The Effects of Alternative Public Pension Financing on Capital Formation: Consumption versus Payroll Taxes

Abstract

An unfunded public pension scheme creates an inter-generational transfer from young to old. Since the former are normally savers and the latter normally dissavers, it is clear that the programme therefore reduces aggregate saving and capital formation (Feldstein, 1974; Sheshinski, 1978; and Kotlikoff, 1979). We show in this paper, however, that the ultimate effects of public pensions on life-cycle capital formation depend on the choice of the tax base used to finance the retirement benefits payments. This is done by considering two schemes, one financed by payroll and the other by consumption taxes. We impose the requirement that the two are equivalent in the sense that at any point of time both raise the same amount of tax revenue and consequently distribute the same amount of benefits to retirees. We demonstrate that the reduction in capital formation caused by the scheme financed by a consumption tax is markedly less than that of the payroll tax. This result can be explained, without loss of generality, by considering an actuarily fair programme. Such a programme implies that the individual's present value of taxes equals his benefits, leaving his present value of wealth unchanged. Faced with a public pension, he would then alter his private saving to replicate the stream of consumption as it would be in the absence of a pension. This means reducing saving in each period by the exact amount of the taxes he pays to the scheme. Since the timing of tax collection is very different under payroll and consumption taxes, they have different effects on savings. In the aggregate, two identical pension schemes imply different intercohort distributions of the tax burden depending on whether they are financed by payroll or consumption taxes. This is because a consumption tax introduces an offsetting inter-generational transfer from old to young, which moderates the scheme's impact on saving. Simulation of a simple general equilibrium model of a hypothetical economy suggests that the capital-labour ratio could be more than 30 per cent higher under the consumption tax regime than it would be under the equivalent payroll tax regime. In the subsequent section we present the standard perfect-foresight lifecycle model of saving extended to include a public pension scheme. From this model we derive the economy's aggregate demand for capital as a function of the market interest rate and the scheme's tax rate. In Section II we join the demand function of the first section with a production function of the CobbDouglas type yielding the supply of capital as a function of the interest rate. We then simulate the entire model with different tax rates to derive the equilibrium steady-state rate of interest and capital-labour ratio under the two methods of pension financing. Suggestions for further research are included in the final section.