Policy effects on transitional welfare in an overlapping generations model: A pay-as-you-go pension reconsidered

Abstract

We study the welfare effects of a pay-as-you-go (PAYG) pension system in transition, as well as in the steady state, by showing how the total welfare effects are determined by a cumulative effect on capital. Theoretical studies have shown that the introduction of a PAYG pension system reduces steady-state welfare under dynamic efficiency. Nevertheless, such pension systems have been widely adopted in the real world. To explain this, we algebraically and graphically prove that the PAYG pension system could be Pareto-improving in transition under dynamic efficiency. Similarly, it is acknowledged that this pension system should be introduced under dynamic inefficiency because it improves steady-state welfare. However, we show that the PAYG pension system may be Pareto-deteriorating in transition. Our findings imply that governments adopt PAYG pension systems to achieve policy targets other than long-run welfare maximization.