Published online by Cambridge University Press: 20 February 2014
In this paper, I show that traditional earnings related pay-as-you-go pension systems as we see them in many OECD countries subsidize human capital formation. The reason is that these systems come along with an implicit tax structure that features high tax rates at the beginning of working life and low tax rates toward the end. When the costs of human capital investment are mainly time costs, such an implicit tax structure lowers the costs of human capital investments and simultaneously increases the payoff. The fact that higher skilled workers tend to have steeper wage profiles over the working phase than the unskilled enforces this mechanism. I first show this result in a simple analytical model and then quantify the macroeconomic and welfare effects of making the implicit tax structure age independent in a large-scale overlapping generation model, in which households can invest in human capital both by going to college and through on-the-job training. In terms of welfare, such a reform comes along with a lot of intergenerational redistribution. Although the welfare of current retirees may increase by about 4.5% of their remaining life-time resources, current older workers will lose due to an increase in their implicit tax rates. The welfare of future generations slightly declines by 0.1%.
I thank the editor Joshua Rauh and two anonymous referees as well as Hans Fehr, Jonathan Heathcote, Kai Eberhard Kruk, Alexander Ludwig, Jochen Mierau and seminar participants at the Netspar Pension Workshop, 4th RGS Doctoral Conference, OLG Days, Jerusalem Summer School in Economic Growth, CMR Macroeconomic Workshop and University of Minnesota for very helpful comments. Research support by the Deutsche Forschungsgemeinschaft (grant FE 377/5-1) is gratefully acknowledged.