Welfare effects of fiscal closures when implementing pension reforms

Modeling the pension reforms

Macroeconomic modeling of the pension reforms1

Work in progress

Krzysztof Makarski 12 Joanna Tyrowicz234 Jan Hagemejer23

with the assistance of Agnieszka Borowska and Karolina GorausThe views expressed herein are those of the authors and not necessarily those of Narodowy Bank Polski

1Warsaw School of Economics2Faculty of Economics, University of Warsaw3Economic Institute, National Bank of Poland

4Rimini Center for Economic Analyses

Netspar - 2014 - Amsterdam1 / 40


Motivation

The big(ger) pictureA (too) broad scientific project at the University of WarsawOLG 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 labor3 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

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Motivation






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Motivation






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Motivation






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Motivation

Questions

How different fiscal closures of the pension system reform affectwelfare?

welfare effect of the reform (aggregate and across generations)?extent of fiscal adjustment for different fiscal closurespensionsmacroeconomic variables

What are the effects of changes proposed/implemented recently?additional welfare redistribution across cohortschanges to pensions and replacement ratesfiscal effect (debt/taxes) and capital

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Motivation

Questions

How different fiscal closures of the pension system reform affectwelfare?

welfare effect of the reform (aggregate and across generations)?extent of fiscal adjustment for different fiscal closurespensionsmacroeconomic variables

What are the effects of changes proposed/implemented recently?additional welfare redistribution across cohortschanges to pensions and replacement ratesfiscal effect (debt/taxes) and capital

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Model

Roadmap

1 Motivation

2 Model

3 Calibration

4 Welfare effects of fiscal closures

5 Summary

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Model

Model overviewOLG model with endogenous labor and savingsHeterogeneity across cohorts (mortality and labor productivity)No heterogeneity within cohortsAgents have time inconsistent preferencesExogenous retirement age and demographicsCompetitive producers with CD production functionPension system + pension system reformInter-generational transfers + utility to compare welfare across time withchanging demographicsDifferent fiscal closures (to do fiscal rules)Calibrated to the Polish economy

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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 todaylower replacement rates + ease fiscal tension in futurecomparing the steady states is not enough - transitory welfare effects

BUT SIF gap needs to be financed ⇒ possible fiscal closures with ownwelfare effects

five closures: lump sum, labor tax, consumption tax, debt + labor tax,debt + consumption taxwe cannot tell ex ante

which fiscal closure is better?effect for savings, labor supply and output?

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Model






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Model






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Model






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Model

ConsumersAre free to choose how much to work, but only until J̄ (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

δsπj+s,t+sπj,t

u (cj+s,t+s, lj+s,t+s) (1)

subject to

(1 + τc,t)cj,t + sj,t + τj + υt = (1− τ ιj,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)

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Model

Producersmaximize

Yt − wtLt − (rkt + d)Kt subject to Yt = Kαt (ztLt)

1−α

where the path of {z}∞t=0 is exogenous (calibrated to AWG, by EC)

Interest rate

interest rate on capital rkt = MPK − d, endogenous(riskless) interest rate on government debt to be rGt = 0.33 · rkthouseholds (and pension funds) by public debt inelasticallyreturns on savings yield a linear combination of risky and risk-less

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Model

Producersmaximize

Yt − wtLt − (rkt + d)Kt subject to Yt = Kαt (ztLt)

1−α

where the path of {z}∞t=0 is exogenous (calibrated to AWG, by EC)

Interest rate

interest rate on capital rkt = MPK − d, endogenous(riskless) interest rate on government debt to be rGt = 0.33 · rkthouseholds (and pension funds) by public debt inelasticallyreturns on savings yield a linear combination of risky and risk-less

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Model

Public financesSIF collects social security contributions and pays out pensions

subsidyt = τ ιt · wtLt −J∑j=J̄

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 debtlong run debt/GDP ratio fixedto finance pension system can use taxes or debt ⇐ fiscal closures

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Model

Public financesSIF collects social security contributions and pays out pensions

subsidyt = τ ιt · wtLt −J∑j=J̄

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 debtlong run debt/GDP ratio fixedto finance pension system can use taxes or debt ⇐ fiscal closures

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Model

Pension systemsinitial steady state: PAYG Defined Benefit (DB), τ ιt = τDB

after the original reform: NDC + FDC (two pillars) τ = τ I + τ II

NDC = contributions indexed with growth of payroll + benefitactuarially fair + post retirement indexation with 20% of payroll growthFDC = contributions earn interest + benefit actuarially fair + postretirement also earn interest

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Model




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Model




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Model




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Model

Solution method: Gauss-Seidel algorithmStart from the initial steady stateAssume the economy eventually achieves the new steady stateReform is unexpectedAlgorithm

Guess k per worker (or path) and compute wt, rtt = 0T

Compute individual choices (may need value functions).Aggregate to get new k

′(or path)

If |k − k′ | < err finishJust in case ... check feasibility

No contraction mapping theorem

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Model




′(or path)



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Model




′(or path)



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Model




′(or path)



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Model

How do we know what is "better"? LSRA!Lump Sum Redistribution Authority as Nishiyama & Smetters (2007)

1 Run the no policy change scenario ⇒ baseline2 Run the policy change scenario ⇒ reform3 For each cohort compare utility, compensate the losers from the winners4 If net effect positive ⇒ reform efficient5 Run reform again, with the compensation, to observe GE effects

What is baseline?

