DP6972 Political Intergenerational Risk Sharing

Author(s): Marcello D'Amato , Vincenzo Galasso

Publication Date: September 2008

Keyword(s): Markov equilibria , Pension Systems , social optimum

JEL(s): D72 , H55

Programme Areas: Public Policy

Link to this Page: www.cepr.org/pubs/dps/DP6972.asp.asp

In a stochastic two-period OLG model, featuring an aggregate shock to the economy, ex-ante optimality requires intergenerational risk sharing. We compare the level of time-consistent intergenerational risk sharing chosen by a social planner and by office seeking politicians. In the political setting, the transfer of resources across generations — a PAYG pension system — is determined as a Markov equilibrium of a probabilistic voting game. Negative shocks represented by low realized returns on the risky asset induce politicians to compensate the old through a PAYG system. Unless the young are crucial to win the election, this political system generates more intergenerational risk sharing than the (time consistent) social optimum. In particular, these transfers are more persistent and less responsive to the realization of the shock than optimal. This is because politicians anticipate their current transfers to the elderly to be compensated through offsetting transfers by future politicians, and thus have an incentive to overspend. Perhaps surprisingly, aging increases the socially optimal transfer but makes politicians less likely to overspend, by making it more costly for future politicians to compensate the current young.