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Pension Reform and Welfare

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

2 Pension Reform and Welfare
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 Pension Reform and Welfare

3 Pension Reform and Welfare
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 2050. While the total population is not expected to increase, the elderly population will increase from 61 to 103 million. Pension Reform and Welfare

4 Pension Reform and Welfare
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. Pension Reform and Welfare

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

6 Pension Reform and Welfare
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 individual’s behalf. Pension Reform and Welfare

7 Pension Reform and Welfare
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. Pension Reform and Welfare

8 Pension Reform and Welfare
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. Pension Reform and Welfare

9 Pension Reform and Welfare
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 Pension Reform and Welfare

10 Pension Reform and Welfare
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. Pension Reform and Welfare

11 Pension Reform and Welfare
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 Pension Reform and Welfare

12 Pension Reform and Welfare
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 Pension Reform and Welfare

13 Pension Reform and Welfare
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). 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 individual’s 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. Pension Reform and Welfare

15 Pension Reform and Welfare
UK Pension Reform Four tiers: State social security benefits for pensioners, which consist of 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. Pension Reform and Welfare

16 Pension Reform and Welfare
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. Pension Reform and Welfare

17 Pension Reform and Welfare
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. Pension Reform and Welfare

18 Pension Reform and Welfare
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 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. 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. Pension Reform and Welfare

21 Pension Reform and Welfare
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. Pension Reform and Welfare

22 Pension Reform and Welfare

23 Pension Reform and Welfare
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%. Pension Reform and Welfare

24 Pension Reform and Welfare
Employment Rates Japan USA EU15 Pension Reform and Welfare

25 Pension Reform and Welfare
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. Pension Reform and Welfare

26 Working life and education
40 years working life - men Unemployment Inactive Employment Low education Medium education High education OECD 1996 Pension Reform and Welfare

27 Pension Reform and Welfare
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 Pension Reform and Welfare

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

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

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

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

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

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

34 Pension Reform and Welfare
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 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. Pension Reform and Welfare

36 Pension Reform and Welfare
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. 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. Income B C E D U2 F U1 A Hours of leisure 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. Pension Reform and Welfare

38 Pension Reform and Welfare
The pre-shock budget constraint is AB, and earnings are E. The guaranteed annual income is Yg. 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. At point C the person achieves higher utility than at D. If Yg were reduced sufficiently, point D would be preferred. Income B D E C Yg U2 U1 F A Hours of leisure 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. Income B D E G C Yg F H A Hours of leisure 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. Pension Reform and Welfare

41 Pension Reform and Welfare
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. Pension Reform and Welfare

42 Pension Reform and Welfare
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. Pension Reform and Welfare

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

44 Pension Reform and Welfare
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. See Ehrenberg-Smith: p. 215. Bruce D. Meyer and Dan T. Rosenbaum, “Welfare, the Earned Income Tax Credit, and the Employment of Single Mothers,” JCPR Working Paper No. 2, Joint Center for Poverty Research, Nothewestern University, May 1998. Nada Eissa and Hilary Williamson Hoynes, “The Earned Income Tax Credit and the labor Supply of Married Couples,” Working Paper No. 6856, NBER, Cambridge, Mass, Dec Pension Reform and Welfare

45 Pension Reform and Welfare
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 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. Pension Reform and Welfare

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

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

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

50 Pension Reform and Welfare
Further Guidelines 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 government’s 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. 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) Pension Reform and Welfare

52 Pension Reform and Welfare
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. Instead of the current welfare state systems - where welfare services are financed predominantly out of general taxes - people would make ongoing, mandatory contributions to each of these welfare accounts. The balances in these accounts would cover people’s major welfare needs. This reform would replace the current tax-and-transfer system by a system of compulsory saving. When people retire, they would make withdrawals from their retirement accounts. When they become unemployed, they would make withdrawals from their unemployment account instead of claiming unemployment benefits. When they acquire skills, they could draw on their human capital account instead of receiving government grants, subsidies, and loans for education and training. If they are ill or disabled, they could draw on their health account. If individuals know that their government will care for them in old age, sickness, disability, and poverty regardless of the size of their account balances, they will have an incentive to make insufficient contributions to their accounts and excessive withdrawals from them. Consequently, the government must set mandatory minimum contribution rates and mandatory maximum withdrawal rates. The mandatory contribution rates would depend on income and age. 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 people’s welfare accounts. Pension Reform and Welfare

