Welfare effects of fiscal closures when implementing pension reforms

1. Modeling the pension reforms Macroeconomic modeling of the pension reforms1 Work in progress Krzysztof Makarski 12 Joanna Tyrowicz234 Jan Hagemejer23 with the assistance of Agnieszka Borowska and Karolina Goraus The views expressed herein are those of the authors and not necessarily those of Narodowy Bank Polski 1 Warsaw School of Economics of Economics, University of Warsaw 3 Economic Institute, National Bank of Poland 4 Rimini Center for Economic Analyses 2 Faculty Netspar - 2014 - Amsterdam 1 / 40

2. Modeling the pension reforms Motivation The big(ger) picture A (too) broad scientific project at the University of Warsaw OLG modeling of the pension system reform in Poland (Our intended) Contributions: fiscal closures have welfare effects (Pareto efficient reform?) labor market effects when intensive and extensive margin is combined with indivisibility of labor 3 political stability of pension reforms 1 2 We have (almost) completed (1), still work on (2) and (3) Today: welfare effects of various fiscal closures for 1999 reform 2 / 40

6. Modeling the pension reforms Motivation Questions How different fiscal closures of the pension system reform affect welfare? welfare effect of the reform (aggregate and across generations)? extent of fiscal adjustment for different fiscal closures pensions macroeconomic variables What are the effects of changes proposed/implemented recently? additional welfare redistribution across cohorts changes to pensions and replacement rates fiscal effect (debt/taxes) and capital 3 / 40

7. Modeling the pension reforms Motivation Questions How different fiscal closures of the pension system reform affect welfare? welfare effect of the reform (aggregate and across generations)? extent of fiscal adjustment for different fiscal closures pensions macroeconomic variables What are the effects of changes proposed/implemented recently? additional welfare redistribution across cohorts changes to pensions and replacement rates fiscal effect (debt/taxes) and capital 3 / 40

8. Modeling the pension reforms Model Roadmap 1 Motivation 2 Model 3 Calibration 4 Welfare eﬀects of ﬁscal closures 5 Summary 4 / 40

9. Modeling the pension reforms Model Model overview OLG model with endogenous labor and savings Heterogeneity across cohorts (mortality and labor productivity) No heterogeneity within cohorts Agents have time inconsistent preferences Exogenous retirement age and demographics Competitive producers with CD production function Pension system + pension system reform Inter-generational transfers + utility to compare welfare across time with changing demographics Different fiscal closures (to do fiscal rules) Calibrated to the Polish economy 5 / 40

10. Modeling the pension reforms Model What we do not know before modeling? 1999 reform: DB PAYG ⇒ NDC + FDC = partially funded DC part of contributions stay in the PAYG system (SIF) part of contributions shifted away (OPFs) + fiscal tension today lower replacement rates + ease fiscal tension in future comparing the steady states is not enough - transitory welfare effects BUT SIF gap needs to be financed ⇒ possible fiscal closures with own welfare effects five closures: lump sum, labor tax, consumption tax, debt + labor tax, debt + consumption tax we cannot tell ex ante which fiscal closure is better? effect for savings, labor supply and output? 6 / 40

14. Modeling the pension reforms Model Consumers ¯ Are free to choose how much to work, but only until J (forced to retire) Optimize lifetime utility derived from leisure and consumption J−j δs Uj (cj,t , lj,t ) = uj (cj,t , lj,t ) + β s=1 πj+s,t+s u (cj+s,t+s , lj+s,t+s ) πj,t (1) subject to ι (1 + τc,t )cj,t + sj,t + τj + υt = (1 − τj,t − τl,t )wj,t lj,t ← labor income + (1 + rt (1 − τk,t ))sj,t−1 ← capital income + (1 − τl,t )pι,j,t + bj,t ← pensions + bequests where u(c, l) = φ log(c) + (1 − φ) log(1 − l) 7 / 40

