Social Security Parameterization Under Skills Heterogeneity and the Provision of a Subsistence Pension

Abstract

This paper explores the partial equilibrium effects of the social security system in an overlapping generations economy, where individuals are distinguished according to their skills/productivity type. The emphasis is placed on building a parameterized model of the social security system in a flexible and coherent way that enables the State to choose the parameters according to its policy orientations and scopes. The system can have the form of a mixed social security system, where both a redistributive PAYGO component and a Trust Fund which invests in stocks coexist, of a pure PAYGO system or of a fully funded scheme, by changing the relevant parameters. A subsistence pension, which actually acts like a pension subsidy, is provided to the low-skilled when old, so as to compensate them for their lower basic pension. The subsistence pension then acts like a motive for dis-saving for the low-skilled when they are young. Among other things, under certain assumptions, the financing method of the social security system, i.e. whether it is PAYGO redistributive or funded, has no effect on the subsistence pension of the low-skilled and thus their utility or the way the replacement ratio is determined.The model is extended, by introducing distortions in the labor market and allowing workers to reduce their labor supply in response to increases in the social security contribution rates. It is shown that the subsistence pension increases the low-skilled individuals utility directly, through an increase in consumption, but also indirectly, through leisure. Thus, elastic labor supply reinforces the positive effect of the subsistence pension of the low-skilled, through an increase in their leisure time, i.e. a reduction in optimal labor supply. When labor supply is an endogenous variable, then the state, by the provision of the subsistence pension, gives a motive to the low-skilled when young to work less than they would have if there was no subsistence pension, in order to achieve the same utility level. In this case, the subsistence pension acts as a premium to leisure. However, if the subsistence pension is high enough, then it could motivate the low-skilled individuals to work much less, which could turn out to have a negative effect on their utility, through a substantial decrease in wages and rate of return on capital and thus consumption, when production is also taken into consideration. However, the extensive analysis of the general equilibrium results are beyond the scope of the this paper. Some social welfare implications are also considered, when social welfare is approached through an egalitarian or a utilitarian scope.