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The current Social Security system in Chile replaced the old one which was a state-run bankrupt system. This happened under the watch of General Pinochet in 1981. The new system encompassed a variety of features that still prompt debate over its efficiency. The novel structure required that workers should contribute ten percent of their monthly remuneration towards a private pension account. A further three percentage catered for the pension managers’ commission fees as well as survivors and disability insurances. The amount contributed by a person and the return rate of the pension firm were the fundamental determinants of retirement benefits. In addition, the government ensured that the discrepancy existing between lowest pension amounts were catered for by it (Ensalaco 67).
Principally, the new-fangled system entailed three aspects: the responsibility of private pension managers, the government’s duty, and the investments of individual workers. This three-tiered organization allowed for a variety of factions to share in the accountability of Social Security, lifting the trouble from the government. The responsibility of the government included funding part of the minimum pensions as well as all the pensions for the elderly who were poor. On the other hand, the private sector handles the obligatory Social Security investments of employees (Hudson 56). The accounts created resulted to savings being incentivized.
The Old Pay-as-You-Go System, normally abbreviated as PAYGO, is a system employed by businesses and individuals to pay proportions or installments of their expected tax liability on their income from businesses, investments or employment for the current income year. Current contribution revenues are directly used to finance current pension endowments. In this system, no pension assets are built. The system is very sensitive to demographic fluctuations and is further based on the principle of solidarity.
It is proposed that PAYGO may have useful functions in that it served as an insurance against not having children and as an enforcement device for ungrateful children who were unwilling to pay for their parents’ pension. Essentially, the system is characterized by hazardous effects in terms of reducing the investment in human capital. Nonetheless, when run on a sufficiently small scale, the impact will not be strong enough to prevent a welfare improvement. In addition, if the system scale is too large that parents can bequeath some of their pensions to their children, it is overdrawn and creates unnecessarily strong disincentives for human capital investments (Faundez 82).
The system has faced too much criticism. For instance, Jose Pinera in "The Success of Chile’s Privatized Social Security” states, “Pay-as-you-go social security systems destroy the link between the contribution and benefits as well as the effort and reward. Everyone tries to minimize what he puts into the system while trying to maximize, through political pressure, what they get from it”. This tends to explain why; ‘pay-as-you-go’ plans are becoming bankrupt all over the planet.
One of the major challenges of the system is that the ratio between pensioners and the working population changes whenever the population ages. Fewer working age people will have to pay for an increasing group of pensioners therefore, contributions will go much higher. The system has recently come under heavy attack since it has proved unable to provide satisfactory pension in time of major decline in population growth. It has been faced by labor-leisure distortion resulting from the social security tax. This has resulted to a never-ending situation on whether this distortion can be avoided by a transition to a funded system.
However, it is still too early to make a conclusion on the PAYGO system as it may bring about favorable allocative effects as well as negative ones. Among the effects are; the elimination of adverse selection that occurs with private annuity markets, the avoidance of free-riding by parents planning to exploit the altruism of their children, or intergenerational risk sharing. This would then pose a great economical threat to the whole nation hence, having a huge impact on the country’s development (Sinn 35).
PAYGO system as a mode of insurance against not having any children plays a crucial role. If all households were able to bear children, then they would get pension from their own children. However, with the risk of being unfertile, failure to get an appropriate partner for procreation and pooling system, which makes it possible to receive pension from other people’s children when necessary, could be welcomed as an insurance device. Obviously, this type of insurance may be useful when a well functioning capital market is not available and infertility choices are exogenous. The possibility of retaining its useful role when both of these assumptions are relaxed remains to be experienced and its final outcome may not be predicted as it is dependent on the implementation strategy.
Moreover, PAYGO system as an enforcement device for ungrateful children acts to enhance responsibility among these children. If inter-generational status is one-sided- from parents to children and not vice versa- parents may under-invest in human capital as they are afraid of not being able to get back sufficient amounts of their investment fruits. A system that imposes obligation on children to make pension payments to their own parents may help restore back the proper incentives of human capital investment. However, the currently existing pension systems do not impose such an obligation. As an alternative, they only pool the children’s contribution and distribute them to their own parents and other people’s parents regardless of the individual amount of human capital investment. To others, this may seem unfair since the number of children per household is not and will never be a constant factor. It is not clear whether such an enforcement system can generate welfare improvements.
