Forced Savings: Economic impacts of raising CPP/QPP retirement benefits and premiums
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Forced Savings
Economic impacts of raising CPP/QPP retirement benefits and premiums
Ted Mallett, VP & Chief Economist
There is no free lunch, and no free pension either. Recent calls to boost CPP and QPP benefits, in reaction to concerns about the sustainability of retirement savings in Canada, while touting to save more people from the risk of pensionless retirement, substantially underestimate costs to the economy. Using macro-econometric modeling to simulate the effect of doubling CPP/QPP benefits, and the attendant increases in premiums, CFIB finds that 1.2 million person years of employment will be lost in the short run and wages will be forced down roughly 2.5 per cent in the long run as people are forced to transfer current earnings to the future.
The macro-econometric impact analysis for this study was conducted by Peter Dungan, Adjunct Associate Professor of Business Economics, Rotman School of Business at the University of Toronto, using the FOCUS model of the Policy and Economic Analysis Program.
Background
Calls to reform the Canada and Quebec Pension Plans are not new, but it is not hard to see why attention has become more focused. The financial sector meltdown of 2008, and its aftermath, put large holes in many individuals' retirement income plans, adding voltage to an already highly charged subject.
Although consensus on the importance of retirement savings to the social fabric of the country is easy to observe, there are still wide ranging views on whether there is indeed a serious problem with the current system, or what solutions might be best made to public policy. Canada has a widely distributed series of pension and retirement policies. These include voluntary tax-deferred RRSPs, pre-taxed TFSAs, employer-based plans (RPPs), mandatory public plans, (CPP, QPP), income-tested safety nets (OAS, GIS) and tax treatment for assets (capital gains exemptions).
While some see a weak patchwork of policies, others see a strong system of connected trusses. Arguably, much of the retirement system's strength comes from the variety of tools and techniques available to the public. As a result, it is important to look at the issue broadly as one of retirement savings, rather than of simply pension plan coverage. Today's seniors have the smallest incidence of low income of any age group. In addition, average retirement income in Canada is among the highest in the OECD. Even Canadians without RPPs are shown to have more net wealth than those with plans, on average, because they tend to have sizable financial assets built up outside the formal retirement income system (Mintz, 2009).
Proposals to reform retirement income plans are wide and varied. They range from no action at all, to opt-out-style multi-employer pension plan schemes, to voluntary CPP/QPP supplements, to mandatory CPP/QPP benefit increases-among many others.[1] This paper does not go into the plusses and minuses of all of these proposals, or even if it is appropriate to use a mandatory 'one size fits all' plan like CPP/QPP to address an issue that is highly specific to individuals' circumstances and choices. Instead, we are interested in modeling the reality that putting more of today's earnings aside for tomorrow will put more of today's spending power aside as well. It is one thing for individuals to make inter-temporal choices with their own money; it is quite another for governments to be making choices for them.
Projection Assumptions
For this study we choose to model proposals made by the Canadian Labour Congress (CLC) to double CPP/QPP retirement benefits and to pay for them on a self-sustaining basis with higher employer- and employee-paid premiums. There are other competing proposals[2] on restructuring or increasing benefits; however, these proposals don't always provide clear actuarial estimates of their effects on premiums.
The impacts of the CLC proposal are modeled[3] starting with a base case or a business-as-usual projection for the Canadian economy for 2011 through 2030 in which the CPP contribution rate continues at the current 4.95 per cent of pensionable earnings up to the maximum (for both employers and employees). In addition, the Year's Maximum Pensionable Earnings (YMPE) level is assumed to grow with inflation from its current $47,200.
The macro-econometric modeling base case was developed by the Policy and Economic Analysis Program of the Rotman School of Management of the University of Toronto in June 2010. Briefly, this base case projects the Canadian economy to close gradually the significant excess economic capacity opened in the recent recession and to remain at roughly trend growth and 'full employment' thereafter.
