ECON 20210 - Problem Set 6 Solutions

1 Readings
1. The answers are as follows:
(a) The partial insurance role arises because of the presence of uninsured idiosyncratic
risk. More specifically, social security substitutes for missing annuity markets and
it insures against idiosyncratic income uncertainty.
(b) If social security benefits are imperfectly linked to contributions, the system re-
distributes between individuals with different realizations of the stochastic pro-
ductivity process. Therefore, in a model with idiosyncratic income uncertainty,
a transition to a fully funded system may have less political support than in
a benchmark model in which we abstract from the existence of heterogeneity
within generations. In the authors’ model, agents are ex-ante identical, and the
only source of heterogeneity within generations derives from the individual real-
izations of the labor productivity shock. They find that a bias in favor of the
status quo (the pay-as-you-go system) can arise or be stronger than in the case
without heterogeneity.
(c) The relevance is from a quantitative point of view. Even though individuals do not
have altruistic bequest motives, they can still leave accidental bequests, allowing
the authors to match this aspect of reality without losing tractability.
(d) They distinguish five effects that determine the welfare consequences of potential
reforms as well as the voting decisions of individuals:
• Intergenerational redistribution: Depending on the reform, older agents lose
part of their entitlements or younger agents contribute more than they will
eventually receive
• Intragenerational redistribution: Payroll taxes are proportional and social
security benefits are not tied to contributions in their model. Hence, the
social security system redistributes from agents with high labor earnings (high
productivity agents) to agents with low labor earnings
• Social security as a partial insurance device: In the absence of annuity mar-
kets and insurance against idiosyncratic uncertainty, the social security sys-
tem partially substitutes for these missing markets. Note that it is ex-post
(after uncertainty is revealed) intragenerational redistribution that generates
ex-ante insurance against idiosyncratic uncertainty among ex-ante identical
individuals. For agents that are already born, these two effects are therefore
hard to distinguish.
• General equilibrium effects: Along the transition path wages and interest
rates change. Agents with higher accumulated wealth receive a higher fraction
of their income from interest payments and a lower fraction from labor income
• Elimination of tax distortions: With an endogenous labor-leisure decision,
the payroll tax to finance social security payments is a distortionary tax.

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 Removing this distortion is one of the benefits of a transition to a fully-funded
system.

2. The answers are as follows:

(a) It basically rules out the possibility of dynamic inefficiency. Then, given the
purpose of the paper, it allows the authors to assess whether the introduction of
an unfunded social security system is really beneficial, or its convenience depends
exclusively on having this inefficient path.
(b) As the capital stock increases towards the golden rule level, the rate of return on
capital falls toward the growth rate of output, and the decline in the discount rate
causes the price of land to increase. This increase in the price of land absorbs
the saving of working cohorts and confers capital gains on the owners of land,
inducing higher consumption. Because the price of land can increase without
bound as the capital stock approaches the golden rule, this process is sufficient to
rule out the overaccumulation of capital.
(c) Social security provides two forms of risk sharing that are not available through
the market. First, it provides a retirement annuity that can partially substi-
tute for missing private annuities. Second, because the amount of this annuity
is unrelated to an individual’s employment or contribution history, social secu-
rity entails some pooling of unemployment risk over and above that provided by
explicit unemployment insurance.
(d) With respect to each of the dimensions asked:
• Properties of an economy with land: Market value of land does not exceed the
value of capital until β reaches 1.032, higher than empirical estimates for the
parameter. A β = 0.978 results in a wealth-output ratio of 2.521 (empirical
average of 2.519 since 1954), and closely matches split between land and
capital (land-output ratio: 0.662 model vs. 0.671 data; capital-output ratio:
1.859 model vs. 1.848 data)
• Optimal social security arrangement: As social security replacement rate in-
creases from 0.0 to 1.0, economy’s steady-state capital stock, consumption,
output, and utility all decline. Interest rate is greater than the growth rate
of aggregate output at all replacement rates, indicating that this economy is
dynamically efficient with or without social security. This indicates that a
newborn agent entering one of these steady-states would prefer an economy
with no unfunded social security to an economy with any positive replacement
rate.
• Intertemporal elasticity of substitution: With γ = 5.0 (benchmark is γ = 2.0
with β set to match observed wealth-output ratio), increasing the replacement
rate from 0 to 100% reduces the steady-state capital stock by 43%. With
log-utility, this same policy change reduces the capital stock by only 11%.
Although the higher intertemporal elasticity of substitution implied by log
utility results in smaller reduction in the capital stock, this reduction is still

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 large enough to outweigh the risk-sharing benefits of social security. Result
is even stronger with lower elasticities of substitution.

