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IS
CHILE ON THE ITALIAN MENU? By Steve H. Hanke (The
International Economy July/August 1992) Italy has a history
of jumping from one political-economic crisis to another. Thanks to that nation’s sizeable underground economy and the
Italians’ ability to turn a blind eye towards political scandals, Italy
has been able to muddle trough. However, if Italy plans to stay on the
European Community’s monetary union train, it will have to put its
fiscal affairs in order. By the end of 1996, Italy will have to reduce its
budget deficit from 10.7 percent of gross domestic product (GDP) to 3
percent, and it will have to bring its overall debt as a percentage of GDP
down from a bit over 100 percent to 60 percent or less. If those Community requirements weren’t enough,
the financial markets have begun to put Italy to the test. Until the
markets detect signs that Italy is cleaning its fiscal house, the lira
will remain close to its floor in the ERM of 765 lira against the DM,
interest rates will remain at oppressively high levels, and debt rating
services will continue to downgrade Italian paper. Professor
Giuliano Amato, Italy’s newly appointed prime minister, senses that
Italy’s 5lst government since World War II has little room for maneuver.
Indeed, even before he was sworn in, Professor Amato issued a 23-page
discussion paper that called for radical fiscal reform aimed at cutting
Italy’s state-owned enterprises (SOEs) and its social security pension
system down to size. Although the distribution of that paper took some
political courage, the identification of the two primary causes of
Italy’s fiscal crisis was not too difficult. The state owns almost half
of Italy’s 50 largest companies in terms of turnover as well as other
strategic interests, such as pasta producers. Italy’s social security
pension system is the most generous and corrupt in Europe. Italy’s
SOEs pour out so much patronage in the form of jobs and graft that it has
been difficult to generate much political support for traditional
privatization, and what support can be found is difficult to sustain
because of Italy’s ever-changing political alliances and weak
governments. The politics of fixing the social security pension system
have been even more ticklish than SOE privatizations. Indeed, the mention
of cutting benefits and increasing retirement ages and social security
taxes almost brought Italy’s coalition government down last August. What
to do? I propose a new miracle drug, one that would generate public and
political support by simultaneously privatizing SOEs and the bankrupt
social security system. Before discussing the mechanics of that proposal,
a few remarks about private social security are in order, particularly
since there is only one private system in the world. On
May 1, 1981, Chile created a private social security system. Under the
1981 reform, workers who had participated in the old government system
were given the following option: they could either remain on the old
system or switch to the new private system. All new entrants into the
civilian labour market are required to participate in the new private
system. For
those on the private system, a monthly tax deductible contribution, equal
to ten percent of wages, must be made to an individual savings account. In
addition, workers can voluntarily augment their mandated contributions by
up to another ten percent of their wages. All contributions are invested,
and the investment income accumulates tax free. To
date, the government has authorized 14 private investment companies, known
as Administradoras de Fondos de Pensiones (AFPs) to administer and invest
the individual account funds. In addition, seven new AFPs will enter the
market this year. The AFPs can only engage in pension fund management, and
their portfolio management must conform to government-mandated criteria.
Workers are required to place their accounts with one of the approved
investment companies. However, workers can switch their accounts from one
company to another on short notice. The
new system has a uniform retirement age of 65 for men and 60 for women.
When workers reach retirement age, they can use the funds accumulated in
their accounts to finance retirement benefits. For example, a retiree can
choose to use all of his funds to purchase an annuity from an insurance
company. Such an annuity pays a specified annual income for the remainder
of a retiree’s life, plus survivors’ benefits for a retiree’s
dependents. Alternatively, a retiree can choose to keep his account with
the AFP and rely on periodic withdrawals for retirement income. Such
withdrawals are subject to limits based on the life expectancy of retirees
and their surviving dependents. Since retirement accounts are private,
funds that remain in accounts at the time of an owner’s death revert to
that person’s estate. If retirees have more than enough funds in their
accounts to finance normal expected benefits, excess funds can be
withdrawn and used for any purpose. The
new system is designed so that workers who contribute the required amounts
over their entire working lives would, with normal investment returns,
receive retirement benefits equal to 70 percent of their final salary,
plus survivors’ benefits. These survivors’ benefits are to equal 50
percent of the worker’s retirement benefits for a surviving spouse or
dependent parent and an additional 15 percent for each dependent child.
The new system allows workers to retire before the minimum retirement age
if the accumulated funds in their accounts are sufficient to pay the
targeted benefit level of 70 percent of final salary plus commensurate
survivors’ benefits. The
government guarantees a minimum pension benefit to all workers under the
new system. Hence, for low wage workers, the government supplements
required private savings. Moreover. for all participants, the government
is an insurer of last resort. For
workers who were participating in the old system and made the switch to
the private system, the government issued special non transferable bonds
to compensate them for their past contributions to the old government
system. These bonds represented a sum roughly equal to the proportion of
benefits already earned under the old system by past contributions. The
reform has been both popular and highly successful.
