Erling Holmøy and Kyrre Stensnes - PDF

Discussion Papers No. 557, September 2008 Statistics Norway, Research Department Erling Holmøy and Kyrre Stensnes Will the Norwegian pension reform reach its goals? An integrated micro-macro assessment

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Discussion Papers No. 557, September 2008 Statistics Norway, Research Department Erling Holmøy and Kyrre Stensnes Will the Norwegian pension reform reach its goals? An integrated micro-macro assessment Abstract: The Norwegian pension reform of 2006 intends to (1) improve long run fiscal sustainability by reducing the growth in public old-age expenditures, (2) strengthen labour supply incentives, and (3) maintain the main redistributive features of the present system. We assess to what extent the reform is likely to achieve these three goals, using two empirical models iteratively: We combine a detailed dynamic micro simulation of individual benefits and government pension expenditures with a CGEmodel, which captures behavioural effects and equilibrium repercussions. We find that the pension reform improves fiscal balances substantially. Compared to a no-reform scenario, the payroll tax rate can be cut by 10 percentage points in Increased employment contributes more to the fiscal improvement than the reduction in pension expenditures. However, these changes are basically level effects; the reform has a surprisingly small effect on the growth rate of the necessary tax burden starting in In particular, the growth rate of public pension expenditures is hardly affected. Stronger government finances and higher employment is obtained at the expense of a significant increase income inequality among old age pensioners. Keywords: Pension reforms, Fiscal sustainability, Income distribution, Computable general equilibrium model, Dynamic micro simulation JEL classification: H30, H55, H62, H68, O15 Acknowledgement: The assumptions on the reform effects on retirement draw extensively on the insights of Dennis Fredriksen. Birger Strøm and Erling M. Kravik carried out the simulations of the CGE model. Thanks to Ådne Cappelen for useful comments to an earlier draft. The usual disclaimer applies. Address: Erling Holmøy, Statistics Norway, Research Department. Kyrre Stensnes, Statistics Norway, Research Department. Discussion Papers comprise research papers intended for international journals or books. A preprint of a Discussion Paper may be longer and more elaborate than a standard journal article, as it may include intermediate calculations and background material etc. Abstracts with downloadable Discussion Papers in PDF are available on the Internet: For printed Discussion Papers contact: Statistics Norway Sales- and subscription service NO-2225 Kongsvinger Telephone: Telefax: 1. Introduction Around half of the OECD countries have substantially reformed their pension system over the last decade, see OECD (2007) for an overview. Most of these reforms share three goals. First, they are intended to save costs for the government, at least in the long run. In this respect they are a policy response to population ageing, which will erode the fiscal sustainability of welfare states. Second, most reforms seek to stimulate employment. An efficient stimulus will partially offset the tax burden caused by ageing, improve social efficiency, and allow higher earnings to mitigate unpopular benefit cuts. Third, reforms typically seek to distribute income more evenly than a laissez-faire regime, and this concern influences the design of the pension system. These three goals have also dominated the design of the pension reform approved by the Norwegian parliament in The purpose of this paper is to assess as realistically as possible to what extent the Norwegian reform is likely to achieve them. Such an assessment must weigh together empirical estimates of a multitude of effects identified and analysed using stylized models in the theoretical literature on social security and pension reform. Barr and Diamond (2006), Diamond (2002) and Lindbeck and Person (2003) represent just a few of several excellent surveys. In our view, any profound analysis of pension reform performance must integrate three separate approaches, and is therefore a very demanding modelling task. First, huge amounts of details is required to provide an operational and relevant description of the reform elements, as well as the heterogeneity of individual earning profiles and other aspects of individual life courses. Dynamic Micro Simulation (DMS) models provide such details, which make them frequently used by the authorities to compute effects on individual benefits and public pension expenditures. Adopting the terminology used in Gruber and Wise (2004), we will refer to these effects as mechanical in the sense that they ignore behavioural adjustments and general equilibrium repercussions. OECD (2007), Flood (2007), Fredriksen and Stølen (2007), Stølen (2007), Bonin (2001) are but a few examples of studies of mechanical pension reform effects. Second, realistic estimates should capture that pension reforms indeed intend to affect behaviour, notably labour supply. A vast empirical literature has studied how pension schemes affect labour supply, especially through retirement, see Gruber and Wise (2004) for a comprehensive overview. From 12 comparable microeconometric country studies, Gruber and Wise conclude that the pension system has an enormous effect on retirement. 