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Pension Reform and Welfare 1 Dennis J. Snower at ISEO, 4 July 2005 at ISEO, 4 July 2005.

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Presentation on theme: "Pension Reform and Welfare 1 Dennis J. Snower at ISEO, 4 July 2005 at ISEO, 4 July 2005."— Presentation transcript:

1 Pension Reform and Welfare 1 Dennis J. Snower at ISEO, 4 July 2005 at ISEO, 4 July 2005

2 Pension Reform and Welfare 2 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

3 Pension Reform and Welfare 3 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 –While the total population is not expected to increase, the elderly population will increase from 61 to 103 million.

4 Pension Reform and Welfare 4 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.

5 Pension Reform and Welfare 5 The government budget constraint: twL N =pL P where t =payroll tax, w = wage, L N = number of workers, p = pension income per person L P = number of pensioners Thus: t = (P/W) (L P /L N ) where (P/W) is the generosity of pensions, and (L P /L N ) is the aged dependency ratio.

6 Pension Reform and Welfare 6 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 individuals behalf.

7 Pension Reform and Welfare 7 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.

8 Pension Reform and Welfare 8 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.

9 Pension Reform and Welfare 9 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

10 Pension Reform and Welfare 10 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.

11 Pension Reform and Welfare 11 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

12 Pension Reform and Welfare 12 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

13 Pension Reform and Welfare 13 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).

14 Pension Reform and Welfare 14 Swedish Pension Reform 1992/1994: Sweden moved from a traditional income- related 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 individuals 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.

15 Pension Reform and Welfare 15 UK Pension Reform Four tiers: –State social security benefits for pensioners, which consist of a basic flat rate state retirement pension and 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.

16 Pension Reform and Welfare 16 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.

17 Pension Reform and Welfare 17 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.

18 Pension Reform and Welfare 18 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

19 Pension Reform and Welfare 19 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.

20 Pension Reform and Welfare 20 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.

21 Pension Reform and Welfare 21 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.

22 Pension Reform and Welfare 22

23 Pension Reform and Welfare 23 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%.

24 Pension Reform and Welfare 24 Japan USA EU15 Employment Rates

25 Pension Reform and Welfare 25 Education and Skills 60% of year olds had at least upper secondary education. But only 8% of this group participate in training or ongoing learning.

26 Pension Reform and Welfare 26 Low education Medium education High education OECD years working life - men Unemployment Inactive Employment Working life and education

27 Pension Reform and Welfare 27 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

28 Pension Reform and Welfare 28 Macroeconomic Consequences Taxes and benefits Incentives to work and search for jobs Rates of employment and non-employment Tax rate and replacement ratio

29 Pension Reform and Welfare 29 The Effect of the Tax Rate on Output Replacement ratio Tax rate Job search effort Work effort Output and income Output Tax rate Macroeconomic Activity An increase in the tax rate reduces output and income

30 Pension Reform and Welfare 30 Replacement ratio Tax rate Job search effort Work effort Output and income Output Tax rate Government Budget Constraint The Effect of Output on the Tax Rate A reduction in output and income raises the tax rate necessary to finance a given replacement ratio.

31 Pension Reform and Welfare 31 Increasing the Replacement Ratio Replacement ratio Tax rate Job search effort Work effort Output and income

32 Pension Reform and Welfare 32 Tax rate Macroeconomic Activity (MA) Output Government Budget Constraint (GBC) 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).

33 Pension Reform and Welfare 33 Response to Adverse Macroeconomic Shocks Tax rate Macroeconomic Activity Output Government Budget Constraint The more generous the benefit system, the more destabilizing macroeconomic shocks become, because the tax base is smaller.

34 Pension Reform and Welfare 34 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

35 Pension Reform and Welfare 35 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.

36 Pension Reform and Welfare 36 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. Thus the income replacement program discourages work. Income Hours of leisure A B C D U1U1 U2U2 E F 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.

37 Pension Reform and Welfare 37 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.

38 Pension Reform and Welfare 38 D The pre-shock budget constraint is AB, and earnings are E. The guaranteed annual income is Y g. 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. Income Hours of leisure A B C U1U1 U2U2 E F YgYg At point C the person achieves higher utility than at D. If Y g were reduced sufficiently, point D would be preferred.

39 Pension Reform and Welfare 39 Guaranteed Annual Income with Work Requirement To tackle the disincentive problem, impose a work requirement. For example, the government may require recipients to work 3 hours per day to qualify for the guaranteed 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 minimum hours needed to qualify. D Income Hours of leisure B C E F YgYg G A H

40 Pension Reform and Welfare 40 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.

41 Pension Reform and Welfare 41 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.

42 Pension Reform and Welfare 42 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.

43 Pension Reform and Welfare 43 Let W be the gross wage and W n be the net wage. Work incentives: The income effect pushes in the direction of less work. –Segment AC: W n = 1.34 W; substitution effect pushes for more work. –Segment CD: W n = W; substitution effect is absent. –Segment DE: W n = 0.84 W; substitution effect pushes for less work. –Segment EB: W n = W Income Hours of leisure B A $6,680 $12,300 $26,494 C A D E

44 Pension Reform and Welfare 44 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 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.

45 Pension Reform and Welfare 45 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

46 Pension Reform and Welfare 46 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.

47 Pension Reform and Welfare 47 Proposal 1: Vouchers –Employment vouchers. –Training vouchers.

48 Pension Reform and Welfare 48 Unemployment duration PV from employment PV from unemployment PV from unemployment: traditional policy Employment vouchers and job search

49 Pension Reform and Welfare 49 Benefits Costs Skill, Effort Income Training vouchers and skill acquisition

50 Pension Reform and Welfare 50 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 governments 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 unable to work or acquire skills. Further Guidelines

51 Pension Reform and Welfare 51 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)

52 Pension Reform and Welfare 52 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.

53 Pension Reform and Welfare 53 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 tax- and-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 peoples welfare accounts.

54 Pension Reform and Welfare 54 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.

55 Pension Reform and Welfare 55 Redistribution The government can make balanced budget redistributions. Redistributing income across peoples 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.

56 Pension Reform and Welfare 56 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.

57 Pension Reform and Welfare 57 Employment Incentives Additional transfers to the welfare accounts of long-term unemployed people who purchase employment vouchers: –Recruitment vouchers (also for pensioners) –Training vouchers

58 Pension Reform and Welfare 58 The Self-Regulating Welfare State If peoples 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.

59 Pension Reform and Welfare 59 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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