- Jerald Schiff, Axel Schimmelpfennig, Niko Hobdari, and Roman Zytek
- Published Date:
- January 2001
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Over the next 30 to 50 years, the structure of the Estonian population will change dramatically (Figure A.1). Low fertility could cause the total population to decline, while decreasing mortality will increase the number of elderly. The share of the population that is 65 years of age or more is projected to roughly double, from 15 percent of the population in 2000 to almost 30 percent in 2050. Concomitantly, the old-age dependency rate—defined as the ratio of people 65 and over to the working-age (aged 15 to 64) population—will more than double, from 20 percent to 50 percent. To address these trends before they create severe financial stress on the pension system, the authorities have adopted a two-pronged reform strategy. First, the parameters and administration of the current pay-as-you-go system are being carefully reviewed and, where appropriate, adjusted. The authorities are also considering a new provision for the indexation of both new and existing pensions. Second, the government is considering a funded pension pillar, whereby a portion of pension contributions would be redirected into individual retirement savings accounts. This would be in addition to a third, voluntary funded pillar already in place for which tax incentives are given.
Figure A.1Estonia: Demographic Dependency Rates, 1999–20751
Source: Estonian authorities, US Census Bureau, and IMF staff estimates.
1 A demographic dependency rate represents the share of population belonging to a particular group relative to the working age population (aged 15 to 65). Here, the dependency rates for those under 15, for those over 65, and for those either under 15 or over 65 are plotted.
The Framework for Pension Reform
The first step in the reform of the pension system was the introduction in 1994 of a plan to increase the retirement ages for both men and women. Under a revised and accelerated schedule, the retirement age will also be unified at 63, with men reaching the target age in 2001. The retirement age for women will increase more gradually, reaching 63 in 2016. The next step was the preparation in 1997 by the newly established Social Insurance Reform Committee of a “Conceptual Framework for Pension Reform.” This paper identified the problems with the then-current system and laid out an overall reform strategy, including adjustments to the pay-as-you-go pillar, introduction of a funded, second pillar, and the establishment of the necessary institutional structure to support these reforms.
Pay-as-you-go pillar. The “Conceptual Framework” identified several problems with the pay-as-you-go pillar, including:
the unfavorable demographic trends:
easy access to the system, including a low retirement age, and loose eligibility requirements for disability pensions, and an array of pensions granted on favorable terms:
various conditions under which participants received credit toward a pension without making contributions;
social tax evasion;
increasing participation in the shadow economy: and
Thus far, these problems have been addressed in a piecemeal fashion. In addition to the phased increase in retirement ages, the conditions for obtaining disability and special pensions have been tightened, and the definition of noncontributory service has been narrowed. To improve compliance, the responsibility for collecting social-insurance contributions has been shifted from the Pension Fund to the Tax Board. A new formula for benefits was introduced that provides a (somewhat tenuous) link between contributions and benefits. Finally, to support the new benefit formula, a Central Securities Depository has been established to maintain individual records and serve as an intermediary for the proposed second pillar. The likely effects of these changes on the finances of the pay-as-you-go pillar are examined here and possible options for addressing the problems identified in the “Conceptual Framework” are suggested.
Funded, defined-contribution pillar. A variety of reasons have been offered for the introduction of a funded, defined-contribution pillar. Some relate to its direct effect on the pension system, including:
the opportunity to benefit from investment in financial markets, where the rate of return is likely to be higher than the implicit rate of return to contributions in a pay-as-you-go pension system;
a more individual focus, which can make retirement saving more transparent and improve compliance incentives; and
a reduction in the vulnerability of the pension system to adverse demographic trends and political pressures.
In addition, it has been suggested that a shift to at least partial funding will provide additional capital to spur economic growth and contribute to the deepening of capital markets. These macroeconomic justifications are problematic. First, fully funded pension schemes are subject to the same rate of return risk from demographic developments as pay-as-you-go schemes. Second, the increase in private retirement saving may be offset—in full or in part—by a reduction in other private and government saving, although the offset can be limited by a prudent fiscal stance that limits the reduction in public saving,2 Moreover, it is not necessary to reform the pension system to pursue the goal of increased national saving. Finally, the presumed deepening of capital markets is likely to be of limited value in a small, open economy such as Estonia. Consequently, this appendix focuses on the direct implications of a funded pillar on the pension system.
