Lifetime Labor Supply and Human Capital Investment

Abstract

We develop a model of retirement and human capital investment to study the effects of tax and retirement policies on the supply of effective labor over an individual’s lifetime. Workers choose the supply of raw labor (career length) and also the human capital embodied in their labor. Our model explains a significant fraction of the schooling/retirement differences between Europe and the US. The model predicts that reforms of the European retirement benefit regimes modeled after the US system can deliver 15–35 percent gains in output per worker in the long run. Increased human capital investment in and out of school accounts for most of such output gains, with relatively small changes in career length. This result reconciles the view that taxes can have a large economic impact (Prescott, 2006) with the view that labor supply at the extensive margin may be inelastic owing to institutional rigidities (Ljungqvist and Sargent, 2010). We conclude that models that ignore human capital investment decisions will significantly underestimate the economic impact of tax and retirement policies.