15. Modeling the pension reforms Model Producers maximize k Yt − wt Lt − (rt + d)Kt subject to α Yt = Kt (zt Lt )1−α where the path of {z}∞ is exogenous (calibrated to AWG, by EC) t=0 Interest rate k interest rate on capital rt = M P K − d, endogenous G k (riskless) interest rate on government debt to be rt = 0.33 · rt households (and pension funds) by public debt inelastically returns on savings yield a linear combination of risky and risk-less 8 / 40

16. Modeling the pension reforms Model Producers maximize k Yt − wt Lt − (rt + d)Kt subject to α Yt = Kt (zt Lt )1−α where the path of {z}∞ is exogenous (calibrated to AWG, by EC) t=0 Interest rate k interest rate on capital rt = M P K − d, endogenous G k (riskless) interest rate on government debt to be rt = 0.33 · rt households (and pension funds) by public debt inelastically returns on savings yield a linear combination of risky and risk-less 8 / 40

17. Modeling the pension reforms Model Public finances SIF collects social security contributions and pays out pensions J subsidyt = τtι · wt Lt − bj,t πj,t Nt−j (2) ¯ j=J any debt/surplus in SIF is government debt/surplus Government collects taxes on earnings, interest and consumption + υ spends fixed amount of GDP/money + services debt long run debt/GDP ratio fixed to finance pension system can use taxes or debt ⇐ fiscal closures 9 / 40

18. Modeling the pension reforms Model Public finances SIF collects social security contributions and pays out pensions J subsidyt = τtι · wt Lt − bj,t πj,t Nt−j (2) ¯ j=J any debt/surplus in SIF is government debt/surplus Government collects taxes on earnings, interest and consumption + υ spends fixed amount of GDP/money + services debt long run debt/GDP ratio fixed to finance pension system can use taxes or debt ⇐ fiscal closures 9 / 40

19. Modeling the pension reforms Model Pension systems initial steady state: PAYG Defined Benefit (DB), τtι = τ DB after the original reform: NDC + FDC (two pillars) τ = τ I + τ II NDC = contributions indexed with growth of payroll + benefit actuarially fair + post retirement indexation with 20% of payroll growth FDC = contributions earn interest + benefit actuarially fair + post retirement also earn interest 10 / 40

23. Modeling the pension reforms Model Solution method: Gauss-Seidel algorithm Start from the initial steady state Assume the economy eventually achieves the new steady state Reform is unexpected Algorithm Guess k per worker (or path) and compute wt , rt t = 0T Compute individual choices (may need value functions). Aggregate to get new k (or path) If |k − k | < err ﬁnish Just in case ... check feasibility No contraction mapping theorem 11 / 40

27. Modeling the pension reforms Model How do we know what is "better"? LSRA! Lump Sum Redistribution Authority as Nishiyama & Smetters (2007) 1 Run the no policy change scenario ⇒ baseline 2 Run the policy change scenario ⇒ reform 3 For each cohort compare utility, compensate the losers from the winners 4 If net effect positive ⇒ reform efficient 5 Run reform again, with the compensation, to observe GE effects What is baseline? Always the same: births, mortality, productivity and retirement age 1999 Reform: baseline = PAYG DB | reform = NCD + FDC 12 / 40

30. Modeling the pension reforms Calibration Roadmap 1 Motivation 2 Model 3 Calibration 4 Welfare eﬀects of ﬁscal closures 5 Summary 13 / 40

31. Modeling the pension reforms Calibration Baseline: no of births (20 year olds): Demographic projection (2060), constant afterwards (conservative) 14 / 40

32. Modeling the pension reforms Calibration Baseline: mortality rates Demographic projection (2060), constant afterwards 15 / 40

33. Modeling the pension reforms Calibration Baseline: old age dependency ratio Demographic projection (2060), constant afterwards 16 / 40

34. Modeling the pension reforms Calibration Baseline: labor augmenting technological progress Historical data, projection from AWG, new steady state at 1.7% 17 / 40

35. Modeling the pension reforms Calibration Baseline: retirement age Historical data, assumed (based on law) afterwards 18 / 40

36. Modeling the pension reforms Calibration Baseline (outcomes): pension beneﬁts in GDP Aging plus decreasing labor force 19 / 40

