Pension reform in China: a question of property rights.

• Author: Dorn, James A.

China's aging population will sharply increase the number of retirees who have to be supported by each worker in the next several decades. That demographic problem combined with the inability of state-owned enterprises (SOEs) to cover even the pensions of current retirees makes reform of the pay-as-you-go (PAYG) system a top priority. The State Council has issued a number of decrees calling for moving to a multi-pillar system, incorporating both a defined benefit PAYG plan and a defined contribution plan with fully funded individual accounts, but little progress has been made (Wang et al. 2004).

Today China has a highly fragmented social security "system" confined primarily to workers in urban SOEs and some collectives. The high payroll tax rates and precarious nature of the system have led to noncompliance and evasion, and workers in the nonstate sector have little incentive to join (Zhao and Xu 2002).

To solve China's pension crisis, one must also address the loss-ridden SOEs and the weak condition of the four large state-owned banks. Pension reform cannot be successful without a broad-based change in China's ownership structure. The lack of well-defined property rights to pensions, enterprise assets, and bank capital means that China's financial sector needs radical reform.

This article focuses on China's pension crisis from the perspective of property rights theory. The issue of pension reform is essentially a question of property rights: Should pension funds be fully funded and individually owned or should the state socialize assets by taking wealth from the younger working generation and redistributing it to the older retired generation? In the privatized system, individuals will have an incentive to act responsibly and to save and invest for the future. In the PAYG system, there is no saving and investment. Individuals look to the state for their future welfare, retirement becomes politicized, and property plundered.

I shall argue that the best way for China to put its pension system on a sound footing is by large-scale privatization. Implicit pension debt must be made explicit and the current hybrid system must be fully privatized along with SOEs and state-owned banks. Trying to "revitalize" SOEs and "recapitalize" state banks will not do the job as long as majority ownership remains in the hands of government officials. Investment decisions will be politicized and capital will not go to its highest valued uses. Corruption will continue and wealth will be squandered as special interests vie for political favors.

Although the pace of economic reform will depend to a large extent on political reform, a sound understanding of the importance of private property rights for the future of capital markets in China is an essential first step toward reform.

China's Pension Crisis

Table 1 summarizes the key data illustrating the problems confronting China's PAYG pension system. The old-age dependency ratio (i.e., the number of people who are age 65 or older relative to those age 15 to 64) will increase from 11 percent in 2005 to 25 percent in 2030 and 39 percent by midcentury. Meanwhile, the system dependency ratio (that is, the number of pensioners supported by each worker paying into the system) will increase from 35 percent in 2005 to 53 percent in 2030 and 69 percent by 2050 (Figure 1). In other words, less than 3 workers will be supporting each retiree in 2005, less than 2 by 2030, and less than 1.5 by midcentury.

[FIGURE 1 OMITTED]

The more immediate problem is that there is a negative cash flow in the pension system that will increase significantly over the next several decades (Figure 2). In 2005 the deficit is expected to be nearly RMB 50 billion (in constant 2000 yuan) or nearly $6 billion ($1 = RMB 8.28). By 2030 the deficit will reach RMB 630 billion ($76 billion), and by 2050 nearly RMB 1.5 trillion ($181 billion). Without reform the accumulated reserves in the current pension system will be--RMB 123 billion in 2005 (in constant 2000 yuan), increasing to --RMB 8.6 trillion in 2030 and--RMB 41 trillion in 2050. To balance the system, payroll tax rates would have to rise dramatically from 27 percent in 2005 to 45 percent in 2030 and nearly 60 percent in 2050 (Wang et al. 2004: Table 5). Such increases would cripple economic growth.

[FIGURE 2 OMITTED]

Another useful measure of the system's financial condition is the implicit pension debt (IPD)--that is, the present value of all future benefits promised to current retirees and to those still in the work force who have paid into the system, assuming the PAYG system is immediately terminated (World Bank 1997: 33). (1) Wang et al. (2004: Table 6) estimate that China's IPD is about RMB 4.4 trillion (in constant 2000 yuan) or 48 percent of gross domestic product (GDP). They assume that the old system ended in 2000, public institutions and government workers are excluded, and the discount rate is 4.5 percent. They also assume that the old pension regime was a pure PAYG system because most of the individual accounts set up as part of the multi-pillar system announced in 1997 were not funded. Indeed, they are notional and contain no real assets. Finally, the authors assume that the payroll tax rate is 24 percent and that the replacement rate is 60 percent. When public institutions and government workers are included, the IPD increases to nearly 64 percent of GDP.

The above data paint a very bleak picture of the present system. As Wang et al. (2004: 120) conclude, "Our baseline calibration confirms that the current PAYG system is not financially sustainable and that its high annual deficit threatens China's fiscal stability." Even if benefits were reduced and the retirement age increased, the system would still not be viable because payroll taxes would have to be increased dramatically. Fundamental, not piecemeal, reform is necessary.

Empowering Workers

Before leaving office, Premier Zhu Rongji argued that pension reform is "the lifeline of our workers ... and we absolutely can't allow any payment delays or embezzlement of the funds" (Hutzler and Leggett 2001: A10). For that reason he recommended that retirement funds be professionally managed and workers be given a wider range of investment options. Moving from a PAYG system to a fully funded system in which workers have property...