The Effect of an Expansion of the Pay-as-You-Go Social Security System in China

Abstract China is in the process of industrialization with a large amount of the labor force moving from the agricultural sector to industrial sectors. An expansion of the pay-as-you-go social security system benefits current urban retirees, and may solve the social security payment problem faced by many state enterprises. Also, although facing a declining population growth rate, China may not have a social security crisis under a pay-as-you-go social security system just covering the wage earners, as many industrialized countries face. However, the expansion of the pay-as-you-go social security system may have an adverse effect on capital accumulation in the long run, hurting the rural old, and either benefiting or hurting the wage earners in urban areas before the completion of industrialization, and is likely to reduce wage earners' welfare after industrialization. Introduction As economic reforms in other areas proceed in China, social security reform has become urgent. China has a pay-as-you-go social security system which covers only a small portion of the population. The social security reform can go different directions: expanding the existing system to cover more people, or privatizing the present system by establishing individual accounts, or a combination of the two. This paper analyzes the effect of an expansion of the current pay-as-you-go system on the Chinese economy. Many countries in the world provide social security to their residents. Most social security systems are pay-as-you-go in nature, i.e., government collects taxes from the working generation to finance the benefits to the retired generation. This system is also called an "unfunded system" because the benefit received and the taxes paid by an individual may not be the same. Under this system population growth will benefit each generation since there will be more young people supporting the retirees. Problems arise when the population growth rate begins to decline, i.e., each generation has to pay more and more to keep the parent generation as happy as their grandparent generation. As capital markets become well-developed, it is also possible for a person to provide old-age security for him- or herself. When working, each individual deposits a portion of his or her salaries into a fund. Over time the fund would accumulate interest, and on retirement, each individual receives the principal and accrued interest as old-age security benefits. This form of old-age security can be called "individual security," and it is a fully-funded system because individuals receive exactly what they paid in terms of the present value. Recent research on Chinese social security reforms have identified two major problems China's new social security system must solve. One is to reduce the social security burden of the state enterprises, and the second is to avoid a social security crisis due to the decrease in the population growth rate (Zhou and Wang, 1994; and the World Bank, 1997). To solve these problems, a mixed social security system which combines a social account (an account through which the government collects social security contributions from the young and pays social security benefits to the old) and an individual account (a mandatory savings account through which an individual saves when young and withdraw savings and interest when old) has been recommended. On one hand, this proposed system is an expansion of the current pay-as-you-go social security system since more workers are covered; on the other hand, the system is a partial privatization of the existing system since each worker has his or her own mandatory saving account. The size of the social account and the individual account is essential to determine the nature of the social security system. At present, the social account is the major part. Thus, the social security system is largely pay-as-you-go in nature. This paper argues that a pay-as-you-go social security system can easily solve the social security payment problem in the state enterprises. …