2 Exercises
1. The answers are as follows

(a) The γc,t = 0 locus is determined by the steady-state capital per efficiency unit
ratio k ∗ that satisfies:
1
[β(1 + f 0 (k ∗ ) − δ)] θ − (1 + g) = 0

which implicitly defines a function k ∗ in terms of parameters β, δ, θ, and g. If we

consider a tax τ on the rental rate of capital, the new condition will be:
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[β(1 + (1 − τ )f 0 (k ∗ ) − δ)] θ − (1 + g) = 0

Solving for f 0 (k ∗ ):
(1 + g)θ
 
0 ∗ 1
f (k ) = −1+δ
1−τ β
Differentiating both sides:

(1 + g)θ
 
00 ∗ dτ
∗
f (k )dk = −1+δ
(1 − τ )2 β

Solving for dk ∗ /dτ :

dk ∗ (1 + g)θ
 
1
= 00 ∗ −1+δ
dτ f (k )(1 − τ )2 β
Evaluating at τ = 0:

dk ∗ (1 + g)θ
 
1
|τ =0 = 00 ∗ −1+δ <0
dτ f (k ) β
Then the γc,t = 0 locus moves to the left.
The γk,t = 0 locus, on the other hand, is determined by the set of points (c, k)
that satisfy:
c = f (k) − ((1 + g)(1 + n) − (1 − δ))k
We can immediately observe that the tax does not enter this expression. There-
fore, the locus does not change.
(b) At the moment of the adoption of the tax, the individual will suffer two effects:
an income and a substitution effect. Depending on which one dominates we
might see either a decrease or an increase in consumption. However, we know
that the individual is rebated the tax levied, so there will not be an income
effect. This means that consumption will actually increase, as the relative price

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 of consumption today versus tomorrow has gone down. The higher consumption
level will allow the economy to decrease their capital holdings, which in turn will
reduce total resources available and will gradually make consumption smaller until
converging to the new steady-state.
(c) We know that k ∗ is smaller from (a). As we will be in the increasing part of the
(c, k) locus, then c∗ will also be smaller.
(d) The answers are as follows:
i. Using the γk,t = 0 locus, we know that the steady-state savings ratio, s∗ , is
equal to:
y ∗ − c∗ ∗ k∗
= s = ((1 + g)(1 + n) − (1 − δ))
y∗ f (k ∗ )
Differentiating both sides:
f (k ∗ ) − k ∗ f 0 (k ∗ )
 
∗
ds = ((1 + g)(1 + n) − (1 − δ)) ∗ 2
dk ∗
(f (k ))
Then:
ds∗ f (k ∗ ) − k ∗ f 0 (k ∗ )
 
= ((1 + g)(1 + n) − (1 − δ))
dk ∗ (f (k ∗ ))2
Given that f (k) is a strictly concave function:
f (k ∗ ) > k ∗ f 0 (k ∗ )
This means that:
ds∗
>0
dk ∗
Hence, countries with higher tax rates (lower k ∗ ) will see lower saving rates
on the BGP
ii. No, they do not. Capital income net of taxes will be the same across countries.
This can be seen more clearly from (a). Recall that:
(1 + g)θ
f 0 (k ∗ )(1 − τ ) = −1+δ
β
The RHS of this equation is the same for all countries, which confirms what
we just said. There are no incentives to save elsewhere for any agent on the
BGP.
(e) No, competitive equilibrium is Pareto optimal. Hence, there is no room for any
intervention that can improve over the decentralized outcome.
(f) γc,t = 0 locus moves in the same direction as in (a). No parameter is affected
by the policy modification. γk,t = 0 will change though. In particular, there will
be less resources for consumption for each possible level of capital per efficiency
unit. Let us define xt as government purchases per efficiency unit. Assuming no
government debt, government budget constraint in efficiency unit terms implies:
xt = τ f 0 (kt )

