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1
How to Finance Retirement with an Aging Population
Edward C. PrescottW. P. Carey School of Business, Arizona State University
andFederal Reserve Bank of Minneapolis
June 2005
2
Objective of Retirement System
• Guarantee a decent minimal consumption level for all
retirees.
• Most countries have been using a pay-as-you-go system
with benefits less than proportional to contributions on
margin to achieve this objective.
3
With Aging Population this System Is Becoming Infeasible
• There are, or will soon be, too few workers per
retiree.
• I will establish that increasing tax rates on
workers cannot solve the problem; in Europe and
in the U.S., increasing tax rates will not increase
tax revenue.
4
What about a Fully Funded, Proportional Benefits System?
• Has a modest dead-weight taxation cost if
population is growing
• But, not sustainable in democratic societies
5
Dead-weight Loss of Proportional Pay-as-You-Go System
If benefits are proportional to contributions then
• Modest loss if population growing
• Larger loss if population constant
• Big loss if population declining
WHY?
6
Answer
• The return that people realize is less than the real
interest rate.
• If they realize the market return, it is just forced
saving and there is no dead-weight loss.
• The productive capital stock will be smaller and
output smaller, but no inefficiency.
7
The Big Problem with PAYG Systems
• Inevitably the system evolves so that benefits are
not proportional to contributions
• The additional benefits from working a few extra
years are zero in the United States
• The additional benefits to a household with two
earners rather than one are zero
8
On Margin, Contribution to Retirement Account Is a Tax
• In U.S. the tax rate for funding the public
retirement system is 10.6 percent
• And the dead-weight loss is over 10 percent of
consumption
9
The Solution: Mandatory Personal Savings Accounts
• Benefits are proportional to contributions
• Returns on these savings are market returns
• Difficult for governments to get their hands
on these savings and redistribute them
10
Dead-weight Loss of Tax and Transfer System
• Is big if aggregate labor supply elasticity is
high
• Associated with one dollar of additional taxes
paid, a household must be given two dollars to
leave it equally well off
11
Definition of Aggregate Labor Supply Elasticity
Holding wealth constant, it is the percentage
change in labor supplied associated with a 1%
change in the after-tax real wage
12
There Is Overwhelming Scientific
Evidence that Aggregate Labor Supply
Elasticity is HIGH
13
Business Cycle Evidence
• Finn Kydland and I found that if and only if
this elasticity is high, about 3, does the
neoclassical growth model quantitatively
predict all the key business cycle facts
• A multitude of others have come up with
the same finding (see Cooley 1995 volume)
14
Depression Evidence
• Fumio Hayashi and I find this neoclassical growth
model accounts for the behavior of the economic
aggregates in Japan’s lost decade of growth,
1992-2002, if and only if this elasticity is about 3
• See Kehoe and Prescott Depressions volumes
(2002, 2005) for 15 other studies coming up with
the same conclusion
15
Cross Country Labor Supply and Tax Evidence
• I found that differences in tax rates predict the large
differences across the G-7 countries if and only if this
elasticity is about 3
• Americans, Chileans, and Japanese all work over 40%
more than Western Europeans because their marginal
tax rates are 40% and not 60% as in Western Europe
16
Increase in Labor Supply in Spain: Tax Cut and Labor Market Reform
Hours/Week per Working-Age Person
16
18
20
22
24
26
1993 1995 1997 1999 2001
Predicted
Actual
17
Theoretical Evidence
• Rogerson (1984) and Hansen (1985) use theory
to establish that the aggregate elasticity is much
greater than individual elasticity
• When the margin of labor supply adjustment is
the number employed and is not hours per
employed person
18
Most Adjustment Is in Number Employed
• Over business cycle
• Over postwar depressions and prosperities
• Over the seasons
• Over the life cycle
19
Question: Why Number Employed and Not Hours per Employed Varies
• Hornstein-Prescott (1993) find that theory
predicts it in the empirically interesting case
• The empirically interesting case is when payment
per hour increases with the number of hours an
employed person works in the relevant range of
hours per employee
20
Summary
• High aggregate labor supply elasticity is
implied by aggregation theory
• Theory predicts both the micro and macro
observations
• Thus, it is an established scientific finding
21
A Further Point
• All the other Nobel Prize winners who have
been concerned with labor supply came to
the same conclusion (i.e. Lucas, Heckman,
and Becker)
22
Why Mandatory Savings
• Not subject to the time consistency problem
23
A Good Retirement System
• Mandatory savings of 10% of wage and salary income in
personal income accounts up to 1.0 times the average
level of wage and salary income
• These savings will provide a decent level of consumption
for retirees
• Savings are in a low cost, highly diversified portfolio that
realizes market return
24
An Illustrative Example
• People work for 45 years and then retire for 20
years
• The real interest rate is 4% and productivity
grows at 2% a year
• The tax rate minus the Social Security
retirement tax rate is 30%
• These are U.S. numbers
25
Pay-as-You-Go System
• Social Security retirement tax finances
retirement
• Retirement benefits: 50% of average
consumption
• Government debt is zero
26
Personal Savings System
• Social Security retirement tax is zero
• Other benefits are kept same as under
pay-as-you-go system
• Mandatory savings accounts for
retirement
27
Welfare Gains of Moving to a Personal
Savings System Are BIG
28
Key Findings
Increase in welfare in terms of lifetime
consumption equivalents
Population
growth rate
Welfare
gain
1.01 8.9%
1.00 13.9%
0.99 19.8%
29
Gains much bigger in Europe
WHY?
• Because social security taxes there are much higher than in the U.S.
• Gain about 25% in lifetime consumption equivalents.
30
Concluding Remarks
1. Welfare of everyone increases with mandatory
personal savings accounts for retirement
2. Low population growth is not a problem with
people saving for retirement
3. My advice, don’t throw away 25% of
consumption
31
Concluding Remarks
4. A number (25) of countries have adopted
mandatory savings plans
5. In Mexico these savings are growing
rapidly and are being used to finance
new businesses and home ownership
32
Concluding Remarks
6. In Sweden their adoption in 1998 reduced the
marginal tax rate and that economy has grown
faster than the EU average
7. The U.S. should follow the lead of Eastern
Europe, Sweden, Mexico, and a number of
other countries