Starting from this base case, we begin the simulation of the altered CPP regime at the beginning of 2011 and extend it through 2030. Under the CLC proposal, the CPP contribution rate is to rise to 7.7 per cent each for employers and employees over a seven-year span. [4] Combined, this amounts to a maximum $2,596 increase in annual contributions per employee ($1,298 each from employer and employee contributions). We phase in the rate increase in equal steps from 2011 through 2017. In 39 years this increased contribution should be able to double CPP retirement benefits according to the CLC's calculations.[5]
By 2030 therefore (about half-way through the 39 year span), CPP retirement benefits are being paid out at 50 per cent higher than in the base case. (Note that in 2008/9 CPP retirement benefits were about 73 per cent of total CPP payouts -- the rest being accounted for by survivor benefits, death benefits and disability payments, which are assumed not to increase from the base.) Note also that no increase in the year's basic exemption (YBE -currently $3500) has been assumed although such a proposal is made in passing in the CLC's position paper.
Two simulations are conducted: the first (which we call 'Full Shock') as described above increases the contribution rates of both employees and employers. At the same time, retirement benefits are doubled. In the second simulation only the employees' contribution rate increases-and the increased payouts from the CPP are only half of those of the first simulation. That is, in the second simulation the increase in CPP benefits is funded entirely from additional employee contributions. We call the second simulation 'Partial Shock.'
This 2011-2030 modeling span is half of the roughly four-decade period the CLC estimates would be required, at this higher rate of contribution, to double CPP benefits. Since most of the premium impacts are front-end loaded, the modeling period is sufficient to measure most of the effects on the economy. We would expect further effects through to 2050-the completion of the phasing in of CLC's proposed benefit increases-to be relatively minor.
Estimated Impacts
Scenario 1: Full Shock
The simulation results are presented in the accompanying appendix tables. [6] In the simulation in which both employer and employee contributions are increased there is in effect a double hit to the economy in the initial years. First, purchasing power is being withdrawn because of the additional CPP contributions which are only very partially offset in the initial years by a minor increase in CPP payouts. This shortfall in aggregate demand would itself be expected to have a negative impact on GDP and employment. In addition, as employers find that their wage costs after tax are increased, they economize on the use of labor and some of them simply withdraw from the market as production becomes unprofitable at the higher after-tax wage costs. Firms also try to pass through into prices the increases in their wage costs from higher CPP contributions, much as they would any other increase in unit labor costs. This backward shift of the aggregate supply curve of the economy of course both lowers output and raises prices.
The net result of all of this is reduced real GDP relative to the base outlook (please note that GDP does not actually fall, it simply rises less than it otherwise would in the base case), reduced employment, a higher unemployment rate and increased inflation. Despite the higher inflation we do assume that the Bank of Canada would ease off to the extent of letting the exchange rate depreciate by almost half a percent about five years into the simulation. [7] The maximum impact on real GDP occurs in the fifth year when GDP is just over 1 per cent below base (or almost $20 billion (2009 dollars) below base)
The maximum impact on employment actually occurs one year later with 235,000 jobs lost relative to base and the unemployment rate just over seven tenths of a percent higher than in the base. The base case scenario projects employment growth to decline anyway due to demographic shifts; however, the full shock scenario slows employment growth considerably through 2015. Similarly, the unemployment rate, which is projected to decline gradually and stabilize at 6 per cent by 2016, would not do so until four years later under full-shock conditions.
With reduced employment, relative to base, and a higher unemployment rate, the model estimates that wage demands will be muted. Eventually firms are induced to hire again and inflationary pressures are withdrawn. By 10 years into the simulation, and three years after the CPP rate increases have ceased, GDP is back at base case levels and the inflation rate has been below the inflation rate of the base case for several years. At this point also, employment and the unemployment rate are largely back at base case levels. However, a cumulative total of 1.2 million person-years of employment are lost, never to be regained.
Briefly what has happened is that, through the natural working of the economy, market forces have, in effect, forced labour to take up the other half of the CPP rate increase from businesses. Given the mobility of capital, at least in the model's view of the world, there is no mechanism whereby the CPP increase on employers will come permanently out of profits.
