Welfare effects of fiscal policy in reforming the pension system

Most reforms of the pension systems imply substantial redistributions between cohorts and within cohort. Fiscal policy, which accompanies these changes may counteract or reinforce this redistribution. Moreover, the literature has argued that the insurance motive implicit in some pension systems plays a major role in determining the welfare effects of the reform: reforms otherwise improving welfare become detrimental to welfare once insurance motive is internalized. We show that this result is not universal, i.e. there exists a variety of fiscal closures which yield welfare gains and political support for a pension system reform. In an OLG model with uncertainty we analyze two sets of fiscal adjustments: fiscally neutral adjustments in the pension system (via contribution rate or replacement rate) and balancing pension system by a combination of taxes and/or public debt. We find that fiscally neutral pension system reforms are more likely to yield welfare gains. Many adjustments obtain sufficient political support despite yielding aggregate welfare losses and vice versa. Furthermore, we point to fiscal closures which attenuate and reinforce the relevance of the insurance motive in determining the welfare effects.