Reform and Welfare
Dennis J. Snower
at ISEO, 4 July 2005
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Contents
Pension Issues
Pension Reform: Comparative Perspective
Labor Market Issues
Macroeconomic Implications of the
Unemployment Benefits System
Microeconomic Implications of Labor
Market Reform
Policy Proposals
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EU Problems
Population projects for the EU indicate that
– The ratio of persons of working age (15 to 64)
to those aged over 65 will decline from 4.1 in
2000 to 2.1 in 2050.
– While the total population is not expected to
increase, the elderly population will increase
from 61 to 103 million.
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PAYG vs Funded Schemes
In PAYG, payments to current pensioners
are funded out of the contributions of
working members.
In funded schemes, the pension funds are
invested in assets, and their return
provides retirement income.
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The government budget constraint:
twLN=pLP
where t =payroll tax,
w = wage,
LN = number of workers,
p = pension income per person
LP = number of pensioners
Thus:
t = (P/W) (LP /LN)
where (P/W) is the generosity of pensions, and
(LP /LN) is the aged dependency ratio.
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DB vs DC schemes
A defined benefit scheme pays out a
predetermined amount,
– usually related to number of years of service
and salary in the final years.
A defined contribution scheme pays out
the return on funds invested on the
individual’s behalf.
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Risks:
– DB schemes are less portable,
thus favour people who do not switch jobs.
– DB schemes favour people with steep
intertemporal earnings profiles,
who tend to be skilled workers.
– The DC pensions depend on the position of
the stock and bond markets.
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The introduction of a PAYG system is
Pareto improving as long as
– the growth rate of the population
– plus the growth rate of real wages
is greater than the rate of interest.
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Efficiency Issues
The value of a pension is affected by the rate of
inflation.
– Only the government can provide relevant insurance.
– Solution: Inflation-indexed bonds.
Myopia
– Pensions are a merit good.
– Solution: Compulsory pensions.
Incentives to work and save
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Equity Issues
Pensions related to past or current incomes:
– In a funded system, pensioners’ incomes are related
to their past incomes, whereas under PAYG, they
could be related to current incomes.
The gender gap:
– Women earn less than men.
– Women have fewer years of full-time work.
– Women live longer than men.
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Contents
Pension Issues
Pension Reform: Comparative
Perspective
Labor Market Issues
Macroeconomic Implications of the
Unemployment Benefits System
Microeconomic Implications of Labor
Market Reform
Policy Proposals
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The US Pension System
Three pillars:
– State-financed, PAYG pillar
– Funded occupational pension
– Funded personal pension
Problem: Underfunding
– In the aftermath of the stock market decline of
2000-02.
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Occupational pensions:
– 45% of employees have voluntary occupation
pension.
– Two types: DB and DC
401(k) Plans
–
–
–
–
Since the early 1980s.
Cross between occupational and personal pensions.
Both employers and employees can contribute.
Employees can choose among plans with different
risk-return profiles.
– Relatively few restrictions on withdrawals (after 60
years of age).
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Swedish Pension Reform
1992/1994: Sweden moved from a traditional incomerelated DB system to two types of DC systems:
– 14% of contributions go into individual financial accounts und
the financial DC system.
Managed by a variety of private funds, chosen by the individual.
– The remaining 86% go into the new PAYG system.
– The equivalent of 16% of each individual’s annual
pensionable income is credited yearly to his notional
account, under the Notional DC System.
– Because of the commitments to keep the contribution rate
fixed, the new system will accommodate demographic and
economic developments by adjusting the value of the
pensions.
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UK Pension Reform
Four tiers:
– State social security benefits for pensioners,
which consist of
a basic flat rate state retirement pension and
a state earnings related pension scheme (SERPS)
– Occupational pension schemes, offered by
employers.
– Pension schemes established by private
insurance companies.
– A state minimum guarantee.
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The problem is not so much the cost of the
system, but the growth in income
inequality among pensioners.
– Too many people have difficulty adding on to
their flat-rate basic state old age pension.
– Occupational and private pensions tend to
benefit the better off most.
