Consumption taxation to finance pension payments

Abstract

To assess how a permanent shift from financing a public pay-as-you-go pension by direct taxation toward financing it by indirect taxation affects the economy and welfare, we use an overlapping-generations-augmented two-region general equilibrium framework with search frictions on the labor market. The analyzed tax reform partially shifts the tax burden from domestic to foreign producers, lowers marginal costs of domestic production and generates positive domestic macroeconomic effects. Furthermore, the partial postponement of a household’s tax burden to retirement leads to higher savings and increases domestic assets; however after the implementation of the tax reform, the policy-induced increase in consumption costs makes retirees and households close to retirement worse off. Moreover, the increase in domestic net foreign assets implies that consumption of foreign households eventually falls, which contradicts results commonly found in models without an endogenous savings motive.