Welfare effects of the pension system reform

1. Welfare eﬀects the pension reforms Welfare eﬀects of the pension reforms Krzysztof Makarski 12 Joanna Tyrowicz23 Jan Hagemejer23 with the assistance of Agnieszka Borowska and Karolina Goraus 1Warsaw School of Economics 2Faculty of Economics, University of Warsaw 3Economic Institute, National Bank of Poland ISCEF - 2014 - Paris 1 / 37

2. Welfare effects the pension reforms Motivation The big(ger) picture A (too) broad scientific project at the University of Warsaw OLG modeling of the pension system reform in Poland (Our intended) Contributions: 1 fiscal closures have welfare effects (Pareto efficient reform?) 2 labor market effects when intensive and extensive margin is combined with indivisibility of labor 3 political stability of pension reforms We have (almost) completed (1), still work on (2) and (3) Today: welfare effects of various fiscal closures for 1999 reform in Poland (PAYG DB ⇒ FDC + NDC) 2 / 37

6. Welfare effects the pension reforms Motivation Questions How different fiscal closures of the pension system reform affect welfare? welfare effect of the reform (aggregate and across generations) extent and timing of fiscal adjustment for different fiscal closures pensions general equilibrium effects 3 / 37

11. Welfare eﬀects the pension reforms Motivation What do we do? Things we really care for: private and public savings (inter-temporal choice) + time inconsistency labor supply decision (intra-temporal choice) + retirement age pension system + pension system reform inter-generational transfers + utility to compare welfare across time with changing demographics calibrating the model closely Things we simplify: production sector (just standard CB production function with depreciation) labor market (elastic labor supply now, will become “indivisible” labor in extension) input data (demographics, life-cycle patterns, etc.) no heterogeneity within cohorts 4 / 37

22. Welfare effects the pension reforms Model Roadmap 1 Motivation 2 Model 3 Calibration 4 Welfare effects of fiscal closures 5 Summary 5 / 37

23. Welfare effects the pension reforms Model Model overview OLG model with endogenous labor and savings Heterogeneity across cohorts (mortality and labor productivity) No heterogeneity within cohorts Agents have time inconsistent preferences Exogenous retirement age and demographics Competitive producers with CD production function Pension system + pension system reform Inter-generational transfers + utility to compare welfare across time with changing demographics Different fiscal closures (to do fiscal rules) Calibrated to the Polish economy 6 / 37

24. Welfare effects the pension reforms Model What we do not know before modeling? 1999 reform: DB PAYG ⇒ NDC + FDC = partially funded DC part of contributions stay in the PAYG system (SIF) part of contributions shifted away (OPFs) + fiscal tension today lower replacement rates + ease fiscal tension in future comparing the steady states is not enough - transitory welfare effects BUT SIF gap needs to be financed ⇒ possible fiscal closures with own welfare effects five closures: lump sum, labor tax, consumption tax, debt + labor tax, debt + consumption tax we cannot tell ex ante which fiscal closure is better? effect for savings, labor supply and output? Comparing steady states (baseline and reform) is not enough ⇒ need to analyze the whole path Which closure in the baseline? 7 / 37

30. Welfare eﬀects the pension reforms Model Consumers Are free to choose how much to work, but only until ¯J (forced to retire) Optimize lifetime utility derived from leisure and consumption Uj(cj,t, lj,t) = uj(cj,t, lj,t) + β J−j s=1 δs πj+s,t+s πj,t u (cj+s,t+s, lj+s,t+s) (1) subject to (1 + τc,t)cj,t + sj,t + τj + υt = (1 − τι j,t − τl,t)wj,tlj,t ← labor income + (1 + rt(1 − τk,t))sj,t−1 ← capital income + (1 − τl,t)pι,j,t + bj,t ← pensions + bequests where u(c, l) = φ log(c) + (1 − φ) log(1 − l) 8 / 37

