Home production and Social Security reform

By Michael Dotsey, Wenli Li and Fang Yang

http://d.repec.org/n?u=RePEc:fip:fedpwp:12-5&r=dge

This paper incorporates home production into a dynamic general equilibrium model of overlapping generations with endogenous retirement to study Social Security reforms. As such, the model differentiates both consumption goods and labor effort according to their respective roles in home production and market activities. Using a calibrated model, we find that eliminating the current pay-as-you-go Social Security system has important implications for both labor supply and consumption decisions and that these decisions are influenced by the presence of a home production technology. Comparing our benchmark economy to one with differentiated goods but no home production, we find that eliminating Social Security benefits generates larger welfare gains in the presence of home production. This result is due to the self insurance aspects generated by the presence of home production. Comparing our economy to a one-good economy without home production, we show that the welfare gains of eliminating Social Security are magnified even further. These policy analyses suggest the importance of modeling home production and distinguishing between both time use and consumption goods depending on whether they are involved in market or home production.

This is by far not the first time home production is used, but usually it is added to a model to explain some quirk in the data. Here, it matters in very fundamental ways. It gives the households more options (and margins) in their life-cycle choices, and thereby eliminates the need for the retirement portion of Social Security. Of course, this may be associated with important transition costs, which may or may not wipe out the long-run benefits of this reform.