Aging, the World Economy and the Coming Generational Storm

Studies | Economy

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


The Impact of Private Pension Reform on Selected Groups by Income and Age

“A consumption tax would spread the transitional costs among generations.”

The advantageous macroeconomic effects of privatization come at a cost. Private pension reform implies a redistribution from older generations in all three economies toward younger and future generations. The intergenerational and intragenerational redistribution is less severe in the United States than in Europe and Japan, however. This is because part of the financing burden of the pension system is shifted toward the elderly via the consumption tax. How substantial are these gains and losses?

Table XVIII - XIX

“The benefits of reform are greatest for younger, low-income workers.”

Closed Economies Simulation. Table XVIII shows the impact (relative to the base case) of pension reform on the remaining lifetime welfare of different groups of workers. In the table, the groups are distinguished by their year of birth and income levels. The welfare change is calculated by asking by what percentage would one need to increase a person’s annual consumption and leisure in the base case to achieve the same level of wellbeing with private pension reform.

There are two striking features about this table:

  • Among younger workers (especially those yet to be born), the long run benefits of a reformed system are very large and very progressive.
  • Among older workers (retirees) the costs of reform are relatively small but somewhat regressive.

Consider the generation of workers who will be born three decades hence. If private pension reform were instituted today:

  • In the United States, the lowest-income workers born in 2030 will experience a 30 percent increase in their standard of living; middle-income workers will enjoy a 20 percent increase; and the highest income workers will gain a mere 6 percent.
  • In Europe the gains are even more dramatic: almost a doubling of living standards (95 percent) for the lowest-income group, a two-thirds increase for those in the middle and a 14 percent gain for those at the top.
  • In Japan, the gains are 85 percent, 61 percent and 10 percent, respectively.

By contrast, older workers (through the consumption tax) will bear a net cost as a result of this reform. For example:

“Because of reform, a middle income worker born in the USA will see a 22% increase in living standards.”

  • Low-income U.S. retirees born in the 1940s will see a 6.6 percent drop in their living standard because of the consumption tax, compared to a 1.5 percent drop for higher-income retirees.
  • In Europe the comparable numbers are 10.9 and 2.9 percent.
  • In Japan they are 11.5 and 3.3 percent.

Note, however, that senior citizens who would bear a disproportionate cost under this proposal are the very people who have disproportionately gained from the current system. Note also that many consumption tax proposals are combined with measures to give relief to lower income taxpayers and such features could be added to this reform as well.

“Middle-income workers born in 2030 in Europe and in Japan will see gains of 60% or greater.”

Open Economies Simulation. The open economy welfare effects are quite similar to the closed economy effects, but some differences should also be mentioned. In the United States the elderly lose more in the closed than in the open economy model, while the opposite happens in Europe and Japan. This is due to the above-mentioned changes in consumption tax rates. On the other hand, long-run intragenerational redistribution favors the European top income class in the open economy more than in the closed economy. The opposite happens in the United States. Again, this is due to the long-run interest rate, which decreases less in the European open economy; consequently, progressive wage taxes are lower.


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