31. Welfare eﬀects the pension reforms Model Producers maximize Yt − wtLt − (rk t + d)Kt subject to Yt = Kα t (ztLt)1−α where the path of {z}∞ t=0 is exogenous (calibrated to AWG, by EC) Interest rate interest rate on capital rk t = MPK − d, endogenous (riskless) interest rate on government debt to be rG t = 0.33 · rk t households (and pension funds) by public debt inelastically returns on savings yield a linear combination of risky and risk-less 9 / 37

32. Welfare eﬀects the pension reforms Model Producers maximize Yt − wtLt − (rk t + d)Kt subject to Yt = Kα t (ztLt)1−α where the path of {z}∞ t=0 is exogenous (calibrated to AWG, by EC) Interest rate interest rate on capital rk t = MPK − d, endogenous (riskless) interest rate on government debt to be rG t = 0.33 · rk t households (and pension funds) by public debt inelastically returns on savings yield a linear combination of risky and risk-less 9 / 37

33. Welfare effects the pension reforms Model Public finances SIF collects social security contributions and pays out pensions subsidyt = τι t · wtLt − J j= ¯J bj,tπj,tNt−j (2) any debt/surplus in SIF is government debt/surplus Government collects taxes on earnings, interest and consumption + υ spends fixed amount of GDP/money + services debt long run debt/GDP ratio fixed to finance pension system can use taxes or debt ⇐ fiscal closures 10 / 37

34. Welfare effects the pension reforms Model Public finances SIF collects social security contributions and pays out pensions subsidyt = τι t · wtLt − J j= ¯J bj,tπj,tNt−j (2) any debt/surplus in SIF is government debt/surplus Government collects taxes on earnings, interest and consumption + υ spends fixed amount of GDP/money + services debt long run debt/GDP ratio fixed to finance pension system can use taxes or debt ⇐ fiscal closures 10 / 37

35. Welfare effects the pension reforms Model Pension systems initial steady state: PAYG Defined Benefit (DB), τι t = τDB after the original reform: NDC + FDC (two pillars) τ = τI + τII NDC = contributions indexed with growth of payroll + benefit actuarially fair + post retirement indexation with 20% of payroll growth FDC = contributions earn interest + benefit actuarially fair + post retirement also earn interest 11 / 37

39. Welfare effects the pension reforms Model How do we know what is "better"? LSRA! Lump Sum Redistribution Authority as Nishiyama & Smetters (2007) 1 Run the no policy change scenario ⇒ baseline 2 Run the policy change scenario ⇒ reform 3 For each cohort compare utility, compensate the losers from the winners 4 If net effect positive ⇒ reform efficient 5 Run reform again, with the compensation, to observe GE effects What is baseline? Always the same: births, mortality, productivity and retirement age Pension reform: baseline = PAYG DB | reform = NCD + FDC 12 / 37

42. Welfare effects the pension reforms Calibration Roadmap 1 Motivation 2 Model 3 Calibration 4 Welfare effects of fiscal closures 5 Summary 13 / 37

43. Welfare eﬀects the pension reforms Calibration Baseline: no of births (20 year olds): Demographic projection (2060), constant afterwards (conservative) 14 / 37

44. Welfare eﬀects the pension reforms Calibration Baseline: mortality rates Demographic projection (2060), constant afterwards 15 / 37

45. Welfare eﬀects the pension reforms Calibration Baseline: old age dependency ratio Demographic projection (2060), constant afterwards 16 / 37

46. Welfare eﬀects the pension reforms Calibration Baseline: labor augmenting technological progress Historical data, projection from AWG, new steady state at 1.7% 17 / 37

47. Welfare eﬀects the pension reforms Calibration Baseline: retirement age Historical data, assumed (based on law) afterwards 18 / 37

48. Welfare eﬀects the pension reforms Calibration Baseline (outcomes): pension beneﬁts in GDP Aging plus decreasing labor force 19 / 37

