Aging, the World Economy and the Coming Generational Storm

Policy Reports | Economy

No. 273
Friday, February 04, 2005
by Laurence Kotlikoff, Hans Fehr, and Sabine Jokisch

Can Private Pension Reform Solve the Problem?

Table XIII - XV

“Pension reform would allow workers to invest their payroll taxes in private accounts.”

Our proposed pension privatization reform eliminates existing public pension systems at the margin, while still paying successive retirees all the benefits they accrued under the existing system. This reform is modeled in the following way: Pension benefits of current retirees are paid in full, and benefits for new retirees are phased out linearly over a 45-year period starting in 2000. Furthermore, payroll tax contributions to the pension system are eliminated, and transitional benefits are financed by a new consumption tax, such as a general national sales tax or Value-Added Tax.6

“A transitional consumption tax would increase saving and capital formation.”

Closed Economy Simulation. In the United States, the new consumption tax rate needed to finance the transition to a private pension system is initially 7.9 percent. It rises to a maximum value of 8.7 percent in 2020 and gradually declines thereafter. After 2071 the consumption tax is zero. The U.S. payroll tax rate declines immediately by 6.2 percentage points. Over the transition, the payroll tax rate rises by 2.4 percentage points because expenses for health care and disability insurance grow. In Europe, a similar consumption tax rate would have an initial value of 16.9 percent, rising to a maximum of 18 percent in 2012 and then decline. The tax is zero after 2074. Because of this reform, the payroll tax is reduced by 17.2 percentage points in year 2000 and rises to a maximum of 11.4 percent in 2050. In Japan, the added consumption tax rate is initially 14.2 percent. It rises to a maximum of 18.3 percent in 2014 before declining. As in Europe, the targeted consumption tax is zero after 2074. The payroll tax, however, is 16.8 percentage points lower in 2000 and the maximum value reached is 11.8 percent in 2050.

The impact of this reform on the U.S. economy is stunning (see Table XIII vs. Table I):

  • Whereas without reform, the relative real wages of U.S. workers are expected to decline by 15 percent at mid-century, with reform the drop is only 8 percent;
  • Whereas combined taxes on U.S. labor income is expected to approach 40 percent without reform, with reform taxes on labor will be less than half as much.

The effects on European economies are even more dramatic (see Table XIV vs. Table II):

“By 2050, U.S. real wages would fall by 8% instead of 15% and the tax on labor would be cut in half.”

  • Instead of a 14 percent drop in relative real wages by 2050, European workers will actually see a real wage increase.
  • Without reform, European workers can expect to pay two of every three future dollars they earn in taxes, whereas after reform, taxes will claim only one in four dollars earned.
Table XVI - XVII

“In Europe, real wages would actually rise and taxes on labor would fall to 25%.”

Results are similar in Japan, where the real wage gains and tax reductions are even greater (see Table XV vs. Table III).

Note that the consumption tax depresses aggregate consumption, which permits an increase in national saving and capital formation. The long-run consequences of this reform are dramatic in all three regions.

  • Relative to the base case simulations, the year 2100 capital stock increases by 62.9 percent in the United States, 163.5 percent in Europe and 149.3 percent in Japan.
  • Higher capital stocks increase gross wages, which, relative to the base case, rise through 2100 by 13 percent in the United States, 29 percent in Europe and 28 percent in Japan.
  • The combination of higher gross wages and reduced payroll and wage taxes boosts net wages especially in Europe and Japan: they almost triple in Europe and more than double in Japan relative to the base case.

“In Japan, wage gains and tax reductions would be even greater.”

A reduction in the labor supply in the three regions is a direct consequence of the positive income effects experienced by younger generations. Capital accumulation drives up capital valuations in all economies and leads to lower long-run interest rates.

Open Economies Simulation. Not surprisingly, the consequences of private pension reform in an open economy are very similar to those in the closed economies simulation. (See Tables XVI, XVII and XVIII vs. Tables IV, V and VI.)

“In the open economy simulation, trade and capital flows make reform a better deal for U.S. workers.”

In the United States, the consumption tax increases slightly less in the open economies model than in the closed economies model, whereas in Europe the consumption tax increases slightly more. The reason is that privatization has a stronger positive effect on wages in the open U.S. economy compared to the closed U.S. economy, while the opposite applies in the EU and Japan. Finally, the drop in the interest rate due to privatization is greater in the open than in the closed U.S. economy. In Europe and Japan exactly the opposite happens.

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