Pension reform: how macroeconomics may help microeconomics – the Czech case

In a system where current Czech pensions are paid from current payroll pension taxes, what would be the advantages of a different pension system? The paper combines macro and microeconomic approaches to reforming the pension system. First, a modified over-lapping generations (OLG) model is formulated and macroeconomic effects estimated of a pension system switch from a pure pay-as- you-go (PAYG) to a mixed system where a substantial part of pensions is financed from private savings. The results show that the gradual shift from the PAYG to a mixed system facilitates higher capital accumulation that in turn spurs economic growth and raises wages. The authors demonstrate that young generations may gain as much as 20%.

These macroeconomic results are then employed in microeconomic simulations in which individual welfare gains for various income groups in each relevant cohort are estimated. The model is built around an unorthodox sequencing of the pension reform in which the pre- retirement generations would enter the reformed system first. This sequencing has three main benefits:

It brings forward the pensions that are paid both from the PAYG and the funded pillar first. It will be possible to start paying such “combined” pensions after a year of the reform. These are higher than without the reform, thus illustrating the benefits of reform.

The proposed reform alleviates fiscal problems as only older workers leave the PAYG and the young keep paying their contributions in full.

The reform also gives the government control over the whole process as it can manipulate the “entry age” in which participants can enter the multipillar system. The government will be able to choose between low fiscal costs of the reform and a fast reform scenario by keeping either high “entry age” (thus keep young “captive contributors” in the PAYG system) or lowering the “entry age” (thus bringing more workers into the multipillar scheme).

The paper shows that all cohorts may gain if the proposed pension reform is pursued, the gain being pronounced among higher income groups that do particularly badly in the existing program. However, even low-income groups gain.

Finally, the financial costs of a reform are estimated. The reverse sequencing approach allows authorities to sequence costs according to their fiscal preferences. Two reform scenarios (cautious and expansionary) are modeled and their costs estimated. The results confirm that the more ambitious reform increases utility of workers more rapidly, but accumulates higher debt.