Academic journal article Journal of Economics and Finance

Myopia and Pensions in General Equilibrium

Academic journal article Journal of Economics and Finance

Myopia and Pensions in General Equilibrium

Article excerpt

Abstract The US social security tax rate has doubled in the last half century. Does the degree of myopic behavior that we observe in the US justify the size of the social security program? To study this question we build a computable general equilibrium model that is composed of life-cycle permanent-income consumers who save optimally and "hand-to-mouth" consumers who just consume their disposable income. Our model is a continuous-time, general equilibrium extension of the model by Cremer et al. (Int Tax Public Financ 15(5):547-562, 2008), though we abstract from the redistributive function of social security to focus on myopia. Retirement is a choice variable in our model and the social security program is designed to mimic the US program in which the annuity value of benefits increases with the retirement age. Also, we allow for delayed claiming beyond the date of retirement. The model matches a variety of important data targets relating to saving and retirement. We find that small reductions in the social security tax rate provide significant welfare gains to both groups of consumers.

Keywords Myopia · Public Pensions · Retirement · Delayed Claiming · General Equilibrium

JEL Classification E60 · H55 · C61 · J26

(ProQuest: ... denotes formulae omitted.)

1 Introduction

The OASI social security tax rate in the US has doubled in the last half century, and it is five times larger than when the program was created in 1935. Currently, the OASI part of social security is funded by a 10.6% payroll tax (split evenly between employers and employees), making it the largest government program in the world. Social security is traditionally justified among the lay public on the grounds that people are myopic and have trouble saving for retirement on their own. If we take this foundation seriously in modeling the program, has it grown too big? That is, does the degree of myopic behavior that we observe in the US justify the size of the social security program?1 Our focus on the US is merely for convenience since pay-as-you-go programs with similar institutional features are common throughout the OECD.

To study this question we build a general equilibrium life-cycle model with overlapping generations of individuals who choose when to retire. Our economy is composed of a mixture of life-cycle permanent-income (LCPI) consumers who save optimally and "hand-to-mouth" consumers who don't save at all. The LCPI consumers solve a two-stage optimal control problem that defines optimal consumption, saving, and retirement age for a given set of factor prices, social security taxes, and social security benefit incentives. The hand-to-mouth consumers just consume their disposable income and never save for the future, but they do choose when to retire. At the macro level, factor prices are determined competitively and the social security administration runs a pay-as-you-go program with a balanced budget. Lifetime utility in a stationary competitive equilibrium is the welfare criterion for both consumers, even though the hand-to-mouth consumers do not maximize utility. This paternalistic approach opens up the possibility that social security could be welfare improving.

Quantitatively speaking, our model performs fairly well along some dimensions that are important for studying the question that we have posed. For example, the model endogenously produces a realistic capital-output ratio and a realistic interest rate, realistic retirement choices, a realistic discrete drop in consumption spending at the date of retirement, and a realistic incentive structure that rewards delayed collection of social security benefits. The model also bears a realistic portion of the population who never save for retirement (20% in the US), so it appears to be a reasonable instrument for quantitatively studying myopia as a justification for social security.

We compare lifetime utilities in a stationary competitive equilibrium with the current tax rate to lifetime utilities in a different equilibrium with a smaller tax rate. …

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