TCS Daily

Golden Years

By Pavel Kohout - May 26, 2005 12:00 AM

Many politicians think the problem of pension systems deficits can be solved by just changing the parameters of the pay-as-you-go system. They believe it's necessary only to raise the social security tax rate, cut the replacement ratio or postpone the pension age - and, presto, everything will be fine and the system will be stabilized.

Unfortunately, this is not the case. The most important hazard of the PAYG system is not financial, as economists Isaac Ehrlich and Jinyoung Kim show in their recent working paper "Pension Systems, Demographic Trends and Economic Growth" (NBER, February 2005). The very principle of the pay-as-you-go system adversely affects demographic structure, rate of private savings and long term economic growth. The flaw is not in the system's parameters, but in its fundamental nature.

Ehrlich and Kim's conclusions are based on a model which assumes that family forming is an endogenous variable. In other words, humans do not live in a vacuum. They make rational decisions about marriages and children, and these decisions are influenced by economic factors, such as taxes and welfare benefits. Empirical data indeed show that people strive to maximize their utility functions, even if very few people would openly admit that.

Ehrlich and Kim's model underlines an important finding: it's not possible to neutralize the impact of forced intra-generational transfers, a.k.a. a pay-as-you-go system. The demographic crisis (which endangers all PAYG systems to some extent) has not come out of the blue sky. It's a direct consequence of how PAYG pension systems work. Ehrlich and Kim illustrate this assertion on the panel of data from 57 countries during 1960-92. "We find that PAYG tax measures account for a sizeable part of the downward trends in family formation and fertility worldwide, and for a slowdown in the rates of savings and economic growth, especially in OECD countries."

The continue: "Our analysis suggests that the expanded scale of the PAYG system over the last century has contributed to the diminished importance of intergenerational transfers going from children to old parents - the traditional family security system." Public pension systems have eroded traditional family ties. Children can live without their parents; and people who might become parents can live childless - or childfree, to use recent term describing people who intentionally do not want children at all. People rely on government in their old age rather than on their children.

Researchers Michele Boldrin, Mariacristina De Nardi and Larry Jones come to the same conclusion in the working paper "Fertility and Pension System" (NBER, February 2005). "The data show that an increase in government-provided old-age pensions is strongly correlated with a reduction in fertility," concludes the study. The effect is massive enough to explain 80 percent of observed differences in cross-country birth rates. The empirical results also support the hypothesis that parent's choice concerning number of children is not primarily driven by cultural or religious habits.

The main factor is economy. People are motivated to have children by the need for an economic base. Why do Chinese peasants want to have more than two children despite government-imposed "one-child" policy? The answer is that they are not covered by any pension system at all.

An old Czech story, "Three Pence", tells of a peasant who earns three pence a day. He spends one penny, lends another penny to his son, and pays the debt to his father with the third. That's the way society had worked until government stepped in - whether in Europe's history or in China today. The anonymous machine of government-run pension systems has destroyed the traditional patterns of family life. Since human capital is the engine of growth, family choices affect human capital formation.

The low birth rate results in lower GDP growth. Pension system resources slowly dry up. Attempts to raise the social security tax rate may result in expensive labor, and thereby lower demand for it - create high unemployment, in short. The vicious circle is completed. There is no combination of parameters that could make a PAYG system sustainable in the long run. This assertion may one day enter economic textbooks as a theorem whose ignoring ruined the once-rich economies of Western Europe.

There is only one way to moderate the damage: to minimize the total value of pensions paid by the government. This may sound harsh, but wait: low government-paid pensions do not mean that pensioners must starve. Take Iceland. Retirees are paid flat pensions by the government. The total value of the Icelandic PAYG system does not exceed 7 percent of GDP, vs 12 percent in Italy. The total fertility rate in Iceland is 1.9 child per woman vs. 1.2 in Italy. Is Iceland a poor country? No, it's more than 20 percent wealthier than Germany. Pity that Iceland is too small and too little-known to be taken as a serious role model.


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