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Pension reform, employment by age, and long-run growth

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Abstract

We study the effects of pension reform on hours worked by three active generations, education of the young, the retirement decision of older workers, and aggregate growth in a four-period OLG model. The model explains important facts well for many OECD countries. Our simulation results prefer an intelligent pay-as-you-go system above a fully funded private system. Positive effects on employment and growth are the strongest when the pay-as-you-go system includes a tight link between individual labor income and the pension, and when it attaches a high weight to labor income earned as an older worker to compute the pension assessment base.

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Notes

  1. Fougère et al. (2009) and Ludwig et al. (2012) also develop a model with endogenous employment by age and human capital, but they have exogenous growth. Moreover, Fougère et al. (2009) do not study pension reform.

  2. Long ago, Sheshinski (1978) already showed in a model that a pension system can encourage work and late retirement if pension benefits increase in the retirement date. This idea has been picked up also by Gruber and Wise (2002).

  3. The former may be particularly valuable from the perspective of relaxation and time to spend on personal activities of short duration. The latter may be valuable to enjoy activities which take more time and ask for longer-term commitment (e.g. long journeys, non-market activity as a volunteer).

  4. The main results in this paper are not in any way influenced by the magnitude of π, Ω or ρ.

  5. Our approach to model early retirement benefits as a function of a worker’s last labor income, similar to standard non-employment benefits, reflects regulation and/or common practice in many countries. In some countries (e.g. Belgium, the Netherlands) workers can enter the early retirement regime only from employment, with their benefits being linked to the last wage. In other countries (e.g. Denmark) there is only access from unemployment, with the early retirement benefit being linked to the unemployment benefit (Salomäki 2003). As to common practice, Duval (2003) confirms that in many countries, unemployment-related or disability benefits can be used de facto to bridge the time between the effective retirement age and old-age pension eligibility. Again there is a link between benefits and former wages.

  6. We explain economy-wide wage growth in Section 3.3. Individuals take it as exogenous.

  7. Domestic output and net factor income from abroad at the LHS of Eq. 24 constitute national income. Since in our model there are no unilateral transfers between a country and the rest of the world, we have that CA t  = NX t  + r t F t , with NX t representing net exports of goods and services. It is then easy to see that Eq. 24 can also be written in a maybe more common way as Y t  = C t  + I t  + G ct  + G yt  + NX t .

  8. And with the values of two parameters in the human capital production function (v, κ) that we discuss below (see also footnote 9).

  9. From our model’s predictions and the true data for 13 countries we computed for each variable (n 1, n 2, n 3, e, R, growth) the root mean squared error normalized to the mean. We minimized the average normalized RMSE over all six variables. More precisely, we adopted the following iterative procedure. We chose values for v and κ and then calibrated the efficiency parameter ϕ and the scale parameter σ. The values for v and κ had no influence on the calibration results for γ j and ρ. Given the obtained values for ϕ and σ, we computed the average normalized RMSE over all six variables. We then checked whether changes in v and κ, and a recalibration of σ and ϕ, could further reduce this statistic. We did this until no further reduction was possible.

  10. This is the case in Austria, Belgium, France, Germany, Finland, and the UK. Workers cannot be structurally non-employed and still receive unemployment benefits in the Netherlands, Italy, Denmark, Norway and the US (OECD, 2004).

  11. Note that we calculate government consumption as total government consumption in % of GDP, diminished with the fraction of public education outlays going to wages and working-expenses. The latter are included in productive expenditures.

  12. In most countries, mandatory programs are public. For Denmark, the Netherlands and Sweden the data also include benefits from mandatory private systems. These benefits are earnings-related. Voluntary, occupational pensions are not included in our data.

  13. For the sake of completeness, it should be mentioned that our proxy for b 4b also includes targeted and minimum pensions if they are relevant for a worker with mean income. Basic pensions pay the same amount to every retiree. Targeted plans pay a higher benefit to poorer pensioners and reduced benefits to better-off ones. Minimum pensions are similar to targeted plans. Their main aim is to prevent pensions from falling below a certain level (OECD 2005, p. 22–23). Our main motivation to merge these three categories in our proxy for b 4b is that they are not (or even inversely) linked to earnings.

