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How to Finance Retirement with an Aging Population

Edward C. PrescottW. P. Carey School of Business, Arizona State University

andFederal Reserve Bank of Minneapolis

June 2005

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Objective of Retirement System

• Guarantee a decent minimal consumption level for all

retirees.

• Most countries have been using a pay-as-you-go system

with benefits less than proportional to contributions on

margin to achieve this objective.

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With Aging Population this System Is Becoming Infeasible

• There are, or will soon be, too few workers per

retiree.

• I will establish that increasing tax rates on

workers cannot solve the problem; in Europe and

in the U.S., increasing tax rates will not increase

tax revenue.

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What about a Fully Funded, Proportional Benefits System?

• Has a modest dead-weight taxation cost if

population is growing

• But, not sustainable in democratic societies

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Dead-weight Loss of Proportional Pay-as-You-Go System

If benefits are proportional to contributions then

• Modest loss if population growing

• Larger loss if population constant

• Big loss if population declining

WHY?

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Answer

• The return that people realize is less than the real

interest rate.

• If they realize the market return, it is just forced

saving and there is no dead-weight loss.

• The productive capital stock will be smaller and

output smaller, but no inefficiency.

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The Big Problem with PAYG Systems

• Inevitably the system evolves so that benefits are

not proportional to contributions

• The additional benefits from working a few extra

years are zero in the United States

• The additional benefits to a household with two

earners rather than one are zero

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On Margin, Contribution to Retirement Account Is a Tax

• In U.S. the tax rate for funding the public

retirement system is 10.6 percent

• And the dead-weight loss is over 10 percent of

consumption

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The Solution: Mandatory Personal Savings Accounts

• Benefits are proportional to contributions

• Returns on these savings are market returns

• Difficult for governments to get their hands

on these savings and redistribute them

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Dead-weight Loss of Tax and Transfer System

• Is big if aggregate labor supply elasticity is

high

• Associated with one dollar of additional taxes

paid, a household must be given two dollars to

leave it equally well off

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Definition of Aggregate Labor Supply Elasticity

Holding wealth constant, it is the percentage

change in labor supplied associated with a 1%

change in the after-tax real wage

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There Is Overwhelming Scientific

Evidence that Aggregate Labor Supply

Elasticity is HIGH

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Business Cycle Evidence

• Finn Kydland and I found that if and only if

this elasticity is high, about 3, does the

neoclassical growth model quantitatively

predict all the key business cycle facts

• A multitude of others have come up with

the same finding (see Cooley 1995 volume)

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Depression Evidence

• Fumio Hayashi and I find this neoclassical growth

model accounts for the behavior of the economic

aggregates in Japan’s lost decade of growth,

1992-2002, if and only if this elasticity is about 3

• See Kehoe and Prescott Depressions volumes

(2002, 2005) for 15 other studies coming up with

the same conclusion

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Cross Country Labor Supply and Tax Evidence

• I found that differences in tax rates predict the large

differences across the G-7 countries if and only if this

elasticity is about 3

• Americans, Chileans, and Japanese all work over 40%

more than Western Europeans because their marginal

tax rates are 40% and not 60% as in Western Europe

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Increase in Labor Supply in Spain: Tax Cut and Labor Market Reform

Hours/Week per Working-Age Person

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1993 1995 1997 1999 2001

Predicted

Actual

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Theoretical Evidence

• Rogerson (1984) and Hansen (1985) use theory

to establish that the aggregate elasticity is much

greater than individual elasticity

• When the margin of labor supply adjustment is

the number employed and is not hours per

employed person

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Most Adjustment Is in Number Employed

• Over business cycle

• Over postwar depressions and prosperities

• Over the seasons

• Over the life cycle

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Question: Why Number Employed and Not Hours per Employed Varies

• Hornstein-Prescott (1993) find that theory

predicts it in the empirically interesting case

• The empirically interesting case is when payment

per hour increases with the number of hours an

employed person works in the relevant range of

hours per employee

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Summary

• High aggregate labor supply elasticity is

implied by aggregation theory

• Theory predicts both the micro and macro

observations

• Thus, it is an established scientific finding

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A Further Point

• All the other Nobel Prize winners who have

been concerned with labor supply came to

the same conclusion (i.e. Lucas, Heckman,

and Becker)

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Why Mandatory Savings

• Not subject to the time consistency problem

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A Good Retirement System

• Mandatory savings of 10% of wage and salary income in

personal income accounts up to 1.0 times the average

level of wage and salary income

• These savings will provide a decent level of consumption

for retirees

• Savings are in a low cost, highly diversified portfolio that

realizes market return

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An Illustrative Example

• People work for 45 years and then retire for 20

years

• The real interest rate is 4% and productivity

grows at 2% a year

• The tax rate minus the Social Security

retirement tax rate is 30%

• These are U.S. numbers

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Pay-as-You-Go System

• Social Security retirement tax finances

retirement

• Retirement benefits: 50% of average

consumption

• Government debt is zero

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Personal Savings System

• Social Security retirement tax is zero

• Other benefits are kept same as under

pay-as-you-go system

• Mandatory savings accounts for

retirement

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Welfare Gains of Moving to a Personal

Savings System Are BIG

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Key Findings

Increase in welfare in terms of lifetime

consumption equivalents

Population

growth rate

Welfare

gain

1.01 8.9%

1.00 13.9%

0.99 19.8%

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Gains much bigger in Europe

WHY?

• Because social security taxes there are much higher than in the U.S.

• Gain about 25% in lifetime consumption equivalents.

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Concluding Remarks

1. Welfare of everyone increases with mandatory

personal savings accounts for retirement

2. Low population growth is not a problem with

people saving for retirement

3. My advice, don’t throw away 25% of

consumption

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Concluding Remarks

4. A number (25) of countries have adopted

mandatory savings plans

5. In Mexico these savings are growing

rapidly and are being used to finance

new businesses and home ownership

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Concluding Remarks

6. In Sweden their adoption in 1998 reduced the

marginal tax rate and that economy has grown

faster than the EU average

7. The U.S. should follow the lead of Eastern

Europe, Sweden, Mexico, and a number of

other countries