Pension Funding and Human Capital

In this paper we analyze the consequences of pension funding in a general equilibrium model of both formal schooling decisions and on-the-job human capital formation à la Heckman, Lochner and Taber (1998). Our focus lies on the distortive and redistributive effects of a Bismarckian pension system as well as the macroeconomic and welfare consequences of its abolition. We find that a Bismackian PAYG style pension system like the German one strongly enhances on-the-job human capital formation and redistributes from the lower to the higher skilled, a result that, to the best of our knowledge, is new to the literature. Our reform simulations indicate that in a small open economy setting pension funding reduces the amount of human capital formed via on-the-job training by about 50 percent on average. In a closed economy setup however, the annual interest rate decreases by 2.6 percentage points which in turn boosts human capital accumulation. In the long run, we report a strong welfare gain of about 6.5 percent of initial resources. However, this gain comes along with short run losses up to nearly 5 percent for the middle aged generations, who still have to pay contributions in order to finance existing pension claims. Overall, pension funding comes at efficiency costs of about 2.2 percent in a closed economy setting