Pension System Reform and the Savings-Investment Balance

A pension reform that introduces an FF pillar or increases the importance of an existing FF pillar will affect the macroeconomic savings-investment balance in three basic ways. First, a tax-financed pension reform strengthens savings by substituting an FF pillar based on capital accumulation for a PAYG pillar based on intergenerational redistribution. Second, a pension reform involves transition costs that need to be financed; other things equal, this reduces national savings. Third, a pension reform can affect private savings outside the pension system.

This section focuses on the macroeconomic implications of a pension reform, in particular on its impact on private and aggregate savings. It is assumed throughout this section that the rate of return on FF savings is greater than the implicit rate of return on PAYG contributions.³¹ As argued in Section III, this assumption should hold in the long run. However, this higher average rate of return is associated with a higher volatility. Two types of individual behavior are considered, one in which individuals are forward-looking, and a second in which they are myopic. Forward-looking individuals optimize an intertemporal preference function. Hence, their savings behavior is determined by their expected income, the rate of return, and the expected returns from the mandatory pension system. It is further assumed that Ricardian equivalence does not hold. Myopic individuals do not base their savings decision on intertemporal utility maximization.³² Instead, savings are assumed to be based on a constant marginal propensity to save. Hence, myopic individuals can be expected to disregard some changes in lifetime income for their savings decision. Only changes in disposable income would lead to changes in savings, while changes in the rate of return leave savings unchanged. This case is quite relevant, since the existence of public pensions is based, in part, on the assumption that individuals are to a certain extent myopic.³³

Individuals can use their private savings outside the mandatory pension system to adjust their pension savings in a utility-maximizing way. Prior to pension reform, individuals save for their retirement through a government-mandated pension system, funded by a payroll tax. In addition, individuals can accumulate private savings outside the pension system. If the government pension is perceived as too low, individuals build up additional savings to achieve a desired level of consumption during retirement.³⁴

Individuals can also use private savings outside the pension system to react to an exogenous shock that leads to a fall in expected pension benefits. For example, an increase in the dependency ratio lowers PAYG pensions if the payroll tax and the replacement ratio are left unchanged because a smaller labour force has to provide for a larger number of pensioners. Demographic projections that show an increase in the dependency ratio over the next 30 years are readily available today. Forward-looking individuals who learn about this trend may increase their savings outside the pension system, since their expected PAYG pensions have declined. Myopic individuals, however, may not change their private savings behavior, since they may not adequately provide for retirement on a voluntary basis in the first place.

One option for governments concerned about future pension levels in the face of rising dependency ratios is to introduce a mandatory FF pillar alongside the existing PAYG pillar. Such “prefunding” would require a rise in the payroll tax, with the additional pension contributions invested in an FF pillar. This payroll tax hike should optimally be set equal to the increase in private savings outside the pension system that would be accumulated by forward-looking individuals. Given that individuals behave, at least in part, myopically and therefore do not fully adjust their savings behavior outside the pension system, prefunding would imply a rise in aggregate savings and an improvement in the macroeconomic savings-investment balance.³⁵

A policy considered in the Baltics would reduce the size of the existing PAYG pillar with the introduction of an FF pillar. The payroll tax would be left constant, with a reduced share going to the PAYG pillar, and the remainder going to the new FF pillar. This reduction in PAYG contributions leads, ceteris paribus, to a deficit in the PAYG pillar that needs to be financed. It should be noted that these transition costs result from the design of the PAYG system, under which the first generation receives a pension without having had to contribute to the system. Since the present value of contributions to and payments from the pension system over the life of its existence must be equal, the “last” generation—the reform generation—has, in effect, to pay for the first generation’s pension, by providing a pension for the next-to-last generation (that is, current retirees) and for itself.³⁶

Whether the PAYG pillar deficit is financed through fiscal adjustment or increased debt, the pension reform’s impact on the savings-investment balance depends crucially on the adjustment of private savings outside the pension system.³⁷ This in turn depends on whether individuals behave more in a forward-looking way or more in a myopic way.³⁸

