Public pension reform, demographics, and inequality

Starting from a simple, descriptive model of individual income, an explicit link between the age composition of a population and the personal distribution of incomes is established. Demographic effects on income inequality are derived. Next, a pay-as-you-go financed state pension system is introduced. The resulting government budget constraint entails interrelations between fiscal and demographic variables, causing an additional, indirect demographic impact on the distribution. This is shown not only to change, but in some cases even to reverse the distributional incidence of an aging population. Several policy conflicts arise. The point is re-emphasized by an analysis of the German Pension Reform Act of 1992. The study reveals that the design of the pension formula decisively drives the relation between demographics and inequality.