Pareto Improving Social Security Reform when Financial Markets are Incomplete!?¤

This paper studies an overlapping generations model with stochastic production and incomplete markets to assess whether the introduction of an unfunded social security system leads to a Pareto improvement. When returns to capital and wages are imperfectly correlated a system that endows retired households with claims to labor income enhances the sharing of aggregate risk between generations. Our quantitative analysis shows that, abstracting from the capital crowding-out e®ect, the introduction of social security represents a Pareto improving reform, even when the economy is dynamically e±cient. However, the severity of the crowding-out e®ect in general equilibrium tends to overturn these gains.