1 How to Finance Retirement with an Aging Population Edward C. Prescott W. P. Carey School of Business, Arizona State University and Federal Reserve Bank of Minneapolis June 2005

2 Objective of Retirement System Guarantee a decent minimal consumption level for all retirees. Most countries have been using a pay-as-you-go system with benefits less than proportional to contributions on margin to achieve this objective.

3 With Aging Population this System Is Becoming Infeasible There are, or will soon be, too few workers per retiree. I will establish that increasing tax rates on workers cannot solve the problem; in Europe and in the U.S., increasing tax rates will not increase tax revenue.

4 What about a Fully Funded, Proportional Benefits System? Has a modest dead-weight taxation cost if population is growing But, not sustainable in democratic societies

5 Dead-weight Loss of Proportional Pay-as-You-Go System If benefits are proportional to contributions then Modest loss if population growing Larger loss if population constant Big loss if population declining WHY?

6 Answer The return that people realize is less than the real interest rate. If they realize the market return, it is just forced saving and there is no dead-weight loss. The productive capital stock will be smaller and output smaller, but no inefficiency.

7 The Big Problem with PAYG Systems Inevitably the system evolves so that benefits are not proportional to contributions The additional benefits from working a few extra years are zero in the United States The additional benefits to a household with two earners rather than one are zero

8 On Margin, Contribution to Retirement Account Is a Tax In U.S. the tax rate for funding the public retirement system is 10.6 percent And the dead-weight loss is over 10 percent of consumption

9 The Solution: Mandatory Personal Savings Accounts Benefits are proportional to contributions Returns on these savings are market returns Difficult for governments to get their hands on these savings and redistribute them

10 Dead-weight Loss of Tax and Transfer System Is big if aggregate labor supply elasticity is high Associated with one dollar of additional taxes paid, a household must be given two dollars to leave it equally well off

11 Definition of Aggregate Labor Supply Elasticity Holding wealth constant, it is the percentage change in labor supplied associated with a 1% change in the after-tax real wage

12 There Is Overwhelming Scientific Evidence that Aggregate Labor Supply Elasticity is HIGH

13 Business Cycle Evidence Finn Kydland and I found that if and only if this elasticity is high, about 3, does the neoclassical growth model quantitatively predict all the key business cycle facts A multitude of others have come up with the same finding (see Cooley 1995 volume)

14 Depression Evidence Fumio Hayashi and I find this neoclassical growth model accounts for the behavior of the economic aggregates in Japan’s lost decade of growth, , if and only if this elasticity is about 3 See Kehoe and Prescott Depressions volumes (2002, 2005) for 15 other studies coming up with the same conclusion

15 Cross Country Labor Supply and Tax Evidence I found that differences in tax rates predict the large differences across the G-7 countries if and only if this elasticity is about 3 Americans, Chileans, and Japanese all work over 40% more than Western Europeans because their marginal tax rates are 40% and not 60% as in Western Europe

16 Increase in Labor Supply in Spain: Tax Cut and Labor Market Reform

17 Theoretical Evidence Rogerson (1984) and Hansen (1985) use theory to establish that the aggregate elasticity is much greater than individual elasticity When the margin of labor supply adjustment is the number employed and is not hours per employed person

18 Most Adjustment Is in Number Employed Over business cycle Over postwar depressions and prosperities Over the seasons Over the life cycle

19 Question: Why Number Employed and Not Hours per Employed Varies Hornstein-Prescott (1993) find that theory predicts it in the empirically interesting case The empirically interesting case is when payment per hour increases with the number of hours an employed person works in the relevant range of hours per employee

20 Summary High aggregate labor supply elasticity is implied by aggregation theory Theory predicts both the micro and macro observations Thus, it is an established scientific finding

21 A Further Point All the other Nobel Prize winners who have been concerned with labor supply came to the same conclusion (i.e. Lucas, Heckman, and Becker)

22 Why Mandatory Savings Not subject to the time consistency problem

23 A Good Retirement System Mandatory savings of 10% of wage and salary income in personal income accounts up to 1.0 times the average level of wage and salary income These savings will provide a decent level of consumption for retirees Savings are in a low cost, highly diversified portfolio that realizes market return

24 An Illustrative Example People work for 45 years and then retire for 20 years The real interest rate is 4% and productivity grows at 2% a year The tax rate minus the Social Security retirement tax rate is 30% These are U.S. numbers

25 Pay-as-You-Go System Social Security retirement tax finances retirement Retirement benefits: 50% of average consumption Government debt is zero

26 Personal Savings System Social Security retirement tax is zero Other benefits are kept same as under pay-as-you-go system Mandatory savings accounts for retirement

27 Welfare Gains of Moving to a Personal Savings System Are BIG

28 Key Findings Increase in welfare in terms of lifetime consumption equivalents Population growth rate Welfare gain % % %

29 Gains much bigger in Europe WHY? Because social security taxes there are much higher than in the U.S. Gain about 25% in lifetime consumption equivalents.

30 Concluding Remarks 1.Welfare of everyone increases with mandatory personal savings accounts for retirement 2.Low population growth is not a problem with people saving for retirement 3.My advice, don’t throw away 25% of consumption

31 Concluding Remarks 4.A number (25) of countries have adopted mandatory savings plans 5.In Mexico these savings are growing rapidly and are being used to finance new businesses and home ownership

32 Concluding Remarks 6.In Sweden their adoption in 1998 reduced the marginal tax rate and that economy has grown faster than the EU average 7.The U.S. should follow the lead of Eastern Europe, Sweden, Mexico, and a number of other countries