In 2050 the debt to GDP ratio would reach about 250%. However, debt financing is less
distortionary than financing via social security contributions. Thus relative to the baseline
scenario, employment increases, leading to an increase in GDP. Since households perceive
government debt partly as net wealth, consumption rises as well. Initially, debt accumulation
would be relatively slow because of the positive employment effects resulting from keeping
pension contributions constant. However, the macroeconomic gains would be small. The
employment gains would largely be compensated by a crowding out of the domestic capital stock,
due to the increase in real interest rates.
4.3. Scenario 2: A partial move to a funded system
In this scenario the government makes an effort to reduce current pension contributions and the
generosity of the PAYG system such that the ageing induced increases in pension contributions
will lead to a rate in 2050 equal to the current pre reform rate. This essentially means a reduction
of the generosity of the current first pillar by about 50%. In terms of rates, the replacement rate is
reduced from 75% to 37.5% and social security contributions are reduced from 16% to 8% and
will gradually rise to 16% in 2050. The government respects the entitlements of current pensioners
fully but only partially the entitlements of workers older than 40 years in 2005 by providing
subsidies to individual age cohorts at a (linearly) declining rate according to the following formula.
wtr (age)
wold tr
retage - age I. tn rx f j x
------------I(woldt - wnewt ) for age ∈ (40, retage)
retage - 40 )
r
wnewtr
for age < 40
where wold r is the pension paid under the pre-reform rule while wnew r is the pension consistent
with the new contribution rate. Workers below 40 years of age at the year when the reform is
introduced only receive wnew r . The pension subsidies for those cohorts fulfilling the eligibility
criteria are financed via issuing new debt. Notice, this transition is not actuarially fair for current
workers, since the government only partially compensates current workers for their pension
contributions and does not compensate at all workers younger than 40 in 2005. Nevertheless the
government provides old age income support in such a way that a change in savings allows
individual age cohorts to adjust smoothly to the new institutional environment. Also taking into
account the life expectancy this policy implies increased government transfers for more than 40
years to come.
Even under this restrictive compensation scheme, the transition burden would be large. As can be
seen from figure 4, government debt would increase by 80% of GDP over the next 40 years and
would only decline afterwards. Government deficits would increase by about 4% points initially
and decline gradually until the subsidies to older age cohorts are terminated after about 40 years.
These simulation results show that a transition to a funded system is most likely not self financing
via increased economic activity. Because of the transition burden, the question can be raised when
to expect positive economic effects from such a reform. There are at least two arguments in favour
of a positive effect. First, because of a reduction in social security contributions positive
employment effects should emerge and second there should be increased savings and higher
capital formation to build up a second pillar. However, the build up of government debt
accompanying the transition could dampen or even offset the positive savings effect.
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