Always the same: births, mortality, productivity and retirement age1999 Reform: baseline = PAYG DB | reform = NCD + FDC

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Model



What is baseline?


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Model



What is baseline?


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Calibration

Roadmap

1 Motivation

2 Model

3 Calibration


5 Summary

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Calibration

Baseline: no of births (20 year olds):Demographic projection (2060), constant afterwards (conservative)

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Calibration

Baseline: mortality ratesDemographic projection (2060), constant afterwards

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Calibration

Baseline: old age dependency ratioDemographic projection (2060), constant afterwards

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Calibration

Baseline: labor augmenting technological progressHistorical data, projection from AWG, new steady state at 1.7%

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Calibration

Baseline: retirement ageHistorical data, assumed (based on law) afterwards

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Calibration

Baseline (outcomes): pension benefits in GDPAging plus decreasing labor force

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Calibration

Calibration to replicate 1999 economyPreference 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 ratioConsumption tax (τc) set to match VAT/GDP ratioCapital tax (τk) de iure = de factoThe initial capital

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Calibration

Life cycle productivity: flat or Deaton (1997)

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Calibration

Parameters for different calibrations

Calibrated parameters

β = 1 β = 0.9 β = 0.8ω = 1 ω - D97 ω = 1 ω - D97 ω = 1 ω - D97

φ 0.535 0.577 0.537 0.575 0.538 0.578δ 0.981 1.007 0.986 1.005 0.993 1.012d 0.052 0.055 0.057 0.055 0.055 0.06tl 0.11 0.11 0.11 0.11 0.11 0.11τ 0.061 0.0608 0.0608 0.061 0.0606 0.0611ρ 0.25 0.15 0.25 0.15 0.251 0.151

resultingxt/yt 21.1 21.1 21.1 21.1 21.1 21.1r 7.5 7.3 7.5 7.5 7.5 7.3

Note: D97: Deaton (1997) decomposition.

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Welfare effects of fiscal closures

Roadmap

1 Motivation

2 Model

3 Calibration


5 Summary

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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 adjustedamong 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 heldconstant, then debt gets automatically reduced to 45% of GDPexponentially, 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 amongall the living

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Results








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Results








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Results: Welfare

Efficiency of the reforms

baseline closurereform 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%

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Results: Welfare

LSRA after redistribution (% of perm. cons.)

Fiscal β = 1 β = 0.9 β = 0.8closure flat D97 flat D97 flat D97τl 0.021 0.016 0.015 0.012 0.009 0.005Debt/τl 0.021 0.015 0.015 0.012 0.009 0.005τC 0.020 0.017 0.015 0.012 0.009 0.006Debt/τC 0.020 0.016 0.014 0.012 0.008 0.005υt 0.020 0.019 0.015 0.013 0.011 0.007

Note: D97 denotes calibration according to Deaton (1997) decomposition.

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Results: Fiscal adjustment

Debt/consumption tax - higher taxes initially, becomeeventually lower

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Debt/labor tax - higher taxes initially, become eventuallylower

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Labor tax - higher taxes initially, become eventually lower

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Consumption tax - higher taxes initially, become eventuallylower

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Extent of fiscal adjustment - lump sum tax

Higher taxes initially, become lower after a while.Note; lump sum taxes have real effects (redistribution)

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Results: Pensions

Replacement rates - relative to baselinePensions are substantially reduced by PAYG DB → DCFiscal closure matters littleInitial cohorts unaffected

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Results: Macroeconomic effects

Closure GDP Labor supply CapitalPeriod D97 ω flat ω D97 ω flat ω D97 ω flat ω10 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%

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Results: Distribution of welfare effects

Welfare: all closures, no time inconsistency

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Results: Decomposition of welfare effects

Decomposition - consumption tax (left) anddebt/consumption tax (right)

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Results: Decomposition of welfare effects

Decomposition - labor tax (left) and debt/labor tax (right)

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Results: Time inconsistency

Time inconsistency - matters little for capitalCapital - consumption tax closure and debt closure with consumption tax

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Results: Time inconsistency

Time inconsistency - preserves the general findingsWelfare - consumption tax closure and debt with consumption tax closure

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Summary

Roadmap

1 Motivation

2 Model

3 Calibration


5 Summary

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Summary

Generally, 1999 reform is welfare enhancing

Overall effects positive

Majority comes from DB->DC changeFiscal closure matters for (cohort) composition effectsPensions fall which implies that considerable redistribution acrosscohorts neededIntroduction of funded DC makes debt desirable (redistributes)

To do

Log utility: taxes affect labor marginally (GHH preferences)Endogenous retirement

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Summary

Generally, 1999 reform is welfare enhancing

Overall effects positive

Majority comes from DB->DC changeFiscal closure matters for (cohort) composition effectsPensions fall which implies that considerable redistribution acrosscohorts neededIntroduction of funded DC makes debt desirable (redistributes)

To do

Log utility: taxes affect labor marginally (GHH preferences)Endogenous retirement

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Education

Welfare effects of fiscal closures when implementing pension reforms