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Research Details

UM04-02 - Pareto Improving Personal Accounts

Kent Smetters

It is widely believed that creating personal accounts as a partial replacement to Social Security benefits will simply involve a reallocation of resources between generations with no gains in economic efficiency. This paper demonstrates that this traditional wisdom only holds within the standard two-period modeling framework in which agents work the first period and retire the second period. But the two-period model rules out an important source of potential efficiency gains: tax distortions over the life cycle. Once a more realistic setting containing three or more periods is considered, pure (Pareto) efficiency gains are possible even if the government’s only tax instrument is a “second-best” distorting labor tax, i.e., the results do not rely on unrealistic “first best” taxes. The type of reform shown to increase efficiency is a modified version of Model 1 of the recent President’s Social Security Commission. The results suggest that a move to personal accounts could produce sizeable efficiency gains.

Working Paper:
On the Potential for Pareto Improving Social Security Reform with Second-Best Taxes