The primary impediment to the introduction of a funded pillar are the transition costs that are generated. Redirecting pension contributions from the current pay-as-you-go system to funded individual accounts will reduce revenues in the short and medium term without reducing benefits. This problem has been at the forefront of the authorities’ deliberations. The goal is to effect the transition without increasing the social-insurance contribution rate. Consequently, the trade-off is stark: the smaller the share of contributions redirected to the second pillar, the lower the benefits of funding; the higher the share, the greater the financing gap in the pay-as-you-go pillar. A plan currently under consideration is to shift 4 percentage points of the current contribution rate to the second pillar, while requiring participants in the second pillar to pay an additional 2 percentage points. This appendix evaluates the implications of this proposal and presents alternative structures.
Summary of Findings
Macroeconomic and Demographic Setting
Estonia’s conditions for pension reform are positive. Strong growth is likely to continue over the next several years, and longer to the extent that productivity—and wages—in Estonia converge to levels in more advanced economies (the base case assumes that wages will converge to the average level in the European Union over 75 years). Long-term demographic trends heighten the need for pension reform. Population in Estonia is projected to fall at an average annual rate of 0.3 percent over the next 30 years, curtailing the growth of aggregate pension contributions, just as population aging and decreasing mortality add to the number of pensioners. These adverse trends provide the motivation for the authorities’ proposal to introduce a funded pension pillar. However, it is important to note that medium-term population trends are more favorable. The ratio of contributors to beneficiaries is projected to grow over the next decade, and to stay above the current level of 1.7 for almost 20 years. This provides a window for pension reform to proceed at an orderly pace.
The essential dilemma in reforming the pay-as-you-go pillar is to balance the desire to maintain replacement rates—defined here as the average benefit as a percentage of the average wage gross of tax—against the requirement for financial integrity.3 For this reason, the key assumption in the base case for simulating pension reform options is that new and existing pensions will be indexed with a simple average of the rate of increase in the CPI and wages subject to contributions. This index—which is the preferred indexation option of the Social Insurance Reform Committee—strikes a compromise between the desires to limit increases without reducing real benefits (the CPI) and to allow pensioners to share the benefits of increasing aggregate wages (the wage fund). Under the assumptions of this base-case scenario (Figures A.1 and A.2):
Figure A.2Estonia: Surpluses and Replacement Rates of the First Pillar Under Alternative Scenarios, 1999–2075
Source: Estonian authorities and IMF staff estimates.
1 Base 50/50: scenario based on an indexation formula of pension with weights of 50 percent each for the CPI and the wage fund.
2 Base 33/67: scenario based on an indexation formula with weights of 33 percent each for the CPI and 67 percent on the growth of the wage fund.
3 Base CPI, wage ret age: scenario based on the indexation of initial pension benefits by wages, and the indexation of subsequent benefits by the CPI.
4 Base CPI, wage ret age: scenario based on the indexation of initial pension benefits by wages, and the indexation of subsequent benefits by the CPI, combined with an increase in the retirement age for both men and women to 65 years by 2025.
the first pillar runs consistent and large surpluses, which average over 1 percent of” GDP over the projection period (2001–75), and
the replacement rate falls dramatically, from 38 percent to 17 percent by 2050.
This scenario implies that, all other things equal, there is room to increase future replacement rates without pushing the system into insolvency. To demonstrate this, an alternative scenario increases the weight of the wage fund in the index used to adjust pensions from one half to two-thirds. This scenario yielded:
a zero average balance over the projection period, and
a modest improvement in future replacement rates over the base scenario.
This second scenario demonstrates how difficult it would be to curtail the fall in replacement rates using the same index to adjust both new and existing pensions. Following practice in many countries, the third simulation holds the replacement rate for new pensions constant and indexes subsequent benefits with the CPI. Under this scenario, benefits are cut for current retirees and those workers who will retire in the near future, but increased for younger workers. Although this scenario runs surpluses over the mid term as benefits are reduced, holding the initial replacement rate constant in the face of an increasing dependency rate eventually drives the system into continuing deficits that average roughly 1 percent of GDP. After an initial fall as a result of the new indexation rule, the average replacement rate stabilizes at approximately 25 percent.
In an attempt to curtail the increase in the dependency ratio, the final simulation assumed that the pending increase in the retirement age for women would be accelerated, and the retirement ages for both men and women would be increased to 65 by 2025. This scenario cuts future benefits relative to the baseline and yields somewhat lower deficits.