3 Third, the mechanical fiscal effect and the behavioural responses to plausible pension reforms are likely to be strong enough to have significant general equilibrium repercussions. Coile and Gruber (2003) provide a good example of the striking significance of such repercussions: When estimating the fiscal effects of a Social Security reform in the US, they find that delaying retirement raises revenues by expanding tax bases, whereas expenditures are hardly affected because the pension system is close to actuarial. In a previous assessment of the effects of the Norwegian pension reform, Fredriksen, Heide, Holmøy and Solli (2007) find that the expansion of the tax base has a stronger fiscal effect than the reduction in pension expenditures. Recent examples of Computable General Equilibrium (CGE) model simulations of pension reforms are Beetsma, Bettendorf and Broer (2003), Bovenberg and Knaap (2005), Fehr and Habermann (2006), Fehr, Sterkeby and Thøgersen (2003), Fehr (2000), Kotlikoff, Smetters, and Walliser (2001), Lindbeck and Persson (2003), McMorrow and Roeger (2002) and Miles (1999). However, while these studies capture behavioural effects and macroeconomic repercussions, the models neglect many potentially important aspects of agent heterogeneity and details of the pension system. Even a specification of 12 lifetime earning classes in each cohort, as in the model used in Kotlikoff et al. (2001), would imply crude approximations when calibrated to the present and the proposed Norwegian pension systems. This paper therefore integrates the three above-mentioned approaches by combining a detailed dynamic microsimulation model with a large scale dynamic CGE model. The models are run iteratively to ensure consistency. Methodologically, we thereby extract the strong sides of the different approaches, and our estimates exploit the maximum of available relevant information. 1 Moreover, we seek to avert the black box criticism often raised against analyses relying on large models, by quantifying the specific contributions from the most significant behavioural and equilibrium repercussions to the total key effects. Realistic long run projection of government finances may have greater policy implications in Norway than in most other countries. Contrary to most other OECD economies, the Norwegian government finances look impressively solid, mainly due to large government petroleum revenues and a highly ambitious pre-funding strategy. This does not create a policy climate conducive to cost saving welfare reforms. However, Norway faces a fiscal sustainability problem in the long run. Ageing, combined 1 The present paper builds on Fredriksen, Heide, Holmøy and Solli (2007). Updates compared to that paper include: 1) The reforms are somewhat different. 2) The demographic projections have been updated. 3) The government petroleum revenues have been more than doubled due to changes in the global energy markets after ) We have revised the labour supply incentives at the intensive margin implicit in the present and the new pension system. 5) We have exploited updates and technical improvements in the modelling framework. 4 with the present public pension system and other relatively generous welfare schemes, imply that fiscal contractions will be necessary in every year after around Quantitative projections are one of the few means to make the long run less abstract, which is needed to ensure that long run policy issues are given proper priority today. The paper is organised as follows: Section 2 provides a brief overview of the main elements of the present Norwegian pension system and the proposed reform. Section 3 describes the microsimulation and the CGE models. Section 4 examines the fiscal motivation for a cost saving pension reform by studying a baseline scenario. Section 5 discusses the reform effects on government finances and employment, whereas section 6 discusses the distributional consequences. Section 7 analyses the robustness of the reform effects with respect to the uncertain labour supply responses and the demographic development. Section 8 concludes. 