It is a widespread belief that introducing and extending pay-as-you-go (PAYG) pension schemes hamper growth. The accumulation of physical capital is reduced because both the higher expected pension and the higher contribution bring down savings. This argument overlooks that growth can also be promoted by investment in human capital. Voters understand that at given contribution rates their future pensions will increase with more investment in public education. Therefore, an additional motive exists to vote in favor of an increase in expenditure on public education. With a higher investment rate in human capital, growth of income per capita will go up. This may offset growth gaps due to lower accumulation of physical capital. The project tries to evaluate the impact of introducing or extending a PAYG scheme on growth in an open economy.
In a framework of a model with overlapping generations, voters decide on the level of a payroll tax that finances public schools. Physical capital is mobile internationally. The analysis considers the case of a small open economy in which domestic savings have no effect on the interest rate. The impacts of different pension formulas - flat pensions and contribution-related pensions - are investigated, where the contribution rate to the public pension scheme is fixed.
Flat pensions will lead to higher growth than contribution-related pensions if the median voter earns less than the average wage, and vice versa. Poor voters tend to give more support to public education when pension benefits are redistributed towards them. As expected, growth under a PAYG scheme generally exceeds growth under a funded scheme. However, there is also a counteracting effect because PAYG pensions are often associated with a lower lifetime income, inducing in itself a lower demand for public education.
M. Kaganovich and V. Meier (2008), Social Security Systems, Human Capital, and Growth in a Small Open Economy, CESifo Working Paper No. 2488, Munich.
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