University of Toronto Winter 2016 Department of Economics

Master of Financial Economics ECO2505H Macro Policy Analysis and Forecast

The Effects of Changing the Rate of the Canada Pension Plan (CPP) Contributions on the Labour Market

Wladimir Hinz Baralt, 1001800107 wladimir.hinz@mail.utoronto.ca

1. Problem and Motivation:

The motivation behind this paper is to analyze what are the effects of changing the rate of the Canada

Pension Plan (CPP) contributions on the labour market.

Focusing on the short term, I study the adjustments that would occur in the labour market as a consequence

of changing the mandatory CPP contribution rate, specifically concentrating on the changes of the

employment rate and real wage. The answers provided by this study could suggest not only if there are

substantial disturbances to the variables of interest, but it could also provide a measure of the potential

effects of such changes on the level of GDP, which would allow us to conclude what are the short term

consequences of a compulsory CPP contribution rate hike. These results are especially relevant when they

are compared to what macroeconomic theory has to say about raising payroll taxes.

Although they are not the same, CPP contributions can be regarded as a payroll tax when the effects of

raising the rate of contribution are analyzed in a short term time frame. In this study, I consider the rate hike

to be of a mandatory nature, in contrast to a voluntary one, which means that all workers who currently

contribute to the CPP are forced to contribute more.

There are a number of differences between CPP contributions and payroll taxes that I am not intending to

overlook. The main one is that the increased contributions would be independently managed by the CPP

Investment Board, without entering into the government’s budget directly, meaning that these funds would

be used to the specific purpose of servicing retirement savings payments. However, with this rate increase,

workers’ take-home income is certainly affected and it generates similar effects as to those created by a

tax increase, particularly in the short run, when the benefits of higher pensions are not yet taken into account

by the economy. I also assume that no further measures will be put in place to offset these effects in the

short run, other than the variant of the model that will be also analyzed.

For this, I examine the forecasted response based on the outputs of the FOCUS model. And to test this, I

have chosen to vary the RTCPP exogenous variable by increasing it 100 basis points, so that the overall

changes reflect a 1% increase in the CPP contributions. The FOCUS model allows us to trace the impact

of this change throughout the whole modeled economy, helping us determine what the economy might look

like in such event.

The variant considered for the model was the Taylor Rule variation, which could have an important effect

on the outcome since, as I mention below, is a monetary policy that controls for the inflation that is generated

when the CPP contribution rate is changed as firms will put pressure on prices when trying to adjust for the

disruption created in their cash flows generated from the increase of CPP payments – or payroll tax.

Further motivations for this study include the recent considerations of the government to enhance the

Canada Pension Plan looking to provide retirement security for all Canadians. Given that the current options

are to move forward, rather quickly, with this enhancement, it seems relevant to analyze the possible

outcomes of such policies, especially in the short term when Canada’s economy still remains in a fragile.

There is on going discussion of whether or not expanding the CPP can have a negative economic impact

or if other options should be considered, but considering that one of the major parts of the political platform

that won both the Federal and Ontario elections, was based on the expansion of the CPP, it seems only

reasonable to try to understand what happens to the economy when such changes are introduced.

Also, this analysis could help shed some light on the proposed Ontario Retirement Pension Plan (ORPP)

set to launch in 2017.

2. Theoretical Discussion:

a. Theoretical Background

Economic theory provides a solid framework of what could happen in the event of an increase of the rate

of CPP contributions, especially when we tie this analysis to an increase in payroll taxes.

Before we discuss what the possible outcomes are, it is appropriate to state, as explained by Romer (2012),

that in real business cycle theory, for monetary disturbances (as well as nonmonetary changes) to have

real effects, some type of nominal rigidity must exist, otherwise the economy would face no barriers when

adjusting for prices and wages. In this modeled economy we would expect to see some nominal wage

rigidity as well as some price rigidity.

