There are two main ways that state-provided retirement income systems are organised - the pension (and contributions) is related to the retiree's pay, either over the working lifetime or a more limited period (the 'Bismarckian model').  The other sees the government set the pension as being similar for all - there may be residence and contribution-period qualifications to receive the full amount.  This model is labelled 'Beveridgean' after the government minister mainly responsible for the design of the UK's social security system in the 1940s.

The size of pay-related systems' benefits (and their cost) is somewhat higher than the flat-rate alternatives but, despite the higher cost, they seem to have the support of their respective electorates.  This report looks at why that might be so.  It first develops a model that looks at whether there is some kind of relationship between benefits and voting.

"We suggest a political economy explanation for the stylized fact that intragenerationally more redistributive social security systems are smaller. We relate the stylized fact to an "efficiency-redistribution" trade-off to be resolved by political process. The inefficiency of social security financing is due to endogenous labor supply. Using data on eight European countries, we find that the stylized fact and a considerable degree of cross-country variation in contribution rates can be explained by the median voter model."

A "smaller" social security system means that it costs less.  Bevridgean systems tend to cost quite a lot less. The average effective contribution rate was 19 percent in countries with flat-rate benefits, and 35 percent in countries with earnings-related benefits."

"The relationship between the level to which benefits depend on past earnings and social security contribution rate has received little attention in the political economy literature, despite its robustness. In this paper, we suggest an explanation based on a standard trade-off between economic efficiency and redistribution. The efficiency cost of redistributing income is lower when benefits are earnings-related, encouraging voters who benefit from social security to support higher contribution rates. Low income voters weigh this effect against the reduced redistributiveness of more earnings-related systems. Our numerical analysis of several European countries suggests that the median voter model is able to explain the stylized fact that intragenerationally more redistributive social security systems are smaller."

One of the difficulties with comparing systems on this basis is that some Beveridgean models (Australia is a case of this kind used in the report) don't have an identified social security contribution.  The report cites imputed contribution rates calculated by others.

"The social security contribution rates predicted by the median voter model also have a strong correlation with the effective rates... This means that our median voter model is able at least in part to explain the levels of contribution rates and their cross-country differences. Even though our analysis focuses on steady-state political equilibria, our main result that [the] benefit formula significantly affects political equilibrium contribution rates can be expected to hold also outside of steady-states. This suggests that the political response to population aging may crucially depend on to what extent benefits are linked to past contributions. Accounting for the dynamic responses is left for future research."

PensionReforms wonders about this.  The report suggests:

Although being a cornerstone in economic policy reasoning, the trade-off between efficiency and equity has (surprisingly for us) not been invoked in rationalizing why earnings-related systems are larger.

But where really do pension systems with no identified contributions from employees, employers and others fit into this?  Australia, New Zealand and a number of other countries with universal, demogrant systems do not link contributions to benefits at all.  PensionReforms thinks that the explanations are likely to be more subtle than the "size and economic efficiency equals success" implied in the report.  Deriving a notional contribution rate from the public accounts of countries that pay benefits from general tax revenues and then suggesting that voters understand that process in a way that allows the trade-offs implied in the report is, PensionReforms suggests, a step too far.

The median voter in Australia probably accepts the relatively low cost of the income and asset-tested Old Age pension because of the relatively expensive, parallel compulsory Tier 2, Defined Contribution scheme and generous tax breaks for private provision that both go to top up state provision.  The position is different in the Beveridgean United Kingdom for several reasons - first, because the overall retirement income system is so complex; secondly, there is an identified, relatively low contribution rate for the state's National Insurance benefits; thirdly, there is a complex system of tax reliefs aimed at higher taxpayers but that stretches down to reach the median voter who is the target of the report.

In other words, PensionReforms thinks that the whole retirement income system must be examined, not just the bits that are passed directly through the government's hands.  We suspect that the report's three period, overlapping-generations model probably couldn't cope with the wider view we think is necessary.  There is a real danger therefore of this 'simple' analysis moving to the 'simplistic'.

PensionReforms also suggests that the Bismarkian systems have yet to face their true test as baby boomers start retiring.  The high contribution rates may need to continue despite an almost inevitable scaling back of benefits.  That will be a test of the political sustainability of earnings-related systems as voters begin to understand that their high past contributions, despite their link with their benefits today, haven't actually paid for those benefits. (File size 258 KB)   227