A simple solution to China's pension crisis.

• Author: Li, David D.

The reform of China's social security system is a critical component of China's overall economic reform. There are many problems and challenges in the current Chinese pension system. China is experiencing a rapidly aging population. The one-child policy and significant improvement in living standards make China's aging problem more serious than any other country. According to the World Bank (1994), China's aging population will reach a peak by 2030. There will be 0.3 billion people over 60, which will account for 22 percent of the population. China's old-age dependency ratio is expected to rise from today's 3.65 for every retired person to only g workers per retiree by 2030 (Li and Xu 1996). Consequently, China faces a monumental challenge to support its aging population, a challenge the old pay-as-you-go (PAYGO) system cannot meet.

Since 1995, China has restructured its pension system by combining the old PAYGO system with a funded system relying on individual savings accounts. That policy change is based on economic theories and other countries' experiences. In 1958, Paul Samuelson showed that an unfunded PAYGO system has a rate of return equal to the growth of aggregate red wages. However, he assumed there is no capital stock in the economy. Once we recognize that actual economies have capital stocks and that the marginal product of capital can exceed the growth of aggregate wages, we realize that a funded system can be more efficient than a PAYGO system. Consequently, for the same level of pension benefits, the required saving rate in a funded system is much less than the tax required in an unfunded system (Feldstein 2000).

Lessons from Western countries 'also show that a national social security program with a PAYGO system is unsustainable. Declining fertility rates, rapidly aging populations, and the incentive problems embodied in a PAYGO system have led to huge unfunded liabilities. As a result, many Western governments must either raise payroll tax rates or reduce promised benefits, or a combination of the two, to keep their PAYGO programs solvent. Rather than continue to increase taxes or reduce benefits, some countries are shifting from a PAYGO to a funded system.

China's rapidly aging population, strong economic growth, and high return on capital mean that a funded pension system would be more efficient than a PAYGO system (Li and XU 1996). Yet, there are many problems in implementing the new Chinese pension system. The root problem is the lack of a well-designed transition plan that bridges the old system and the new one. In this study, we analyze the transition problem and provide a simple solution. We argue that the combination of Chinese families' emphasis on education, strong economic growth into the foreseeable future, and the current lack of income smoothing at the individual level makes borrowing now and taxing future generations a fairer and more cost-effective way to finance the transition cost.

The Dismal State of China's Pension Reform

The long-standing debate on China's pension crisis eventually reached a consensus that China should establish a partially funded pension system. That consensus is embodied in the existing government reform program that aims to establish a three-pillar system. The first pillar is a PAYGO pension financed by pooling funds citywide. The second pillar is a system of individual savings accounts funded by both employees and employers. The third pillar is a supplementary pension funded by employers.

Although China's pension reform is reasonable, its implementation has been dismal. There are three major problems. First, there is widespread payroll tax evasion. According to China's Ministry of Social Security, the deficit of the social pooling funds has been deteriorating. In 1999, the deficit was RMB 18.7 billion, and in 2000 the deficit was nearly RMB 35.7 billion. If the current situation persists, the accumulated deficit will reach RMB 1,800 billion in 25 years. On average, the deficit will be RMB 71.7 billion each year.

Second. the social security agencies have been using workers' individual savings accounts to...