PAY-AS-YOU-GO PENSIONS AND ENDOGENOUS RETIREMENT

Abstract

This paper revisits two classic results in standard overlapping generations models with a pay-as-you-go (PAYG) pension system. Firstly, a PAYG system crowds out private savings and reduces the overall capital stock. Secondly, in dynamically efficient economies, a PAYG system will reduce steady-state welfare. These classic results have been derived and exposed in models with no retirement decision. However, by allowing for endogenous retirement, and without taking recourse to any frictions, uncertainty, or myopia, it is shown that a PAYG system may be neutral and may even increase the capital–labor ratio. In particular, it is shown that the effect of the pension contribution rate on capital intensity depends on the elasticity of substitution between consumption and leisure. If the elasticity of substitution is between 0 and 1, an increase in the contribution rate will increase capital intensity. Moreover, it is shown that the result regarding welfare may also be overturned. An increase in the PAYG contribution rate may increase steady-state welfare.