The risk sharing effects of social security and the stochastic properties of income growth

Abstract

Time-series analyses suggest that income shocks are fairly persistent. This has implications for the intergenerational risk-sharing effects of pay-as-you- go (paygo) social security programs. By means of a simple stochastic specification, we derive theoretically how the variance of individuals’ lifetime income depends on the degree of persistence in the income shocks and the magnitude of the paygo program. A low or medium degree of persistence ensures that properly scaled paygo programs provide intergenerational diversification of income risk. On the other hand, a somewhat higher degree of persistence may well imply that paygo programs in fact increase the exposure to income shocks. Taking into account that it is hard to reject that income shocks are permanent (and income follows a random walk) in many countries, we can not exclude that many individuals in the OECD area do face a heightened exposure to income risk as a consequence of the actual social security programs financed on a paygo basis.