PENSION FUNDING IN A UNIONIZED ECONOMY
| Author | Antonis Adam,Thomas Moutos |
| DOI | http://doi.org/10.1111/j.1467-9485.2009.00481.x |
| Published date | 01 May 2009 |
| Date | 01 May 2009 |
PENSION FUNDING IN A UNIONIZED
ECONOMY
Antonis Adam
n
and Thomas Moutos
nn
Abstract
This paper analyzes the effects of pension funding for a small open economy in
which wages are subject to bargaining. Using an overlapping-generations frame-
work, we show that a reform away from a Pay-As-You-Go towards a funded
pension system will be Pareto improving only if the reform results in a reduction in
the steady-state unemployment rate. However, the reduction in the unemployment
rate is by no means warranted: although for pension systems which involve a
limited amount of intra-generational redistribution this is likely, for systems
displaying a high degree of intra-generational redistribution the unemployment rate
may well rise thus preventing the realization of welfare gains.
I Intro ductio n
The presence of high unemployment is usually considered detrimental to the
viability of public pension systems. Yet what may seem as a challenge to some,
for others it may be an opportunity; Corneo and Marquardt (2000) and Demmel
and Keuschnigg (2000) have argued that in labour markets characterized by the
presence of unemployment-creating labour unions, a move towards a funded
system can be Pareto improving
1
; when the returns to the Pay-As-You-Go
(PAYG) system are lower than the returns of comparable investment in the
capital market, PAYG contributions constitute an implicit tax on labour. A
reduction of the (implicit) tax on labour increases employment, thereby
generating efficiency gains which may be exploited in order to design a Pareto
improving transition policy to a funded system. The above finding is consistent
with the finding that a transition to a funded system is possible when labour
supply is endogenous (Breyer, 1989; Homburg, 1990).
This paper differs from the above analyses in two respects. First, we consider
non-myopic labour unions, i.e. unions maximize the inter-temporal utility of
their members and realize that today’s wage and employment developments may
n
University of Ioannina
nn
Athens University of Economics and Business & CESifo
1
There is a vast literature highlighting the benefits and the efficiency gains from moving to a
private fully funded pension system, see for example World Bank (1994), Diamond (1996),
Gramlich (1996), Holzmann (1997) and Feldstein and Liebman (2002) for a survey.
Scottish Journal of Political Economy, Vol. 56, No. 2, May 2009
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Journal compilation r2009 Scottish Economic Society. Published by Blackwell Publishing Ltd,
9600 Garsington Road, Oxford, OX4 2DQ, UK and 350 Main St, Malden, MA, 02148, USA
213
negatively affect future pension benefits. Schiller and Weiss (1980), Smith (1981)
and Creedy (1994) argue that pensions provide a form of deferred pay, thus it is
natural to assume that when labour unions bargain over wages they also take
into account the effect of bargaining outcomes on future pension entitlements.
Second, we also take into account that the PAYG system affects both inter-
generational and intra-generational redistribution. By incorporating these
elements into the analysis we show that a reform away from the PAYG
towards a funded pension system will be Pareto improving only iff the reform
results in a lower steady-state unemployment rate. However, we find that the
reduction in the unemployment rate is by no means guaranteed.
The rationale for this result hinges on the incentives created by the PAYG
system for wage moderation. In the PAYG system pensions are financed by a
proportional tax on labour income, whereas the benefits are only imperfectly
indexed on the contributions of the individual worker. (This feature of many
pension systems introduces a degree of intra-generational redistribution which is
important for what follows.) Consider then a single union contemplating wage
setting: the higher is the degree of intra-generational redistribution inherent in
the pension system, the less valuable are wage increases because they only
increase the working period income, without (fully) affecting post-retirement
income. Yet, any wage increases come at the cost of higher unemployment.
Accordingly, the benefits of wage increases in systems with a strong degree of
intra-generational redistribution will be smaller, whereas the costs are
independent of it. As a result, to the extent that the PAYG system involves a
higher degree of intra-generational redistribution than the funded one, it creates
a wage moderation effect.
2
Thus, the equilibrium effect of a cut in the public-
PAYG pension scheme will depend on two opposing effects: the first arising
from the cut on the implicit labour tax (as in Corneo and Marquardt, 2000 and
Demmel and Keuschnigg, 2000), which reduces unemployment, and the other
from the wage moderating effect of the PAYG pension, which – as long as the
PAYG system practices some intra-generational redistribution – increases
unemployment.
3
We show that the net effect of these two forces on
unemployment is ambiguous.
4
In an effort to ascertain whether the benefits are likely to be higher than the
costs in actual economies, we solve the model numerically using empirically
plausible parameter values. Given the uncertainty surrounding the parameter
values, the only safe conclusion that we can draw from this analysis is that a
2
From the literature on taxation in unionized economies we know that a more progressive
tax system leads to lower wage demands and higher employment (Koskela and Vilmunen, 1996;
Nickell, 2003). With some sleight of hand we may think that – in effect – an intra-generationally
redistributive pension benefit impacts a higher degree of tax progression.
3
A corollary of the above result is that a close linkage between pension taxes and benefits
increases unemployment, and reduces household welfare. When there is full employment, the
exact opposite result holds, i.e. a closer linkage between taxes and benefits increases welfare (see
Bu
¨tler, 2002).
4
Ono (2007) has also provided an extension of the Corneo and Marquardt (2000) model, by
considering more general production and union objective functions. He finds that an increase in
the contribution rate to the public pension system results in lower unemployment.
ANTONIS ADAM AND THOMAS MOUTOS214
r2009 The Authors
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