The braking effects on employment and wages, and their subsequent effects on personal consumption would in turn affect federal and provincial budget balances. Slower spending and income growth will reduce income and sales tax revenues from the base case scenario, pushing budgets from a position of rough balance toward deficits of about $5 billion per year at each level of government. The model assumes that deficit financing would persist, but the degree to which governments choose to narrow that gap would add to the slowdown of output and employment growth even further.
Once the adjustment to the higher CPP rate has occurred, what follows is a decade of very gradual increases in GDP, which are not inflationary and which leave the levels of employment and the unemployment rate largely untouched. This increase in GDP occurs because the economy, through the CPP rate increase, has been forced to save more and some of the savings has been translated into capital formation that makes labor more productive. Although improved productivity is an important long-term policy goal, in this scenario it comes at the expense of employee wages.
Of course, CPP retirement payments are increasing through this decade and, as can be seen, the impact on personal consumption, although negative through the entire decade is getting progressively smaller. Soon after 2030, the rising payouts and a larger GDP base would actually move consumption above base case levels.
Scenario 2: Partial Shock
In the second 'partial shock' simulation there is only an increase in the CPP contribution rate of employees. In effect this is a form of direct tax increase. It has a negative effect in the short term on GDP because it reduces aggregate demand, but there is no secondary negative impact through the increase in costs to business and the resulting inflation which cannot be fully counteracted by the Bank of Canada. Indeed in this case, we allow the Bank of Canada to stimulate the economy somewhat in the early years, mitigating the negative aggregate demand effects.
The maximum negative impact on real GDP occurs in years three and four at about 1/10 of 1 per cent of base GDP or roughly $2 billion 2009 dollars. The heaviest hit on employment occurs in year four with a loss of about 33,000 jobs. By year eight in this scenario real GDP is actually moving above base case levels and in year nine and after there is some temporary addition to employment. At the end of the subsequent decade, real GDP is positive relative to base, with employment at about base case levels.
In addition, productivity improves, with the aggregate capital stock up almost 1 per cent relative to base. The GDP effects are somewhat smaller than in the first simulation because the collections by the CPP are only half of those in the first simulation, but at the same time there has been no loss of GDP through the many years required in the first simulation to absorb the cost impact on business. In the second last year of the simulation the impact on consumption begins to turn positive and clearly bigger positive impacts will follow.
Crowding-out Effects
Through the above scenarios, we have seen the likely responses from the central bank and governments on monetary and fiscal policy. Outside the model, however, there is one more response that needs addressing-that of savers themselves. With such a large increase in mandatory CPP premiums, coupled with the indirect employment market impacts on earnings, employees would likely cut back on other forms of savings in order to soften the impacts on their current standards of living. It is quite likely that they would reduce discretionary contributions into personal RRSPs, TFSAs, or in the purchases of other long term assets. All the CPP reforms would be accomplishing, therefore, would be in transferring savings from one vehicle to another.
Although the model is neutral on this issue, it may not seem so for those currently working in the financial services sector, which more than any other would likely see the largest displacements or at least the largest change of course from a base-case path of growth.
Other CPP/QPP Reform Proposals
Although these scenarios hinge on CLC proposals to increase the benefits-to-YMPE ratio from 25 per cent to 50 per cent, there are other proposals to increase the YMPE itself. From the model's perspective, the impacts of these alternative proposals would be proportionately the same. The economic impacts are driven by the aggregate dollar changes to total premiums and benefits, not by the mechanisms by which these values are created. Therefore the $2,596 annual increase in combined employer and employee premiums under the CLC proposal would have essentially the same economic impact as a $2,596 increase in premiums caused by expansion of the YMPE. Indeed, the UPP, two-tiered and FSE-CPP proposals would push premiums up by considerably more than CLC's recommendations. Their aggregate economic impacts, therefore, would be scaled up by roughly the same multiple.
A major revision to the YMPE would affect relative employment and wages in higher and lower income groups-however, that granularity is not present in most macro-econometric models. Qualitatively speaking, however, the CLC proposal would likely have more negative impacts on employment and wages among workers below the $47,200 YMPE. Other proposals to increase the YMPE would push some of the negative impacts further into higher income groups.
