Age - specific entrepreneurship and PAYG : Public pensions in
Germany✩
Burkhard Heer a,b,c,
Mark Trede d,*
a.
University of Augsburg, Department of
Economics, Universitatsstr. 16, 86159, Augsburg, Germany
b.
CESifo, Poschingerstr. 5, 81679, Munich,
Germany
c.
Netspar, Tilburg University Campus,
Koopmans Building, K515, Warandelaan 2, 5037 AB, Tilburg, The Netherlands
d.
University of Muenster, Institute of
Econometrics, Am Stadtgraben 9, 48143, Muenster, Germany
Introduction
Worldwide, pension systems are being continually reformed. The
main cause of stress on pension systems is the global demographic shift towards
higher longevity and lower fertility. To counter the effects of the rising
dependency ratio, several policies are available. In the recent past, many
countries in the OECD have decided to raise the retirement age — on average,
the normal retirement age will increase by almost two years by approximately
2060 (OECD, 2019, p. 17). Other policy options include changes in contribution
rates during working life or replacement rates of pension. Another major policy
measure regards extending the groups who are subject to mandatory
contributions, such as the self-employed or entrepreneurs. Across the OECD,
voluntary or mandatory access to pension plans varies widely for entrepreneurs
and non-standard categories of workers.
Including
entrepreneurs in the public pension system is attractive, as they would contribute
immediately to the pension system, thus alleviating the current pension burden.
Even though their share is relatively small in total population – using the
Survey of Consumer Finances, Brüggemann (2021) estimates the
share of entrepreneurs to amount to 7.4% in the US economy in 2010, while we
find a similar share of approximately 8% in Germany using the Social–Economic
Panel (SOEP) data during 2002–2017 – they contribute for a significantly larger
portion of aggregate economic activity. According to Brüggemann (2021), entrepreneurs
generate 17% of total income and own 31% of total net worth in the US in 2010.
Considering the population of full time earners in Germany, the corresponding
shares are broadly comparable. Total earnings accruing to entrepreneurs amount
to 12%, and their share of net wealth is 32%. In the long run, however, the
transitional gain from mandatory social security contributions must be traded
off against the future entitlements of these entrepreneurs. There are also
arguments in favor of exempting entrepreneurs from social security
contributions: compared to regular employees, they have a higher degree of
discretion in calculating their contribution base, which might be considered
unfair. Furthermore, not being required to pay into the public pension system
might induce more individuals to start their own businesses. In this way,
economic policy can promote entrepreneurship, and more businesses will mean
higher total employment.
In
our model, we explicitly account for this economic mechanism described above :
the imposition of social security contribution reduces the investment incentives
of the entrepreneur. The self-employed need to finance their business by means
of their own
savings and
credit in the financial market. If the social security authority forces the
entrepreneurs to form a large part of their precautionary savings for old age
in the form of public pension entitlements, they will reduce their old-age
savings in the form of entrepreneurial capital. In our calibrated model of the
Germany economy, we find that mandatory social security for the entrepreneurs
reduce aggregate savings by 3.4%–7.5% depending on the progressivity of the
pensions even though entrepreneurs only constitute 8% of the households.
Our model builds upon the work of Cagetti and De
Nardi (2006, 2009).1 While these authors only consider two stages in the life of a
household as a worker and a retiree in their model of perpetual youth based
upon Blanchard (1985) and Gertler (1999), we extend their model to an overlapping-generations (OLG) framework
with annual periods that allows for a more realistic life cycle description of
age-dependent shares of entrepreneurs and savings. In particular, we are able
to model the hump-shaped profile of the share of entrepreneurs in each cohort
using a large-scale OLG model in the tradition of Auerbach
and Kotlikoff (1987) that is calibrated to the characteristics of the Germany
economy. Our data sources are the Cross National Equivalent Files and the
wealth samples of the Socio-economic Panel (SOEP). We document the different
age-earnings profiles of entrepreneurs and workers, the hump-shaped share of
entrepreneurs as a function of age, the level of inequality and the degree of
mobility between entrepreneurs and workers.2 The
life-cycle model is then used to run counterfactual experiments to investigate
the consequences of extending the German pay as you go (PAYG) pension system to
entrepreneurs.
