Social security reform with uninsurable income risk and endogenous borrowing constraints

We study the effects of a social security reform in a large overlapping generations model where markets are incomplete and households face uninsurable idiosyncratic income shocks. We depart from the previous literature by assuming that, because of lack of commitment in the credit market, the borrowing constraint in the unique asset is endogenously determined by individuals' incentives to default on previous debts. In our model, after the reform the incentives to default are lower and consequently households face more relaxed borrowing limits, leading to an increase in debt and a reduction in the size of precautionary savings. However, the quantitative impact of this mechanism on stationary aggregate savings is small. Computing the transitional dynamics for the basic model following the social security reform we obtain important welfare gains for workers at the bottom of the income distribution (equivalent to 1.3% of consumption each period) associated to the relaxation of the endogenous borrowing constraints, which are missed in an environment with fixed borrowing limits.