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This paper examines the impact of pension institution on fertility and human capital accumulation of the economy. It considers an overlapping generations model with heterogeneous individuals where fertility and human capital are determined endogenously. Two pension institutions are investigated: the family and the pay-as-you-go pension system. The conventional view is that under the pay-as-you-go pension system, there will always be underinvestment in human capital because of the wedge pension tax places between the marginal product and private return of human capital. By separating fertility from human capital investment decisions, we show that the insurance provided by the pay-as-you-go pension system may also encourage poorly-educated, fertile individuals to invest in their children's education. Under the family system, children from poorly-educated families are likely to remain poorly educated, as poorly-educated parents prefer quantity over quality of their children; under the pay-as-you-go pension system, however, a mandatory pension tax increase provides a trust mechanism where poorly-educated parents are motivated to invest in their children's education. In the latter case, children are highly-educated and more productive when they grow up, and will be able to contribute to their parents' pension income in return.