We
add three results to the literature. (1) We show that both under the present
demographics and the population parameters prevailing in the year 2050, the
total welfare (as measured by expected lifetime utility) of newborn households
decreases if entrepreneurs also contribute to the public pension system in
Germany. This qualitative result does not depend on whether pension payments
are proportional to contributions or lump sum. (2) We demonstrate that Germany
will be unable to finance the PAYG pension system in the year 2050 through
taxes on labor income alone, even if entrepreneurs have to contribute to the
public pension system. (3) An increase in the (effective) retirement age to 70 helps
to establish the sustainability of the public pension system.
Our policy analysis is related to the extensive literature on the
implications of aging for the sustainability of social security systems based
on multi-period overlapping generations models. As one of the earliest and most
prominent studies on the consequences of the effects of demographic transition
on public pensions, De Nardi et al. (1999)
evaluate various policy instruments in a dynamic general equilibrium model with
overlapping generations. They advocate a switch to a purely defined
contributions system. Nishiyama and Smetters (2007)
analyze a 50% privatization of social security and find the welfare effects to
be sensitive to the assumptions of a closed economy, missing annuities markets,
and the progressivity of pensions. In a more recent study, Kitao
(2014) finds that reducing pension benefits is the most efficient
policy in the long run. Heer and Irmen (2014)
also consider the effect of pension reform on the endogenous growth rate. If
labor supply becomes scarcer due to aging, firms have a higher incentive to
invest in laboraugmenting technological change. The growth rate effect is shown
to be largest for the case of a frozen contribution rate so that the level of
pensions falls in comparison to policies with (i) a constant pension level or
(ii) a higher retirement rate. Heer et al. (2020).
study
the sustainability of PAYG public pension
systems in the U.S. and 14 European countries. For the present pension systems
in these countries, as characterized by the replacement rate of pensions with
respect to wage income and the effective retirement age, they find that the
majority of continental European countries, including France, Italy, Spain, and
Germany, cannot finance pensions
beyond
the year 2040 through a social security tax on labor income alone. In contrast,
the English-speaking countries – the U.S., the UK and Ireland – have sufficient
fiscal space to finance future increases in public pension expenditures because
their present tax rates on labor income are still a large distance away from
the top of the Laffer curve.3
This paper is organized as follows. In Section 2, we
describe the data from Germany and present age-specific statistics for both
workers and entrepreneurs together with inequality measures. Section 3 presents
our model with two types of households, workers and entrepreneurs. We allow for
both mobility between the two household types and income uncertainty. In
addition, income taxes are progressive and pensions in the PAYG system depend
on the individual’s contributions. The model is calibrated with respect to
characteristics of the German economy in Section 4. In
Section 5, we describe the distribution of income and wealth both among
workers and entrepreneurs in our model and compare them with the empirical
observations in Germany. Section 6 considers
policy experiments in which entrepreneurs also contribute to the German
pay-as-you-go pension system. We find that welfare declines unanimously for all
types of newborn households for both proportional and lump-sum pensions. In
Section 7, we consider the effects of aging by studying the model economy
using forecasts of United Nations (2015)
for Germany’s demographics. We find that the present pension system cannot be
financed by social security taxes on wage income. Including entrepreneurs in the
PAYG pension system does not help to establish financial sustainability of
social security in Germany; only a postponement of the (effective) retirement
age to age 70 helps to finance pensions from contributions on non-capital
income. Section 8 concludes. The Online Appendix4 describes
the stationary equilibrium of the model in more detail.
Application of Economic
Theory of Business and Strategy
The Science of Macroeconomics
How Economists
Think
Economists
often study politically charged issues, but they try to address these issues
with a scientist’s objectivity. Like any science, economics has its own set of Tools
terminology, data, and a way of thinking that can seem foreign and arcane to
the layman. The best way to become familiar with these tools is to practice using
them, and this book affords you ample opportunity to do so. To make these tools
less forbidding, however, let’s discuss a few of them here.
Theory as Model Building
Young
children learn much about the world around them by playing with toy versions of
real objects. For instance, they often put together models of cars, trains, or
planes. These models are far from realistic, but the model builder learns a lot
from them nonetheless. The model illustrates the essence of the real object it
is designed to resemble. (In addition, for many children, building models is
fun.)
Economists
also use models to
understand the world, but an economist’s model is more likely to be made of
symbols and equations than plastic and glue. Economists build their “toy
economies” to help explain economic variables, such as GDP, inflation, and
unemployment. Economic models illustrate, often in mathematical terms, the relationships
among the variables. Models are useful because they help us to dispense with
irrelevant details and to focus on underlying connections. (In addition, for
many economists, building models is fun.)
