Providing Efficient Incentives to Work: Retirement Ages and the Pension System

Abstract

This paper provides a theoretical and quantitative analysis of the efficient pension system as an integral part of the overall income tax code. We study lifecycle environments with active intensive and extensive labor margins. First, we analytically characterize Pareto efficient policies when the main tension is between redistribution and provision of incentives: while it may be more efficient to have highly productive individuals work more and retire older, earlier retirement may be needed to give them incentives to fully realize their productivity while they work. We show that, under plausible conditions, efficient retirement ages must increase in productivity. We also show that this pattern is implemented by pension benefits that not only depend on the age of retirement, but are designed to be actuarially unfair. Second, in a version of environment calibrated to U.S. individual lifecycle earnings, retirement ages, and intensive and extensive labor elasticities, we find that it is efficient for individuals with higher lifetime earning to retire (i) older than they do in the data (at 69.5 vs. at 62.8 in the data, for the most productive workers) and (ii) older than their less productive peers (at 69.5 for the most productive workers vs. at 62.2 for the least productive ones), in contrast to the pattern observed in the data. Finally, we compute welfare gains of between 1 and 5 percent and total output gains of up to 1 percent from implementing efficient work and retirement age patterns. We conclude that distorting the retirement age decision offers a powerful policy instrument, capable of overcompensating output losses from standard distortionary redistributive policies.