A pension reform that is completely debt-financed and leaves the payroll tax constant will, if individuals are forward-looking, lead to a fall in private savings outside the pension system and in aggregate national savings.³⁹ The financing gap in the PAYG pillar is just equal to the new FF pillar savings because the reduction in the PAYG pillar contribution is equal to the FF pillar contribution. Hence, the savings balance of the pension system remains unchanged during the reform period. Therefore, any change in the aggregate savings-investment balance must stem from changes in private savings outside the pension system. Introducing an FF pillar while reducing the PAYG pillar increases the average return to the mandatory pension contributions because the FF pillar yields a higher return than the PAYG pillar. Thus, savings outside the pension system are reduced to allocate the gain in total income in a consumption-smoothing way over one’s lifetime.^{40 41} If, however, individuals are myopic, the debt-financed pension reform leaves private savings outside the pension system as well as aggregate savings, constant.⁴²

A pension reform that is completely payroll tax-financed, if individuals are forward-looking, leads to a fall in savings outside the pension system that just offsets the mandatory FF pillar savings, so that national savings are unchanged.⁴³ By raising the payroll tax by the full amount that is intended to go into the FF pillar, so that the PAYG pillar incurs no deficit, the government is, in effect, prefunding the existing PAYG pillar. Forward-looking individuals would, therefore, maintain their optimal intertemporal consumption profile, by reducing savings outside the system to the full extent that their mandatory pension savings rises. As there is also no deficit in the PAYG pillar, the macroeconomic savings-investment balance is not affected by the pension reform. If individuals are myopic, however, a payroll tax-financed pension reform would reduce their savings outside the pension system by less than the increase in mandatory FF pillar savings.⁴⁴ As there would be no attempt by myopic individuals to reestablish the optimal consumption path, savings would tend to fall only to the extent that the increased payroll tax lowers disposable income. Thus, aggregate savings rise in response to the pension reform, and the macroeconomic savings-investment balance improves.

If, as an alternative, the pension reform is financed by a consumption tax, national savings would be expected to rise. It is a well-known theoretical result that indirect taxation is associated with higher savings than direct taxation in a life-cycle framework. With indirect taxation, some of the taxes that have to be paid over an individual’s lifetime fall due during retirement. Hence, savings are increased during one’s working life to pay for these taxes during retirement, leaving the intertemporal consumption profile unchanged. The macroeconomic savings-investment balance should therefore improve if the pension reform is financed by a consumption tax. Kotlikoff (1998) shows that a pension reform that is financed by a consumption tax leads to an increase in aggregate savings. However, this effect does not result from the pension reform itself, but rather from the implied tax reform that substitutes indirect taxes for direct taxes.

To summarize, assuming that individuals are neither fully forward-looking nor fully myopic, a debt-financed pension reform leads to a fall in domestic savings, and a tax-financed pension reform leads to a rise in domestic savings. If, in addition, domestic investment is independent of domestic savings—as would likely be the case for small open economies such as the Baltics—the change in domestic savings translates directly to the savings-investment balance and thus the current account: A debt-financed pension reform leads to a deterioration of the current account, and a tax-financed pension reform leads to an improvement of the current account (see Table 4.1).

Table 4.1.

The Macroeconomic Impact of Pension Reform

Table 4.1.

The Macroeconomic Impact of Pension Reform

	Forward-Looking Individuals	Imperfectly Forward- Looking Individuals	Myopic Individuals
Debt-Financed	Current account deteriorates.	Current account deteriorates.	Current account is unchanged.
Payroll Tax-Financed	Current account is unchanged.	Current account improves.	Current account improves.
Consumption Tax-Financed	Current account improves.	Current account improves.	Current account improves.

View Table

Table 4.1.

The Macroeconomic Impact of Pension Reform

	Forward-Looking Individuals	Imperfectly Forward- Looking Individuals	Myopic Individuals
Debt-Financed	Current account deteriorates.	Current account deteriorates.	Current account is unchanged.
Payroll Tax-Financed	Current account is unchanged.	Current account improves.	Current account improves.
Consumption Tax-Financed	Current account improves.	Current account improves.	Current account improves.

The issue of how best to finance a pension reform can therefore also be looked at from a macroeconomic management perspective.⁴⁵ A country with a strong current account position can rely relatively heavily on debt-financing, which allows for a distribution of the transition costs over many generations. A country with a weak current account position, however, should rely more on tax-financing to preserve external balance.