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German Pension Reform
The Riester Reform in 2001
The PAYG pillar: reducing the replacement rate.
– By 2030 the net income replacement ratio will fall to 67-68%, as
compared to 70% today.
– Return to wage-oriented pension adjustment.
– Basic protection for everyone, according to need.
Introducing supplementary funded pensions.
– Voluntary, capital funded provision, promoted by government
subsidies,
– designed to support those on low income and families with
children.
State promotion of occupational pension schemes.
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Contents
Pension Issues
Pension Reform: Comparative Perspective
Labor Market Issues
Macroeconomic Implications of the
Unemployment Benefits System
Microeconomic Implications of Labor
Market Reform
Policy Proposals
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European Unemployment
European unemployment trended upwards between the
mid-1970s and mid-1990s. Since then it has varied
cyclically, without major structural change.
Within Europe, the UK and some small European
countries (Denmark, Ireland, and the Netherlands) have
experienced declines in unemployment, particularly in
the 1990s.
By contrast, other continental European countries
(Germany, France, Italy) have experienced continued
high unemployment.
Long-term unemployment (more than 1 year): 50% of
total adult unemployment.
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Divergent Unemployment Records
Over the 1990s, the countries that experienced
significant drops in unemployment did not
usually see any increase in inflation.
– Denmark, Ireland, the Netherlands, and the UK
The countries that reduced unemployment
significantly tended to have strong growth in
employment.
– These countries reduced unemployment because they raised
employment, not because they found new ways of hiding
unemployment.
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Employment
The population groups that suffer from
weak employment tend to be those at the
margins of the workforce.
Prime-age men are predominantly employed.
By contrast, women, the young and the old have
very different contributions to overall employment
across countries.
Thus the marginal groups are likely to benefit
disproportionately from employment policies, and
these policies should be targeted at them.
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Non-government employment in the Euro
area increased by less than 5% between
1970 and 1998 (in the US the increase
was 70%).
The EU employment rate of older workers
(55-64 years old): less than 40%.
The tax burden on labor income: over
40%.
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Employment Rates
80
75
Japan
70
USA
65
EU15
60
55
60
70
80
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90
00
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Education and Skills
60% of 25-64 year olds had at least upper
secondary education.
But only 8% of this group participate in
training or ongoing learning.
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Working life and education
40 years working life - men
Unemployment
Inactive
Employment
UK
F
D
IT
Low education
ES
UK
F
D
IT
ES
UK
Medium education
F
D
IT
ES
High education
OECD 1996
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Contents
Pension Issues
Pension Reform: Comparative Perspective
Labor Market Issues
Macroeconomic Implications of the
Unemployment Benefits System
Microeconomic Implications of Labor
Market Reform
Policy Proposals
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Macroeconomic
Consequences
Taxes and benefits
Tax rate and
replacement ratio
Rates of
employment and
non-employment
Incentives to work
and search for jobs
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The Effect of the Tax Rate on Output
Replacement
ratio
Job search
effort
Output and
income
Tax rate
Work effort
Output
An
increase in
the tax rate
reduces
output and
income
Macroeconomic
Activity
Tax rate
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The Effect of Output on the Tax Rate
Replacement
ratio
Job search
effort
Output and
income
Tax rate
Work effort
A reduction in Output
output and
income raises
the tax rate
necessary to
finance a given
replacement
ratio.
Government Budget
Constraint
Tax rate
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Increasing the Replacement Ratio
Replacement
ratio
Job search
effort
Output and
income
Tax rate
Work effort
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Output
MA shifts down because higher RR reduces incentives
and thus reduces output (given the tax rate).
GBC shifts right because higher RR requires a higher
tax rate (for given output).
Macroeconomic Activity (MA)
Government Budget Constraint
(GBC)
Tax rate
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Output
Response to Adverse
Macroeconomic
Shocks
The more generous the benefit
system, the more destabilizing
macroeconomic shocks become,
because the tax base is smaller.
