The Gain in Economic Welfare Through Privatization

The move from a pay-as-you-go system to a funded system is the same as the move to a private pension system in a macroeconomic sense. During the transition, public debt is issued. Then, the burden of debt is moved to future generations. If the burden of debt is greater than the benefit of privatization, future generations lose by the move. From now on, let us compare the burden of debt and the benefit of privatization.

Table 7.7 Costs and benefits of each generation

t = 0

t = 1

t = 2

Pay-as-you-go system

Old generation (benefit)

+T0

+T0(1 + Y)

+T0(1+ y)2

Young generation (cost)

—T0

—T0(1+ y)

—T0(1+ y)2

Net benefit

0

0

0

Privatization

Old generation (benefit)

+T0

+T0(1 +r)

+T0(1 + Y)(1 +r)

Young generation (cost)

—T0

—T0(1+ y)

—T0(1+ y)2

Interest payment

—rT0

—rT0

Net benefit

0

—YT0

[(1+ Y)(r—Y)r]T0

We may assume that by privatizing the public pension, the government issues public debt by the amount of T0. Suppose, for simplicity, that the burden of debt is equally shared by future generations. Then, each generation pays rT0 as the interest payment for the debt. This policy means that the outstanding public debt is fixed at the level of T0. In this situation, the costs and benefits of each generation are summarized as follows in Table 7.7.

With regard to a pay-as-you-go system, intergenerational transfer increases by the rate of y. However, the costs and benefits are balanced in each period and a pension fund is not accumulated. With regard to privatization, old period income grows at the rate of r after period t = 1. By assumption, the private pension scheme (private saving) is the same as pension contributions in the pay-as-you-go system. Moreover, we have to consider the interest payment, — rT0, in each period. The net benefit is calculated by subtracting this interest payment. If the present value of this balance is positive, privatization benefits future generations.

The present value of the net benefit of privatization is given as

Thus, PVG becomes positive if r > у (the rate of return on private capital is greater than the rate of return on the pay-as-you-go pension) and у > 0(economic growth rate is positive). In other words, the privatization of the public pension benefits future generations only if the economy grows. Feldstein (1995) pointed out that in reality these conditions are likely to hold; hence, privatization of the public pension benefits future generations to a significant extent.

However, as shown in Table 7.7, in period 1 of the transition, the net balance becomes negative. Even if privatization means an issuance of public debt in period 1, this move harms generation 1 to some extent. As long as labor supply is exogenously fixed, we may not obtain a Pareto-improved form of privatization whereby all generations gain.

 
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