Models
have two kinds of variables: endogenous variables and exogenous variables.
Endogenous variables are those variables that a model tries to explain. Exogenous variables are those variables that a model takes as given. The purpose of a model is to show how the exogenous variables affect the endogenous variables.
How Models Work Models are simplified
theories that show the key relationships among economic variables. The
exogenous variables are those that come from outside the model. The endogenous
variables are those that the model explains. The model shows how changes in the
exogenous variables affect the endogenous variables.
The Data of Macroeconomics
Scientists,
economists, and detectives have much in common: they all want to figure out
what’s going on in the world around them. To do this, they rely on theory and
observation. They build theories in an attempt to make sense of what they see
happening. They then turn to more systematic observation to evaluate the
theories’ validity. Only when theory and evidence come into line do they feel
they understand the situation. This chapter discusses the types of observation
that economists use to develop and test their theories.
Casual
observation is one source of information about what’s happening inthe economy.
When you go shopping, you see how fast prices are rising. When you look for a
job, you learn whether firms are hiring. Because we are all participants in the
economy, we get some sense of economic conditions as we go about our lives.
Measuring the Value of Economic Activity : Gross Domestic Product
Gross domestic product, or
GDP, is often considered the
best measure of how well the economy is performing. This statistic is computed
every three months by the Bureau of Economic Analysis, a part of the U.S.
Department of Commerce, from a large number of primary data sources. The
primary sources include both administrative data, which are byproducts of
government functions such as tax collection, education programs, defense, and
regulation, and statistical data, which come from government surveys of, for
example, retail establishments, manufacturing firms, and farm activity. The
purpose of GDP is to summarize all these data with a single number representing
the dollar value of economic activity in a given period of time.
Income, Expenditure, and the Circular Flow
Imagine an economy
that produces a single good, bread, from a single input, labor.
The Circular Flow
This
figure illustrates the flows between firms and households in an economy that produces
one good, bread, from one input, labor. The inner loop represents the flows of
labor and bread : households sell their labor to firms, and the firms sell the bread
they produce to households. The outer loop represents the corresponding flows
of dollars : households pay the firms for the bread, and the firms pay wages
and profit to the households. In this economy, GDP is both the total
expenditure on bread and the total income from the production of bread.
Stocks and Flows
Many
economic variables measure a quantity of something a quantity of money, a
quantity of goods, and so on. Economists distinguish between two types of
quantity variables: stocks and flows. A stock
is a quantity measured at a given point in time, where as a flow is a quantity measured per unit
of time.
Rules
for Computing GDP
In
an economy that produces only bread, we can compute GDP by adding up the total
expenditure on bread. Real economies, however, include the production and sale
of a vast number of goods and services. To compute GDP for such a complex
economy, it will be helpful to have a more precise definition : Gross
domestic product (GDP) is the market value of all final goods and services
produced within an economy in a given period of time. To see how
this definition is applied, let’s discuss some of the rules that economists
follow in constructing this statistic.
Real GDP Versus Nominal GDP
Economists
use the rules just described to compute GDP, which values the economy’s total
output of goods and services.
The GDP Deflator
From
nominal GDP and real GDP we can compute a third statistic : the GDP deflator.
Chain-Weighted Measures of Real GDP
We
have been discussing real GDP as if the prices used to compute this measure never
change from their base-year values. If this were truly the case, over time the
prices would become more and more dated. For instance, the price of computers
has fallen substantially in recent years, while the price of a year at college
has risen. When valuing the production of computers and education, it would be
misleading to use the prices that prevailed ten or twenty years ago.
To
solve this problem, the Bureau of Economic Analysis used to update periodically
the prices used to compute real GDP. About every five years, a new base year
was chosen. The prices were then held fixed and used to measure year to year changes
in the production of goods and services until the base year was updated once
again.
The Components of Expenditure
Economists and
policymakers care not only about the economy’s total output of goods and
services but also about the allocation of this output among alternative uses.
The national income accounts divide GDP into four broad categories of spending
:
■ Consumption (C)
■ Investment (I
)
■ Government
purchases (G)
■ Net exports (NX).
Reference
Mankiw, Gregory
N. (2010). Macroeconomics. Worth Publishers. 41
Madison Avenue New York, NY.
