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Social Security and the Interactions Between Aggregate and Idiosyncratic Risk

  • Harenberg, Daniel
  • Ludwig, Alexander

    ()

    (Munich Center for the Economics of Aging (MEA))

We ask whether a PAYG-financed social security system is welfare improving in an economy with idiosyncratic and aggregate risk. We argue that interactions between the two risks are important for this question. One is a direct interaction in the form of a countercyclical variance of idiosyncratic income risk. The other indirectly emerges over a household’s life-cycle because retirement savings contain the history of idiosyncratic and aggregate shocks. We show that this leads to risk interactions, even when risks are statistically independent. In our quantitative analysis, we find that introducing social security with a contribution rate of two percent leads to welfare gains of 2.2% of lifetime consumption in expectation, despite substantial crowding out of capital. This welfare gain stands in contrast to the welfare losses documented in the previous literature, which studies one risk in isolation. We show that jointly modeling both risks is crucial: 60% of the welfare benefits from insurance result from the interactions of risks.

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Paper provided by Munich Center for the Economics of Aging (MEA) at the Max Planck Institute for Social Law and Social Policy in its series MEA discussion paper series with number 14280.

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Date of creation: 20 Mar 2014
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Handle: RePEc:mea:meawpa:14280
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