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Social Security: To privatize or not to privatize, that is the question

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Legislative elections in Portugal are just around the corner and a heated debate has been held on the sustainability of the public pension system[1]. One of the most controversial proposals, put forward by the coalition Portugal à Frente (PàF), concerns the horizontal capping of the Social Security, in which above a certain threshold contributors may opt not to discount for the public pension system, thereby having the possibility to discount for mutual or private funds. Considering that currently the public pension program is a defined benefit system, financed on a pay-as-you-go (PAYG) bases, is that proposal the adequate response to a pension system that is under financial distress?

Feldstein and Liebman, two of the authors that more intensely preconize a shift towards an investment-based system, argue that one of the main drawbacks of the PAYG system is that the taxes imposed on labour income distort the labour market, as the implicit PAYG rate of return is usually lower than the marginal product of capital, and so contributors see those income taxes as “actual” taxes. Thus, the authors state that the primary reason to move to private pension systems “is that the rate of return on incremental savings [would permit] future benefits to be financed with a lower rate of contribution during working years, eventually permitting a higher standard of living for both workers and retirees”.  Moreover, the economy must be growing, in order to finance the transition between schemes. Especial caution should be devoted, in my view, to this last condition: for the shift to a mixed system to occur the Portuguese state would eventually have to issue more debt, which does not appear to be a good alternative in a country with a public debt of 129% GDP and an estimated anaemic 1,7% GDP growth in 2015.

Halfway between public and private pension systems, there is the possibility to implement mixed programs. These, supposedly, have the advantage of decreasing the degree to which the retirement income levels are subject to financial market volatility of a pure investment based system as well as to demographic and political threats of a PAYG system. Also, Feldstein and Liebman argue that the PAYG part of the program could be used to attain the politically desired redistribution. In my view, this is a very misleading argument: if only incomes below the established threshold contribute for the public part of the pension system, the margin of the government to carry redistributive policies would be severely hampered.

Interestingly, several of the arguments pro-privatization are considered, by other economists, to lack significant theoretical and empirical support. For instance, Stiglitz and Orszag state that any potential increase on the rate of return will be eroded by the higher administrative costs of the individual accounts, contradicting Feldstein’s main argument to adopt private systems. In this light, Orszag estimated that, several fees and costs absorb around 45% of the value of an individual account for an ordinary worker in UK.

It is clear that this is a topic for which no consensual answer exists. I believe that instead of abandoning the current pension system, we should commit to improve it by widening policies that increase the birth rate, in order to mitigate the consequences of an ageing population, as well as promote sound economic growth and to impose a tax on the added value of big companies, to account for the shift from labour-intensive to capital-intensive methods of production and value creation.

[1] The Portuguese public social security system contemplates two distinct arrangements: one designed for private sector workers and public sector employees registered since January 2006 (the general regime of social security subsystem) and another one for public sector employees who have started working to the public sector until 2005 (the Caixa Geral de Aposentações subsystem). For simplicity, I refer to the overall public pension system as Social Security.

Carolina Santos

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Author: studentnovasbe

Master student in Nova Sbe

One thought on “Social Security: To privatize or not to privatize, that is the question

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