Aging and pension reform: extending the retirement age and human capital formation

Abstract

Projected demographic changes in industrialized countries will reduce the share of the working-age population. Analyses based on standard OLG models predict that these changes will increase the capitallabor ratio. Hence, rates of return to capital decrease and wages increase with adverse welfare consequences for current middle aged asset rich agents. This paper addresses three important adjustments channels to dampen these detrimental effects of demographic change: investing abroad, endogenous human capital formation and increasing the retirement age. Our quantitative finding is that openness has a relatively mild effect. In contrast, endogenous human capital formation in combination with an increase in the retirement age has strong effects. Under these adjustments maximum welfare losses of demographic change for households alive in 2010 are reduced by about 3 percentage points. Nontechnical SummaryThe world will experience major changes in its demographic structure in the next decades. In all countries, this process is driven by increasing life expectancy and a decline in birth rates. In consequence, the fraction of the population in working-age will decrease and the fraction of people in old-age will increase. This process is already well under way in industrial countries.Standard economic analyses predict that these demographic processes will increase the capitallabor ratio. Hence, rates of return to capital decrease and wages increase, which has adverse welfare consequences for current cohorts who will be retired when the rate of return on assets is low.The purpose of this paper is to ask how strongly three channels of adjustment to these ongoing developments and their interactions dampen such adverse welfare effects. First, compared to industrialized countries, developing countries are relatively young. In autarky, rates of return to capital in these economies are therefore higher. From the perspective of industrialized countries, investing capital abroad may therefore stabilize the return to capital. Second, as raw labor will become a relatively scarce factor and as life expectancy increases, strong incentives to invest in human capital emanate. Such endogenous human capital adjustments may thereby substantially mitigate the effects of aging on macroeconomic aggregates and individual welfare. Third, while human capital adjustment increases the quality of the factor labor, a pension reform through increasing the retirement age will increase the quantity of labor. This will increase per capita productivity further. In addition to this direct effect, increasing the retirement age will also extend the worklife planning horizon of households. This amplifies the incentives to accumulate human capital.We quantitatively evaluate these adjustment channels by developing an Auerbach and Kotlikoff (1987) overlapping generations (OLG) model with a realistic demographic transition, two integrated world regions, endogenous labor supply decisions and endogenous human capital formation. As the central part of our ...

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