Pitching income inequality against longevity

Pitching income inequality against longevity

We show that labor tax progression can effectively substitute for the insurance implicit in redistributive social security, challenging the existing view in the literature that linking pensions to individual incomes wages reduces distortions associated with social security, but severely reduces welfare due to removing insurance. Our study shows that privatizing social security can deliver aggregate welfare gains if alternative channels of providing insurance are implemented.

We develop a stylized theoretical model. The agents participate in fully redistributive social security and pay a progressive labor income tax. In this setup, both the pension benefits and labor taxation provide insurance against income uncertainty. Then, we introduce a pension benefit proportional to individual contributions of each agent. In this setup, income shocks from the working period carry over to retirement, and the only source of redistribution is labor tax progressivity. We replace redistributive social security, where benefits partially pool between idiosyncratic income shocks with an arrangement where the individual pension benefit depends solely on individual contributions. We complement this change with an increase in redistribution through labor tax progressivity in during the working period. We show that there exist changes in labor income taxes accompanying such social security reform, which are fiscally neutral and at the same time raise welfare.

We take the intuitions derived from this stylized setup to a calibrated general equilibrium setup, replicating the features of the US economy. We characterize the conditions under which disincentives from redistributive social security may be reduced without loss of welfare. We compensate insurance loss of insurance from privatizing social security through greater progression in the instantaneous labor taxation. We find that for plausible calibrations of Frisch elasticity, privatizing social security coupled with labor tax progression may deliver aggregate welfare gains.