The present paper constructs possible baseline economies with an aging population to analyze Social Security reform plans, using an overlapping generations (OLG) model with heterogeneous households. In this model, households receive idiosyncratic working ability shocks and mortality shocks. Then, the paper shows the effects of simple reform plans as policy experiments. In this process, the following two aspects are stressed: First, like most other developed countries, the population distribution of the United Sates is aging and, accordingly, the economy cannot be described as a stationary equilibrium. The present paper solves the model for equilibrium transition paths from 1961 through 2200, using the actual (and projected) age-population distribution and mortality rates in this period. Second, with a realistic population projection, the current-law Social Security system is not sustainable. To solve the model for an equilibrium transition path, the model needs to have an additional financing assumption to close the intertemporal budget constraint for the Social Security system. In Social Security Administration (2003), Trustees of Social Security have used three possible population projections---alternative II (intermediate), alternative I (low cost), and alternative III (high cost)---to evaluate the sustainability of the current Social Security system. The present paper uses the same three population projections by extrapolating those projections beyond 2080. Regarding the financing assumption, the present paper assumes that the payroll tax is increased and benefits are reduced when the trust funds are depleted, so that each of those policy changes covers half of the deficit and that the trust funds are kept at zero thereafter. Then, the paper shows the effect of alternative financing assumptions---the payroll tax is increased when the trust funds are depleted but benefits are kept at the current-law level; alternatively, benefits are reduced when the trust funds are depleted but the payroll tax rate is kept at the current-law level; and, finally, the payroll tax rate is increased immediately in 2004 by 10 percent. The rest of the government budget is made as simple as possible. Other spending is considered government consumption, which is not in the utility function of the model. In addition, the government budget is balanced by adjusting government consumption, so that the per-capita government net wealth grows at the same rate of the productivity growth. Compared to a balanced growth path, per-capita private wealth increases because of the improved longevity and larger life cycle savings in this model. Private saving and saving rates in the aging baseline are above the levels in the balanced growth path in 2004, but decline throughout the period from 2004 to 2200. Per-capita labor supply increases until 2013, then, decreases monotonically to a level below that in 2004. The capital-labor ratio rises in the aging baseline economy and, as a result, the interest rate falls and the wage rate rises significantly as the population ages. How much factor prices change depends on the population projection and the financing assumption. One of the interesting findings from the numerical experiments is that an immediate increase in the payroll tax rate might not improve the welfare of future generations as much as it deteriorated the welfare of current generations, although the trust funds would last much longer.
Social Security, Life Cycle, Overlapping Generations, Heterogeneous Agent, Aging Population
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