Pareto Improving Personal Accounts

Published: 2004
Project ID: UM04-02


It is widely believed that creating personal accounts as a partial replacement to Social Security benefits will simply involve a reallocation of resources between generations with no gains in economic efficiency. This paper demonstrates that this traditional wisdom only holds within the standard two-period modeling framework in which agents work the first period and retire the second period. But the two-period model rules out an important source of potential efficiency gains: tax distortions over the life cycle. Once a more realistic setting containing three or more periods is considered, pure (Pareto) efficiency gains are possible even if the government’s only tax instrument is a “second-best” distorting labor tax, i.e., the results do not rely on unrealistic “first best” taxes. The type of reform shown to increase efficiency is a modified version of Model 1 of the recent President’s Social Security Commission. The results suggest that a move to personal accounts could produce sizeable efficiency gains.


Kent Smetters