Literature Review: Personal Welfare Accounts

Over the course of the past 40 years, there has been substantial research carried out on personal savings and unemployment accounts, their effect on wealth accumulation, protection in periods of unemployment, the incentives for individuals to work and save, the moral hazard related to insurance systems, as well as the cost of personal welfare accounts in relation to the current unemployment insurance systems. The contribution to research has been substantial by the two world famous economists, Harvard professor and president emeritus of the National Bureau of Economic Research Martin Feldstein as well as Nobel laureate, University of Columbia professor Joseph Stiglitz. The topic has been able to cross ideological boundaries. In this literature review, we will aggregate the main findings of the work carried out by Feldstein and Stiglitz over the years as well as summarise the findings of studies conducted in Europe focusing on adopting welfare accounts in Nordic welfare systems.

In his pioneering research  Feldstein showed the effect of Social Security on personal wealth accumulation. (Feldstein, 1974) Using econometric evidence he stated that social security depresses personal saving by a substantial amount (30-50 %). He defines the present value of social benefits as social security wealth, which is not real, but merely an implicit promise that the next generation will tax itself to pay the promised benefits. The amount of social security wealth represents the amount of real wealth that is lost because of the program.

In his 1990s work, Feldstein stated that the pay-as-you-go Social Security system is acting as a drag on economic growth in two ways.  First, the payroll tax distorts the supply of labor and the type of compensation sought by workers. These losses are inevitable because of the low return implied by the unfunded Social Security system. Second, the system reduces national savings and investment. Feldstein proposes that transforming the social security system from an unfunded pay-as-you-go system to a system of mandatory private savings accounts, would solve both of those problems and increase economic growth. (Feldstein, 1998)

Feldstein’s arguments are consistent with the traditional life-cycle theory of individual consumption-saving behavior that forms a fundamental part of modern economic theory (Modigliani, 1966; Mankiw, 2012). People attempt to even (or smooth) out their consumption over the course of their adult lives. Borrowing allows people to enjoy some of their future expected income earlier in their life. As people grow older and their incomes rise, they pay off debts and start to save for their retirement years. However, a social security program paying substantial retirement benefits distorts this picture. In systems where people view their social security taxes as an alternative to retirement saving and reduce their saving by the full amount, social security can be argued to cause a loss of private savings.

In his work with Daniel Altman, Feldstein (Feldstein & Altman, 2007) proposed Unemployment Insurance Savings Accounts (UISAs) as an alternative to the traditional Unemployment Insurance (UI) system. UISAs would provide the same protection to the unemployed as the current unemployment insurance system but with less of the adverse incentives. The system would require each individual to save a fraction of his or her wage income in the UISA. If he lost his job and would be eligible for unemployment benefits under the current UI rules, he would withdraw an amount equal to the regular UI benefits from his personal UISA.

In the research, the authors investigated a key empirical question as to whether the concentration of unemployment among a relatively small number of individuals implies that the UISA balances would typically be negative, forcing individuals to rely on government benefits with the same adverse effects that characterize the current UI system.

The authors used the Panel Study on Income Dynamics to simulate the UISA system over a 25 year historic period and found that almost all individuals had positive UISA balances, implying that they would remain sensitive to the cost of unemployment compensation. Even among individuals who experienced unemployment, most had positive account balances at the end of their unemployment spell. They found that the cost to taxpayers of forgiving the negative balances was substantially less than half of the taxpayer cost of the current UI system in the United States.

Joseph Stiglitz (Stiglitz & Yun, 2005) has researched integrating social insurance programs with pension programs through individual accounts. The finding is that such integration is desirable unless the risks are perfectly correlated to each other. The system would allow workers to borrow against their future wage income to finance consumption during an unemployment episode. It would improve search incentives while reducing the risks arising from unemployment.

In the past, Stiglitz together with Richard Arnott, has also studied the effect of moral hazard on individuals’ activities and incentives. (Arnott & Stiglitz, 1990) Moral hazard arises whenever risk-averse individuals obtain insurance and their accident-avoidance activities cannot be perfectly monitored. In their 1990 paper the authors contend that economies in which moral hazard problems are present contain numerous forms of inefficiencies. Such problems are pervasive in the economy and do not only arise in explicit insurance policies but also in implicit policies such as on the labor market. Whereas the focus of the analysis was to cast doubt on the decentralizability of economies, the same moral hazard problems can be held true also for government controlled insurance programs, such as unemployement benefits and other social security: if individuals do not bear the full consequences of their actions, incentives for accident avoidance tend to be less.