These simulations demonstrate how difficult it is to maintain replacement rates in the pay-as-you-go pillar simply by adjusting the parameters of the system. This conclusion is the impetus behind the authorities’ proposal to implement a funded second pillar.
As noted above, the attempt to implement a second pillar faces a stark trade-off between the share of contributions that can be redirected to the second pillar and the financing gap this creates. The base case for analyzing second-pillar alternatives is the option to redirect 4 percentage points of the current contribution rate to the funded pillar. The assumption was that workers 35 years of age and younger would be required to switch to the new system, and older workers would be given the option to switch. First-pillar benefits are assumed to be indexed to the same simple average of increases in the CPI and wage fund used in the base-case scenario for the first-pillar simulations. Under this scenario:
the initial financing gap in the first-pillar averages over 1 percent of GDP per year for the first 12 years;
over the remaining years, first pillar gradually recovers, and by the end of the projection period is generating surpluses of about 2 percent of GDP; and
the funded pillar allows replacement rates to be higher for future workers, for instance reaching 25.5 percent in 2050 as compared to 17 percent without the second pillar.
If the initial financing gap, which peaks at 1.5 percent of GDP in 2005, creates too great a strain on the budget, it is possible to delay the transition costs by reducing the flow of workers into the second pillar. The second scenario assumes workers 25 and under would be required to switch and are the only ones who can. Under this scenario, the transition costs are spread out more smoothly into the future, averaging 0.2 percent of GDP during the years prior to 2055, when the system starts running surpluses.
Finally, there is general agreement that it would be preferable to divert more than 4 percentage points of pension contributions to the funded pillar, except for the transition costs that would be incurred. The delayed eligibility in the previous simulation facilitates the adoption of a more aggressive policy. The final second-pillar simulation redirects 6 percentage points to the funded pillar. Although it runs larger initial deficits—an average of 0.75 percent over the first 50 years—it too yields surpluses in the latter years of the simulation period.
An important lesson of the second-pillar simulations is that even if a policy causes first-pillar deficits in the early years, the current balance in each turns positive by 2060. In addition, they allow higher replacement rates for later cohorts than do the first-pillar reforms simulated here. Moreover, the improving balances in the later years of the simulation imply that additional resources might be shifted to the second pillar in the future.
Rate of return risk in the funded pillar. The expected benefits of the second pillar stem from the portfolio diversification they allow. The higher return is obtained at the cost of increased risk, however. A simulation of the replacement rates that could be supported by actual return sequences in the U.S. stock market demonstrates this risk. The expected replacement rates are very high, but so are the risks.
Institutional infrastructure. The authorities have established a number of institutions and a regulatory setting that should be conducive to the efficient operation of the second pillar. Collection of social security contributions has already been shifted to the Tax Board, and the institutions to maintain individual records have been established to enable the shift to contributions-based benefits. These steps should keep transaction costs to a minimum. The government intends to allow international portfolio diversification.
Recent Occasional Papers of the International Monetary Fund
200. Pension Reform in the Baltics: Issues and Prospects, by Jerald Schiff, Niko Hobdari, Axel Schimmelpfennig, and Roman Zytek. 2000.
199. Ghana: Economic Development in a Democratic Environment, by Sérgio Pereira Leite, Anthony Pellechio, Luisa Zanforlin, Girma Begashaw, Stefania Fabrizio, and Joachim Harnack. 2000.
198. Setting Up Treasuries in the Baltics, Russia, and Other Countries of the Former Soviet Union: An Assessment of IMF Technical Assistance, by Barry H. Potter and Jack Diamond. 2000.
197. Deposit Insurance: Actual and Good Practices, by Gillian G.H. Garcia. 2000.
196. Trade and Trade Policies in Eastern and Southern Africa, by a staff team led by Arvind Subramanian, with Enrique Gelbard, Richard Harmsen, Katrin Elborgh-Woytek, and Piroska Nagy. 2000.
195. The Eastern Caribbean Currency Union-Institutions, Performance, and Policy Issues, by Frits van Beek, José Roberto Rosales, Mayra Zermeño, Ruby Randall, and Jorge Shepherd. 2000.
194. Fiscal and Macroeconomic Impact of Privatization, by Jeffrey Davis, Rolando Ossowski, Thomas Richardson, and Steven Barnett. 2000.
193. Exchange Rate Regimes in an Increasingly Integrated World Economy, by Michael Mussa, Paul Masson, Alexander Swoboda, Esteban Jadresic, Paolo Mauro, and Andy Berg. 2000.