Also, it is relevant to mention the elasticity of the labour supply. This variable is important as it determines

the responsiveness of the labour market to the increase in the rate of the CPP contributions. However,

given that this study is focusing in the short term, we would expect to see a highly inelastic labour supply,

which would mean that the effects of the increased contributions could not be completely adjusted for by

the employers (firms), and we would only see the effects of the short run which are stated below.

b. Predicted Outcome

Following a general model in Auerbach and Kotlikoff (1998), it suggests that when analyzing the policy

difference between generations, a change in social security taxes causes savings from current generations

to fall, generating a drop in the capital-labor ratios of future periods. This is because the value of the current

capital-labor ratio is lowered by the amount of the rate that is taken by the government, and since the current

generation has to use part of its income to pay for the social security increase, the capital-labour ratio of

future periods will be lower.

Consequently, this shift leads to lower real wages and lower output. The outcome of this model also

suggests that redistributing the tax burden among generations would also cause, in the present period, an

increase in consumption, while decreasing savings and investment. This could deviate from the outcome

of the model simulations, as the increase in retirement savings would be more of a long run effect.

In addition, given the inelasticity of labour supply, we would also expect to see a reduction in real wages

along with a higher rate of unemployment, driven by the shared burden of the payroll tax from both labour

supply and demand, for which the employers cannot fully adjust for in the short run.

This is because, as labour becomes more expensive, product of the higher payroll tax they have to pay to

the government, employers will be reluctant to hire more at a given level of real wages. Thus, we would

expect to observe a higher rate of unemployment (involuntary unemployment, that is) as one of the

mechanisms employers can use, in the short run, to adjust for these changes is to hire less workers.

Another mechanism of adjustment that employers can use is to raise prices. Hence, we would expect to

see some inflation driven by the change in the CPP contribution rate. Therefore, given that employers might

be reluctant to offer higher salaries in the short run, this higher inflation would lead to a drop in real wages.

This would be case, if the Central Bank allows for some inflation, otherwise, if there is a response to inflation

with some monetary policy rule (such as nominal interest rate targeting), we would expect to see this drop

of real wages dampen. To summarize our expected results from the basic run of the model would be the

following:

a. Higher rate of unemployment

b. Lower real wages

c. Higher rate of inflation

d. Increase in consumption/Decrease in savings

e. Decrease in investment

It is relevant to mention that these effects correspond to a short term analysis, and that in a longer term we

would expect to see further adjustments that not necessarily agree with the short term effects.

3. Basic Outcome:

The results of the basic run of the model can be seen in Table 1. The results a fairly similar to what the

literature and theory proposes. First of all, we see an overall drop in real GDP. We can observe from the

model’s equations that this is motivated by a drop in both the variables related to consumption and the ones

related to investment. We get that the equation for Gross Domestic Product – as a sum of its components

- (GDPL) results in a negative impact. It captures all the effects of the variables that form part of it, which

are overall negative as well.

This said, it is not surprising to see that the variables that form part of GDPL’s equation follow the same

pattern. Theory suggests that we would see a drop in the real GDP, which we see, driven by the drop in

savings and investments, but it also suggests an increasing level of consumption, something that the

model’s results are not showing, implying that this adjustment takes place in future periods out of the scope

of this analysis.

Drawing our attention to Graph 1, we can see a clear contraction of real GDP, consumption and investment,

which lasts for approximately all five years of the forecast, before returning to positive levels. This is an

important result. As we go through the equations, it shows that changes in personal income (YP0),

especially in transitory income (YPTRHR) causes positive responses on the consumer expenditure

variables. Therefore, any negative disruption of this variable, generated, like in this case by the increase of

the contributions, would cause consumption to decrease. The expected behavior of this variable mentioned

in part 2 now seems to have been too naïve for the complexity of this model. We were assuming that overall

consumption would not fall because we were taking into account the smoothening of the social security

contributions among generations. However, this does not appear to happen, as it takes time for the

contributions to stimulate consumption directly, and consumption falls in the short run.

For the investment variables, especially the non residential investment, the driver comes from a change in

the firms’ cash flows. An increase of the CPP contributions will reduce the available funds for the next

period, and will also play a key role in determining a firms return to investment. This analysis seems to be

congruent with what the expected effects are.

The variables of interest, wages and unemployment, behave exactly as expected. We have that the

economy would experience a higher rate of unemployment as firms try to adjust to the new levels of real

wage, which make the hiring process more expensive, and limit the offer of jobs. This can be appreciated

in Graph 2. This was one of the mechanisms firms could use for adjusting, the other one was an increase

of the level of prices.