Although trade unions initially denounced the private social security
system as a ploy to commit workers to Chile’s popular capitalism, the
left-wing union leaders have changed their tune. Indeed, Mr. Miguel Vega,
leader of the textile workers, admitted that the union’ s original
position “was a mistake,” and that the private system is “obviously
very popular among workers.” More than 90 percent of the workers in the
old government social security system switched to the new private system. The
investment returns on funds in the private retirement accounts have been
quite high. The latest available data show that the funds have earned an
average real rate of return (excluding inflation) of 13 percent. As a
result of the high participation rate in the new system and the superior
returns earned, the retirement funds are accruing faster than they are
paying out, with net growth equal to about $200 million per month. The
AFPs now manage $12 billion, which is equal to about one-third of
Chile’s GDP. The
new private system has contributed to the depolitization of Chilean
society. For example, benefits under the new system are based entirely
on individual contributions (apart from government-guaranteed minimum
benefits). Hence, there is no opportunity for pressure groups to demand
special benefits from the social security system. Also, through
investments in their private retirement accounts, workers are developing a
substantial ownership stake in Chile’s private businesses. In
consequence, workers have begun to support policies to secure private
property and free markets. Public opinion in Chile now favours private,
voluntary solutions to problems, rather than politically-driven government
solutions. Now
let’s return to Italy, and outline the procedure for formulating this
new medicine. The following steps should be followed. First, private
investment companies (mutual funds) should be authorized. These companies
would be solely responsible for the management of private social security
accounts. Their activities would be circumscribed and regulated in much
the same manner as those in Chile. Second,
citizens who qualify for social security should be required to designate
one of the mutual funds as the manager of their private pension account. Third,
privatized shares of SOEs should be used to fully fund the newly
established individual private pensions accounts. Since the current
government social security system is bankrupt, members of the current
system have not accumulated pensions savings. Hence, each new private
account will be unfunded, with the funding requirement (deficit) equal to
the difference between the amount that would have accumulated in a
private, fully-funded pension and the amount actually accumulated. To fund
that deficit, shares in SOEs should be used. To
privatize and allocate the SOE’s capital to private pension accounts,
each SOE should be valued and shares for each SOE should be issued against
the total value of the SOE. For each private social security account,
shares should be drawn at random from the population of all SOE shares and
allocated to the new private accounts until the deficit in each account is
eliminated. At that point, each account will be fully funded, and the SOE
shares distributed to the private pension accounts will be privatized. Following
this procedure, those citizens who have participated in the government
system for the longest period will have the largest pensions account
deficits. Hence, in general, older citizens will receive a larger
distribution of SOE shares than younger citizens. That feature of the
distribution of newly privatized shares has attractive equity attributes.
Over the years. the SOE’s capital has been financed by taxpayers. Hence,
the burden for financing SOEs has been a function of the age of taxpayers,
with older taxpayers carrying proportionately more of the burden than
younger taxpayers. To be equitable, the SOE shares should be distributed
free to taxpayers since taxpayers have already paid for that equity. More
specifically, the value of free shares distributed to older taxpayers
should be proportionately more than younger taxpayers. The
share distribution contained in that proposal would meet the equity
criterion because the value of free shares distributed to older members of
the social security system would be proportionately more than younger
members. That equity feature should increase the political acceptability
of that proposal and enhance the prospects for the rapid privatization of
the SOEs. After all, older people will receive a fully-funded pension, and
younger people will be assured that, under the private system, they
won’t have to pay confiscatory taxes to finance benefits promised to
older people under the present government system. The
fourth and last step requires those who receive the newly privatized
shares in their social security accounts to automatically swap their
shares to their designated mutual fund in exchange for shares in the
mutual fund with an equivalent value. That medicine would solve Italy’s
budget crisis. Moreover, it would be popular. Among other things, all
members of the social security system (all voters) would receive a free,
fully funded private pension. What
will work for Italy could also provide other nations in Europe with
relief. Europe’s economies are all weighted down with bloated SOE
sectors that are ripe for privatization. For example, Germany’s
Monopolies Commission recently issued its biannual report, and concluded
that West Germany’s public sector offers an “immense potential for
privatization.” Moreover, according to the OECD in Paris, Europe’s
social security pension systems are in serious trouble and in need of
radical reform. Indeed, the French system almost went under last summer.
By applying orthodox medicine — social security tax increases — Prime
Minister Edith Cresson went under instead. This
medicine, while unorthodox, promises a popular cure. In Italy — and
throughout Europe — a little unorthodoxy could go a long way. Steve II. Hanke is Professor of Applied Economics at the Johns Hopkins Universitv in Baltimore. |