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
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.
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.
What about a Fully Funded, Proportional Benefits System? Has a modest dead-weight taxation cost if population is growingBut, not sustainable in democratic societies
If benefits are proportional to contributions thenModest loss if population growingLarger loss if population constantBig loss if population decliningWHY?
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.
The Big Problem with PAYG Systems Inevitably the system evolves so that benefits are not proportional to contributionsThe additional benefits to a household with two earners rather than one are zero
On Margin, Contribution to Retirement Account Is a Tax In U.S. the tax rate for funding the public retirement system is 10.6 percentAnd the dead-weight loss is over 10 percent of consumption
The Solution: Mandatory Personal Savings Accounts Benefits are proportional to contributionsReturns on these savings are market returnsDifficult for governments to get their hands on these savings and redistribute them
Dead-weight Loss of Tax and Transfer System Associated with one dollar of additional taxes paid, a household must be given two dollars to leave it equally well off
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
There Is Overwhelming Scientific Evidence that Aggregate Labor Supply Elasticity is HIGH
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 factsA multitude of others have come up with the same finding (see Cooley 1995 volume)
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, 1992-2002, if and only if this elasticity is about 3See Kehoe and Prescott Depressions volumes (2002, 2005) for 15 other studies coming up with the same conclusion
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 3Americans, 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
Increase in Labor Supply in Spain: Tax Cut and Labor Market Reform
Theoretical Evidence Rogerson (1984) and Hansen (1985) use theory to establish that the aggregate elasticity is much greater than individual elasticityWhen the margin of labor supply adjustment is the number employed and is not hours per employed person
Most Adjustment Is in Number Employed Over business cycleOver postwar depressions and prosperitiesOver the seasonsOver the life cycle
Question: Why Number Employed and Not Hours per Employed Varies Hornstein-Prescott (1993) find that theory predicts it in the empirically interesting caseThe 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
Summary High aggregate labor supply elasticity is implied by aggregation theoryTheory predicts both the micro and macro observationsThus, it is an established scientific finding
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)
Why Mandatory Savings Not subject to the time consistency problem
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 incomeThese savings will provide a decent level of consumption for retireesSavings are in a low cost, highly diversified portfolio that realizes market return
An Illustrative Example People work for 45 years and then retire for 20 yearsThe real interest rate is 4% and productivity grows at 2% a yearThe tax rate minus the Social Security retirement tax rate is 30%These are U.S. numbers
Pay-as-You-Go System Social Security retirement tax finances retirementRetirement benefits: 50% of average consumptionGovernment debt is zero
Personal Savings System Other benefits are kept same as under pay-as-you-go systemMandatory savings accounts for retirement
Welfare Gains of Moving to a Personal Savings System Are BIG
Key Findings Increase in welfare in terms of lifetimeconsumption equivalents
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.
Concluding Remarks Welfare of everyone increases with mandatory personal savings accounts for retirementMy advice, don’t throw away 25% of consumption
Concluding Remarks A number (25) of countries have adopted mandatory savings plansIn Mexico these savings are growing rapidly and are being used to finance new businesses and home ownership
Concluding Remarks In Sweden their adoption in 1998 reduced the marginal tax rate and that economy has grown faster than the EU averageThe U.S. should follow the lead of Eastern Europe, Sweden, Mexico, and a number of other countries
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