  14. In Austria, Norway and France earnings-related pensions are not calculated from average lifetime income but from average income during the final working years or a number of years with the highest earnings. Ideally, one would impose different weights p 1, p 2 and p 3. However, the pension replacement rate reported by the OECD would then no longer be reliable since it is based on the assumption of equal weights.

  15. We also assume TFP to be the same in all countries. Note, however, that this assumption is not crucial. The utility function being separable and logarithmic in consumption, and goods production being Cobb–Douglas, the level of TFP does not matter for employment or growth rates. Also, differences across countries in TFP have no effect on cross-country performance differences in our model, at least if these TPF differences are constant.

  16. A major element behind the deviation for this country seems to be underestimation of the fallback income position for structurally non-employed young workers. OECD data show very low replacement rates in Italy. However, as shown by Reyneri (1994), the gap between Italy and other European countries is much smaller than it seems. Reyneri (1994) points to the importance of family support as an alternative to unemployment benefits. Fernández Cordón (2001) shows that in Italy young people live much longer with their parents than in other countries. In 1995 for example about 56% of people aged 25–29 were still living with their parents in Italy. In about all other countries this fraction was below 23%. Of all non-working males aged 25–29 in Italy more than 80% were living with their parents. In France or Germany the corresponding numbers were close to 40%.

  17. Effects are even (about 50%) smaller if labor taxes are adjusted to maintain a constant debt to GDP ratio.

  18. More precisely, to keep the debt to GDP ratio constant, the government can raise lump sum transfers by 1.20% of output.

  19. In particular, the gradual decline in b 4a and b 4b is announced at time t = 1 and implemented as follows. Pensions benefits are not reduced for retirees at the moment of policy implementation (t = 1), since retirees are not able to react to a pension reduction. In t = 2 and t = 3 the replacement rates are respectively reduced to 2/3 and 1/3 of their initial rates. From t = 4 onwards, b 4a and b 4b are zero. At each moment, overall labor tax rates are reduced to ex ante compensate for the decline in pension expenditures.

  20. The announcement of the transition to a fully-funded system, and the perspective of a gradual fall in labor taxes during periods 2, 3 and 4, as described in footnote 19, makes individuals work less when young (and work more in later periods—at lower tax rates). Young individuals therefore study more, which is good for the evolution of human capital, and output. As we report in Table 5, however, this positive education effect is not permanent (on the contrary).

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Acknowledgements

We would like to thank David de la Croix, Fabian Kindermann, Pierre Pestieau, Dirk Van de gaer, Kelly Sorgeloos, Geert Vancronenburg, Jan Bonenkamp, and two anonymous referees for their constructive comments on earlier versions of this paper. We have also benefited from comments received at the 2011 OLG Days (Vielsalm, May 2011), the 10th Journées Louis-André Gérard-Varet—Conference in Public Economics (Marseille, June 2011), the 2011 Annual Meeting of the Society for Economic Dynamics (Ghent, July 2011), the 2011 Annual Congress of the International Institute of Public Finance (Ann Arbor, MI, USA) and seminars in Brussels and Louvain. We acknowledge support from the Flemish government (Steunpunt Fiscaliteit en Begroting—Vlaanderen) and the Belgian Program on Interuniversity Poles of Attraction, initiated by the Belgian State, Federal Office for scientific, technical and cultural affairs, contract UAP No. P 6/07. Tim Buyse acknowledges financial support from the Research Foundation—Flanders (FWO). Any remaining errors are ours.

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Authors and Affiliations

  1. SHERPPA, Ghent University, Ghent, Belgium

    Tim Buyse, Freddy Heylen & Renaat Van de Kerckhove

  2. Research Foundation—Flanders (FWO), Brussels, Belgium

    Tim Buyse

  3. IRES, Université catholique de Louvain, Louvain-La-Neuve, Belgium

    Freddy Heylen

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Buyse, T., Heylen, F. & Van de Kerckhove, R. Pension reform, employment by age, and long-run growth. J Popul Econ 26, 769–809 (2013). https://doi.org/10.1007/s00148-012-0416-x

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