49. Welfare eﬀects the pension reforms Calibration What the reform does - replacement rates (relative to baseline) Pensions are substantially reduced by PAYG DB → DC Fiscal closure matters little and initial cohorts unaﬀected 20 / 37

50. Welfare effects the pension reforms Calibration Calibration to replicate 1999 economy Preference for leisure (φ) matches participation rate of 56.8% Replacement rate (ρ) matches benefits/GDP ratio of 5% Contributions rate (τ) matches SIF deficit/GDP ratio of 0.8% Labor income tax (τl) set to 11% to match PIT/GDP ratio Consumption tax (τc) set to match VAT/GDP ratio Capital tax (τk) de iure = de facto The initial capital 21 / 37

51. Welfare eﬀects the pension reforms Calibration Parameters for diﬀerent calibrations Calibrated parameters β = 1 β = 0.9 β = 0.8 ω = 1 ω - D97 ω = 1 ω - D97 ω = 1 ω - D97 φ 0.535 0.577 0.537 0.575 0.538 0.578 δ 0.981 1.007 0.986 1.005 0.993 1.012 d 0.052 0.055 0.057 0.055 0.055 0.06 tl 0.11 0.11 0.11 0.11 0.11 0.11 τ 0.061 0.0608 0.0608 0.061 0.0606 0.0611 ρ 0.25 0.15 0.25 0.15 0.251 0.151 resulting xt/yt 21.1 21.1 21.1 21.1 21.1 21.1 r 7.5 7.3 7.5 7.5 7.5 7.3 Note: D97: Deaton (1997) decomposition. 22 / 37

52. Welfare effects the pension reforms Welfare effects of fiscal closures Roadmap 1 Motivation 2 Model 3 Calibration 4 Welfare effects of fiscal closures 5 Summary 23 / 37

53. Welfare effects the pension reforms Welfare effects of fiscal closures Results SIF deficit resulting from the reform is financed ... ... by labor tax or consumption tax ⇒ debt share in GDP is held constant, so are taxes, but τl or τc is adjusted among all the living ... by debt which is later repaid with labor or consumption tax ⇒ debt share in GDP grows to a threshold of 70%, with all taxes held constant, then debt gets automatically reduced to 45% of GDP exponentially, τc or τl is adjusted for living then onwards ... by lump sum taxes on all living generations ⇒ debt share in GDP and tax rates are held constant, υ is adjusted among all the living 24 / 37

56. Welfare effects the pension reforms Welfare effects of fiscal closures Results: Welfare Efficiency of the reforms LSRA after redistribution (as % of permanent consumption) baseline closure reform closure Υ τc τl debt + τc debt + τl Υ 2.0% 2.4% 2.6% 2.3% 2.5% τc 1.7% 2.0% 2.2% 1.9% 2.1% debt + τc 1.7% 2.1% 2.3% 2.0% 2.2% τl 1.5% 1.9% 2.1% 1.8% 2.0% debt + τl 1.6% 2.0% 2.2% 1.9% 2.1% 25 / 37

57. Welfare effects the pension reforms Welfare effects of fiscal closures Results: Distribution of welfare effects Welfare: all closures, no time inconsistency 26 / 37

58. Welfare effects the pension reforms Welfare effects of fiscal closures Results: Decomposition of welfare effects Decomposition - consumption tax (left) and debt/consumption tax (right) 27 / 37

59. Welfare effects the pension reforms Welfare effects of fiscal closures Results: Decomposition of welfare effects Decomposition - labor tax (left) and debt/labor tax (right) 28 / 37

