Abstract
We study the tradeoff between efficiency and redistribution in a model with overlapping generations, extensive labor supply, and perfect financial markets. The government instruments are a pension scheme and a age-independent nonlinear income tax schedule. At the second-best optimum, the pension system constrains the agents’ labor supply behavior, forcing them to work to achieve a required lifetime performance. Income taxes affect labor supply directly, but also indirectly through pension incentives. The indirect effect of taxes counteracts the usual forces in the efficiency-redistribution tradeoff: through the interplay with the pension system, decreasing taxes induces redistribution and reduces productive efficiency.
Highlights
In the past ten years, following Prescott (2004)’s claim that the differences in work habits in the US and in Europe were largely due to the differences in the tax systems, a number or researchers have estimated labor supply elasticities both at the microeconomic and macroeconomic levels
We study the tradeoff between efficiency and redistribution in a model with overlapping generations, extensive labor supply, and perfect financial markets
We find that the presence of a pension scheme attenuates the usual forces that govern the welfare effects of tax reforms
Summary
In the past ten years, following Prescott (2004)’s claim that the differences in work habits in the US and in Europe were largely due to the differences in the tax systems, a number or researchers have estimated labor supply elasticities both at the microeconomic and macroeconomic levels. In a specialized framework—same marginal utility of consumption for all agents, decreasing productivity and increasing pecuniary cost of work with age—we show that an optimal combination of tax and pension eliminates all rents coming from observable productivity differences. It suppresses all upward labor supply distortions and reduces downward distortions. Second best program Facing the tax schedule R(·) and a pension regime associated with transfers P(·), the consumer chooses her labor supply (a) ∈ {0, 1} and pension plan Z so as to maximize her lifetime utility c(θ ) = max [R(w(a; θ ))) − δ(a; θ )] (a) da + P(Z ).
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