192. Macroprudential Indicators of Financial System Soundness, by a staff team led by Owen Evans, Alfredo M. Leone, Mahinder Gill, and Paul Hilbers. 2000.
191. Social Issues in IMF-Supported Programs, by Sanjeev Gupta, Louis Dicks-Mireaux, Ritha Khemani. Calvin McDonald, and Marijn Verhoeven. 2000,
190. Capital Controls: Country Experiences with Their Use and Liberalization, by Akira Ariyoshi. Karl Habermeier, Bernard Laurens. Inci Ötker-Robe, Jorge Iván Canales Kriljenko, and Andrei Kirilenko. 2000.
189. Current Account and External Sustainability in the Baltics, Russia, and Other Countries of the Former Soviet Union, by Donal McGettigan. 2000.
188. Financial Sector Crisis and Restructuring: Lessons from Asia, by Carl-Johan Lindgren. Tomás J.T. Baliño, Charles Enoch, Anne-Marie Guide. Marc Quintyn, and Leslie Teo. 1999.
187. Philippines: Toward Sustainable and Rapid Growth, Recent Developments and the Agenda Ahead, by Markus Rodlauer, Prakash Loungani, Vivek Arora, Charalambos Christofides, Enrique G. De la Piedra, Piyabha Kongsamut, Kristina Kostial, Victoria Summers, and Athanasios Vamvakidis, 2000.
186. Anticipating Balance of Payments Crises: The Role of Early Warning Systems, by Andrew Berg, Eduardo Borensztein, Gian Maria Milesi-Ferretti, and Catherine Pattillo. 1999.
185. Oman Beyond the Oil Horizon: Policies Toward Sustainable Growth, edited by Ahsan Mansur and Volker Treichel. 1999.
184. Growth Experience in Transition Countries, 1990–98, by Oleh Havrylyshyn, Thomas Wolf, Julian Berengaut, Marta Castello-Branco, Ron van Rooden, and Valerie Mercer-Blackman. 1999.
183. Economic Reforms in Kazakhstan, Kyrgyz Republic, Tajikistan, Turkmenistan, and Uzbekistan, by Emine Gürgen, Harry Snoek, Jon Craig, Jimmy McHugh, Ivailo lzvorski, and Ron van Rooden. 1999.
182. Tax Reform in the Baltics, Russia, and Other Countries of the Former Soviet Union, by a staff team led by Liam Ebrill and Oleh Havrylyshyn. 1999.
181. The Netherlands: Transforming a Market Economy, by C. Maxwell Watson, Bas B. Bakker, Jan Kees Martijn, and Ioannis Halikias. 1999.
180. Revenue Implications of Trade Liberalization, by Liam Ebrill, Janet Stotsky, and Reint Gropp. 1999.
179. Dinsinflation in Transition: 1993–97, by Carlo Cottarelli and Peter Doyle. 1999.
178. IMF-Supported Programs in Indonesia, Korea, and Thailand: A Preliminary Assessment, by Timothy Lane, Atish Ghosh, Javier Hamann, Steven Phillips, Marianne Schulze-Ghattas, and Tsidi Tsikata. 1999.
177. Perspectives on Regional Unemployment in Europe, by Paolo Mauro, Eswar Prasad, and Antonio Spilimbergo. 1999.
176. Back to the Future: Postwar Reconstruction and Stabilization in Lebanon, edited by Sena Eken and Thomas Helbling. 1999.
175. Macroeconomic Developments in the Baltics, Russia, and Other Countries of the Former Soviet Union, 1992–97, by Luis M. Valdivieso. 1998.
174. Impact of EMU on Selected Non-European Union Countries, by R. Feldman, K. Nashashibi, R. Nord, P. Allum, D. Desruelle, K. Enders, R. Kahn, and H. Temprano-Arroyo. 1998,
173. The Baltic Countries: From Economic Stabilization to EU Accession, by Julian Berengaut. Augusto Lopez-Claros, Françoise Le Gall, Dennis Jones, Richard Stern. Ann-Margret Westin, Effie Psalida, Pietro Garibaldi. 1998.
172. Capital Account Liberalization: Theoretical and Practical Aspects, by a staff team led by Barry Eichengreen and Michael Mussa, with Giovanni Dell’Ariccia, Enrica Detragiache, Gian Maria Milesi-Ferretti, and Andrew Tweedie. 1998.
