Chapter

I Introduction and Summary

Author(s):
Alfredo Cuevas, George Mackenzie, and Philip Gerson
Published Date:
September 1997
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Public pension reform arouses great interest virtually everywhere. In the Organization for Economic Cooperation and Development (OECD), it is generally accepted that most existing pension regimes may be financially unsustainable, and that, as the population ages, they will require substantial reform to forestall the emergence of large public sector deficits and reductions in national saving rates (see Chand and Jaeger (1996) for further discussion). High payroll tax rates necessitated by the impact of adverse demographics on public pension systems and health plans are already common in the OECD. This problem is acute in Eastern Europe, the Baltic countries, Russia, and the other countries of the former Soviet Union, although inappropriate benefit structures and administrative problems are also of great concern. In Latin America, which has had the most extensive public pension systems outside the OECD, Eastern Europe, the Baltic countries, Russia, and the other countries of the former Soviet Union, there is concern about the budgetary costs of excessively generous benefits, an eroding payroll tax base, administrative waste, and inequitable coverage and treatment. A number of countries in the region have already moved to adopt a version of the Chilean defined-contributions plan, which is privately managed.

Even in countries where the condition of the staterun schemes is less parlous, there is an ongoing debate about what role the public sector should play in the provision of pensions. The need to reform the legal and regulatory framework of private sector (occupational) pensions is a closely related concern.

Pensions can be viewed from many different angles and raise a host of issues. This paper is concerned specifically with the impact of pension regimes—and pension reform—on aggregate saving and does not pretend to be a general survey of pension economics. It can hardly be overemphasized that the basic objective of a public pension program is not to raise the saving rate, but to provide income security—at the very least, a minimum income1—for the elderly. The advocates of a Chilean-style reform tend to argue that it will bring about the best of both worlds: security in old age and a high saving rate.2

There is, nonetheless, a sense in which the issue of pensions and saving encompasses that of income security in old age because the incomes of the elderly ultimately depend on the stock of savings one generation accumulates while working and its bequest of human and physical capital to its descendants. For the same reason, the pensions and saving issue is also intimately bound up with the fiscal impact of pension reform. A pension system that promotes public sector dissaving is hardly likely to contribute to capital accumulation.

The paper’s main findings and conclusions can be summarized as follows:

(1) Studies of the U.S. economy, on which most research has been done, provide some moderately strong evidence that the introduction and development of the public pension plan have depressed private sector saving, although the extent of this impact has proved hard to estimate. Studies of other countries as a group have tended to be inconclusive. In some countries, a depressing effect has been found, while studies of others have found either no significant effect or even a positive effect. The upshot is that it is not possible to generalize across countries about the impact of the public pension system on saving.

(2) Some reasonably strong evidence exists that the growth and development of private pension plans increase private sector saving. Specifically, other private sector saving falls by less than contractual pension plan saving increases. Support for this contention is drawn largely from studies of the U.S. economy, although studies of several other countries have come to the same conclusion.

(3) Replacing a pay-as-you-go (PAYG) defined-benefits public sector plan with a defined-contributions plan along the lines of the Chilean system can increase aggregate saving. However, critically important are the contribution rates of the new plan and the means of financing the increase in the public sector deficit that characterizes the period of transition during which the old system is phased out. To maximize the impact on saving, the public sector deficit created as workers stop paying payroll taxes and start making contributions to the new system should be financed as much as possible through fiscal consolidation (e.g., tax increases or the maintenance of the payroll tax), and the contribution rate to the new system should be as high as possible.

(4) There is no compelling reason to believe that the addition of a second tier, in the form of a defined-contributions plan, to the public system should increase saving if it is financed by diverting part of the existing payroll tax from the existing system.

(5) A conventional public pension reform, which reduces the cash-flow and actuarial imbalances of the plan, will increase aggregate saving. Such a reform could comprise increases in effective retirement ages, a reduction in the replacement ratio—the ratio of pension to salary—which can be accomplished in a number of ways, or increases in contribution rates. This kind of reform of the existing system, which does not entail a fundamental change in the way it is managed or administered, increases aggregate saving because it increases public sector saving without entailing a fully offsetting decline in private sector saving. That said, any measures to increase public sector saving should boost total saving because such increases are typically not fully offset by a decline in private sector saving. Conceivably, even the announcement of future declines in the replacement ratio could prompt an increase in private saving.

(6) A drastic increase in saving in the short run deriving from a conventional public pension reform would probably require either a major reduction in the real value of the pensions of the current generation of pensioners or large hikes in payroll tax rates. Gradual changes in the pension regime, desirable as they are from the point of view of the welfare of the current generation of pensioners, would take years to boost the saving rate significantly.

(7) The spread of private pension regimes may well increase aggregate saving. There is, however, no reliable way of encouraging a speedy increase in the coverage of the private pension system, except, possibly, through tax incentives. The depressing impact of such incentives on public sector saving may, however, outweigh the positive impact on private sector saving of broader private pension plan coverage.

Notes: The paper uses “saving” to describe that part of current income that is not consumed, and “savings” to describe the stock of accumulated saving. The term “pensions” can cover old-age or retirement pensions, disability pensions, and survivors’ (widows and orphans) pensions. This paper’s primary concern is with oldage and retirement pensions, and, unless it is stated otherwise, the word “pensions” should be taken to refer to this particular class of pensions.

It is worth remembering that there can be too much aving—the saving rate can be so high that the welfare of current generations suffers unduly, as was probably true in the Soviet Union in the 1930s.

Pension system design must also be mindful of how the system treats different generations and of its impact on the distribution of income within generations. Similarly, attention needs to be paid to the way the system affects the labor market and the incentive to work.

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