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 Then, γk,t = 0 will look like:

c = f (k) − ((1 + g)(1 + n) − (1 − δ))k − τ f 0 (k)

Then:
dc∗ (k ∗ )
|τ =0 = −f 0 (k ∗ ) < 0
dτ
Then, we will have lower consumption and lower capital per efficiency unit at the
steady state.
At the moment of the adoption of the tax, we will have the income and the
substitution effect. The substitution effect will come from the traditional channel
of modifying the return to savings. The income effect, on the other hand, will
be negative and will come from the fact that each possible level of savings will
render a lower yield. The net effect on savings will depend on the value of θ.

2. The answers are as follows:

(a) Plugging (1) and (2) into (5):

gt + ett − τtt − st + st−1 (1 + rt−1 ) + et−1

t − τtt−1 = ett + et−1
t
t t−1
⇐⇒ gt − τt − st + st−1 (1 + rt−1 ) − τt = 0

Solving for gt via government budget constraint and plugging the resulting ex-
pression in the equation of above:

Bt−1 (1 + rt−1 ) + τtt + τtt−1 − Bt − τtt − st + st−1 (1 + rt−1 ) − τtt−1 = 0

which implies:
(Bt−1 + st−1 )(1 + rt−1 ) = Bt + st
Given an initial B0 + s0 we can solve the difference equation for a generic Bt + st :
t−1
Y 1
Bt + st = (B0 + s0 )
s=0
1 + rs

But as B0 + s0 = 0, Bt + st = 0 ∀t.
(b) We know that τtt = θ and that τt+1 t
= −θ. Thus, τ̃tt is the present discounted
value of all pension contributions and benefits. Hence, τ̃tt and τ̃t+1
t
correspond to
a situation in which the individual is given back (or taken away) in advance all
the wealth that he or she would have contributed (or extracted) to (from) the
system, with the cost of not receiving any pension benefits when retired. In this
sense, the new scheme is a fully funded pension system, as everyone will have to
take charge of their retirement period on their own.
(c) The interest rate has not changed, hence the associated Euler equation is the same
and individuals do not want to modify the slope of their consumption profile. In
addition, the intertemporal budget constraint has not been modified either, so

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 available inter-temporal resources for people are the same of before. If optimiza-
tion condition and budget constraint remain unchanged, decisions have to be the
same too.
c̃tt = ctt
c̃tt+1 = ctt+1
c̃01 = c01

(d) Government budget constraint, after putting all the values that were assumed for
this new environment will look like:
θ
B̃t = B̃t−1 (1 + r̄) + θ −
1+r
Assuming B̃t = B̃t−1 = B̃, and solving for B̃ we obtain:
θ
B̃ = −
1 + r̄
(e) Before the policy change:
ctt = α − θ
ctt+1 = 1 − α + θ
We know then that:
c̃tt = α − θ
c̃tt+1 = 1 − α + θ
θ
solve the agent’s problem. Replacing s̃t = 1+r̄
into the period t budget constraint
of an agent born at time t:
θ r̄
+ c̃tt = α − θ ⇒ c̃tt = α − θ
1 + r̄ 1 + r̄
and by inter-temporal budget constraint c̃tt+1 = 1 − α + θ. Therefore, s̃t solves the
agent’s problem.
(f) The asset market clearing condition dictates Bt + st = 0. Then, it is trivial to
show that:
θ θ
B̃t + s̃t = − + =0
1 + r̄ 1 + r̄
(g) In period 1 we have young people born in period 1 and old people born in period
0. People born in period 0 will not save, as they will die and do not value afterlife,
thus they will consume everything they have. Young people, on the other hand,
will save an amount θ/(1 + r̄), and the government will be the recipient of those
resources by getting indebted.
In periods t ≥ 2, young people will also save an amount θ/(1 + r̄), old people will
dissave by consuming the return on their savings plus the principal, i.e. θ. The
government will get indebted in the same amount of period 1.