Conclusions
The macro-econometric simulations show what happens with a transfer of current spending power from today's wage earners to tomorrow's retirees. The impacts even out after 40 years, because we are really dealing with consumption by the same people at different stages of their lives. Nonetheless, the interim impacts are substantial, particularly on payrolls, leading to the question of whether such reforms are appropriate for an economy currently operating well below potential. No other study has recently looked at CPP pension reform through this kind of lens. Although the study focuses on a proposal to double benefits over time, the results are scalable. Any fractional change to premium rates, relative to the CLC proposal, would yield proportional impacts on employment and growth. In other words, every 1 per cent increase in employer and employee premiums above the current 9.9 per cent of pensionable payrolls would cost approximately 220,000 person-years of employment in the 2011 to 2020 period.
The other important lesson of this exercise is in showing the respective differences in impacts of employer-paid versus employee-paid payroll taxes. The bulk of the negative economic impacts are a result of increases to employer-paid premium costs. That is because employers receive no benefit from the accumulated savings. For them, the premium increases are simply increases to their cost of labour, with no resultant improvement in the productivity of labour. These lessons have implications on other forms of payroll taxes imposed on businesses, chiefly Employment Insurance and Workers' Compensation premiums.
The simple presumption has always been that employers help share the costs of these programs. It is not well enough understood, however, that businesses are simply transparent inanimate structures that absorb added costs in only three ways: to owners, customers or employees. Any burdens placed on businesses, therefore, ultimately land on people. Modifying the CLC proposal so that premiums are only increased on the employee-paid portion would lead to premiums being split on a 61/39 basis with employers. Considering the significantly less severe spin-off economic impacts such a modification would bring, the price appears worth it.
[1] CFIB's recommendations on pension reform can be found in Dawkins, Securing the Future, (2010). http://www.cfib-fcei.ca/english/advocacy/canada/64-social_policy/1910-securing_the_future.html
[2] These include CARP's 'Universal Pension Plan' (UPP), Keith Horner's two tiered benefit structure, and Bernard Dussault's 'Full-Scale Expansion' of CPP (FSE-CPP). Details differ, but each proposes a doubling, or more, of benefits. Refer to Jonathan Kesselman's recent paper for more complete descriptions.
[3] As a simplifying measure, for the purposes of the analysis, the QPP is modeled on CPP parameters.
[4] Various CLC position documents also refer to 7.8 per cent or 7.95 as the target employee and employer premium rates. These are all plausible self-sustaining rates, depending on the assumed future rates of return for the CPP. For this analysis, CFIB chose the most conservative published figure as the starting point. The choice of rate does not largely affect the model-but the results would be scalable.
[5] CLC's online calculator assumes a 26-year-old today earning YMBE earnings or greater for the next 39 years would be able to qualify for doubled benefits at retirement. Other sources refer to a 40-year transition period, which is the 47 years of CPP eligibility, less 15 per cent for allowable workforce interruptions. http://www.canadianlabour.ca/action-center/retirement-security-everyone/calculate-labours-plan-retirement
[6] For most lines in the tables, the results shown are percentage changes from the base case. For a number of variables, generally marked with asterisks, changes from the base in levels are presented; this is the case for example, for government balances and the balance of the current account of the balance of payments. For real GDP and employment, changes in both percent-change from base and in levels change from the base are presented.
[7] In any shock to the economy, the response of the monetary authorities to inflation is very important in determining the outcome. In the 'full shock' scenario we have assumed that the Bank of Canada will only move to curb inflation gradually, realizing that within a span of years the inflationary shock will gradually pass. It is quite possible that the Bank of Canada could react more vigorously by increasing base lending rates, which would make the near-term negative impacts on GDP and employment more severe. In the second simulation there was in fact no inflationary pressure from the policy shift and the Bank of Canada moves in such a way to offset some of the negative effects on the economy so that the inflation rate does not decline exceptionally, and stays close to their 2% target.
November 25, 2010