171. Monetary Policy in Dollarized Economies, by Tomás Baliñio, Adam Bennett, and Eduardo Borensztein. 1998.
170. The West African Economic and Monetary Union: Recent Developments and Policy Issues, by a staff team led by Ernesto Hernández-Catá and comprising Christian A. Francois, Paul Masson, Pascal Bouvier, Patrick Peroz, Dominique Desruelle, and Athanasios Vamvakidis. 1998.
169. Financial Sector Development in Sub-Saharan African Countries, by Hassanali Mehran, Piero Ugolini, Jean Phillipe Briffaux. George Iden, Tonny Lybek, Stephen Swaray, and Peter Hayward. 1998.
168. Exit Strategies: Policy Options for Countries Seeking Greater Exchange Rate Flexibility, by a staff team led by Barry Eichengreen and Paul Masson with Hugh Bredenkamp, Barry Johnston, Javier Hamann, Esteban Jadresic, and Inci Ötker. 1998.
167. Exchange Rate Assessment: Extensions of the Macroeconomic Balance Approach, edited by Peter Isard and Hamid Faruqee. 1998
166. Hedge Funds and Financial Market Dynamics, by a staff team led by Barry Eichengreen and Donald Mathieson with Bankim Chadha, Anne Jansen, Laura Kodres, and Sunil Sharma. 1998.
165. Algeria: Stabilization and Transition to the Market, by Karim Nashashibi, Patricia Alonso-Gamo. Stefania Bazzoni, Alain Féler, Nicole Laframboise, and Sebastian Paris Horvitz. 1998.
164. MULTIMOD Mark III: The Core Dynamic and Steady-State Model, by Douglas Laxton, Peter lsard, Hamid Faruqee, Eswar Prasad, and Bart Turtelboom. 1998.
163. Egypt: Beyond Stabilization, Toward a Dynamic Market Economy, by a staff team led by Howard Handy 1998.
162. Fiscal Policy Rules, by George Kopits and Steven Symansky. 1998.
161. The Nordic Banking Crises: Pitfalls in Financial Liberalization? by Burkhard Drees and Ceyla Pazarbaşioğlu. 1998.
160. Fiscal Reform in Low-Income Countries: Experience Under IMF-Supported Programs, by a staff team led by George T. Abed and comprising Liam Ebrill, Sanjeev Gupta, Benedict Clements, Ronald McMorran. Anthony Pellechio, Jerald Schiff, and Marijn Verhoeven. 1998.
159. Hungary: Economic Policies for Sustainable Growth, Carlo Cottarelli. Thomas Krueger. Reza Moghadam, Perry Perone, Edgardo Ruggiero, and Rachel van Elkan. 1998.
158. Transparency in Government Operations, by George Kopits and Jon Craig. 1998.
157. Central Bank Reforms in the Baltics. Russia, and the Other Countries of the Former Soviet Union, by a staff team led by Malcolm Knight and comprising Susana Alumiña. John Dalton. Inci Otker, Ceyla Pazarbasioğlu, Arne B. Petersen. Peter Quirk, Nicholas M. Roberts, Gabriel Sensenbrenner, and Jan Willem van der Vossen. 1997.
156. The ESAF at Ten Years: Economic Adjustment and Reform in Low-Income Countries, by the staff of the International Monetary Fund. 1997.
Note: For information on the title and availability of Occasional Papers not listed, please consult the IMF Publications Catalog or contact IMF Publication Services.
The official rate of unemployment jumped from virtually zero in all Baltic countries in 1990 to about 10 percent in 1995 in Estonia, and 7 percent in Latvia and Lithuania. These official figures exclude those who were allowed to retire via disability, as well as the hidden unemployed who remained on Their employers’ payrolls.
In Latvia, the average monthly pension rose 15.5 times between 1990 and 1992. In contrast, the average value of the CPI index rose 23.6 times during the same period. As a result, the real value of the average pension declined by 35 percent over this period.
In Estonia, in 1995, for example, these ratios were, respectively, 57 percent and 37 percent.
In Latvia, the number of pensioners rose from 610.000 in 1990 to 660.000 in early 1993, with over half of this increase attributed to a rise in disability pensioners. In Estonia, the number of pensioners increased from 360,000 in 1990 to 387.000 in 1993, with about 40 percent of the increase from higher disability rolls. It was also hoped that such early retirement would provide the scarce employment opportunities to younger entrants; the retirement age was either officially lowered or loopholes were permitted, and a large number of workers were made eligible to collect disability pensions.