A group of economists have researched the option of adopting welfare accounts in Sweden in the early 2000s. In their research (Fölster;Gidehag;Orszag;& Snower, 2002), they examined a large panel of individual income data and found that the adoption of universal welfare accounts could reduce social insurance expenditure considerably, improve the incentives to work and save, all with relatively small redistributive impact. In Finland, the Research Institute of the Finnish Economy has produced similar findings both in relation to social as well as health accounts. In their work (Lassila & Valkonen, 2008), the authors have called for further studies to simulate the effect of a welfare account policy by using sufficient data panels to analyze effects of income shocks at individual level. They also call for further investigations of dynamic decisions by individuals through a numerical model.

A recent Danish study claims that individual welfare accounts can redistribute lifetime incomes at a lower efficiency cost, compared with a conventional tax–transfer system. (Bovenberg;Hansen;& Sørensen, 2012) The study describes a design for welfare accounts that guarantees a Pareto improvement if behavioural responses to the accounts improve the public budget. It further develops a formula for quantifying the impact of welfare accounts on the government budget and economic efficiency.

One of the few countries to have implemented a personal social security account so far is Chile. Chile was the first country in the western hemisphere to set up a social security system, and the first country in the world to reform it using individual investment accounts. It has again broken new ground by becoming the first country to use individual accounts in an unemployment insurance (UI) system. There has been substantial research and case studies on unemployment accounts in Chile. (Conerly, 2002) (Acevedo;Eskenazi;& Pagés, 2006)

In the past decades, there has also been substantial research in favor of shifting the focus of taxation from capital and income taxes to consumption taxes. Economist Arthur B. Laffer popularized in the mid-1970s the possibility of an inverse relationship between tax rates and government revenue. (Laffer, 2004) The idea behind the formulation was not new, tracing back to Adam Smith (Smith, 1776). The 1980s were largely dominated by supply-side economists, stressing the impact of tax rates on the incentives for people to produce and to use resources efficiently. Whereas marginal tax rates directly affect the incentive of people to work, to save and invest, and to avoid and evade taxes, a consumption tax was argued to have a more neutral effect on economic activity and e.g. no impact on the rate of capital accumulation. (Canto;Joines;Laffer;Miles;& Webb, 1983)


Bibliography

Acevedo, G., Eskenazi, P., & Pagés, C. (2006). Unemployment Insurance in Chile: A New Model of Income Support for Unemployed Workers. SP Discussion Paper, No. 0612, World Bank.

Arnott, R., & Stiglitz, J. (1990). The Welfare Economics of Moral Hazard. Risk Information and Insurance: Essays in the Memory of Karl H. Borch , 91-122.

Bovenberg, A. L., Hansen, M. I., & Sørensen, P. B. (2012). Efficient Redistribution of Lifetime Income through Welfare Accounts. Fiscal Studies, The Journal of Applied Public Economics, Wiley, Volume 33, Issue 1 , pages 1–37.

Canto, V. A., Joines, D. H., Laffer, A. B., Miles, M. A., & Webb, R. I. (1983). Foundations of supply-side economics: theory and evidence. Academic Pres.

Conerly, W. B. (2002). Chile Leads the Way with Individual Unemployment Accounts. Ideas Changing the World, National Center for Policy Analysis, No. 424 .

Feldstein, M. (1998). Privatizing Social Security. ISBN: 9780226241821: The University of Chicago Press.

Feldstein, M. (1974). Social Security, Induced Retirement and Aggregate Capital Accumulation. The Journal of Political Economy, Vol. 82, No. 5 , 905-926.

Feldstein, M., & Altman, D. (2007). Unemployment Insurance Savings Accounts. Tax Policy and the Economy, Vol. 21 .

Fölster, S., Gidehag, R., Orszag, M., & Snower, D. J. (2002). Assessing Welfare Accounts. Uni Kiel.

Laffer, A. B. (2004, June). The Laffer Curve: Past, Present, and Future. Retrieved November 2013, from The Heritage Foundation: http://www.heritage.org/research/reports/2004/06/the-laffer-curve-past-present-and-future

Lassila, J., & Valkonen, T. (2008). Sosiaalitilit ja moraalikato. ETLA.

Mankiw, G. (2012). Macroeconomics. Worth Publishers; Eighth Edition.

Modigliani, F. (1966). The Life Cycle Hypothesis of Saving, the Demand for Wealth and the Supply of Capital. Social Research 33:2 .

Smith, A. (1776). The Wealth of Nations.

Stiglitz, J., & Yun, J. (2005). Integration of unemployment insurance with retirement insurance. Elsevier, vol. 89(11-12) , 2037-2067.

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