Distributive Concerns When Substituting a Pay-As-You-Go by a Fully Funded Pension System

Abstract

The paper uses a simulation model to quantify the impact on income distribution of the substitution of a progressive social security program that redistributes towards the poor, but is financed with the PAYG method, by a neutral social security program that is funded. We find that if the original PAYG system is large enough to yield benefits with a replacement rate that is at least 40% for the middle income class, and its redistributive impact is limited by the requirement of not yielding benefits for the poor with a replacement rate above 200%, then the proposed substitution helps the poor in the long run, provided that the public debt does not rise by more than 40 percentage points of GDP during the transition. Such a reform allows an increase in the capital stock per worker, so in the long run the poor benefit more through higher real wages than what they lose because of the end of progressive redistribution. In the short run, however, a compensatory program for the poor is needed, because they lose their subsidy before receiving the long run benefit. We show that in most cases the 40 percentage points of GDP that are available from the increase in the public debt are enough to finance a transfer program that compensates the poor in the short run. The paper concludes that concern about the welfare of the poor is unwarranted, both in the short and in the long run, provided this compensatory program is implemented.