Modifications and extensions

The empirical implementation of the basic model described above raises several issues, which are discussed in the following.

(a) Pension saving

A key limitation of the LCM is the assumption that individuals are able to make rational decisions in developing a lifetime plan of consumption and saving. However, in practice, many workers are unable to enter retirement with sufficient financial resources (Lesnoy and Leimer, 1985). In fact, this was the main reason for the introduction of the social security program in Malaysia. The analysis provided in Chapter 3 clearly highlights the need to capture the effects of pension saving, given that it is a key driver in the Malaysian financial system that mobilizes a lot of saving.

The importance of social security on the behaviour of saving has been highlighted in an early study by Friedman (1957), and later formally incorporated into the analysis of the LCM by Feldstein (1974) and Munnell (1976).51 This new LCM proposes that the presence of a sound social security framework effectively reduces the amount of saving during the working years. This is because if savers perceive they will receive high pension benefits at the point of retirement, they will tend to reduce the amount saved during their working lives, weakening the precautionary motive for saving. Hence, in principle, an increase in the perceived benefits of pension saving reduces the desire to accumulate financial assets, and may therefore discourage household saving (Feldstein, 1980; Evans, 1983).

Given this consideration, the model set out in section 6.2.1 is modified to capture the effects of pension coverage. Expected pension benefits after retirement (p e p) are considered as part of the total resources of the individual. Thus, Eq. (2) can be rewritten as:

v,r= / +'+<if

ey'

t + ( D - N ) T

+ « £ , + £ P ■i - t (9)

;=/ + ] 0 + / ' ) /=/+1 (1 + ^)

where D is age of death. Average annual expected pension benefits can be written as

1 f t + ( D - N ) T

T 1 V P e U i

P en , = ~n_{D - N { i=t+]}---AT

L

It follows that the consumption function for the whole community in Eq. (6) can then be expressed as:

(10)

C, = a ] Yt + a 2EYt + a 3At_l + a 4PENt (11)

and, finally, the modified saving function is given as:

= (1 - a ) Y t - a 3At_1- a 4PENt (12)

Although the rationale that higher social security benefits tend to lower the savings rate is clear from the modified LCM, some counter-arguments have been proposed in the literature. As Pechman, Aaron and Taussig (1968) postulate, to the extent that savers are not rational, they may ignore the benefits of social security. Cagan (1965) argues that participation in a social security program has an educational effect, which increases the awareness of savers about the importance of saving for their old age. Similarly, Feldstein (1974) postulates that social security can increase saving by

The approaches adopted by these two studies are identical, although they differ in terms of empirical implementation. Munnell (1976) uses a dummy variable to indicate whether an individual expects to receive social security benefits upon retirement whereas Feldstein (1974) employs actual data on the level of social security benefits entitled by retired workers to capture the effects of social security.

inducing early retirement. This expands the span of retirement years and therefore increases the need for more saving during the working life in order to achieve a targeted level of retirement income. In line with these, Barro (1978) and Barro and MacDonald (1979) argue that individual savers may save more in response to an increase in social security benefits. This is because they may increase bequests to their children in order to compensate for the higher social security taxes borne by future generations.

In sum, social security has dual effects on saving: it lowers saving because it substitutes for household assets, but it also increases saving due to irrational behaviour, educational effects, induced retirements, and inter-generational transfers. Thus, it

appears that economic theory provides no a priori argument for or against the effects of

social security on saving. The net effect depends on the relative strengths of these opposing forces. Hence, the expected sign of this variable is indeterminate and the issue is an empirical one.

(b) Age structure

As highlighted in an important study by Horioka (1997), age dependency should be segregated into young and old age dependency, since they each may have a different bearing on the behaviour of saving. This point has been further developed by Athukorala and Tsai (2003) who argue that with economies of scale in family consumption, large families are able to provide a child with the same amount of welfare with a less than proportionate increase in household expenditures compared to a small family. In addition, when parents intend to increase the family size, they may reduce consumption and save more in anticipation of higher expenditures after births. Thus, young and old age dependency may have different effects on saving and they should be treated separately in the analysis.

(c) Financial deepening

Financial deepening may induce more saving through two channels. Firstly, the incentives to save may increase with the proliferation of financial instruments, which can satisfy the diverse needs and portfolio preference of various savers. That is, a greater variety of financial tools can induce individuals to save more since it becomes more convenient to save. Therefore, willingness to save may depend on the degree of sophistication of the financial systems (Goldsmith, 1969; Park, 1994). The second argument is based on Shaw's (1973) financial intermediation view. Shaw argues that the existence of a sophisticated financial system facilitates the intermediation between

savers and investors. More intermediation between savers and investors enhances the incentives to save since an efficient financial system effectively reduces risk and information costs, which can increase net real returns of savers and positively affect saving.

However, financial deepening is also likely to impact negatively on saving. The LCM depends on the ability to borrow when young to smooth out consumption throughout a lifetime. The model assumes a world of perfect capital markets in which credit is easily available. In reality, imperfections in credit markets may prevent households from borrowing as much as they would wish. This may reduce consumption and increase saving (Modigliani, 1986). Financial development takes place when there is an increase in financial intermediating activities, which follows from the removal of credit constraints. Therefore, this implies that the relaxation of credit constraints, which may lead to expanded consumer lending and increased financial development, is likely to result in lower saving. As Liu and Woo (1994) postulate, an insufficient level of financial deepening induces individuals to save more in order to undertake self-financed investment projects. In sum, financial deepening appears to be a double-edged sword with regard to saving.

(d) Public saving

The government can finance fiscal expenditure by issuing bonds. However, it must eventually repay this borrowing by increasing taxes in future. Using an overlapping generations model, Barro (1974) shows that there would be no marginal net-wealth effect of government bonds so long as individuals from one generation can transfer resources to the next generation. This is because households would save more to compensate for the higher taxes they have to pay in future, despite having more disposable income in the present. The model implies that an increase in government debt does not lead to an increase in household wealth, given that tax liabilities can be shifted from one generation to another.

In the analysis of saving behaviour, this hypothesis implies that an increase in government saving will have no effect on total saving, since it will be met by an equal reduction in private saving. That is, when the government runs a budget deficit, the private sector will respond by saving more to offset this undesirable effect on future generations. Hence, any change in public saving will be fully offset by an equal change in private saving. This proposition is based on the assumption of a perfect capital

market where households can borrow as much as they want, widely known as the

# # c ?

Ricardian equivalence hypothesis.