In this paper, we study the progressive labor tax in the context of reforming social security. Social security system in the US to some extent is redistributive, providing partial insurance against income shocks. However: with rising longevity, the current system is bound to put under the unprecedented fiscal strain (Fehr 2000, Diamond 2004, Braun and Joines 2015, Diamond et al. 2016, McGrattan and Prescott 2017). Therefore, some changes appear imperative, Reforms, proposed in the literature, usually involve linking pensions to individual contributions, thus improving effciency at the expense of the insurance loss. There appears to be a consensus that such social security reforms (a.k.a. privatizations) reduce welfare when incomes are subject to idiosyncratic shocks (Davidoff et al. 2005, Nishiyama and Smetters 2007, Fehr et al. 2008).1 Welfare gains arise predominantly through a reduction in distortions generated by social security contributions because, with privatized social security, there is a direct link between contemporaneous labor supply and future pension benefits. The origins of the welfare loss stem from the loss of insurance from redistribution inherent in the design of the current social security (see also Heer 2015).

In this paper we propose a novel way of reforming social security. Our reform consists of two elements. First, we replace the current defined benefit payout scheme characterized by regressive replacement rates with a defined contribution payout scheme, which links individual contributions to individual benefits. It raises efficiency as it reduces labor market distortions associated with contribution rates. Second, we propose to accompany this social security reform with adjustments in progressiveness of labor taxation. Specifically, we propose to increase progression in the income taxes. Thus, we partially replace the redistribution otherwise provided by social security with the one provided within the tax system. We show that more redistribution during the working periods can fully or partially compensate for the redistribution during retirement. Given the efficiency gains, privatization of social security accompanied by increased labor tax progression can improve welfare. We show that the scope for this improvement crucially depends on the response of labor supply to the social security reform. This result extends the findings of Imrohoroglu and Kitao (2009) and Heathcote et al. (2008), who studied the response of labor supply to social security and tax progressiveness.