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We study the optimal provision of social security in a dynamically efficient economy using a continuous-time overlapping-generations model in which consumers have short planning horizons. The short-horizon mechanism leads to dynamic optimization that is time-inconsistent over the life cycle. Our calibrated general-equilibrium results are generally supportive of social security for a wide array of social welfare functions. Thus, the basic life-cycle model can be augmented with only this slight twist in order to rationalize a social security program with the current U.S. tax rate. [ABSTRACT FROM AUTHOR]

We study the optimal size of a pay-as-you-go social security program for an economy composed of both permanent-income and hand-to-mouth consumers. While previous work on this topic is framed within a two-period partial equilibrium setup, we study this issue in a life-cycle general equilibrium model. Because this type of welfare analysis depends critically on unobservable preference parameters, we methodically consider all parameterizations of the unobservables that are both feasible and reasonable-all parameterizations that can mimic key features of macro data (feasible) while still being consistent with micro evidence and convention (reasonable). The baseline model predicts that the optimal tax rate is between 6 percent and 15 percent of wage income. [ABSTRACT FROM AUTHOR]

Unfunded public pension systems are primarily justified on grounds that many individuals lack sufficient capacity to appropriately save for retirement. We begin with a review of the known principle that a standard life-cycle/permanent-income consumer who discounts the future at an exponential rate can benefit from an unfunded public pension system only if the internal rate of return exceeds the private rate of return. However, a pay-as-you-go program with a below market internal rate can in fact improve lifetime utility if the consumer misestimates social security benefits, uses a hyperbolic discount function rather than the exponential function, uses a short planning horizon, behaves impulsively, or if a fraction of the population do no saving at all. A literature has consequently arisen to study how severe these behavioral defects need to be in order to justify a pay-as-you-go program. We survey this literature, and we conclude that the results are highly mixed as to whether an unfunded public pension that earns a below-market internal rate of return can be justified on grounds of shortsightedness in model economies. The challenge for this literature is that the conclusions crucially depend on the particular values of the preference parameters that are used in the simulation experiments, and these preference parameters are not observable, nor is there much consensus concerning the values that should be used in simulations. In fact, even when the analysis is confined to a small and reasonable space of the unobservable preference parameters, it is possible to reach nearly any policy conclusion. We offer some guidance for future work in this area. [ABSTRACT FROM AUTHOR]