Retirement Savings Accounts and Human Capital Investment ∗ Tetyana Dubovyk †

This paper studies the role of endogenous human capital accumulation in evaluating tax and Social Security policies. It considers two overlapping generations environments with borrowing constraints: one with exogenous human capital and a second with human capital accumulation through time investment. Baseline environments are calibrated to the U.S. tax and Social Security system. This paper analyzes two alternative Social Security systems: (a) voluntary and (b) mandatory retirement savings accounts. The paper finds that the welfare ranking of these alternatives depends on the endogeneity of human capital investment. Both systems are welfare improving when compared to the baseline. However, the system with mandatory (voluntary) accounts leads to lower welfare gains in the endogenous (exogenous) human capital environment. This difference is due to young individuals (i) switching time allocation towards human capital accumulation and (ii) being borrowing constrained under mandatory savings in the endogenous environment. ∗I am grateful for insightful comments and suggestions by Ellen R. McGrattan, Timothy J. Kehoe, Edward C. Prescott, Zvi Eckstein, and seminar participants at the University of Minnesota, Federal Reserve Bank of Minneapolis, Kyiv School of Economics, SITE Stockholm School of Economics, Collegio Carlo Alberto, CERGE-EI, Cardiff Business School. All errors are mine. †Tetyana Dubovyk, CeRP Collegio Carlo Alberto, Via Real Collegio 30, Moncalieri (Torino), 10024, Italy. E-mail: tetyana.dubovyk@carloalberto.org. 1. Introduction Labor productivity over an individuals life-cycle is modelled in a number of ways. One strand of literature calibrates the life-cycle pro le to match the observed earnings pro le. This approach is widely used in empirical macroeconomics literature. Example of these papers are Auerbach and Kotliko¤ (1987), DeNardi et al. (1999), and Kotliko¤ et al. (1999). In the empirical public nance literature, an individuals schooling or labor force participation decisions determine the evolution of labor productivity over the life-cycle. For example, Imai and Keane (2004) show the importance of human capital accumulation in estimating the intertemporal elasticity of labor supply. This paper studies the importance of human capital accumulation decisions in evaluating tax and social security policies. I analyze two retirement systems alternative to the Pay-As-You-Go (PAYG) social security system. Welfare ranking of these alternatives depends on the endogeneity of human capital accumulation. To evaluate the role of human capital investment, I set up two baseline environments that di¤er by evolution of labor productivity over an agents life-cycle. In the environment with exogenous human capital, the labor productivity is exogenously given. In the environment with endogenous human capital, an agent chooses the amount of time allocated to human capital accumulation. In both environments, labor supply is elastic, the retirement decision is exogenous, and negative asset holdings are not permitted. These baseline environments incorporate the stylized version of the U.S. tax and social security system. There is concern over the nancial solvency of the current PAYG system due to demographic changes. A number of reforms have been proposed. These proposals stress the e¤ect of reforms on savings and output. I evaluate two alternative retirement arrangements and consider the welfare e¤ects as well. Under the rst alternative, the PAYG social security system is removed and the labor income tax is reduced for the portion used to nance social security bene ts. Within this alternative, agents nance their consumption during the retirement years through their own savings. These savings are accumulated on the Voluntary Retirement Savings Accounts (RSA). The second retirement system does not have the PAYG system, and agents are required to contribute a xed portion of their labor income toward tax-deferred retirement accounts. These accounts are called Mandatory Retirement Savings Accounts. Under both alternatives, output and savings are higher than in the baseline. However, there are di¤erent welfare implications. Both systems are welfare improving when compared to the baseline. However, the system with Voluntary RSA leads to higher welfare gains in the environment with endogenous human capital investment. These welfare gains are measured by life-time consumption equivalents in comparison to the baseline. On the contrary, the arrangements with Mandatory RSA are the preferred ones in the environment with exogenous human capital. This di¤erence is due to young individuals (i) switching time allocation towards human capital accumulation and (ii) being borrowing constrained under mandatory savings in the endogenous environment. This paper builds on the quantitative tradition of evaluating tax and social security policies in an overlapping generations (OG) framework started by Auerbach and Kotliko¤ (1987). I also incorporate the human capital investment technology proposed by Ben-Porath (1967). The papers closest to my work are Davies andWhalley (1991), Heckman et al. (1999), and Alvarez-Albelo (2004). This paper di¤ers from Davies and Whalley (1991) and Heckman et al. (1999) in two dimensions. First, I consider an elastic labor supply. As a result, time reallocation among di¤erent activities has important welfare implications. Second, I study di¤erent sets of tax and social security policies. In my models, time investment is an input into human capital accumulation while Alvarez-Albelo (2004) studies human capital enhancement through learning-by-doing, i.e., participation in the market production enhances the human capital from tomorrow on. One of the experiments in Alvarez-Albelo (2004) closely resembles the Voluntary RSA studied in this paper. However, Alvarez-Albelo (2004) does not perform welfare analysis. The environment with exogenous human capital is motivated by and is comparable to DeNardi et al. (1999) and Kotliko¤ et al. (1999). The paper is organized as follows. In section 2, I construct two baseline OG models with exogenous and endogenous human capital decisions. These models incorporate the stylized version of the U.S. tax and social security system. Section 3 discusses the alternative retirement arrangements and welfare implications of each. Section 4 discusses conclusions and extensions for the future research.