Graph 3, shows the response of inflation, as measured by the CPI variable. We can clearly observe that

there is some inflation generated by the change of the CPP contribution rate in the first periods (2016 and

2017). It latter falls, which could suggest that the effects of the Phillips Curve are at play. As real wages

adjust for higher prices, unemployment begins to fall and real wage starts to rise, as we saw in Graph 2.

4. Unpacking The Results

To unpack the results, I will go through the model looking for the drivers of each relevant variable in the

study following Dungan (2000), and they can be seen in Table 2. To unpack the variant results, I will present

them accordingly and look for the biggest divergence in the variables and explain why it happened.

1. Employment

To analyze this, we can look at the equation of the LPRIV variable, which is the Employment in the Private

Sector. As the model states, the relationship between this variable and the real wage is negative. The

equation for this variable (M.1) contains a coefficient 𝑎𝑖 that is always negative. This coefficient is multiplied

by the logarithm of real wages log(𝑟𝑒𝑎𝑙𝑤𝑖) which is an increasing function of other variables, one of which

is the CPP contribution rate (RTCPP). Hence, an increase in RTCPP would lead to a decrease of LPRIV.

This real wage term can be interpreted as the after tax real wage burden relative to the firms’ prices and

capital.

2. Wages

For this, we can look at the variable WPAA which is the average annual wages and salaries per employee

in the private sector. From the model, we take that WPAA comes from the identity present in N.2.a, so that

RWPAA, the Four-quarter Per Cent Change in Average Annual Wages Salaries per Employee in the Private

Sector, is really our variable of interest here, and its driven by three principal explanatory variables:

a. Productivity: this is captured by the RGPRD5 variable, such that productivity can be captured by

wages in a specified time frame, with a 5 year moving average, so that earlier shocks in productivity

can be passed along to future wages. This variable measures the private sector productivity growth

with its key drivers being LPRIV (mentioned above) and GDPP the private sector GDP. As the

effect is captured by a 5 year moving average, we would not expect that this variable is a relevant

driver for the present study.

b. Unemployment Gap: this is captured by the RUNAT/RU term. From the way the RWPAA equation

is constructed, the farther away the rate of unemployment is from the NAIRU, the lower will be the

nominal wage inflation. Given that the RUNAT/RU term goes from 0.86 to 0.945 in the model, we

would expect to see some nominal wage inflation working against real wages.

c. Inflation: past and future inflation are being captured here, hence, anticipated changes in inflation

will enter into nominal wages

The important part of this variable is that unemployment would tend to its NAIRU, and that it has relevant

effects on nominal wage inflation. Given the drivers and the outcome from the model, we can say that the

unemployment gap, as well as the expected inflation generated by the pressure that firms have to raise

prices, are the ones that are pushing the real wages down at the beginning, with a tendency to return to

their original level as the economy adjusts itself.

3. Prices

For this, we can look at the CPI variable, which is driven by all the deflators of the economy. As this variable

might be too complicated to unpack on its own, we will talk about it more in the next points. Overall, we see

inflation rising at the beginning of the 5 years of the study, to then drop, as the effects from the Phillips

Curve begin to take place, so that prices would tend to return to their original level before the CPP rate

increase.

4. Labour Supply

Given that this variable LF, from Labour Force, is determined exogenous to the model, no significant

variations are expected to be seen from the change in the CPP contribution rate. Thus, we do not consider

this to be a key driver of the overall effects.

5. Consumption/Savings

After careful analysis of the model’s equations, the route of incidence of the RTCPP variable on

consumption or savings is not obvious. The clearest connection is between consumption and

unemployment. The real consumer expenditure equations (like the one for CDO in A.5) consider the

unemployment gap as having a negative relationship with real consumption. This is one of the key drivers

of the contraction of real GDP, as unemployment is farther away from its NAIRU, the less the real

consumption is.

There are no other equations for consumption where social security payments are considered, which could

be a reason of why the results we obtained from the model do not show the increase in consumption that

the theory suggests.