Macroeconomic Activity
Government Budget Constraint
Tax rate
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Contents
Pension Issues
Pension Reform: Comparative Perspective
Labor Market Issues
Macroeconomic Implications of the
Unemployment Benefits System
Microeconomic Implications of Labor
Market Reform
Policy Proposals
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Income Replacement Programs
These programs pay benefits only to those not at work.
Examples:
– Workers’ compensation insurance for work injuries,
– disability programs,
– unemployment compensation.
For simplicity, consider a program in which
– after the adverse shock, workers’ receive their pre-shock
income,
– once they work, their benefits are withdrawn,
– after recovery, the pre-shock income is restored.
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The pre-shock budget
constraint is AB, and
earnings are E.
Maximum utility is achieved
at point D, where the
person works.
The post-shock budget
constraint is CAB.
Maximum utility is achieved
at point C, where the
person does not work.
Note that the returns to the
first hours of work are
negative.
The worker is better off at C
than at D.
Reducing the benefit to AF would
ensure no loss of utility through the
shock, and still provide an
incentive to return to work after the
shock.
Income
B
C
E
Thus the income
replacement program
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discourages work.
D
U2
F
U1
A
Hours
of
leisure
36
Guaranteed Annual Income
The guaranteed annual income is based on family
size, living costs, and local welfare regulations.
Actual earnings are subtracted from this guaranteed
level, and the person receives a check for the
difference.
Example: US welfare programs.
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The pre-shock budget
constraint is AB, and
earnings are E.
The guaranteed annual
income is Yg.
The post-shock budget
constraint is ACDB.
If one receives the subsidy,
an extra hour of work
generates no net
increase in income. This
is a disincentive to work.
At point C the person achieves
higher utility than at D.
If Yg were reduced sufficiently,
point D would be preferred.
Income
B
E
D
C
Yg
U2
F
A
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U1
Hours
of
leisure
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Guaranteed Annual Income with Work
Requirement
To tackle the disincentive
Income
problem, impose a “work
requirement.”
For example, the government
B
may require recipients to
work 3 hours per day to
E
qualify for the guaranteed
Yg
annual income.
The post-shock budget
constraint is AHGDB.
The effect of the policy is to
induce the recipients to work,
but as long as they are on
welfare, they have the
incentive only to work the
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minimum hours needed
to
D
G
C
F
H
A
Hours
of
leisure
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The Earned Income Tax
Credit (EITC)
The EITC is an earnings subsidy.
Tax credit for low-income families with at least
one worker.
If their tax credit exceeds their total income tax
liability, recipients receive a check for the
difference.
The tax credits vary with earnings and the
number of dependent children.
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The EITC is meant to be an income maintenance
program that preserves work incentives.
Many believe that the EITC is the most effective way to
subsidize the working poor.
Its benefits are more concentrated on the poor than are the
benefits of the minimum wage.
Since the subsidy is issued to workers through the income tax
system, it avoids the stigmatizing effects associated with
wage subsidies to the employer.
It is currently the largest cast subsidy program directed
a low-income households with children.
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For workers with one child:
– For earnings of $6,680 per year or less, the tax
credit is 34% of gross earnings,
– up to a maximum of $2,271 (= $6,680 x 0.34).
– For earnings between $6,680 and $12,300,
receive the maximum credit.
– For earnings above $12,300, the tax credit is
gradually phased out, so that when earnings
reach $26,494, the tax credit is zero. This means
that net earnings are 84% of gross earnings.
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Let W be the gross wage
and Wn be the net wage.
Income
B
Work incentives:
The income effect pushes in
the direction of less work.
– Segment AC: Wn = 1.34
W; substitution effect
pushes for more work.
– Segment CD: Wn = W;
substitution effect is
absent.
– Segment DE: Wn = 0.84
W; substitution effect
pushes for less work.
– Segment EB: Wn = W
$26,494
E
D
$12,300
C
$6,680
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A
A
Hours
of
leisure
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The Evidence
Modest effects on labor supply (in the US):
– Those in the lowest earnings zone increased their
labor supply by 18 hours per year;
– those in the middle and upper zones reduced their
labor supply by 35-51 hours per year, respectively.
