A number of economists have recently advocated a policy of linking pension benefits (or contributions) to individuals’ fertility choices. The reason for this is that, with a pay-as-you-go social security system, the higher the number of children, the higher will be the available tax revenues (levied on the children when they grow up) to finance the pensions of the retired population. With all parents sharing the benefits associated with their own and every other parents’ having more children (the extra tax revenues their action generates), there is a positive externality in the system. This externality, if not corrected, implies that the equilibrium number of children in a decentralized system would be suboptimal.
A second and related issue concerns the “quality” of children and their human capital accumulation through educational decisions of the parents. The externality here arises because the rate of return of a pay-as-you-go (PAYG) system depends not just on the fertility rate, but also on productivity growth. The more productive the children, the higher will be their ability to produce and to pay taxes. This reinforces the public good nature of a family’s child rearing activities.
The counter argument to such a policy is that one does not really know what truly determines fertility, and what accounts for the observed evolution in fertility behavior. In particular, it is clear that no one can fully control fertility. Miscarriage, multiple births and plain infertility imply that the number of children the parents intend to have does not necessarily coincide with the actual number of children they will have. Similarly, one cannot deterministically determine the future earning abilities of children simply by investing in their education and training. Given these realities, linking benefits to the number and/or some measure of the quality of children opens the parents to undesirable and uncontrollable risks.
The underlying problem with such a policy then, at least in case of identical individuals, is one of moral hazard. The parents’ effort level in having and raising productive children is not publicly observable. Nor can it be inferred from the outcome, due to the inherent randomness in the process. Under this circumstance, the pension system provides insurance against the fertility and educational achievements risks. When individuals differ in child-rearing ability, or in taste for children, the problem will include a dimension of adverse selection as well. The actual number of children will then be determined by effort, child-rearing ability, preferences and a random component. Again, risk sharing through a PAYG pension scheme may be desirable.
This paper attempts to shed light on these contrasting views. The main question is if one should fully ensure parents against the shocks in fertility and educational attainment of their children by offering everyone the same pension, or if one should link the pensions to the number of children. If the latter is the answer, one would also want to know how.
We posit a model which allows for the externality that different parents impose on one another (through their decisions on how many children to have and how much to invest in them). Now the key distinguishing element between quantity and quality decisions is one of timing. The number of children born is known quite early; the quality of children (i.e. their future earning capacity) is determined much later. To account for both features one needs a model with at least three periods of decision making. This makes the problem far more complicated than necessary. We thus do not specifically distinguish between fertility and investment decisions. Instead, we lump the investments in quantity and quality together as if one decision determines both. This simplifies the modeling substantially by allowing us to concentrate on a setting with two periods of decision making (as opposed to three). In so doing, we use the concept of number of children in efficiency units that is widely used in growth theory.
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