Optimal Response to a Transitory Demographic Shock in Social Security Financing

By Conesa, Juan C.; Garriga, Carlos | Federal Reserve Bank of St. Louis Review, January-February 2009 | Go to article overview

Optimal Response to a Transitory Demographic Shock in Social Security Financing


Conesa, Juan C., Garriga, Carlos, Federal Reserve Bank of St. Louis Review


The authors consider a transitory demographic shock that affects negatively the financing of retirement pensions--that is, workers either would have to pay more or retirees would receive less. In contrast to the existing literature, the authors endogenously determine optimal policies rather than explore the implications of exogenous parametric responses. Their approach identifies optimal strategies of the Social Security Administration to guarantee the financial sustainability of existing retirement pensions in a Pareto-improving way. Hence, no cohort will pay the cost of the demographic shock. The authors find that the optimal strategy is based on the following ingredients: elimination of compulsory retirement, a change in the structure of labor income taxation, and a temporary increase in the level of government debt. (JEL D58, D91, H55)

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The financial sustainability of the Social Security system is an important policy concern due to the aging of the U.S. population and in particular of the baby-boom generation. According to estimates of the Social Security Administration, the dependency ratio (measured as population age 65 or older over population between ages 20 and 64) will increase from its present 21 percent to 27 percent in the year 2020, 37 percent in 2050, and 42 percent in 2080 under the scenario they call the medium population growth (Figure 1).

Under this demographic scenario, the Social Security system, which is a pay-as-you-go (PAYG) program, will face clear financial imbalances unless some reforms are introduced. In this paper, we explore the optimal response to a transitory demographic shock that affects negatively the financing of retirement pensions. (1) In contrast to existing literature, we follow an approach that is similar to that used in Conesa and Garriga (2008) and endogenously determine optimal policies rather than exploring implications of exogenous parametric policies. Our approach determines the optimal strategy of the Social Security Administration to guarantee the financial sustainability of current retirement pensions in the least distortionary way. Moreover, no cohort will have to pay the welfare cost of the demographic shock.

Notice that we are concerned only about efficiency considerations in the financing of retirement pensions rather than about the efficiency of their existence in the first place. Their existence might be justified on different grounds. (2) We do not model why Social Security was implemented in the first place or why Social Security benefits are provided through a potentially inefficient tax system.

[FIGURE 1 OMITTED]

We consider for our experiments an unexpected transitory demographic shock, even though these shocks are certainly predictable by looking at Figure 1. If the demographic shock is predictable, the fiscal authority should have reacted to it in advance. However, we believe it is more interesting to focus on what should be done from now on rather than on what should have been done. In this sense, prediction of a demographic shock without action is equivalent to the shock being unexpected. However, the transitory nature of the shock considered is a limitation of the analysis driven by computational tractability.

The quantitative evaluation of Social Security reforms has been widely analyzed in the literature. (3) Demographic considerations play an important role in the Social Security debate, but there are few quantitative studies of policy responses to demographic shocks and none to our knowledge from an optimal fiscal policy perspective. In particular, De Nardi, Imrohoroglu, and Sargent (1999) consider the economic consequences of different alternative fiscal-adjustment packages to solve the future Social Security imbalances associated with the projected demographics in the United States. They find that all fiscal adjustments impose welfare losses on transitional generations. In particular, policies that partially reduce retirement benefits (by taxing benefits, postponing retirement, or taxing consumption), or that gradually phase benefits out without compensation yield welfare gains for future generations but make most of the current generations worse off. …

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Optimal Response to a Transitory Demographic Shock in Social Security Financing
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