54 Pension Reform and Welfare
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. Welfare services would be financed solely from what people choose to spend on these services out of their welfare accounts. Consequently, the government would have no incentive to manipulate the contribution rates and withdrawal rates of the welfare accounts in order to ease fiscal pressures outside the welfare state (e.g. to use tax receipts from welfare accounts to finance spending on defence). The public and private sectors would provide welfare services on an equal footing, setting prices for these services and competing with one another for the custom of the welfare account holders. For instance, with regard to health services, people’s health accounts would pay for their health insurance and they could then choose the provider of their health services, whether public or private. The resulting competition between the public and private sectors in the provision of welfare services would encourage efficiency in welfare provision in both sectors. Cream skimming :providing services only to those who are unlikely to receive large payouts and leaving the others to the public sector. Pension Reform and Welfare

55 Pension Reform and Welfare
Redistribution The government can make balanced budget redistributions. Redistributing income across people’s 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. The government would be able to redistribute income across people’s welfare accounts, but these redistributions would be constrained to be of the balanced-budget variety: total (economy-wide) taxes on each of the welfare accounts would be equal to total transfers into each of accounts. People’s mandatory contributions to each of their welfare accounts would rise with their incomes. The lowest income groups would receive transfers from the government into each of their welfare accounts. These transfers would pay all or a portion of these people’s mandatory account contributions. This redistributional mechanism would give rise to substantially less distortions than the present welfare systems. For example, with regard to the unemployment account, the conditional negative income tax mechanism would discourage job search, but by substantially less than unemployment benefits do, for when a person finds a job, he loses all his unemployment benefits, but only a fraction of his negative income taxes. Moreover, since the transfers under the negative income tax system would be conditional on proving willingness to accept work (except in cases of disability, illness, or other accepted personal circumstances), they would provide incentives for people to engage in productive activity. Finally, the proposed redistributional mechanism would be more efficient than the current systems at redistributing income from rich to poor, since unemployment benefits, training schemes, and other welfare entitlements are not targeted exclusively at the poor, whereas the transfers under the conditional negative income tax system would be. 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. Employers would be encouraged to contribute to their employees’ accounts at the same preferential rates as the employees. The account balances would be fully portable across employers. 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 The size of the vouchers would be set so that they could be financed through the tax revenues from people’s first two years of subsequent employment and through the abolition of in-work benefits. The size of each person’s voucher would depend on his wages earned over next one or two years of subsequent employment, and the firm could claim the voucher at the end of that period. Since the size of the vouchers would depend on future wages, the employment agencies would have the incentive not just to place their unemployed clients, but to find the highest-paying jobs for them. Along the same lines, the government could supplement the retirement accounts of pensioners who purchase recruitment vouchers. These vouchers could be financed through the pensions foregone, and the size of these vouchers would depend on the size of the pensions. Pension Reform and Welfare

58 The Self-Regulating Welfare State
If people’s 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. If people’s balances in a particular account exceeded a specified limit, they could be transferred to other welfare accounts. For example, a person with excess funds in the health account could transfer these to the human capital account to purchase training. At the end of their working lives, the remaining balances in their unemployment and human capital accounts could be transferred into their retirement account. Furthermore, excess funds (above the mandatory limit) could be withdrawn entirely from the accounts, but doing so would involve a tax penalties commensurate with the tax advantages of contributing to the accounts. Pension Reform and Welfare

59 Pension Reform and Welfare
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. Moving from the current welfare state systems to a welfare account system may be expected to play a substantial role in reducing unemployment, encouraging labour force participation, promoting skills, reducing governments’ budgetary pressures, cushioning people against economic risks, ensuring efficient provision of health and education services, providing social safety nets and redistributing incomes more efficiently. Incentives for productive activity: Adopting the welfare account system would improve incentives for productive activity as well as for the efficient use and provision of welfare services. For example, moving from unemployment benefits to unemployment accounts would give people greater incentives to avoid long periods of unemployment. For the longer people remain unemployed, the lower will be their unemployment account balances and consequently the smaller the funds available to them later on. Thus the unemployment accounts generate more employment than unemployment benefits, for a given amount of income redistribution. By implication, the unemployment account contributions necessary to finance a given level of unemployment support would be lower than the taxes necessary to finance the same level of unemployment benefits. Reduce waste: In general, the welfare accounts would help people to internalise both the benefits and the costs of welfare provision., and thereby discourage them from using welfare services wastefully. For instance, people would have little incentive to use health services wastefully, since the more health services they purchase, the lower will be their health account balances. The same holds for education and training. The human capital accounts would be better suited than the current education and training programmes to ensure people’s lifetime employability, since the accounts could be accessed whenever employees and their employers found it maximally worthwhile. Nor would people have an incentive to use pensions wastefully, since they would have the opportunity of finding employment by using their pension withdrawals to purchase recruitment vouchers. Encourage investment: The welfare account funds invested by the financial sector would stimulate investment. Indeed these funds could become a key component of EU investment: since the funds would characteristically have liabilities with relatively long durations, these funds could be used to finance long-term investments crucial for maintaining economic growth and competitiveness. Pension Reform and Welfare


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