Until 1990, none of the centrally planned economies had faced large-scale open unemployment. The limited social protection schemes that did exist operated on the basis of state enterprises and were mostly focused on assisting families in distress.
At end-1992, Latvian households held about 15 lats per person in bank deposits, equal to about 10 percent of the average annual pension. In 1998, about 80 percent of pensioners” income still came from social transfers. (Central Statistical Bureau of Latvia. 1998). In contrast. 1995 U.S. data on the wealth distribution indicate that households headed by 55 to 64 year olds had a median net worth of $110.000 compared with 111,400 for households headed by those under 35 (see Federal Reserve Board, 1997).
A PAYG system cannot technically go bankrupt. However, political claims for pension payments can far exceed actual revenues
The fertility rate in the Baltics is projected to increase to about 1.6 in 2010. The fertility rate in the neighboring Scandinavian countries stands at 1.7 in Finland and 1.8 in Sweden and was projected to decline to about 1.5 and 1.7, respectively, in 2010. The fertility rate is projected to remain under 1.7 for most of the central and eastern European countries through 2010.
Life expectancy at birth is projected to increase by about 2–3 years in all transition economies over the next ten years. In Estonia life expectancy declined from 64.4 years for men and 74.8 years for women in 1991 to 61.1 for men and 73.1 for women in 1994 and recovered to 64.4 for men and 75.5 for women in 1998. Similarly, in Latvia and Lithuania, life expectancy for both men and women declined sharply in 1991–94, but has recovered and exceeds its 1991 levels.
In Latvia, between 1991 and 1995, the number of persons for whom contributions were being paid had declined by almost 50 percent. Further, many employers falsely reported that they paid minimum wages and paid contributions bused on these wages.
In 1996, social (payroll) tax rates in the Baltics varied from 31 percent of gross wages in Lithuania to 38 percent in Latvia. The pension component was 20 percent for Estonia and Latvia, and 23.5 percent for Lithuania. Within the Baltic countries, Russia and other countries of the former Soviet Union (BRO), the payroll tax was highest in Ukraine, at 52 percent (32.6 percent for pensions) and lowest in Lithuania and Turkmenistan, at 31 percent. In major industrialized countries (the U.S., Japan. Germany. France. Italy, the United Kingdom, and Canada) the payroll tax rates varied from 4.6 to 26.2 percent.
In Latvia, for example, in 1996, the incidence of poverty in households headed by someone 65 or older was 37 percent compared with 40 percent for all households and 48 percent for households with a head 15–39 years old (see Gassmann, 1998).
Legislation for implementing the first tier was approved by parliament in November 1995 and took effect in January 1996.
In the transition period, the PAYG pension scheme also includes pensioners receiving pensions granted under the previous legislation and financed from the funds generated by the current working population. Also, as a transition mechanism, retirement benefits of workers retiring in the years immediately following the reform were based only on contributions in the most recent 1–3 years.
For example, assuming a constant wage, annual pension benefits would double when an individual worked until age 70 instead of 60.
To compensate for this, the notional pension capital of eligible workers was increased to reflect their pre-reform early retirement right and years of service in the occupation. For example, for a man with 20 years of service in an occupation which provided the right to retire at 50, the pension capital for those years would be increased by 20 percent (60/50).
See World Bank (1998).
In parallel with these modifications, parliament approved the Social Benefits for the Disabled Act, which entered into effect on January 1, 2000, and establishes benefits for disabled individuals not qualifying for the work-incapacity pension.
In addition, in November 1997, the government changed from adjusting for past CPI increases (backward indexation) to a combination of backward and forward-looking indexation. As a result, pensioners were given a one-time double indexation, totaling 7 percent. Further, in March 1998, the government announced an additional ad hoc indexation.
The size of the distortions introduced by the payroll tax would be expected to rise more than linearly with increases in the tax rate.
It is argued that, in a dynamically stable economy, the return on capital (or real interest rate (r)) is generally higher than me real growth rate of the economy (g). If the opposite were true (that is, if g > r) those assets whose dividends grow with the economy would attain an infinite price, offering an arbitrage opportunity to private investors. Issues of private and public debt will eventually push the market yield r above g (see, for example, Hemming (1998)). Empirical evidence suggests that this is the case.
