Taking progressivity research to European Commission
Social security is essentially about insurance. First, it gives insurance against mortality risk by providing annuitization. Second, it provides partial insurance against low-income realization by providing intra-cohort redistribution. However, such redistribution is costly because it distorts labor supply incentives. When the link between social security contribution and future benefits becomes weaker, we treat contributions more and more as taxes, not as implicit savings.
With rising longevity, the social security system in many countries is bound to be put under unprecedented fiscal strain. Therefore, some changes appear imperative. Reforms proposed in the literature usually involve linking pensions to individual contributions, thus improving efficiency at the expense of the insurance loss.
In this paper, we propose a novel way of reforming social security. Our reform consists of two elements. First, we replace the redistributive defined benefit payout scheme 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 the progressiveness of labor taxation. Specifically, we increase progression in 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.