Social Security Reform, Income Distribution, Fiscal Policy, and Capital Accumulation

Abstract

The author explores the effects a transition from a pay-as-you-go (PAYG) social security system to a fully funded system may have on income distribution, fiscal policy, and capital accumulation. The author presents a heterogeneous agent model developed to study the transition from a state-managed pay-as-you-go social security system to a privately managed fully funded system. He assumes that agents can differ in their human capital endowments and in their access to the financial system. The author finds that, for some initial distributions, when access to the financial system is restricted for some individuals, income distribution may improve with privatization of the pension system. Where there is complete access to the financial system before reform, however, income distribution deteriorates in all cases. Regardless of the initial distributions, reform of the type described here increases the level of physical capital in the economy. But the increase will be larger the larger the fraction of the population composed of poor individuals, or the higher their level of human capital. The author also finds that different initial distributions will have different effects on the fiscal policy needed to finance reform. Similarly, different forms of reform financing will have different effects on intragenerational distribution. In the case in which government decides to maintain a constant level of debt, generations alive when the reform takes place will have lower lifetime earnings than those born after them. The author also finds that the taxes needed to pay for transitional workers' pensions will be higher when the fraction of the population with access to the financial system in the PAYG equilibrium is higher.