None of these requires absence of a capital market as may be suspected. In fact, the parent household always makes use of this market, optimizing the time path of its own consumption by an appropriate financial investment strategy. The reason why a household would prefer a substantial amount of human capital investment is the high intra-marginal returns to such investment, which exceeds the constant returns the capital market can offer. The results should be a warning to those who find the theoretical case for the abolition of the PAYGO system clear enough to make corresponding policy recommendation. There are more effects brought about by this system than the labor-leisure distortions that are worth to be put in mind by the policy makers (Sinn 67). Although this distortion may not provide strong arguments in favor of a transition to a funded system, it is impossible to disregard the existing pension claims. Despite all the arguments supporting the system, the Chilean government still pushed through to change its taxation system. This was principally due to the opinions of the majority and as a result the rule of majority was applied.
As time progressed, the essence to employ the Transition of Pay-As-You-Go to Privatization was imminent. The privatization system of taxation was finally adopted due to the much opposition and the set-back of the PAYGO system. Consequently, there arose a general public feeling in Chile that there was need to shift to a better system of taxation. Despite the change to the privatization system, the citizens were given an opportunity to remain in the older system though they strictly had to follow the policies of the latter.
Geoffrey Kollman in Social Security: The Chilean Example states, “In 1981, Chile began to phase out its ‘traditionally’ state-run pay-as-you-go Social Security system financed by the employees and their employers in favor of mandatory individual private accounts”. This reveals that the old system had several major problems. First, it was fragmented as it had more than three dozen plans covering white and blue collar workers with different benefit structures. The self-employed, wage earners, and salaried workers paid different payroll tax rates compared to their employers, which was usually at a higher rate than that applicable to employees. Secondly, it was widely seen to be inequitable as the plans covering workers at the low end of the economic spectrum tended to provide the least generous benefits. Thirdly, the multitude of systems and many methods of benefit computations led to high administrative inefficiencies and expenses. Another factor was that many of the plans were underfinanced, forcing the government to make up the difference with general funds. These factors led to noncompliance and widespread contempt of the system.
To take its place, the law provided that, beginning in 1983; wage-earners and salaried employees entering the work force were no longer covered by the old system. In its place, they were required to pay a proportion of their earnings to a private pension fund of their choice. Coverage for the self-employed was made voluntary. Workers under the old system were given the choice of joining the new system or remaining in the old one. However, if they stayed in the old system, they were made responsible for paying the full share of the payroll tax as there would be no employer contributions (Kollman 56).
To help in the proper implementation of the new system, the Government of the Republic of Chile further went into an agreement with the Government of the United States of America. This would also regulate the relationship between these two countries in the field of Social Security. According to this agreement, several agencies were designated for the application of the Agreement. For Chile, with regard to old-age, disability and survivors benefits: -The Pension Fund Administrators for Persons covered under the New Pension System as well as The Institute of Social Security Standardization for Contributors to the old Social Security systems were the responsible agencies (Feldstein 38). In Chile, the certificates were issued by the Superintendency of Pension Fund Administrators for persons covered under the New Pension System, and the Superintendency of Social Security for contributors to the old Social Security systems. On the other hand, the certificates in the United States of America were issued by the Social Security Administration.
The Privatization of Social Security in Chile, as a novel idea, brought to light some improvements. The new system has since been introduced and is gaining popularity all over as more people, even those who had chosen to remain in the old system, are shifting to adopt it. This improved the economy of the country and the financial standards of its citizens. The private pension system has had a positive impact, both culturally and politically. The majority of the Chilean population opted to shift to the new system due to its impact. This system has ensured a cultural change in that the workers have been given the power to own a portion of their country through possession of financial assets belonging to the country. They are much more involved in democracy, free society as well as free market (Diamond 56). Nonetheless, as the figures of beneficiaries enlarge, there may develop a shortage in revenues to cater for similar benefits. Putting this in mind, the Social Security program needs to be corrected in order to take care of individual s in the years to come.