2. The Norwegian public pension reform 2.1. The present system The present public pension system was established in 1967 as a mandatory, defined benefit, pay-asyou-go pension system. The total benefit combines a flat-rate universal benefit, a means-tested supplement and an earnings-related income benefit according to the formula: Pension benefit = universal benefit + max(means-tested supplement, income benefit). The income benefit is based on pension entitlements accrued through labour market earnings after In addition, imputed pension entitlements are granted to parents caring for young children and recipients of social security benefits compensating for unemployment, sickness, rehabilitation, and disability. Both entitlements and benefits are in principle wage indexed, although practice has tended to fall somewhat short of this intention. In the stylised case where an individual earns the average wage for 40 years, the after-tax replacement ratio of the public old age benefit will be about 65 per cent. 2 2 Special tax rules for pension benefits makes the after-tax replacement ratio about 15 percentage points higher than the corresponding pre-tax ratio. Income from private pension schemes and special pension schemes for public employees come in addition to this figure. 5 The income pension scheme has several non-actuarial elements. Most important is the best-years rule, according to which a full benefit requires that 40 years of covered earnings will only be calculated using the 20 years with highest earnings. On average, the non-linear elements result in a relatively weak income dependency of pension benefits. Simulations on the microsimulation model used in this paper, shows that increasing earnings by 1 NOK raises the average present value of future pension benefits by 0.10 NOK, see Stensnes (2007). Moreover, this income dependency is hard to compute ex ante, and varies highly across individuals, which probably weakens the labour supply incentive of the income dependency. The formal retirement age is 67 years. Roughly per cent of the population receives disability benefits at retirement age, and about 60 per cent of the (still) employed are entitled to early retirement from the age of 62. Disability pension and early retirement imply that the present effective retirement age averages about 60 years in Norway. Note that early retirement through these arrangements does not reduce future pension benefits at any point in time, neither because of a shorter period of labour market earnings nor through a longer period as pensioner. Both disability pensioners and early retirees obtain entitlements as if they remained working until the age of Main reform elements 3 The new system is to be gradually phased in from It continues to be a defined benefit system financed on a pay-as-you-go basis. The reform is designed to stimulate labour supply, maintain most of the distributional properties of the present system, and reduce the long run growth in future government pension expenditures not the compensation level in The most important reform elements are: 1. The pension benefit continues to include two components, a minimum income guanatee and an earnings-based benefit. The minimum benefit is maintained at the same level as the current minimum benefit. Contrary to the basic benefit in the present system, however, it is means-tested against the income based pension benefit. New indexation rules imply that the minimum benefit over time is reduced relative to the income component. 3 Since this paper was written, some elements of the pension reform have been modified, and it is likely that further revisions will come when all details are made precise. However, the reform proposal discussed in this paper is still a good approximation to the actual reform as far as it has been clarified. 6 2. The expenditure risk associated with increases in longevity is shifted from tax payers onto each cohort of pensioners through an actuarial mechanism. With some qualifications with respect to the redistributive guarantee pension, the new system converts the implicit pension wealth of accumulated entitlements into an annuity over the average expected remaining lifetime. An increase in the expected number of retirement years reduces the annual benefit such that the present value of total pension benefits is nearly invariant to changes in current remaining life expectancy and retirement age. This is one implementation of what Lindbeck (2006) identifies as an automatic rule mimicking the functioning of actuarially fair private income insurance systems The statutory retirement age and current early retirement arrangements are phased out and replaced with a flexible retirement age from the age of 62 years, available to everyone. The mechanism described in point 2 intends stimulate labour supply by increasing the individual cost of early retirement. If life expectancy increases by one year, an additional eight months of labour market participation will be needed to maintain the annual benefit. 4. Labour supply is also stimulated by a stronger dependency between earnings and pension benefits. The income based benefit is basically 1.35 per cent of lifetime labour market earnings below an annual wage-indexed threshold The income dependent entitlements are indexed by wage growth only until retirement, and by an average of wages and consumer prices in payment. 