In a closed economy, the pension burden of a future generation of workers is determined by the pensions that have to be paid and not by the way in which they are financed. When pensioners are making too large a claim on an economy’s output, the working generation will likely scale down the pension contributions required to meet pension claims under the PAYG system. The result is not likely to be significantly different under a funded scheme, as the value of the assets held by pensioners in this case will fall as increasing numbers of pensioners attempt to sell assets to relatively fewer workers. See Brooks (2000).
See Kotlikoff (1999)
This effect could also be achieved under a PAYG system by introducing notional accounts which provide a link between contributions and pension benefits.
The Law requires contributions to be “not less than 2 percent” during 2001–06.
In Kazakhstan, by contrast, the second pillar receives 10 percentage points of the social tax, which has created tremendous pressure on the central government budget, and led to a reduction in existing real pension claims, via inflation.
For a detailed review of typical switching options in pension reforms around the world and the switching decision process, see Palacios and Whitehouse (1998).
The government may determine who can establish a pension fund and under what conditions. Typically, employers, chambers of trade, professional associations, as well as employees’ and/or employers’ interest representation organizations, and government run pension administration units are allowed to apply for licenses, provided they satisfy requirements, such as representing a certain minimum number of workers.
In Kazakhstan, for example, the state pension accumulation fund-for those who did not opt for private funds-has largely purchased illiquid stale securities.
The return on FF savings equals the interest rate on long-term savings while the implicit return on PAYG contributions depends on the future dependency ratio, productivity growth, and the political process that sets the PAYG payroll tax and the pension benefit level.
Myopic behavior as defined here does not include a discount rate which is considered “too high.”
Alternatively, seemingly myopic behavior could reflect the calculation that governments will step in to provide some minimum income level for individual retirees who do not save sufficiently.
If the government pension is perceived as too high, an individual may borrow against future pension payments in capital markets.
This assumes no labour supply response to the tax increase. Should the tax increase lead to a decline in formal labour market participation-which is not unlikely in the Baltics where payroll tax rates are already high-the impact on aggregate savings is not easily inferred. See Mackenzie, Gerson, and Cuevas (1998),
Sinn (1999) shows that while these transition costs can be distributed over several generations through temporary debt financing, the present value of the transition costs remains unchanged.
Financing the deficit by selling government assets is equivalent to tax-financing since it amounts to a hidden tax. See below,
A formal exposition of the following discussion is given in Schimmelpfennig (1998).
Debt-financing of the pension reform cannot be turned into a Ponzi-scheme in which the outstanding debt including interest payments is rolled over from generation to generation. Eventually, the debt stock needs to be repaid. Sinn (1999) shows that this repayment is equivalent to the first generation’s pension benefits.
The riskiness of returns from FF pensions may also be higher, which might lead to an increase in precautionary savings.
This line of reasoning assumes that there is only partial Ricardian equivalence. In the case of full Ricardian equivalence, debt-financing and tax-financing are equivalent in their macroeconomic impact. Full Ricardian equivalence is, however, based on very rigid assumptions that are commonly thought not to hold in the real world. For example, see Leiderman and Blejer (1987).
This assumes that myopic individuals save a constant share of their disposable income. Since the pension reform leaves disposable income unchanged, private savings remain unchanged, too.
The same would hold if the deficit is financed by a reduction in other government spending.
Again assuming a constant savings rate out of disposable income.
For a somewhat different discussion of pension reform financing, see Holzmann (1998).
The treatment of pension reforms in IMF programs is also addressed in International Monetary Fund (SM/97/108) and Heller (1998).
Pension issues have been usefully addressed in the framework of intergenerational accounting. See, for example, Auerbach, Kotlikoff, and Leibfritz (1999).
Some authors (for example, Feldstein, 1998) hope that a pension reform may pay for itself if the rate of return in the FF pillar exceeds the PAYG return sufficiently and the tax increase needed to cover the transition costs is modest.
This was suggested by Jenkins (1992) with respect to transition economies.
The Appendix is based on the work of a Fiscal Affairs Department mission on pension reform headed by Mr. Gillingham. The authorities have agreed to the use of the materials contained in the technical assistance report.
Although we measure replacement rates with respect to before-tax income, it is important to remember that labor income over EEK 800 is subject to a 26 percent marginal income tax rate while pensions are not taxed. Consequently, the rate of replacement of after-tax income is substantially higher (currently approximately 47 percent).