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Social Security Systems, Human Capital, and Growth in a Small Open Economy


  • Michael Kaganovich, Department of Economics, Indiana University, Wylie Hall, Bloomington, IN 47405, United States ( Volker Meier, Department of Economics, University of Munich, Schackstr. 4, 80539 Munich, Germany (

  •  We gratefully acknowledge financial support by CAEPR at Indiana University, CESifo, and the Stifterverband fuer die Deutsche Wissenschaft. We are grateful to the audiences at CESifo 2008 Public Economics Conference, IIPF Congress 2008, NETSPAR 2009 Pension Workshop, PET’09, and the EEA Congress 2010 for helpful discussions. We also wish to thank Matthias Wrede, two anonymous referees, and an associate editor of the journal whose detailed comments have helped us improve the paper.


We consider a small open economy in which the level of public education funding is determined by popular vote. We show that growth can be enhanced by the introduction of pay-as-you-go pensions even if the growth rate of aggregate wages falls short of the interest rate. The reason is that the pay-as-you-go (PAYG) system allows future retirees to partially internalize positive externalities of public education due to the positive effect of higher future labor productivity on their pension benefits. The majority support for education funding will be especially strong when the PAYG benefit formula is flat, i.e., progressively redistributive. If a flat benefit PAYG pension system is in place then the economy will achieve the highest growth rate relative to the alternative pension system designs. While such PAYG pension system may be opposed by the majority of working individuals due to inferior returns to their pension contributions relative to a funded scheme, it is likely to be politically sustained by a coalition of older individuals and lower income workers.