The Welfare Effects of Social Security in a Model with Aggregate and Idiosyncratic Risk

Abstract

We analytically characterize and quantitatively evaluate the welfare effects of expanding the US PAYG financed social security system in an overlapping generations model with idiosyncratic and aggregate risk. We contrast gains from improved inter-generational risk sharing and insurance with losses from crowding out taking into account the transitional dynamics. Our framework features various interactions between the two components of risk affecting both the benefits and costs of introducing the system. One of these interactions is a counter-cyclical conditional variance of idiosyncratic wage income risk. We find that increasing the contribution rate of the current US social security system from 0.12 percent to 0.14 percent -and correspondingly adjusting the benefits- leads to long-run welfare gains of 0.5 percent of life time consumption on average. This number is downward biased because the current version of our paper ignores the welfare benefits along the transition. Co-authors and affiliation: Alex Ludwig, University of Cologne