Pareto Improving Transition from a Pay-as-you-go to a Fully Funded System - is it Politically Feasible?

Abstract

Almost all papers on the feasibility of a Pareto improving transition path from a Pay-as-you-go to a fully funded system employ lump sum or wage taxes for financing the compensating transfers. This paper focuses on this issue by using consumption or proportional income taxes and applying a dynamic computable general equilibrium (CGE) model of the Auerbach-Kotlikoff type. The simulations show that in these cases a Pareto improving transition is not feasible. The reason is that due to a positive tax-benefit linkage in the German pension system efficiency losses of higher consumption or income taxes exceed the gains caused by reduced wage taxes. But combining these taxes with public debt to generate tax smoothing allows a Pareto improving transition.