6. Investment

For this, we look at the IFNB variable, which is business investment in non-residential structures, more

specifically at the variables that correct for tax adjustments, such as a payroll tax. The route of incidence

takes the path of tax adjustment to determine the returns to capital through the variables RRDIF real after-

tax, rate of return differential and RRIFN, real after-tax rate of return on new investment. However, like with

the consumption equations, there is no direct channel for the RTCPP variable to disrupt directly investment.

The clearest way again, was by making firms adjust their cash flows to the new CPP contribution rate,

which is done through tax (payroll taxes) adjustments that affect the return of investment, which, in turn,

affects the quantity of investment done in the next periods.

The results of this simulation can be seen in Table 1 and in Table 2.

5. Unpacking The Variant Results

We now turn to the analysis of the variant, where the same variable was changed, in the same way and by

the same amount, but changing the monetary policy response. The results of this simulation can be seen

on Table 3.

The results are certainly different and this is motivated mostly by the Bank of Canada’s reaction to use

monetary policy to control for some of the effects produced by the change in the CPP contribution rate.

First of all, we see that increasing the RTCPP, generates temporary inflation as before, as we can see a

similar rise of the CPI variable, which is much alike in the first year of the model simulation. As we mentioned

before, this is interpreted as one of the results of the firms trying to shift the tax burden onto output prices.

But in this simulation, the Bank of Canada takes action. By using the Taylor Rule, it does not let inflation

rise sufficiently enough so real wages experience a sudden rise. This can be observed in Graph 6, and it

can be compared to what happened before in Graph 2.

Looking again at Graph 6, firms react to this control in inflation by reducing employment. In this case, we

expect to see a higher rate of unemployment, which is exactly what happens, as one of the mechanisms

they have to adjust their cash flows is not as effective as before, because of the Central Bank’s intervention.

The lower level of employment, and following the first “wave” of firms’ pressure to get higher prices,

necessarily triggers a lower level of real consumption expenditure, since real wages fall driven by both

inflation and less take-home real income caused by the increase in CPP contributions.

This is similar to what happened in the earlier case, however after this first period a very important difference

rises. With the new monetary policy rule the adjustment in the economy comes earlier, which is why we

can observer that real wages begin to rise to their original level in later periods (after the first year’s

decrease).

Thus, the real GDP contraction we saw in the base case simulation is now dampened by the effect of a

lower expected inflation. With inflation being controlled for, other variables that take into account inflation,

like the after-tax real return on investment are higher than before. The effect of the Central Bank’s

intervention is so that we can confidently say that the real GDP contraction from before is now being driven

by the higher levels of investment that are taking place in the economy. Even though consumption still

drops, higher investment more than offsets these negative effects, preventing real GDP from contracting.

The results, moreover, could be suggesting something much subtler about the behavior of the real wages,

unemployment and the way firms are now hiring. The sudden drop of real wages and raise in

unemployment, followed immediately by a shift in direction of these variables, may be due to a shift in the

burden of the payroll tax from the firms to employees. As firms, by raising output prices cannot overcome

the total burden of the increased CPP, by solely raising prices, they seem to be adjusting the offered salaries

to shift the burden to employees. But, as we have seen from the equation of wages, future levels of inflation

are also taken into account in this variable, so we could interpret that the rise is being driven mostly by

efforts of employees to negotiate better wages that capture the expected level of future prices.

Overall, the most relevant effect seems to be the faster recovery of the economy after the RTCPP increase

when the Bank of Canada intervenes to control inflation, which accelerates the adjustments happening in

the economy and avoids a prolonged contraction of the GDP.

6. Conclusion

As we have seen, an apparently small change in RTCPP can generate disturbances all around the

Canadian economy. Disruptions that, if they are not actively controlled for by the Bank of Canada, could

have some very negative effects on the short term, possibly triggering a real GDP contraction.

In both simulations we saw that the labour market is indeed sensitive to changes on payroll taxes. Even

when these changes imply higher retirement savings, the short term effects on the economy are very similar

to those caused by an income or payroll tax. The main advantage of changing the CPP contribution rate

would be to receive higher pensions, but this does not come into effect in the immediate years following a

rate increase.

