Smetters, Kent A
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Publication The Equivalence of the Social Security’s Trust Fund Portfolio Allocation and Capital Income Tax Policy(2001-07-01) Smetters, KentThis paper proves that the stock-bond portfolio choice of the public social security trust fund is Arrow-Debreu equivalent to the tax treatment of private capital income by the non-social security part of government: the state-contingent consumption of every agent is the same under both policies. A larger [smaller] share of social security’s portfolio invested in stocks is equivalent to a larger [smaller] symmetric linear tax on the risky portion of capital income returns received on assets held by private agents. The tax change causes agents to adjust their private portfolios so that the total (private plus public) levels of demand for equities and bonds are the same under both policies. At first, it would seem that this equivalency requires that there are no pre-existing tax distortions or market frictions. However, the equivalency is shown to be quite general. First, the initial tax rate on private capital can be non-zero, and the initial tax can take any form (hence, possibly different form than the new tax). Although the amount of revenue collected at the initial tax rate (i.e., not including the rate change) is disrupted after private agents alter their portfolio, this pre-existing tax distortion does not undo equivalency. Second, since private trading with the unborn is impossible, trading markets between generations are allowed to be missing. It follows that the social security trust fund’s stock-bond portfolio choice is not neutral since risk is transferred across non-trading generations. But policy equivalency still holds. Third, an arbitrarily large share of agents (short of everyone) can even be borrowing constrained. Borrowing constrained people do not even have a portfolio of assets that can respond to taxes. Still, while consumption levels vary by state and agent type, they are identical under both policies, even for the constrained. To the extent that trust fund investment in equities improves risk sharing in the context of missing or incomplete markets, as shown in some previous papers, the equivalent capital income tax rate can be interpreted as a Lindahl (corrective) tax. This tax gives a decentralized way of achieving the same potential risk sharing outcomes as the government directly owning part of the capital stock. The decentralized approach to improving risk sharing might be more palatable to those who fear direct government intervention in financial markets (e.g., Greenspan, 1999). General-equilibrium simulation results are presented using an overlapping-generations model with aggregate uncertainty. The model incorporates a fully endogenous equity return distribution, and several other features that have been taken as exogenous in previous models. The model is used to produce policy-equivalent tax rates along the non-neutral ex-post mean transition path from the initial stochastic steady state (before the trust fund is invested in equities) to the final stochastic steady state (after the trust fund is invested in equities). The results suggest that investing the entire US Social Security trust fund in equities is equivalent to a 4 percent tax on risky capital income tax returns. This equivalent tax rate is fairly constant along the mean transition path.Publication Regulating “Too Big to Fail”(2013-04-01) Smetters, Kent; Pericak, ChristopherThe Dodd-Frank Act does not provide sufficient protection against another major financial crisis. A better regulatory system would promote financial stability by correcting the key market failures that lead to excessive risk taking by Strategically Important Financial Institutions (SIFIs). Regulatory policies centered on contingent capital would offer a clearer and purer market signal when a SIFI is performing poorly and trigger steps to mitigate the financial risks.Publication The Market for Retirement Financial Advice: An Introduction(2012-08-01) Mitchell, Olivia S; Smetters, KentPublication Ricardian Equivalence Under Asymmetric Information(2010-04-01) Smetters, Kent A; Nishiyama, ShiniciSeveral empirical studies have found that extended household units do not appear to be highly altruistically linked, thereby violating the very premise of the Ricardian Equivalence Hypothesis (REH). This finding has a very strong implication for the effectiveness of fiscal policies that change the allocation of resources between generations. We build a two-sided altruistic-linkage model in which private transfers are made in the presence of two types of shocks: an “observable” shock that is public information (for example, a public redistribution like debt or pay-as-you-go social security) and an “unobservable” shock that is private information (for example, individual wage innovations). Parents and children observe each other’s total income but not each other’s effort level. In the second-best solution, unobservable shocks are only partially shared, whereas, for any utility function satisfying a condition derived herein, observable shocks are fully shared. The model, therefore, can generate the low degree of risk sharing found in previous empirical studies, but REH still holds.Publication A Matter Of Trust: Understanding Worldwide Public Pension Conversions(2010-04-01) Smetters, Kent A; Theseira, WalterSecurity markets between generations are naturally incomplete in a laissez-faire economy since risk sharing agreements cannot be made with the unborn. But suppose that generations could trade if, for example, a representative of the unborn negotiated on their behalf today. What would the trades look like? Can government fiscal policy be used to replicate these trades? Would completing this missing market be Pareto improving when the introduction of the new security changes the prices of existing assets? This paper characterizes analytically the hypothetical trades between generations and shows how the government can replicate these trades by taxing the realized equity premium on investments in a symmetric fashion. This tax is equivalent to the government providing a “collar-like” guarantee on personal investments. When technology shocks are mostly driven by changes in depreciation, a positive tax (a long collar) replicates the hypothetical trades; this tax is also Pareto improving under fairly general conditions. When technology shocks are mostly driven by changes in productivity, the choice between a positive and negative tax rate is unclear. However, with log utility, Cobb-Douglas production, and a depreciation rate less than 100 percent, a negative tax (short collar) is Pareto improving. Simulation analysis is used to consider more complicated cases, including when depreciation and productivity are both uncertain. Under the baseline calibration for the U.S., a positive tax (a long collar) on the equity premium is Pareto improving.Publication Optimal Portfolio Choice over the Life Cycle with Social Security(2010-04-01) Smetters, Kent A; Chen, YingThis paper examines how households should optimally allocate their portfolio choices between risky stocks and risk-free bonds over their lifetime. Traditional lifecycle models in previous work suggest that the allocation toward stocks should start high (near 100%) early in life and decline over a person’s age as human capital depreciates. These models also suggest that, with homothetic utility, the allocation should be roughly independent of a household’s permanent income. The actual empirical evidence, however, indicates more of a “hump” shape allocation over the lifecycle; the lifetime poor also hold a smaller percentage of their portfolio in stocks relative to higher income groups. Households, therefore, appear to be making considerable “mistakes” in their portfolio allocation. Target date funds, which have grown enormously during the past five years, aim to simplify the investment process in a manner consistent with the predictions of this traditional model. We reconsider the portfolio choice allocation in a computationally-demanding lifecycle model in which households face uninsurable wage shocks, uncertain lifetime as well as a progressive and wage-indexed social security system. Social security benefits, therefore, are correlated with stock returns at a low frequency that is more relevant for lifecycle retirement planning. We show that this model is able to more closely replicate the key stylized facts of portfolio choice. In fact, when calibrated to the age-based income-wealth ratios found in the Survey of Consumer Finances, we demonstrate that the portfolio allocation “mistakes” being made by the vast majority of households actually lead to larger levels of welfare relative to the traditional advice incorporated in target date funds.Publication Developments in Risk Management for Retirement Security(2002-06-01) Mitchell, Olivia S; Smetters, Kent