IREF - Institute for Research in Economic and Fiscal issues
Fiscal competition and economic freedom
In 2010 the public deficit in Poland reached at least 7.9% of GDP. The public debt, in turn, balanced around 55% of GDP. In order to rescue public finance, the Polish government announced end of 2010 the dismantling of the reform of pension system. In the opinion of Polish authorities, this system (and especially its obligatory private component) is one of the major causes of the budget gap. This interpretation and the reform proposal, shifting majority of contributions currently allocated to fully funded private pension scheme (the second pillar to public pay-as-you-go long run, divide the Polish society and especially economists. The strongest and the most constructive opposition is led by prof. Leszek Balcerowicz – father of market economy in Poland.
Why is the funded pension scheme beneficial?
In 1999 Poland started to build fully funded (FF) pension system, so called second pillar, which was supposed to operate alongside deeply reformed pay-as-you-go (PAYG) system (the first pillar). After the reform the total contributions of 19.52% of salaries have been divided between first pillar (12.22%) and second pillar (7.3%). Currently government aims to change this proportion for 17.2% in first pillar and 2.3% in second pillar. Over time the contribution to second pillar will increase a little and by 2017 it will reach 3.5%, leaving 16.22% in the first pillar. In our opinion such change is unwelcome. There are three main reasons why the funded pension system is better than sole PAYG.
First, the funded pension system gives a chance for faster economic growth. It increases domestic savings and therefore investments. Furthermore, it contributes to development of capital market and facilitates privatization. The only case when shifting resources from FF to PAYG would not decrease national savings rate is when all these resources would be used to decrease public finance deficit. This might be the case in the short run, but without serious reforms deficits most probably will start to raise again (notice that government presents changes in pension system as less painful alternative to cuts in public spending).
Secondly, the pension based on different sources (public and private) is less risky than the pension funded from a unique source.
Thirdly, the contributions to the private system should (with high probability) result in higher future income comparing to the realistic variant of indexation.
Simple calculations made by National Bank of Poland (NBP 2011) can illustrate second and third point. In its opinion to the governmental proposals NBP points that during the period 2000-2009 combined rate of return from the first (contribution: 12.22%) and the second pillar (7.3%) was 8.3% with standard variation of 2.6%. Assuming that during the same period the split of contribution had been 16.22% and 3.5% as proposed by the government, the rate of return would have fallen to 7.9% while the standard variation would have grown to 3.1%. Time series for rates of return in second pillar and indexation in the first pillar are very short, but the result are consistent with the common sense and literature – funded pillar gives higher rates of return and more diversified pension system reduces variation in overall rates of return.
Therefore, the funded pension system increases the security of future pensions compared to the situation with the sole PAYG system and it even gives the opportunity for higher pension for people currently in the working age, especially for the young persons. The severe reduction of contribution to the private pension system can be harmful for these people and the whole economy (Balcerowicz 2011).
It is worth to notice that governmental officials have been presenting simulation showing that after proposed changes future pensions will be higher. However to achieve such results very optimistic (unrealistic) assumptions about labour productivity growth, employment and salaries have been used. Substituting them with the figures given by Ageing Work Group (figures officially recognized and used by European Commission, Ministry of Labour and Social Policy and Ministry of Finance) changes the outcomes significantly – after the changes future pensions will be lower.
Is it really the pension scheme that caused immense public deficit?
The government claims that governmental transfers to the first pillar, which are needed to make up for the part of contributions going to the second pillar and fund current pensions are one of the major factors of growing budget deficit. However, according to FOR estimation these transfers were of minor importance in period of the biggest fiscal distress, i.e. 2007-2010. In this time, the public deficit increased from 1.9% to 7.9% of GDP. During that period, transfers to the second pillar rose from 1.4% to 1.6% of GDP. In other words, the payments from budget to the private pension system are responsible for only 1/30 of total growth of deficit of public finance in 2007-2010.
The main reason for the high budget deficit in Poland is excessive public expenditure. Large public spending inhibits economic growth and at the same time discourages productive activities, such as work and saving. In 2010, public expenditure in Poland constitutes 45.6% of GDP. This is about 10 percentage points higher than the rate observed in the countries of Western Europe when, in the 1960s, they were at the same level of development as Poland is today. Out of those 45.6% of GDP, transfers to the second pillar accounted for just 1.6% of GDP (Wojciechowski 2011). A large portion of the remaining 44% of GDP is spent on social protection. As it turns out some of these expenditures are poorly addressed, weaken the incentive to work and save or are simply unjustified, e.g. double baby allowance and death grant.
Some lessons from the past... and present
The cut in contributions to the private pension scheme will help reach the short run target, namely, reduction of public deficit. However, the same result can be achieved by at least a dozen of other steps, like reduction of counterproductive social expenditure or simplification of tax. The government should consider also gradual increase of the mandatory retirement age and further privatization.
One of the reasons why the Polish government made the scapegoat of the private pension scheme is opportunism induced by the political cycle (next parliamentary elections will be held in November 2011). The government is reluctant to carry out bold reforms for fear of losing votes. As empirical studies demonstrate, however, the conventional wisdom regarding the political consequences of large reductions of budget deficits is unjustified. The governments which implement the harsh reform aiming on reducing public deficit are not systematically more punished by electorate and voted out than the governments engaged in a lax fiscal policy. Alesina et al. (2010) looking at 19 OECD countries within time framework 1975-2008 found no dependence between reforms and elections’ result.
If the Polish government is unwilling to believe this study, it should be able at least to draw conclusions from the last events in Latvia. Despite a huge fiscal adjustment of 14% of GDP, the Unity party government headed by Valdis Dombrovskis won the parliamentary election with almost 60% of votes in 2010 (Economist 2010).
The scenario of re-election, even when carrying out bold and pro-development reforms, could occur even more likely in Poland than in Latvia. This follows from the fact that the major political opponents are weak. Law and Justice Party is more focused on Smole?sk tragedy than on substantive debate, and the left-wing party lacks a charismatic leader. Paradoxically, the proposal of reform diminishing the importance of the private pension scheme, unexpectedly for the government, met with great criticism and emergence of strong and constructive opposition. It seems that ruling party is already paying the bills of this anti-development proposal. From January to mid-February the support for Civil Platform dropped by 2 percentage points.
Alesina A., Carloni D., Lecce G. (2010), The Electoral Consequences of Large Fiscal Adjustments, unpublished academic paper available on Alberto Alesina’s webpage, 18.02.2011.
Balcerowicz L. (2011), Uwa?ajcie na obietnice, (nie)?wi?ci Miko?ajowie, Gazeta Wyborcza, 28.01.2011.
Economist (2011), Guts and glory, 7.10.2010.
European Commision (2007), European Economy, 3/2007, Public finances in EMU 2007.
Najnowszy sonda?: PO spada, PiS stoi, SLD dosta?o skrzyde?, wp.pl, 02.02.2011.
National Bank of Poland (2011), Evaluation of the governmental proposal.
Wojciechowski W. (2011), Opinia Fundacji FOR do projektu ustawy o zmianie ustaw zwi?zanych z funkcjonowaniem systemu ubezpiecze? spo?ecznych z dnia 23 stycznia 2011 r., Fundacja FOR, Warszawa.