The disruptions in the economy would directly affect employment, wages and output, as the model

simulations suggest. The question that is lurking behind all this analysis is whether or not these

disturbances are of a permanent nature. The way the model is constructed seems to propose that this is

not the case, as the variables tend to adjust to an original level, but even if this is so, we can deliberate on

the potential short run costs.

It is also relevant to mention that both simulations were fairly robust in providing the values for the first year

when the Bank of Canada is not yet in the equation.

In dealing with the model, several recommendations came to mind. The first one would be to try to connect

more directly consumption and investment with workers’ income. There seems to be some disconnection

in those equations that, even though appear to give the results proposed by theory, could be over or under

estimating the overall effects, leading to wrongful conclusions in terms of impact. This is especially relevant

when we are trying to analyze policy outcomes. However, looking at the results and equations, the model

performs quite consistently in terms of theory.

Another improvement that could be suggested is the inclusion of a way for employees to negotiate their

future wages in a clearer manner.

Trying to address the issues exposed in the motivation for pursuing this analysis, I can say that the answers

are much less straightforward than what I thought they where going to be. The importance of the

participation of the Bank of Canada I believe rests shown, but it does not say anything about the potential

future benefits of raising the CPP rate. Regardless, it has been also shown that seemingly small disruptions

can generate quite large disturbances in the economy and that much care is needed when deciding on

policy. Politicians should understand what is at stake here.

References

Auerbach, A. J., & Kotlikoff, L. J. (1998). Macroeconomics: An integrated approach. Cambridge, MA: MIT

Press.

Dungan, P. (2000) The Effect of Workers' Compensation and Other Payroll Taxes on the Macro

Economies of Canada and Ontario, inNew Perspectives on Workers' Compensation Policy (edited by

Gunderson, Morley and Hyatt, Douglas), University of Toronto Press, 118–161

Dungan, P. (2011). “Quarterly Forecasting and User Simulation Model of the Canadian Economy.”

Institute for Policy Analysis - Rotman School of Management, University of Toronto.

Dungan, P., & Wilson, T. (1985). Altering the Fiscal-Monetary Policy Mix: Credible Policies to Reduce the

Federal Deficit. Canadian Tax Journal. March-April

Dungan, P., Mintz, J., Poschmann F., & Wilson, T. (2008) Growth-Oriented Sales Tax Reform for Ontario,

C.D.Howe Institute Commentary No. 273

Kesselman, J. (1996) Payroll Taxes in the Financing of Social Security. Canadian Public Policy / Analyse

de Politicoes 22(2): 162-79.

Romer, D. (2012). Advanced macroeconomics. New York: McGraw-Hill/Irwin.

Taylor, J.B. (1999) “The Robustness and Efficiency of Monetary Policy Rules as Guidelines for Interest

Rate Setting by the European Central Bank.” Journal of Monetary Economics 43(3): 655–79.

Appendix: Tables and Graphs

Base Case Graphs:

-2

-1.5

-1

-0.5

0

0.5

2016 2017 2018 2019 2020

Graph 1 - GDP, Consumption and Investment

Real GDP Consumption Investment

Table 1 - Base Case Simulation Results - Percentage Impact of a 1% Rate Increase in CPP Contributions