37. Modeling the pension reforms Calibration Calibration to replicate 1999 economy Preference for leisure (φ) matches participation rate of 56.8% Replacement rate (ρ) matches beneﬁts/GDP ratio of 5% Contributions rate (τ ) matches SIF deﬁcit/GDP ratio of 0.8% Labor income tax (τl ) set to 11% to match PIT/GDP ratio Consumption tax (τc ) set to match VAT/GDP ratio Capital tax (τk ) de iure = de facto The initial capital 20 / 40

38. Modeling the pension reforms Calibration Life cycle productivity: ﬂat or Deaton (1997) 21 / 40

39. Modeling the pension reforms Calibration Parameters for diﬀerent calibrations Calibrated parameters β=1 ω = 1 ω - D97 0.535 0.577 0.981 1.007 0.052 0.055 0.11 0.11 0.061 0.0608 0.25 0.15 β = 0.9 ω = 1 ω - D97 φ 0.537 0.575 δ 0.986 1.005 d 0.057 0.055 tl 0.11 0.11 τ 0.0608 0.061 ρ 0.25 0.15 resulting xt /yt 21.1 21.1 21.1 21.1 r 7.5 7.3 7.5 7.5 Note: D97: Deaton (1997) decomposition. β = 0.8 ω = 1 ω - D97 0.538 0.578 0.993 1.012 0.055 0.06 0.11 0.11 0.0606 0.0611 0.251 0.151 21.1 7.5 21.1 7.3 22 / 40

40. Modeling the pension reforms Welfare effects of fiscal closures Roadmap 1 Motivation 2 Model 3 Calibration 4 Welfare effects of fiscal closures 5 Summary 23 / 40

41. Modeling the pension reforms Welfare effects of fiscal closures Results SIF deficit resulting from the reform is financed ... ... by labor tax or consumption tax ⇒ debt share in GDP is held constant, so are taxes, but τl or τc is adjusted among all the living ... by debt which is later repaid with labor or consumption tax ⇒ debt share in GDP grows to a threshold of 70%, with all taxes held constant, then debt gets automatically reduced to 45% of GDP exponentially, τc or τl is adjusted for living then onwards ... by lump sum taxes on all living generations ⇒ debt share in GDP and tax rates are held constant, υ is adjusted among all the living 24 / 40

44. Modeling the pension reforms Welfare effects of fiscal closures Results: Welfare Efficiency of the reforms reform closure Υ τc debt + τc τl debt + τl Υ 2.0% 1.7% 1.7% 1.5% 1.6% τc 2.4% 2.0% 2.1% 1.9% 2.0% baseline closure τl debt + τc 2.6% 2.3% 2.2% 1.9% 2.3% 2.0% 2.1% 1.8% 2.2% 1.9% debt + τl 2.5% 2.1% 2.2% 2.0% 2.1% 25 / 40

45. Modeling the pension reforms Welfare effects of fiscal closures Results: Welfare LSRA after redistribution (% of perm. cons.) Fiscal closure τl Debt/τl τC Debt/τC υt Note: D97 denotes β=1 β = 0.9 flat D97 flat D97 0.021 0.016 0.015 0.012 0.021 0.015 0.015 0.012 0.020 0.017 0.015 0.012 0.020 0.016 0.014 0.012 0.020 0.019 0.015 0.013 calibration according to Deaton β = 0.8 flat D97 0.009 0.005 0.009 0.005 0.009 0.006 0.008 0.005 0.011 0.007 (1997) decomposition. 26 / 40

46. Modeling the pension reforms Welfare eﬀects of ﬁscal closures Results: Fiscal adjustment Debt/consumption tax - higher taxes initially, become eventually lower 27 / 40

47. Modeling the pension reforms Welfare eﬀects of ﬁscal closures Results: Fiscal adjustment Debt/labor tax - higher taxes initially, become eventually lower 28 / 40

48. Modeling the pension reforms Welfare eﬀects of ﬁscal closures Results: Fiscal adjustment Labor tax - higher taxes initially, become eventually lower 29 / 40

