We analyze the consumption and wealth inequality in an OLG model with obligatory pension systems. Our framework features within cohort heterogeneity of endowments (individual productivities) and heterogeneity of preferences (preference for leisure and time preference). We allow for population aging and gradual productivity slowdown. We show four main results. First, longevity increases substantially aggregate consumption inequality and wealth inequality, regardless of the pension system features. Second, the effect of a pension system reform from a defined benefit to a defined contribution works to reinforce the consumption inequality and reduce the wealth inequality. Third, minimum pension benefits are able to counteract a part of that increase in inequality, at a fiscal cost. Fourth the minimum pension benefit guarantee addresses mostly the inequality which stems from differentiated endowments and not that which stems from heterogeneous preferences. Slides from GRASS XI talk at Bocconi

1. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Inequality in an OLG economy
with heterogeneous cohorts and pension systems
Marcin Bielecki, Krzysztof Makarski and Joanna Tyrowicz
FAME|GRAPE & University of Warsaw & Warsaw School of Economics
GRASS XI, Milano, 2017

2. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Motivation
Motivation
Wealth inequality increases due to:
Demographic transition
Pension reform: defined benefit → defined contribution
Effects for consumption inequality: unclear

3. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Motivation
Motivation
Wealth inequality increases due to:
Demographic transition
Pension reform: defined benefit → defined contribution
Effects for consumption inequality: unclear
Can policy instruments help?
minimum pensions: ↑ pensions; ↓ labor supply incentives
contribution caps : obligatory savings replaced with private savings
Intuition insufficient

4. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Motivation
Literature review
Distributional effects of pension systems: OLG models with ex post
heterogeneity:
Castaneda et al. (2003, JPE); Fehr et al. (2008, RED); Song (2011, RED);
Bucciol (2011, MD); Cremer and Pestieau (2011, EER); Kumru and
Thanopoulos (2011, JPubE); Fehr and Uhde (2014, EM); St-Amant and
Garon (2014, ITPF)

5. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Motivation
Literature review
Distributional effects of pension systems: OLG models with ex post
heterogeneity:
Castaneda et al. (2003, JPE); Fehr et al. (2008, RED); Song (2011, RED);
Bucciol (2011, MD); Cremer and Pestieau (2011, EER); Kumru and
Thanopoulos (2011, JPubE); Fehr and Uhde (2014, EM); St-Amant and
Garon (2014, ITPF)
Ex ante + ex post heterogeneity: education affects mortality rates
Hairault and Langot (2008, JEDC):
McGrattan and Prescott (2013, NBER)
Kindermann and Krueger (2014, NBER)

6. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Motivation
Our approach
Question 1: distributional effects of a pension system reform
Question 2: are standard instruments effective in reducing the increase in
inequality

7. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Motivation
Our approach
Question 1: distributional effects of a pension system reform
Question 2: are standard instruments effective in reducing the increase in
inequality
Ex ante heterogeneous agents: age + within cohort
endowments + preferences ← not a stand
separate endowments from preferences
most countries: no data on mortality by education / income groups

8. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Motivation
Results preview
DB → DC reform: both wealth and consumption inequalities ↑

9. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Motivation
Results preview
DB → DC reform: both wealth and consumption inequalities ↑
Demographic transition ⇒ inequalities ↑, more than due to reform

10. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Motivation
Results preview
DB → DC reform: both wealth and consumption inequalities ↑
Demographic transition ⇒ inequalities ↑, more than due to reform
Minimum pensions:
reduce inequality from the reform by 40-50%
work on the endowments margin, but not on preferences
Effects of the contribution cap: negligible (hence omitted)

11. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Motivation
Outline
1 Motivation
2 Model
3 Calibration
4 Results

12. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Model
Method
Model
Deterministic
OLG
ex ante heterogeneity: endowments + preferences

13. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Model
Method
Model
Deterministic
OLG
ex ante heterogeneity: endowments + preferences
Calibrate to Poland in 1999

14. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Model
Households I
“Born” at age 20 (j = 1) and live up to 100 years (J = 80)
Subject to time and cohort dependent survival probability π
Belong to a type k:
productivity level ω
time discounting δ
relative leisure preference φ
Choose labor supply l endogenously
Maximize remaining lifetime utility derived from consumption c and leisure
1 − l:
Uj,k,t =
J−j
s=0
δs
k
πj+s,t+s
πj,t
c
φk
j+s,k,t+s (1 − lj+s,k,t+s)1−φk

15. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Model
Households II
Subject to the budget constraint
(1 + τc
t )cj,k,t + sj,k,t = (1 − τl
t )(1 − τ)wtωklj,k,t ← labor income
+ (1 + (1 − τk
t )rt)sj−1,k,t−1 ← capital income
+ (1 − τl
t )bj,k,t ← pension income
+ beqj,k,t ← bequests
− Υt ← lump-sum tax
There exists a closed-form solution to this problem

16. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Model
Producers
Perfectly competitive representative firm
Standard Cobb-Douglas production function
Yt = Kα
t (ztLt)1−α
Profit maximization implies
wt = zt(1 − α)ˆkα
t
rt = αˆkα−1
t − d
where d is the capital depreciation rate
and ˆk is capital per effective unit of labor

17. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Model
Government
Spends a fixed share of GDP (g) on government consumption
Collects taxes T
Closes the gap between pension system contributions and benefits
Can take on debt D
Tt + Dt = (1 + rt)Dt−1 + gYt + subsidyt
We fix debt at constant 45% debt to GDP ratio.
Consumption tax varies to satisfy the government constraint.

18. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Model
Pension System
Pay As You Go Defined Benefit (PAYG DB)
b ¯J,k,t = ρ · gross wage ¯J−1,k,t−1
Pay As You Go Defined Contribution (PAYG DC)
b ¯J,k,t =
accumulated sum of contributions ¯J,k,t
expected remaining lifetime ¯J,t
Pensions indexed by the rate of annual payroll growth

19. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Model
Instrument 1: minimum pensions
Definition
bj,k,t ≥ ρmin · gross average waget
We set ρmin = 0.2 → 4% coverage (consistent with the data)

20. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Model
Instrument 1: minimum pensions
Definition
bj,k,t ≥ ρmin · gross average waget
We set ρmin = 0.2 → 4% coverage (consistent with the data)
Expectations
Directly affects only the left tail of income distribution
Increases lifetime incomes of targeted group → consumption inequality
should decrease
Lower incentives to work → possible reduction in hours worked
Lower incentives for private savings → possible increase in consumption

21. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Model
Instrument 2: lump sum indexation
Definition:
Take all the indexation (growth in payroll x pensions to be paid out)
Split that equally among all pension benefit recipients (lump sum)

22. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Model
Instrument 2: lump sum indexation
Definition:
Take all the indexation (growth in payroll x pensions to be paid out)
Split that equally among all pension benefit recipients (lump sum)
Expectations
Redistributes from high income to low income, but within pension system
Higher benefits of targeted group and implicit taxation of high income
groups → lower voluntary savings of low income and higher of high income
→ wealth inequality ↑
Possible reduction in consumption inequality

23. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Model
Solution procedure
Gauss-Seidel iterative algorithm
Steady states (initial and final)
1 Guess an initial value for ˆk
2 Use it to compute the prices
3 Have households of each type and age solve their problem given prices
4 Aggregate individual labor supply and savings to get new values
for L and K
5 If the new value for ˆk satisfies predefined norm, finish,
else update ˆk and return to point (2)

24. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Calibration
1 Motivation
2 Model
3 Calibration
4 Results

25. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Calibration
Exogenous assumptions
Projections for Poland provided by the European Commission
Population Size TFP Growth

26. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Calibration
Exogenous assumptions
Projections for Poland provided by the European Commission
Population Size TFP Growth
Kept constant across scenarios, don’t affect results

27. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Calibration
Within cohort heterogeneity - endowments
Structure of Earnings Survey, 1998, Poland
Productivity ω
Resulting: 10 values for ω

28. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Calibration
Within cohort heterogeneity - leisure preference
Structure of Earnings Survey, 1998, Poland
Leisure Preference φ
Resulting: 4 values for φ

29. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Calibration
Within cohort heterogeneity - time preference
Again: no data on mortality rates or wealth by income or education groups
Calibrate the central value of δ to match the investment rate
Split population ad hoc to 3 groups:
to match the wealth inequality Gini (HFCN)
discount factors are (0.988δ, δ, 1.012δ)

30. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Calibration
Within cohort heterogeneity - summary outcomes I
In total we have 120 types within each cohort
The resulting consumption Gini index in the initial steady state is 25.5,
consistent with Brzezinski (2011)

31. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Calibration
Within cohort heterogeneity - summary outcomes II

32. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Calibration
Within cohort heterogeneity - summary outcomes III

33. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Calibration
Within cohort heterogeneity - summary outcomes IV

34. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Calibration
Within cohort heterogeneity - summary outcomes V

35. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Results
1 Motivation
2 Model
3 Calibration
4 Results

36. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Results
Minimum pensions coverage

37. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Results
Macroeconomic effects
No instrument DC with minimum DC with lump sum
DB DC benefits indexation
Capital 184% 197% 193% 197%
Tax rates
initial steady state 11.00 11.00 11.00 11.00
t = 2080 20.50 10.97 14.21 10.95
Pension system deficit
initial steady state 0.56
t = 2080 7.06 -0.14 2.52 -0.18

38. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Results
Consumption and wealth Gini coefficient – total.21.22.23.24
2000 2020 2040 2060 2080
year
.59.6.61.62.63.64
2000 2020 2040 2060 2080
year
DB: No instruments DC: Minimum benefits
DC: No instruments DC: Lump sum indexation
Left: consumption; right: wealth

39. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Results
Consumption and wealth Gini coefficient – at retirement.185.19.195.2
2000 2020 2040 2060 2080
year
.24.26.28.3.32
2000 2020 2040 2060 2080
year
DB: No instruments DC: No instruments
DC: Minimum benefits DC: Lump sum indexation
Left: consumption; right: wealth

40. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Results
Welfare effects – aggregate

41. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Results
Welfare effects – minimum benefits

42. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Results
Welfare effects – lump sum indexation

43. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Results
Inequality decomposition – endowments vs preferences
Instruments should reduce inequality stemming from endowments (luck)
but not from preferences
To isolate the effects of the two sources:
Shut down each channel separately
Keep prices constant from the full model to avoid GE effects
Solve for decisions of households in partial equilibrium

44. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Results
Consumption inequality decomposition - minimum pensions

45. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Results
Wealth inequality decomposition - minimum pensions

46. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Results
Conclusions
Consumption inequality increase due to
aging processes
DB→DC reform
Minimum pensions
effective in reducing consumption inequality resulting from the DB→DC
reform by 40-50%
with 80% coverage minimum pension costs appox 1 pp higher consumption
tax
wealth inequality increases
Lump sum indexation too small to have any effects
(Also contribution cap is too small)

47. Inequality in an OLG economy with heterogeneous cohorts and pension systems
Results
Questions?
Thank you for your attention!
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