The expansion of the EITC
– induced more single mother recipients to join the
labor market, but
– slightly reduced labor force participation and hours of
work among married mother recipients.
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Contents
Pension Issues
Pension Reform: Comparative Perspective
Labor Market Issues
Macroeconomic Implications of the
Unemployment Benefits System
Microeconomic Implications of Labor
Market Reform
Policy Proposals
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Guidelines for Policy Design
Redistribute income primarily through
economic incentives to work and acquire
skills.
– For example, the longer a person is unemployed,
the larger the employment and training incentives
he or she should receive.
Subsidies rise with the duration of unemployment, and fall
the duration of subsequent employment.
– Training should be customised to the needs of
employers.
Subsidised work experience.
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Proposal 1: Vouchers
– Employment vouchers.
– Training vouchers.
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Employment vouchers and job search
PV from employment
PV from unemployment:
traditional policy
PV from unemployment
Unemployment duration
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Training vouchers and skill acquisition
Income
Costs
Benefits
Skill, Effort
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Further Guidelines
Allow all existing benefits to be
exchangeable for employment and
training vouchers.
– The rate at which they are transferred should
make the transfers neutral to the government’s
budget.
Further redistribution through a
conditional negative income tax.
– Simplify the tax-transfer system: Replace the
plethora of redistributive measures by a scheme
based on income.
Income support for the disadvantaged
after interviews and counselling.
– These are to ensure
support
for those who are
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Proposal 2: Welfare Accounts
Retirement account (covering pensions)
Unemployment account (covering
unemployment support)
Human capital account (covering
education and training)
Health account (covering insurance
against sickness and disability)
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Salient Features
Contributions to welfare accounts rather
than taxes.
Mandatory minimum contribution rates and
mandatory maximum withdrawal rates.
– Rates set in an actuarially fair manner: for
each account, the discounted value of the
associated aggregate benefits equals the
discounted value of the aggregate
contributions.
– Rates depend primarily on income and age.
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Encourage the Private Sector to
Contribute to the Welfare System
The private sector will contribute only if it is
impossible for the government to use the taxand-transfer system to drive the private
providers out of business.
Thus the government must have two budgetary
systems:
– one in which non-welfare expenditures are financed
through the existing array of taxes, and
– another system in which the public-sector
expenditures on welfare services are financed
through payments from people’s welfare accounts.
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Competition
The public and private sectors would
provide welfare services on an equal
footing.
To prevent the private sector from
“cream-skimming”, private-sector pricing
needs to be regulated:
– make prices of welfare services dependent
only on a small number of characteristics,
such as age and income.
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Redistribution
The government can make balanced budget
redistributions.
Redistributing income across people’s accounts along
the lines of a “conditional negative income tax.”
Conditions attached to the transfers for low-income
groups:
– Evidence of willingness to work.
If account balance falls below zero:
– replenish that account with excess funds from the other
accounts.
– If all balances fall below zero, the government would make
specified deposits.
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Voluntary Contributions
People are encouraged to voluntarily
contribute more than the specified
minimum amounts to their accounts.
– While their contributions are taxed or
subsidised in accordance with the conditional
negative income tax scheme, withdrawals and
capital income from their accounts are taxed
at preferential rates.
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Employment Incentives
Additional transfers to the welfare
accounts of long-term unemployed people
who purchase “employment vouchers:”
– Recruitment vouchers (also for pensioners)
– Training vouchers
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The Self-Regulating Welfare State
If people’s balances in a particular account
exceeded a specified limit, they could be
transferred to other welfare accounts.
Welfare services are financed solely from what
people choose to spend on these services out of
their welfare accounts.
– Thus the government has no incentive to manipulate
the contribution rates and withdrawal rates of the
welfare accounts in order to ease fiscal pressures
outside the welfare state.
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The Upshot
To increase incentives for productive activity.
To reduce waste in welfare provision.
To encourage investment.
To increase consumer choice regarding the magnitude
and composition of welfare services.
To make redistribution less wasteful, by promoting
competition between the public and private sectors in the
provision and finance of welfare services.
To induce the private sector to contribute to the provision
and finance of welfare services.
To be self-financing.
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