2016 2017 2018 2019 2020

Real GDP (change in $ 2002) -7637 -19932 -23029 -15875 -

4723

Real GDP -0.51 -1.30 -1.46 -0.99 -0.29

Consumption -0.56 -1.42 -1.77 -1.50 -0.92

Investment -0.45 -1.44 -1.80 -1.02 0.17

Exports -0.05 -0.22 -0.43 -0.55 -0.47

Imports 0.01 -0.30 -0.71 -0.84 -0.75

Savings -11.67 1.07 9.29 6.54 -0.68

Consumer Price Index 0.44 0.48 0.09 -0.47 -1.01

Unemployment Rate 0.07 0.07 0.07 0.07 0.06

Employment -0.33 -0.93 -1.22 -0.99 -0.46

Wages and salaries per employee 0.33 -0.55 -1.39 -1.85 -1.93

Annual Wage of Employees in the Private Sector 0.09 -0.21 -0.79 -1.50 -2.10

Real Permanent Income -0.47 -1.28 -1.69 -1.58 -1.16

Capital Stock -0.01 -0.06 -0.12 -0.15 -0.12

-2

-1.5

-1

-0.5

0

0.060

0.062

0.064

0.066

0.068

0.070

0.072

2016 2017 2018 2019 2020

Graph 2 - Unemployment and Real Wage

Unemployment Rate Real Permanent Income

-1.2

-1

-0.8

-0.6

-0.4

-0.2

0

0.2

0.4

0.6

0.060

0.062

0.064

0.066

0.068

0.070

0.072

2016 2017 2018 2019 2020

Graph 3 - Unemployment and Inflation

Unemployment Rate Consumer Price Index

0.060

0.062

0.064

0.066

0.068

0.070

0.072

-1.6

-1.4

-1.2

-1

-0.8

-0.6

-0.4

-0.2

0

2016 2017 2018 2019 2020

Graph 4 - GDP and Unemployment

Real GDP Unemployment Rate

Table 2 - Key Drivers

2016 2017 2018 2019 2020

RTCPP

LPRIV -0.343 -0.973 -1.280 -1.043 -0.481

WPAA 0.094 -0.213 -0.790 -1.499 -2.096

RWPAA 1.464 1.437 1.515 1.547 1.641

RGPRD5 -1.317 -4.045 -2.954 -0.235 1.444

RUNAT/RU 0.885 0.867 0.860 0.890 0.945

RUNAT 6 6 6 6 6

RU 6.783 6.917 6.974 6.739 6.351

RECPI1 0.167 -0.179 -0.349 -0.262 -0.143

CPI 0.44 0.484 0.091 -0.471 -1.011

LF -0.058 -0.239 -0.406 -0.432 -0.308

C -0.549 -1.38 -1.719 -1.46 -0.905

IFNB -0.406 -0.781 -0.668 -0.075 0.416

Table 3 - Variant Case Simulation Results - Percentage Impact of a 1% Rate Increase in CPP Contributions

2016 2017 2018 2019 2020

Real GDP (change in $ 2002) -12280 -13240 4455 7231 7263

Real GDP -0.82 -0.86 0.28 0.45 0.44

Consumption -0.63 -1.36 -1.28 -0.85 -0.49

Investment -1.18 -0.55 2.51 2.12 0.56

Exports -0.16 -0.12 0.06 0.39 0.71

Imports 0.11 -0.62 -0.79 -0.70 -0.84

Savings -12.69 0.30 15.36 6.09 -3.11

Consumer Price Index 0.40 0.47 0.27 0.23 0.12

Unemployment Rate 6.87 6.81 6.41 6.29 6.25

Employment -0.44 -0.82 -0.45 -0.23 -0.13

Wages and salaries per employee 0.14 -0.48 -0.11 0.10 0.12

Annual Wage of Employees in the Private Sector 0.01 -0.25 -0.24 -0.24 -0.33

Real Permanent Income -0.47 -1.34 -1.52 -0.99 -0.56

Capital Stock -0.03 -0.08 0.01 0.14 0.19

Variant Case Graphs:

-2.00

-1.50

-1.00

-0.50

0.00

0.50

1.00

1.50

2.00

2.50

3.00

2016 2017 2018 2019 2020

Graph 5 - GDP, Consumption and Investment

Real GDP Consumption Investment

5.80

6.00

6.20

6.40

6.60

6.80

7.00

-0.60

-0.50

-0.40

-0.30

-0.20

-0.10

0.00

0.10

0.20

2016 2017 2018 2019 2020

Graph 6 - Unemployment and Real Wage

Wages and salaries per employee Unemployment Rate

5.906.006.106.206.306.406.506.606.706.806.907.00

0.00

0.05

0.10

0.15

0.20

0.25

0.30

0.35

0.40

0.45

0.50

2016 2017 2018 2019 2020

Graph 7 - Unemployment and Inflation

Consumer Price Index Unemployment Rate

5.90

6.00

6.10

6.20

6.30

6.40

6.50

6.60

6.70

6.80

6.90

7.00

-1.00

-0.80

-0.60

-0.40

-0.20

0.00

0.20

0.40

0.60

2016 2017 2018 2019 2020

Graph 8 - GDP and Unemployment

Real GDP Unemployment Rate