6 The reform strengthens the incentives to retire as a disability pensioner. Changes in the disability pension scheme were presented by a government committee in May 2007, but this is a separate reform process. Our analysis takes as given both the disability scheme and observed rates of transition into disability. We have further assumed that public sector employees are exposed to the retirement incentives outlined above, and that any expenditure increase in the scheme for occupational pensions in the government sector is fully financed by higher premiums and does not imply any additional need for raising taxes. Finally, we have assumed that the state contribution to the present early retirement scheme is phased out from 2010 in line with the proposals put forth by the Pension Commission. (NOU 2004). 4 However, special rules imply deviations from an exact actuarial adjustment. For instance, the annual benefits and pension premium are independent of gender and other observable characteristics correlated with life expectancy. See Stølen (2007) for details. 5 In 2007 the ceiling was approximately euro. 6 In practice, the reform implements the less generous indexation in payment as a fixed annual deduction of 0.75 percentage points relative to wage indexation. This is consistent with an implicit real wage increase of 1.5 percent. 7 The new system is not intended to give benefit cuts at the time of implementation, that is for those from the 1943-cohort who retire at the present statutory retirement age of 67 in Instead, expenditure cuts are the result of both the actuarial life expectancy adjustment, for given retirement behaviour, and the less generous indexation of benefits in payment. To the extent that postponed retirement neutralizes the reduction of average annual benefit, the fiscal improvement will instead come from a decline in the number of pensioners and increased tax revenues. 3. Modelling framework Our ambition of providing realistic estimates of the total fiscal effects of a fully specified pension reform imposes five fundamental requirements on the modelling framework: First, accounting for system complexity requires an accurate description of most elements in the existing and the proposed pension system. Specifically, one must account for the complex interplay between minimum guarantees and earnings-dependent pensions. Second, a detailed description of population heterogeneity with respect to age and income is necessary for accurate calculations of individual and aggregate pension entitlements and benefits. In particular, the increasing trend of female labour supply implies a surge in the future old-age entitlements of women. Third, the simulations should take into account that changes in employment affect most tax bases. Fourth, the fiscal effects should capture expenditure effects caused by changes in relative prices. For example, wage rate adjustment affects pension expenditures and other transfers through indexation of entitlements and benefits, and the relative prices of government consumption. Fifth, analyses of fiscal sustainability and pension reform require a long-run perspective that captures both the stationary reform effects as well as the capacity effects of investments and productivity growth. The integrated micro-macro model framework used in this paper is designed to meet these requirements. It enables us to account consistently for the existing relevant knowledge about the pension systems, individual heterogeneity, behavioural effects and general equilibrium repercussions. Admittedly, it is complex and not easily accessible, but a more simple and transparent model framework would necessarily produce less realistic estimates. 3.1 The dynamic microsimulation model Tax and pension systems are typically detailed and complex, and individuals may face different rules. Accordingly, there are substantial aggregation problems when calculating the total effect on government budgets of changes in tax or pension systems. To overcome these problems, microsimulation models, as advocated among others by Orcutt et al. (1986), have become increasingly 8 used in the last few decades to support governments with analyses regarding the effects of different social and financial policies. The basic idea in microsimulation modelling is to represent a socioeconomic system by a sample of decision units (e.g. persons), and then model the behaviour of these primary units. Contrary to what is possible in aggregate models, inhabited by one or a few representative agents, the detailed and complicated tax and benefit rules may be exactly reproduced. Figure 1: Structure of the dynamic microsimulation model MOSART Demography Migration Mortality Adoption Children leaving home Cohabitation / marriage Separation / divorce Fertility Instituttional clients Model population at time t Next year: t = t + 1 Education Graduation (dropout) from upper secondary education Entry to university or college education Graduation (dropout) from university or college From labour market to university From labour market to adult education From adult education to university Social security status Disability Rehabilitation Early retirement Old age retirement Surviving sp
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