Sunday, July 13, 2008

Progressivity versus generosity around the world

Looking around the world, some government pension plans pay high benefits (with high contribution rates). These plans tend not to be very progressive. Likewise, plans paying lower average benefits tend to be more progressive. I've put together a chart below based on data from the OECD, where the average replacement rate is on the vertical axis and the level of progressivity is on the horizontal axis. (Progressivity runs from 0, which implies a totally earnings related plan, to 100, which implies a flat dollar benefit for everyone, regardless of earnings.) You can see visually, and a quick regression confirms, that the two are highly correlated: about half the difference in the size of a program can explained by looking at the progressivity of the program.

The Netherlands, for instance, is both the most generous but the least progressive of the 19 OECD countries listed. The U.S. is around the middle of the pack: it's ranked 7th in terms of progressivity and 13th in terms of generosity. (If you invert the generosity scale, the U.S. is ranked 6th, matching it up closely with its progressivity rank.)

I had played with this data a couple years ago, but thought of it again when I spotted a new paper entitled "Why are More Redistributive Social Security Systems Smaller? A Median Voter Approach," by Marko Koethenbuerger, Panu Poutvaara, and Paola Profeta. (The published paper is behind a firewall, but a working paper version is available here.) Here's a key paragraph:

Countries with earnings-related public pension programs have considerably higher contribution rates than those with flat-rate benefits. Disney (2004) reports that the effective contribution rates in the 10 OECD countries dominated by flat-rate systems varied between 14.7 percent in Australia and 23.7 percent in the United Kingdom in 1995. The range in the 12 OECD countries with more earnings-related benefits was between 22.4 percent in Germany and 57.7 percent in Greece. The average effective contribution rate was 19 percent in countries with flat-rate benefits, and 35 percent in countries with earnings-related benefits.

Here are their concluding remarks:

The relationship between the level to which benefits depend on past earnings and Social Security contribution rate has received little attention in the political economy literature, despite its robustness. In this paper, we suggest an explanation based on a standard trade-off between economic efficiency and redistribution. The efficiency cost of redistributing income is lower when benefits are earnings-related, encouraging voters who benefit from Social Security to support higher contribution rates. Low income voters weigh this effect against the reduced redistributiveness of more earnings-related systems. Our numerical analysis of several European countries suggests that the median voter model is able to explain the stylized fact that intragenerationally more redistributive social security systems are smaller.

The social security contribution rates predicted by the median voter model also have a strong correlation with the effective rates calculated by Disney (2004). This means that our median voter model is able at least in part to explain the levels of contribution rates and their cross-country differences. Even though our analysis focuses on steady-state political equilibria, our main result that benefit formula significantly affects political equilibrium contribution rates can be expected to hold also outside of steady-states. This suggests that the political response to population aging may crucially depend on to what extent benefits are linked to past contributions.

This last sentence is important, as Social Security proposals on both sides tend to make the system more progressive. Sen. Obama would increase taxes on high earners while implementing a tax credit to effectively lower payroll taxes for low earners. On the GOP side, most plans focus on reducing benefits for high earners, such as through "progressive price indexing." Social Security's progressivity hasn't changed a lot over the system's history, and it will be interesting to see how these proposals might alter political support for the program.


Jim Glass said...

Interesting paper, thanks.

"...This suggests that the political response to population aging may crucially depend on to what extent benefits are linked to past contributions..."

This last sentence is important, as Social Security proposals on both sides tend to make the system more progressive.

Especially as the US system is categorized here as not among those with "earnings-related benefits" to begin with. Which is interesting on its own.

Andrew G. Biggs said...

Which is interesting because we usually think of Social Security as being fairly strongly earnings related, and certainly Roosevelt and his folks thought of it that way. But it seems there are programs that are much MORE earnings related (and therefore less progressive) than Social Security.