Macroeconomic Effects of Public Pension Reforms - Net Effect is Positive

Macroeconomic Effects of Public Pension Reforms. By Karam, Philippe D ; Muir, Dirk ; Pereira, Joana ; Tuladhar, Anita
IMF Working Paper No. 10/297
Dec 22, 2010

Excerpts with no footnotes:

INTRODUCTION
The fiscal impact of the global crisis has reinforced the urgency of pension and health entitlement reform.2 Staff projections suggest that age-related outlays (pensions and health spending) will rise by 4 to 5 percent of GDP in the advanced economies over the next 20 years, underscoring the need to take steps to stabilize these outlays in relation to GDP. With the economic recovery not yet fully established, this paper emphasizes their short-run macro impact in order to address concerns that these reforms can undermine short-run growth.3

We examine the preferred set of public pension reforms using the IMF's Global Integrated Monetary and Fiscal (GIMF) model parameterized on data for five regions as representing the entire world. We consider three policy reform options relating to pay-as-you-go public pension systems that are commonly discussed in the literature. This analytical framework allows us to approximately gauge the effects of these reforms on labor and capital markets and growth in the short and long run.4 (i) Raising the retirement age: this reduces lifetime benefits paid to pensioners. Encouraging longer working lives with higher earned income may lead to a reduction in saving and increase in consumption during working years. In addition, increased fiscal saving will have long-run positive effects on output through lowering the cost of capital and crowding in investment. (ii) Reducing pension benefits: this increases agents‘ incentives to raise savings in order to avoid a sharper reduction in income and consumption in retirement. It would reduce consumption in the short to medium run, but would increase investment over the long run. (iii) Increasing contribution rates: this leads to distortionary supply-side effects for labor, which combined with a negative aggregate demand on real disposable income, depresses real activity in both the short and long run.

We assess how the policies compare in attaining the twin goals of strong, sustainable, and balanced growth and fiscal stability (i.e., stabilizing the debt-to-GDP ratio against rising pension entitlements). The key results show that increasing the retirement age has the largest impact on growth compared to reducing benefits, while increasing contribution rates as approximated by an increase in taxes on labor income has the least favorable effect on output. Besides boosting domestic demand in the short run, lengthening working lives of employees reduces the pressure on governments to cut pension benefits significantly or to raise payroll and labor income taxes. Reducing such benefits can lead to an increase in private savings and an unwarranted weakening of a fragile domestic demand in the short run, while raising taxes can distort incentives to supply labor. We also found that if regions cooperate in pursuing fiscal reform, the impact will be greater than if only one or some of the regions in the world undertake reform separately. In all, early and resolute action to reduce future age-related spending or finance the spending could improve fiscal sustainability over the medium run, significantly more if such reforms are enacted in a cooperative fashion.

[...]

CONCLUSION

We considered reforms to the pension system that can help ensure the long-run viability of public finances, while mindful of their short-run effect on economic activity in the midst of a global financial crisis. This is carried out within a dynamic general equilibrium model (GIMF) that captures the important economic interrelationships at a national and international level. We emphasized measures to contain and fund the rising costs of age-related spending in the medium to long run. We find that reforms which lead to short-run adverse effects on real GDP (i.e., benefit reductions) are largely outweighed by the benefits of declining real interest rates and the positive effect on future potential productive capacity. The reform which has the most positive effects in the long run is lengthening the working lives of employees, effectively raising the size of the active labor force relative to the retiree population. It helps boost domestic demand in the short run but also eases off the pressure on governments to cut pension benefits alone—which can lead to additional private savings and cause fragile domestic demand to fall in the short run—or to raise payroll and labor income taxes—which can distort incentives to supply labor. We also found that the impact on real GDP of a cooperative approach to age-related fiscal reforms is greater compared to a case where one but not all regions undertake reform.

In terms of public finances, our results generally show that stabilizing the GDP share of age-related expenditures leads to a sizable decline in the debt-to-GDP ratio. Early efforts and resolute action to reduce future age-related spending or finance the spending through additional tax increases and other measures (preferably through an increase in retirement age) could significantly improve fiscal sustainability in several countries over the medium run, and more so if such reforms are enacted in a cooperative fashion.

Link: http://www.imf.org/external/pubs/cat/longres.cfm?sk=24536.0