60. Welfare effects the pension reforms Welfare effects of fiscal closures Results: Decomposition of welfare effects LSRA after redistribution (% of perm. cons.) Fiscal β = 1 β = 0.9 β = 0.8 closure flat D97 flat D97 flat D97 τl 0.021 0.016 0.015 0.012 0.009 0.005 Debt/τl 0.021 0.015 0.015 0.012 0.009 0.005 τC 0.020 0.017 0.015 0.012 0.009 0.006 Debt/τC 0.020 0.016 0.014 0.012 0.008 0.005 υt 0.020 0.019 0.015 0.013 0.011 0.007 Note: D97 denotes calibration according to Deaton (1997) decomposition. 29 / 37

61. Welfare effects the pension reforms Welfare effects of fiscal closures Results: Fiscal adjustment Debt/consumption tax - higher taxes initially, become eventually lower 30 / 37

62. Welfare effects the pension reforms Welfare effects of fiscal closures Results: Fiscal adjustment Debt/labor tax - higher taxes initially, become eventually lower 31 / 37

63. Welfare effects the pension reforms Welfare effects of fiscal closures Results: Fiscal adjustment Taxes - higher taxes initially, become eventually lower 32 / 37

64. Welfare effects the pension reforms Welfare effects of fiscal closures Results: Macroeconomic effects Closure GDP Labor supply Capital Period D97 ω flat ω D97 ω flat ω D97 ω flat ω 10 0.6% 0.7% -0.9% -0.5% 1.8% 2.3% Labor tax 50 2.2% 2.0% -1.3% 0.9% 7.2% 6.4% ∞ 2.5% 2.1% -1.2% 0.4% 8.3% 7.0% 10 0.6% 0.7% -0.8% -0.2% 1.9% 2.4% Consumption 50 2.9% 2.7% -0.6% 1.1% 9.8% 9.1% tax ∞ 2.4% 2.0% -0.9% 0.5% 7.8% 6.7% 10 0.2% 0.2% -0.3% 0.1% 0.6% 0.5% Debt with 50 2.0% 1.8% -1.1% 1.1% 6.7% 5.8% τl ∞ 2.5% 2.1% -1.2% 0.4% 8.3% 7.0% 10 0.2% 0.1% -0.4% 0.1% 0.6% 0.4% Debt with 50 3.0% 2.8% -0.5% 1.1% 10.0% 9.2% τl ∞ 2.3% 2.0% -0.9% 0.5% 7.8% 6.7% 10 0.5% 0.6% -0.2% 0.4% 1.7% 2.1% Lump sum 50 2.2% 2.0% -1.9% -0.5% 7.3% 6.7% tax ∞ 2.6% 2.0% -2.3% -0.5% 8.5% 6.6% 33 / 37

65. Welfare effects the pension reforms Welfare effects of fiscal closures Results: Time inconsistency Time inconsistency - matters little for capital Capital - consumption tax closure and debt closure with consumption tax 34 / 37

66. Welfare effects the pension reforms Welfare effects of fiscal closures Results: Time inconsistency Time inconsistency - preserves the general findings Welfare - consumption tax closure and debt with consumption tax closure 35 / 37

67. Welfare effects the pension reforms Summary Roadmap 1 Motivation 2 Model 3 Calibration 4 Welfare effects of fiscal closures 5 Summary 36 / 37

68. Welfare effects the pension reforms Summary Generally, 1999 reform is welfare enhancing Overall effects positive Majority comes from DB->DC change Fiscal closure matters for (cohort) composition effects Pensions fall which implies that considerable redistribution across cohorts needed Introduction of funded DC makes debt desirable (redistributes) To do Log utility: taxes affect labor supply only marginally (GHH preferences) Endogenous retirement 37 / 37

69. Welfare effects the pension reforms Summary Generally, 1999 reform is welfare enhancing Overall effects positive Majority comes from DB->DC change Fiscal closure matters for (cohort) composition effects Pensions fall which implies that considerable redistribution across cohorts needed Introduction of funded DC makes debt desirable (redistributes) To do Log utility: taxes affect labor supply only marginally (GHH preferences) Endogenous retirement 37 / 37

Welfare effects of the pension system reform

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