Uldis Osis, Pensions, and Capital

14. marts, 2011


Vjačeslavs Dombrovskis

Uldis Osis, “doctor of economics, professor, member-correspondent of Latvian Academy of Sciences”, joined the discussion on pensions with an article on Delfi.

What does he have to say? He argues that proponents of reduced pensions “confuse two principally different things, cash flow and cash savings”. “In truth pensions are savings”, says Mr. Osis. “[Pensions] have no connection to the state [social] budget. These are payments from a pensioner’s individual account, which content is … capital”. Thus, Mr. Osis argues that attempts to reduce pensions amount to taking what rightfully belongs to the pensioners, their “accumulated capital”. According to Mr. Osis, this makes those who argue for some accommodation in the social budget “bolsheviks”. Mr. Osis also argues that “the personal income tax, that pensioners pay on their accrued pensions, is also requisition of savings, because earlier incomes, from which social tax was paid, were also subject to the personal income tax”.

“Sounds absurd?” – asks Mr. Osis at one point in his article.
Well, yes.

Lets start with a relatively minor thing. There is no double taxation of pensions with a personal income tax (PIT). A tax base for the PIT does NOT include the social security contributions. In this country there is a concept of “gross wage”, which (at least before recent changes) is subject both to employer’s social tax contribution (about 24%),and also employee’s social tax (9%). PIT is levied on gross salary less employee’s social security contribution. Every accountant knows this.

Next, savings. In economics as I know it, savings is defined as “income not spent, a deferred consumption”. Usually, but not always, savings are accompanied by investment, the result of which is an increase in capital, which is used to produce goods and services. Is social tax a saving, which is then invested into capital, so that a pension is some return on this accumulated capital? As far as today’s pensioners are concerned, the answer is no, no, and no.

Today’s pensioners get their pensions from the social security contributions of today’s workers. When they were workers themselves, their social security contributions (if they made any) were transferred to those who were pensioners back then. Pensioners then largely spend this income. This is known as an unfunded, or a “pay-as-you-go” pension system. Perhaps, the source of Mr. Osis’ confusion is that a 2nd pillar of the Latvian pension system is a funded one, in which a certain share of a worker’s social security contributions is accumulated in his individual account and invested. But this does not apply to pensions of most of the existing pensioners. Once more, what today’s pensioners paid in taxes when they were younger was not saved but spent by people who are long gone.

Moreover, I think Mr Osis is not just wrong but also hypocritical. Here is a question. If Mr Osis really does believe in what he is saying, where was he when the Kalvitis government pumped the funds out of the social budget in 2007 to cover the deficit in the state budget? Did he write an article calling Mr. Kalvitis a Bolshevik and a thief? Did he rise up in protest? If I somehow missed it, please let me know.

But since we started talking about pensions, lets think about their nature some more. As I understand them, participation in a pay-as-you-go (PAYG) pension system amounts to an intergenerational contract, the value of which depends on certain demographic and economic outcomes. What a pensioner has is a claim on a share of income from today’s workers. Naturally, the value of each individual claim depends on (i) the number of other claimants (pensioners) and their expected life span; (ii) number of contributing workers; and (iii) the workers’ incomes. Note that PAYG pension system has all the features of a financial pyramid. All the participants are doing great as long as new participants join (i.e. population grows) and there is a reasonable economic growth. The biggest problem with that contract is that it is not fully spelled out to its participants, i.e. the letters in fine print are not even there. In a world of growing population this does not present a big problem. Unfortunately, we live on a different planet.

If demographics works against you, you’re in trouble, as the base of a pyramid start shrinking and you’re on your way to end up with the pyramid that’s turned upside down. Clearly, such a pyramid will collapse. So your pension ‘claim’ is clearly worth less if this happens. If, on top of this, the economy dips nearly 25 percent, with the accompanying unemployment and emigration? I think any sensible person would agree that this implies lower pensions, one way or the other.

The worst is that the pensioners have different expectations about what they’ve got. This is because no-one ever bothered to fully spell out the (implicit) nature of this intergenerational contract. There was no need when the pyramid was doing well. But now many pensioners seem to think they’ve “earned” some “capital”, or that they have a “right” to a pension of the size they’re comfortable with. With expectations like this, we’re heading for a disaster. What is happening with the budget consolidation now, and all these red lines, is peanuts compared to what will happen in the not too distant future, when a demographic tsunami will properly hit us.

What we need is to do a lot of explaining to people on the street, to the pensioners. We need to explain them where their pensions really come from, and that it is in their best interests not to squeeze the working with higher taxes and encouraging them to leave. Mr. Osis is really not helping.

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