Education and Lifetime Income During Demographic Transition

The paper studies the power of educational investments in relation to transfers for fostering lifetime income and for reducing income inequality in Germany and contributes to the discussion of sustainability in the German public pension system in times of demographic transition in a novel way.

Costs and benefits of public transfer payments are examined that directly reduce income inequality at older age (called remedial policies) and compared with investments into education, beginning already at preschool age (called preventative policies). Furthermore, the paper studies the power of age-dependent educational investments for the development of lifetime income and inequality for cohorts born 1940 to 2044 over the period from 2010 to 2080 (intergenerational redistribution). The analysis is based on a model of age-dependent human capital accumulation, featuring dynamic complementarities in skill formation over the life cycle.

According to the findings educational investments are more effective in reducing income inequality than transfers in one generation until the age of 17 years. The relationship reverses after the age of 17. In case of remedial pension transfers in old age, the "rich" pensioner has to spend 100,000 € at the age of 65 years in order to increase the income of the "poor" pensioner so that the income inequality ratio is reduced moderately from 3.3 to 3.1 in Germany. To achieve the same reduction in inequality, the value of additional educational investments in preschool assessed at the age of 65 years is only 10,398 €, demonstrating the power of the childhood skill multiplier.

Forecasts demonstrate that in the next decades the German population will decline as a consequence of declining fertily rates. Presumably, the old age dependency ratio will increase from 30 to over 50 percent, and the growth in average pensions will be moderate or even negative. According to our analysis tax-financed educational investments starting in 2011 could help to moderate the economic consequences of demographic transition.

The findings suggest that benefits will be positive on average, but not for all cohorts, mainly because of the significant lags between educational investments in childhood and increased human capital in adulthood. Cohorts born after 1976 will gain. The longer the planning horizon, the more positive the impact of educational investments on pensions in the German pension system will be. Investments into the youngest are the most productive. Additional educational investments into secondary education will presumably not raise lifetime income enough to compensate its costs.

Pfeiffer, Friedhelm and Karsten Reuß (2013), Education and Lifetime Income During Demographic Transition, ZEW Discussion Paper No. 13-021, Mannheim.