Optimal intergenerational transfers: Public education and pensions

Abstract

In presence of imperfections in the education loan market, the standard policy response of intervening solely on the education front, funded through taxes and transfers, necessarily hurts the initial working population. The literature suggests compensating them via Pay-As-You-Go (PAYG) pensions as a possible solution. We carry out the optimal policy exercise of a utilitarian government in a dynamically efficient economy with pension and education support obeying the Pareto criterion. We find that expansion of one instrument along with the other emerges as the optimal response, however, once the complete market level of education is achieved, the optimal policy suggests phasing pensions out. Eventually, government leads the economy to an equilibrium with zero pension and the Golden Rule level of education. This is achieved by exploiting only market opportunities without relying on other factors including human capital externalities, general equilibrium effects, or socio-political factors. We complement our theoretical results with a numerical exercise and compute the optimal policy path under different initial conditions and parameter values.