Urban public pension, replacement rates and population growth rate in China

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Abstract

This paper uses an overlapping generations model to investigate the urban public pension in China. It examines the effects of the replacement rates and population growth rate on the capital–labor ratio, pension benefits, consumption and utility, and finds the optimal replacement rate. It is shown that raising the individual account benefit replacement rate only induces the increase in the individual account benefits. Raising the social pool benefit replacement rate induces the increase in the social pool benefits and retirement-period consumption, while the decrease in the capital–labor ratio, individual account benefits, working-period consumption and utility. The fall in the population growth rate leads to the increase in the capital–labor ratio, social pool benefits, individual account benefits, working-period consumption and utility, and leads to a decrease in the retirement-period consumption. The optimal social pool benefit replacement rate depends on the individual discount factor, social discount factor, capital share of income and population growth rate, and it decreases in the case of falling population growth rates. It will do more good than harm to raise the individual account benefit replacement rate, reduce the social pool benefit replacement rate and strictly implement China’s population policy.

Introduction

The publication of “The Chinese State Council Decision on Improving the Basic Pension System for Enterprise Employees” in December 2005 implies a new round of reform of the urban public pension system in China. The government discloses the target replacement rate of pension benefits via the People’s Daily as follows: “The target replacement rate before the reform was 58.5%, where the social pool benefit replacement rate was 20% and the individual account benefit replacement rate 38.5%. The target replacement rate after the reform is 59.2%, where the social pool benefit replacement rate is 35% and the individual account benefit replacement rate 24.2%”.1 The government has increased the pension benefits in recent years, and has pledged to continue increasing it. Hence, it is valuable to answer the following questions: what level should be the optimal replacement rate, what is the criterion to determine the optimal replacement rate, what are the determinant elements, and how should the optimal replacement rate be calculated?

Some of the literature on public pension with overlapping generations (OLG) model study pay-as-you-go (PAYG) pension system (e.g., Pecchenino and Pollard (2002) and Groezen et al. (2003)). Several studies analyze fully funded pension system (e.g., Abel (1987)). Some investigate both PAYG and fully funded pension systems (e.g., Altig and Davis (1993) and Zhang et al. (2001)). This paper will explore China’s partially funded public pension system combining social pool and individual accounts. Samuelson (1975) studies the optimum social security in a life-cycle growth model. He adjusts the capital–labor ratio to the modified golden rule level to maximize the social welfare by controlling social security taxes. The approach to find the optimal social security taxes is to equate the rate of interest to the growth rate of economy in a decentralized economy. Blanchard and Fischer (1989) elaborate the principle of social optimum, which is the Pareto Optimum. A social planner maximizes social welfare by rationally allocating the social resources.

In the above literature, pensions are financed only by wage taxes. However, in most of the countries that have public pension systems, the governments levy pension taxes on each employee’s wage and on each enterprise’s payroll using a proportional taxation schedule. Thus in this model, as real life, the government levies pension taxes on each worker’s wage and on each firm’s payroll; and the pension taxes are proportional taxes.

The population growth rate in China is also taken into account in this model since it has been falling in the last three decades. This is mainly because of China’s special population policy. In general, the government requires a couple to have not more than one child. In some special cases, e.g., both wife and husband are one child in their respective families before they get married, a couple of peasants with no child but a daughter, a couple from the minority nationalities with population below one million persons, and so on, the couples are eligible to have two or more children. There are some ways for rural residents to become urban residents. For example, graduated college students get jobs in urban area; military officers transfer to civilian works in an urban area; urbanization makes corresponding rural residents become urban residents; and so on.

Employing an OLG model within general equilibrium framework, this paper investigates China’s urban public pension system. It examines the effects of the individual account benefit replacement rate, social pool benefit replacement rate and population growth rate on the capital–labor ratio, social pool benefits, individual account benefits, working-period consumption, retirement-period consumption and utility. This paper also seeks the optimal replacement rate. Under the specializations of logarithmic utility function and Cobb–Douglas production function, we use the data such as urban population, capital share of income and the like in China to simulate the effects of the exogenous variables on the endogenous variables and that of the population growth rate on the optimal social pool benefit replacement rate.

The rest of this paper is organized as follows: Section 2 presents the model in decentralized economy. Section 3 examines the effects of the exogenous variables. Section 4 simulates the effects in the last section. Section 5 derives the optimal social pool benefit replacement rate and simulates the effect of the population growth rate on it. Section 6 gives the conclusions.

Section snippets

The model

A closed economy is composed of numerous individuals and firms and a government. The generation born at the beginning of period t is called generation t. The population grows at the rate of n=Nt/Nt11, where Nt is the population size of generation t.

Comparative statics

Totally differentiating Eq. (12) around the steady state gives (a+e)dk+idξ+jdn=0, where i=(1α)Akα(1+n+ξ)2[(1+n)+θ(1+αAkα1)]<0,j=(1α)Akα(1+n+ξ)2[ξθ(1+αAkα1)]<0if ξ<θ(1+αAkα1).

In general, the condition of ξ<θ(1+αAkα1) can be satisfied because ξ is usually less than 50% and θ more than 50%.

Estimation of parameter values

According to the disclosure of the People’s Daily, the target replacement rate of pension benefits has been adjusted from January 1, 2006. The social pool benefit replacement rate ξ has been raised from 20% to 35%, and the individual account benefit replacement rate μ reduced from 38.5% to 24.2%.

Assume that the individual discount factor per year is 0.98, which is similar to that found by Auerbach and Kotlikoff (1987) and used by Pecchenino and Utendorf (1999). Hence, the individual discount

The Pareto optimum

Since the social pool benefit replacement rate, one of the policy variables that has an effect on the capital–labor ratio, it is possible to find the optimal social pool benefit replacement rate to maximize social welfare. The social welfare function is defined as the sum of the lifetime utilities of all current and future generations4: W=θlnc20+i=0ρi(lnc1i+θlnc2i+1) where ρ(0,1) is the

Conclusions

Employing the OLG model with general equilibrium, this paper investigates the urban public pension in China. We examine the effects of the individual account benefit replacement rate, social pool benefit replacement rate and population growth rate on the capital–labor ratio, social pool benefits, individual account benefits, working-period consumption, retirement-period consumption and utility. By controlling the policy variable to adjust the capital–labor ratio to the modified golden rule, we

Acknowledgements

Financial support from the Social Science Foundation of the Ministry of Education of China (No. 06JA630079) is gratefullyacknowledged. The author is grateful to the anonymous referees and the editors for helpful comments and suggestions. Any remaining omissions or errors are the author’s responsibility.

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