7.3 Long-term saving
7.3.1 PAYGO versus SAYGO
New Zealand has a “defined benefit” state-run pension scheme funded out of general tax revenue. Until 2001, this was run on pay-as-you-go (PAYGO) principles, that is, eligible pensioners were paid directly from current taxes. Since the NZ Superannuation Act (2001), the Government has partially prefunded its pension obligations. Under the Act, additional general taxation revenues are placed in the NZ Superannuation Fund, and used to purchase a diverse basket of investment assets. The fund is to be drawn down when pension obligations increase in the future as a result of population ageing. Additional prefunding ceased in 2008, but is intended to begin again once the Government's fiscal position improves.
The 2001 Act represents the first attempt to move New Zealand from a pay-as-you-go government pension scheme to a save-as-you go (SAYGO) pension scheme. The switch was made without changing the underlying flat-rate, universally eligible pension.
PAYGO and SAYGO pension schemes
Pension schemes can be classified according to their funding arrangements and their payment arrangements.
Under a PAYGO scheme, each year's pension payments are financed from current taxes. There is no saving or accumulation of assets.
Under a pure SAYGO scheme, taxes are collected in advance and accumulated into a fund, and the pension is financed by drawing down the fund. A SAYGO scheme is fully funded if each cohort contributes enough in taxes to cover their retirement pension entitlements.
During a transition from a PAYGO to a SAYGO system, savings accumulate since the new money paid into the fund as taxes together with investment earnings will be larger than the total pensions being paid out. However, as the fund matures, total pension payments will rise, and the size of the fund will stabilise. A mature SAYGO scheme in a demographically stable country will not generally affect the saving rate, as payments into the fund will equal money being withdrawn. However, the country will have greater accumulated wealth, and larger gross national product. Also, during the transition period, the impact on national saving (the flow measure) could be expected to be positive.
If New Zealand further increased the SAYGO component of its pension funding arrangements it could either keep the current defined benefit scheme, or adopt a “defined contribution” scheme whereby individual pensions depend on each person's contributions and investment return. Although the following discussion assumes the current defined benefit payment arrangements will be maintained, the points remain relevant even if the arrangements are changed.
Advantage of a mature SAYGO scheme
For the same ‘defined benefit' pension payments, a mature SAYGO system requires lower contributions from taxpayers than a mature PAYGO system so long as the return to capital is greater than the growth rate of GDP. This condition is true in most countries including New Zealand. A SAYGO scheme can have the same pension payments with lower taxes because the tax contributions are saved, wealth accumulates and earns interest and dividends. Furthermore, the saved contributions can be invested overseas, where the returns to capital may be higher than in New Zealand. In the long run, therefore, a fully funded SAYGO pension scheme is likely to be more attractive than a PAYGO pension scheme.
The costs and benefits of making the transition to SAYGO
While attractive, making the transition from a PAYGO scheme to a SAYGO scheme is costly. To reduce the future tax burden facing taxpayers and/or their descendents, taxpayers will temporarily have to pay higher taxes. Whether a society believes these changes in the pattern and timing of tax payments are worthwhile is fundamentally a political question. The answer will depend on who pays higher taxes, who pays lower taxes, and how current and future taxpayers value the tradeoff. The extent current taxpayers benefit from the transition will depend on:
- The extent they benefit from lower taxes in the future, which depends on the length of the transition and the difference between the returns to invested capital and the growth rate of GDP.
- The extent they value paying lower taxes in the future compared to paying higher taxes now.
- The extent they value future cohorts obtaining lower taxes.
If New Zealand continues to operate a PAYGO-funded pension scheme with current payment levels, population ageing means future taxes will have to increase. In this case, the transition to a SAYGO-funded pension scheme entails increasing taxes now to prevent even higher taxes in the future. This transition has the benefit of reducing the long run deadweight costs of taxation.
These benefits of making the transition will be greater the higher the investment returns earned by the fund. To obtain higher returns, most economists recommend the fund should be invested in a diverse basket of long-term assets, rather than government bonds. Purchasing diverse assets has different risks from purchasing government bonds, but governments are ideally situated to bear this risk, as they have long horizons and can use their balance sheet to shift abnormal shocks from one generation to another (see Diamond, Auerbach et al(1997) or Lindbeck and Persson (2003)).
Government-run investment funds face the risk of government interference, government expropriation, and the desire of government agents or political parties to intervene in corporate management. These risks can be managed if the fund uses professional wholesale money managers, the approach used by the NZ Superannuation Fund. The risk of misappropriation is smaller when the country's citizens closely identify the fund's assets with a particular purpose. This can be done by ring-fencing the fund from general expenditure, or by financing the fund from a dedicated tax stream. Several OECD countries use dedicated taxes to fund pensions.
The government could require the fund to invest in government bonds. When contributions to the fund are financed out of general tax revenues, this is broadly equivalent to paying off government debt. The transition will still be worthwhile so long as interest rates exceed the growth rate of GDP. However, the benefits of investing in bonds or repaying debt will on average be lower than the benefits of investing in diverse assets, since the expected long run returns are lower.
The effect on national saving
An economy with a balanced budget and a PAYGO pension scheme has no direct effect on government saving, as the tax revenues in are equal to the payments out. National wealth may be less than otherwise, however, as households have to save less for their own retirement. When making the transition to a SAYGO pension scheme, there are a number of effects:
- During the transition, government saving increases. National saving is also likely to increase as the tax rises reduce private consumption as well as private saving.
- Over time, national wealth increases as the pension fund accumulates.
- When the fund is mature, there may be a modest boost to national saving rates if wages increase through time. This could mean that the contributions of the working age exceed the withdrawals of the old, although this would also depend on the design of the scheme. The lower equilibrium taxes that would be required would further encourage wealth accumulation.
Peter Diamond concludes: “a near-term tax increase to build and maintain a permanently larger trust fund would increase national saving” (Diamond, Auerbach et al 1997, p65).
Prefunding other expenditure
The logic of a prefunded SAYGO tax-pension system can be extended to other aspects of fiscal policy. A government could temporarily raise taxes and build up an asset fund in order to reduce the long-term taxes needed to pay for health care or education. Alternatively, it could temporarily raise taxes to lower debt and reduce taxes in the long run. In each case there would be a temporary increase in the saving rate and a long-term increase in wealth.
The extent to which a society will wish to pay temporarily higher taxes to build up a trust fund to lower future taxes will depend on tax incidence during the transition period and people's confidence that these funds can be appropriately managed and not dissipated by a future government.
A well structured, prefunded SAYGO pension scheme will raise national savings (accumulated assets) relative to the current PAYGO scheme. During the transition from a PAYGO system to a partially or fully prefunded scheme, national saving (flow measure) should also rise. A mature SAYGO system will allow lower taxes than a mature PAYGO scheme, which may further encourage private asset accumulation.
Note, however, that while the transition from a PAYGO system to a SAYGO system is likely to raise national saving, it will not necessarily raise welfare. In the circumstances prevailing in New Zealand, the transition essentially requires a temporary increase in taxes to prevent taxes from rising even higher in the long-term. These taxes will in part fall on different cohorts, making the estimation of the welfare consequences of the transition complicated.
- Refer to Coleman (2010) for a more detailed discussion of this topic.