Optimal Taxation Paper 7, Part IIB Dr Toke Aidt

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Optimal TaxationPaper 7, Part IIBDr Toke Aidt
Lecture 7
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The optimal tax scheduleunder undertainty
c(y)
y
c(y)
c(y)
y
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The optimal tax schedule

• Trade off between
• Prudence Reducing the MTR results in more
  precautionary action been taken (saving, effort,
  education).
• Risk aversion Reducing the MTR exposes
  individuals to more risk
• The optimal tax schedule balances the benefit of
  social insurance with the disincentive to
  self-insure

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MTR
P low
P high
y
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Intuition

• Little prudence high risk aversion increasing
  MTRs. Why?
• Little prudence most extra income is due to
  luck rather than savings incentive effect of
  high MTRs low.
• High risk aversion preference for safe
  average over uncertain extremes strong take
  extra income off individuals with high incomes.

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Outline

• Why does the government provide pensions?
• PAYG vs Funded Pensions
• The demographic problem and sustainability

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Saving for retirement
Income
c,y
Asset path
Planned Consumption path
T
R
t
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Saving for retirement

• Consumption smoothing trough a perfect capital
  market makes it rational for individuals to save
  retirement
• Precautionary saving motive if there is some
  uncertainty about future income or consumption
  need in old age.

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Rationale for government intervention

• Efficiency rationale
• A pension scheme may allow trades that can
  improve the welfare of all.
• Capital market imperfections.
• Redistribution rationale
• Inter-generational redistribution motivated by
  systematic differences in productivity across
  generations.
• Intra-generational redistribution motivated by
  desire to transfer resources over time within a
  generation.

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Rationale for government intervention

• Paternalistic rationale
• Bail out myopic individuals who fail to save
  sufficiently.
• Insurance rationale
• Life span is uncertain
• Risks to earning potential while young

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Two types of government pension systems
PAYG Pension pension of current old paid for by
current young. Funded Pension pension of
current old paid for by savings when young.
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PAYG vs Funded pensionThe behavioural effects

• Funded system
• private savings are displaced by public savings
  through the pension system, so aggregate savings
  are unchanged.
• Capital accumulation is unaffected
• PAYG system
• Private savings are reduced but without any
  compensating increase in public savings, so
  aggregate savings fall.
• Capital accumulation is reduced.

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Efficiency rationale for a PAYG system

• An economy is dynamically inefficient if the
  capital stock is greater than that which
  maximises consumption per worker (the golden
  rule).

f gtng gt efficient f ltng gt inefficient
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Efficiency rationale for a PAYG system

• A PAYG system reduces total savings and hence the
  steady state capital stock. If an economy is
  dynamically inefficient this
• Benefits those who save less now
• Benefits those who get more consumption in the
  future.
• A funded system cannot achieve this because total
  savings are unaffected.

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Relative Return on PAYG and Funded Pension
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Return on a PAYG System

• Each person (of whatever generation) pays a
  proportion t of income when young
• Benefits when old depend on contribution of
  current young

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The Return on a Funded System

• Each person (of whatever generation) pays a
  proportion t of income when young
• This is invested in financial markets and earns
  a market return equal to 1r
• When old, the individual receives this return on
  the initial payment

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The return comparison
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Comparison

• PAYG better than Funded Pension if the economy is
  dynamically inefficient.
• Return to PAYG system affected by demographic
  shocks (aging) and by the long run growth
  potential of the economy.
• Return to funded system is not directly affected
  by demographic shocks, but linked to financial
  market risk.

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Comparison

• So, why have a PAYG state pension?
• high income growth?
• uncertainty about time of death (and no private
  insurance)?
• pensioners tend to be poor (low life-cycle wealth
  relative to the young) but majority of pensioners
  had similar life-cycle wealth?

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Comparison

• Why have a Funded Pension rather than no public
  pension?
• Myopia individuals dont save enough
• Imperfect capital or insurance markets

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The pension crises
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Sustainability
Demographic trends
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Funding Gaps
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What can be done?

• Switch from PAYG to a funded system
• Clean-break
• Cohort-specific
• PAYG can be made sustainable
• if benefits are falling
• retirement age is increased
• taxes are rising
• economic growth is fast enough

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Summary

• PAYG vs funded depends on r vs (ng)
• PAYG can be sustainable
• PAYG discourages saving

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What is next?

• Lindahl taxation and the benefit principle
• Taxation by concent