Abstract
In the next 50 years, the Latvian labor force is projected to decrease by approximately 0.6 percent per year. The effect, a rapidly increasing old-age dependency ratio would, in most developed countries, constitute a serious threat due to exploding old-age social security expenditures. The recently reformed Latvian public pension system is designed to handle the upcoming difficulties. Special attention has been given in the design to keep the expenditures low relative to the revenues by introducing rules dampening the increase in the pension expenditures. This paper evaluates the performance of the PAYG system. In the light of the pessimistic projection of the Latvian demography, the newly reformed PAYG system performs remarkably well. The expenditure reducing rules introduced have significant effects on the system's financial balance. The reduction in pension expenditures in the next 50 years amounts to more than 120 percent of GDP, measured as a year 2000 present value. The pension reform also includes the launch of a publicly run defined contributions pension system. It is shown that the resulting implicit tax imbosed by the public pension system imposes on labor earnings is negative and increasing with age. That is, savings are subsidized in the public pension system. It is also shown that private savings are fully crowded out as individuals try to offset their savings in the pension system. Since individuals are capital constrained, they will have no private assets at all. From a welfare perspective, this suggests the overall contribution rate to the public pension system to be too high.