In case of emergency, tax capital income
Demographic processes are extremely slow, typically. Issues such as rising longevity or declining fertility literally take generations to materialize and thus we should be able to accommodate for them in policy. Not so fast. In fact, most of the time, we simply disregard them and then ... it is too late. We offer that for contexts such as longevity, if you are late with policy adjustment, taxing capital income may be particularly suitable.
We study the interactions between capital income tax and social security privatization in the context of rising longevity. In an economy with idiosyncratic income shocks, redistributive defined benefit pay-as-you-go social security provides some insurance against income uncertainty. However, this redistribution makes social security contributions distortionary. Reforming such social security to (partially funded) defined contribution involves on the one hand loss of insurance, and on the other hand reduced distortions associated with contributions, and raised pension wealth. Furthermore, it necessitates fiscal adjustment: transition costs in the medium term and reduction in the overall taxation in the long term. The current view in the literature states that such reform would reduce welfare. We show that capital income taxation provides a superior alternative, especially in the case of longevity whereas compared to fiscal closures utilized in earlier studies attenuate them. We explain the mechanism behind this result and reconcile our results with the earlier literature.