Pareto Improving Social Security Reform when Financial Markets are Incomplete?

This paper studies an Overlapping Generations model with stochastic production and incomplete markets to assess whether the introduction of an unfunded social security system can lead to a Pareto improvement. When returns to capital and wages are imperfectly correlated, the consumption variance of all generations can be reduced if government policies enable them to pool labor and capital incomes. A social security system that endows retired households with a claim to labor income may serve as an effective tool to share aggregate risk between generations. Our quantitative analysis shows that, first, abstracting from the crowding-out effect of social security on the aggregate stock in general equilibrium, the introduction of social security does indeed represent a Pareto improving reform, if households are both fairly risk-averse and fairly willing to intertemporally substitute consumption. Second, the severity of the capital crowding-out effect in general equilibrium overturns these gains for degrees of risk aversion and intertemporal elasticity of substitution commonly used in the literature.