49. Modeling the pension reforms Welfare eﬀects of ﬁscal closures Results: Fiscal adjustment Consumption tax - higher taxes initially, become eventually lower 30 / 40

50. Modeling the pension reforms Welfare effects of fiscal closures Results: Fiscal adjustment Extent of fiscal adjustment - lump sum tax Higher taxes initially, become lower after a while. Note; lump sum taxes have real effects (redistribution) 31 / 40

51. Modeling the pension reforms Welfare effects of fiscal closures Results: Pensions Replacement rates - relative to baseline Pensions are substantially reduced by PAYG DB → DC Fiscal closure matters little Initial cohorts unaffected 32 / 40

52. Modeling the pension reforms Welfare effects of fiscal closures Results: Macroeconomic effects Closure Labor tax Consumption tax Debt with τl Debt with τl Lump sum tax Period 10 50 ∞ 10 50 ∞ 10 50 ∞ 10 50 ∞ 10 50 ∞ GDP D97 ω flat ω 0.6% 0.7% 2.2% 2.0% 2.5% 2.1% 0.6% 0.7% 2.9% 2.7% 2.4% 2.0% 0.2% 0.2% 2.0% 1.8% 2.5% 2.1% 0.2% 0.1% 3.0% 2.8% 2.3% 2.0% 0.5% 0.6% 2.2% 2.0% 2.6% 2.0% Labor supply D97 ω flat ω -0.9% -0.5% -1.3% 0.9% -1.2% 0.4% -0.8% -0.2% -0.6% 1.1% -0.9% 0.5% -0.3% 0.1% -1.1% 1.1% -1.2% 0.4% -0.4% 0.1% -0.5% 1.1% -0.9% 0.5% -0.2% 0.4% -1.9% -0.5% -2.3% -0.5% Capital D97 ω flat ω 1.8% 2.3% 7.2% 6.4% 8.3% 7.0% 1.9% 2.4% 9.8% 9.1% 7.8% 6.7% 0.6% 0.5% 6.7% 5.8% 8.3% 7.0% 0.6% 0.4% 10.0% 9.2% 7.8% 6.7% 1.7% 2.1% 7.3% 6.7% 8.5% 6.6% 33 / 40

53. Modeling the pension reforms Welfare effects of fiscal closures Results: Distribution of welfare effects Welfare: all closures, no time inconsistency 34 / 40

54. Modeling the pension reforms Welfare effects of fiscal closures Results: Decomposition of welfare effects Decomposition - consumption tax (left) and debt/consumption tax (right) 35 / 40

55. Modeling the pension reforms Welfare effects of fiscal closures Results: Decomposition of welfare effects Decomposition - labor tax (left) and debt/labor tax (right) 36 / 40

56. Modeling the pension reforms Welfare eﬀects of ﬁscal closures Results: Time inconsistency Time inconsistency - matters little for capital Capital - consumption tax closure and debt closure with consumption tax 37 / 40

57. Modeling the pension reforms Welfare effects of fiscal closures Results: Time inconsistency Time inconsistency - preserves the general findings Welfare - consumption tax closure and debt with consumption tax closure 38 / 40

58. Modeling the pension reforms Summary Roadmap 1 Motivation 2 Model 3 Calibration 4 Welfare eﬀects of ﬁscal closures 5 Summary 39 / 40

59. Modeling the pension reforms Summary Generally, 1999 reform is welfare enhancing Overall effects positive Majority comes from DB->DC change Fiscal closure matters for (cohort) composition effects Pensions fall which implies that considerable redistribution across cohorts needed Introduction of funded DC makes debt desirable (redistributes) To do Log utility: taxes affect labor marginally (GHH preferences) Endogenous retirement 40 / 40

60. Modeling the pension reforms Summary Generally, 1999 reform is welfare enhancing Overall effects positive Majority comes from DB->DC change Fiscal closure matters for (cohort) composition effects Pensions fall which implies that considerable redistribution across cohorts needed Introduction of funded DC makes debt desirable (redistributes) To do Log utility: taxes affect labor marginally (GHH preferences) Endogenous retirement 40 / 40

Welfare effects of fiscal closures when implementing pension reforms

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