Reforming Social Security: Lessons from Thirty Countries

Studies | Social Security

No. 277
Thursday, June 09, 2005
by Estelle James

Covering Transition Costs

When money that used to pay benefits to pensioners is instead diverted to personal accounts, a temporary financing gap is created, known as the “transition cost.” This is not a real cost in the long run, since eventually the accounts will offset future government promises and reduce costs. But that is many years into the future. How will ongoing benefits be financed in the meantime? All countries that started their personal accounts by diverting money from the payroll tax faced the issue of how to finance the transition (though the few countries that used add-ons avoided this problem). How did they do it?

“Transition costs disappear in the long run, as benefits from the accounts allow a reduction in government obligations.”

It is difficult to answer this question because money is fungible, many other government policies were changing at the same time, the old systems were usually insolvent and so would have had to change anyway, and the counterfactual (what would have happened otherwise) is unknown. For those reasons, we don’t really know the degree to which tax hikes, spending cuts or debt finance were used to finance the transition to personal accounts. We do know that Chile accumulated a fiscal surplus before the reform to help cover transition costs. Most countries downsized their traditional systems so they had a smaller pension debt to cover. And all countries used some degree of debt finance.

Honoring Past Promises and Recognition Bonds in Chile. In Chile, old system pensions were downsized, mainly by raising the retirement age. Beyond that, workers who stayed in the old system got their old pensions, and Chile is still paying that bill. Over the past 20 years, the Chilean government has paid between 2 and 3 percent of GDP per year to old system retirees — the government was paying almost as much to subsidize the old system before the reform15 — and this will be a considerable part of total government spending for another 10-20 years.

Workers who switched to the new system received “recognition bonds” for their past service. The bonds could be cashed in and applied toward their pension upon retirement. This was equivalent to a forced loan from workers to the government, with redemption tied to their dates of retirement. The cash-ins therefore did not begin until the late 1980s and have been growing since; they now cost the government about 1 percent of GDP.16 This financing gap will slowly diminish until all workers who switched have died — about 40 years from now. Econometric studies indicate that the government has financed these expenditures largely out of higher taxes and lower government spending on other goods and services, not out of debt finance as a primary source. This has produced an increase in national saving to which economists attribute much of Chile’s dramatic and prolonged economic growth.

“Short-term transition costs can be financed in a variety of ways, but pure debt finance should be avoided.”

Debt Finance in Argentina. Unlike Chile, Argentina did not issue recognition bonds, but promised to pay all workers who switched part of their old benefits. This implied a longer redemption than Chile’s, since the loan was to be gradually repaid over the workers’ entire retirement period. Also unlike Chile, Argentina had greater political difficulties in raising taxes and cutting benefits or other government spending. Thus, transition costs added large amounts to Argentina’s debt and was one factor leading to its economic crisis, rather than to the economic growth that occurred in Chile.

Lessons for the United States. The impact of reform on the U.S. economy will be largely determined by how the transition is financed. And the broader economic impact largely determines whether or not the reform was desirable in the first place. As we plan for personal accounts in the United States, we should take care not to do what many other countries have done — underestimate transition costs by underestimating the propensity of workers to switch. And we should include an explicit strategy for covering transition costs, which does not place heavy reliance on borrowing. If we finance the transition primarily by borrowing, this will negate one of the primary goals of the accounts — to increase national saving — and will perpetuate the burden that will have to be paid by future generations. Increased personal saving would be offset by increased public dissaving. Options we should consider include, among others, downsizing benefits by raising the retirement age or slowing benefit growth, raising the ceiling on wages subject to the payroll tax, postponing income and estate tax cuts for the wealthiest Americans, creating a new “legacy debt surtax” or financing the accounts in part by an add-on, which does not create transition costs.

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