By Sagiri Kitao
In an economy with aging demographics and a generous pay-as-you-go social security system established decades ago, reform to reduce benefits is inevitable unless there is a major increase in taxes. Often times, however, there is uncertainty about the timing and structure of reform. This paper explicitly models policy uncertainty associated with a social security system in an aging economy and quantifies economic and welfare effects of uncertainty as well as costs of delaying reform. Using the case of Japan, which faces the severest demographic and fiscal challenges, we show that uncertainty can significantly affect economic activities and welfare. Delaying reform or reducing its scope involves a sizeable welfare tradeoff across generations, in which middle to old-aged individuals gain the most at the cost of young and future generations.
Much has been written how policy uncertainty can have an impact of the economy, including on this blog. But as far as I can see, this uncertainty was pertaining to fiscal or monetary policy. The uncertainty this paper addresses, social security reform, is an order of magnitude more important because it implies bigger policy shifts that are perceived as permanent and have potential large impact on many people, in particular regarding labor supply decisions. And the uncertainty is potential larger, too, as policy makers tend to put off such politically dangerous reforms for many years.