Implications of Pension Reform for Macroeconomic Policy Design

Several issues related to pension reform are relevant for macroeconomic policy design. First, the reform should seek to close any intertemporal PAYG financing gap. Second, fiscal accounts should allow this issue to be examined in a transparent fashion. Third, the financing of a pension reform should be appropriate in light of the country’s macroeconomic position.⁴⁶

Pension reforms are motivated in part by the need to close projected financing gaps over time in the PAYG system. While a PAYG system’s intertemporal budget constraint (that is, that the present value of current and future revenues equals the present value of current and future expectations) can always be met if pension expenditures are determined by pension revenues, governments may target a pension benefit level and a payroll tax level that are not consistent given demographic trends and productivity growth, resulting in a potential financing gap. Moreover, the payroll tax required to achieve even a subsistence pension benefit level may be too high in the sense that it would lead to significant efforts at tax evasion and impose a heavy deadweight loss on the economy. A pension reform should then be judged, in part, on the basis of whether it closes the projected financing gap. The pension reform must produce a pension system that is able to deliver the pension benefits level targeted and promised by the government without undue strain on the economy.

The issues involved in pension system reform make clear that governments should report their accounts not only for the current period—on a cashflow basis—but also on an accrual basis. Ideally, the sustainability of a pension reform would be analyzed in the context of an intertemporal budget constraint.⁴⁷ In light of this constraint, the current period fiscal stance can be analyzed with respect to how well it contributes to the intertemporal budgetary objectives. Of course, any long-term fiscal strategy must be based on viable short- and medium-run fiscal stances as well, in particular given the uncertainties associated with projecting long-run developments. In addition to ensuring consistency with the intertemporal budget constraint, each period’s fiscal balance must be achievable in an orderly fashion, that is, any deficit must be financed without unsettling financial markets.

Financing a pension reform by borrowing amounts to making an implicit government debt explicit (see for example, Cangiano, Cottarelli, Cubeddu, 1998). Under a PAYG system, the government promises current workers future pension benefits in return for their social security payroll tax contribution, incurring an implicit government debt. A pension reform that pays for the shortfall of PAYG contributions by issuing government debt makes this implicit government debt explicit, but does not increase the level of debt including contingent liabilities.

There may, however, be a recognition effect associated with moving from an implicit government debt to an explicit government debt. If international investors had not accounted for the implicit pension debt—perhaps reflecting the view that governments can more easily default on such debt—making it explicit could lead to a reassessment of the country’s fundamentals. To counter such a recognition effect, international organizations such as the IMF should support a well-designed pension reform as a proper step toward intertemporal fiscal solvency and sound macroeconomic policies. EU accession countries should be commended for openly addressing any demographic challenge to their pension system.

Financing a pension reform by taxing amounts to a simple prefunding of an existing PAYG system, imposing a forced saving on current workers. To achieve a certain pension benefit level that exceeds the one provided by the PAYG system, the government requires workers to save. If this saving is channeled into an FF pillar within the social security system, government savings increase although, on an accrual basis, the effect on the government budget is zero.⁴⁸

Financing a pension reform by using budget surpluses or one-time privatization proceeds amounts to levying a hidden tax.⁴⁹ If the budget surplus or the one-time privatization proceeds had not been used to finance the pension reform, they could have been passed on to workers through reduced taxes. Alternatively, they could have been used to pay down existing government debt. In this sense, financing a pension reform by using budget surpluses or one-time privatization proceeds increases government debt compared to the counterfactual, although it leaves it unchanged in an accounting sense. With respect to the pension budget, this way of financing also turns an implicit debt into an explicit debt.

The above analysis suggests that macroeconomic policy design should focus on the following issues:

• What is the size of the intertemporal budget gap, given the current policy stance and pension promises?

• Does the pension reform close the intertemporal budget gap?

• Is the short-run fiscal stance sustainable? If the pension reform is at least partly debt-financed, some fiscal consolidation may need to be programmed over the short and medium run to pay down the debt.

• Is the financing mix of the pension reform between taxes and debt appropriate given the country’s current account and debt situation?