Social Security
Retirement incentives

Social security programmes around the world link public pensions to retirement: people do not lose their pensions if they make a million dollars a year in the stock market, but they do confront marginal tax rates of up to 100% if they choose to work. Social security systems, therefore, seem to want the elderly to retire, and this simple fact represents a big puzzle from the point of view of existing positive theories of social security. In Discussion Paper No. 1025, Research Fellow Xavier Sala-i-Martin argues that most existing theories cannot explain this fact, and constructs a positive theory which is consistent.

The main idea is that pensions are a means to induce retirement, that is, to buy the elderly out of the labour force. The reason is that aggregate output is higher if the elderly do not work. This is modelled through positive externalities in the average stock of human capital: because skills depreciate with age, the elderly have lower than average skills and, as a result, they have a negative effect on the productivity of the young. When the difference between the skill level of the young and that of the old is large enough, aggregate output in an economy where the elderly do not work is higher. Retirement is desirable in this case, and social security transfers are the means by which such retirement is induced. The model predicts that when the dependency ratio increases, the desirability of any given social security programme falls. Hence, given the recent population trends in the US, the debate surrounding the potential elimination of the social security programme does not seem entirely unreasonable.

A Positive Theory of Social Security
Xavier Sala-i-Martin

Discussion Paper No. 1025, September 1994 (HR/IM)