Pension design, labor supply distortions and human capital investment

This paper studies the optimal design of a PAYG pension system in the presence of endogenous human capital formation. We therefore construct a large scale OLG model in the spirit of Heckman, Lochner and Taber (1998) and Gallipoli, Meghir and Violante (2008) in which individuals can decide about both their schooling level and about how much to invest into human capital formation on the job. Labor supply is endogenous and labor income is due to idiosyncratic shocks. In this model we try to find the optimal pension system with respect to progressivity and the number of years that should be used to calculate pension benefits. Our simulations indicate that a progressive pension system only comes at efficiency costs, since the distortive effect of pension progressivity on both labor supply and human capital investment outweighs the gains from income insurance. In addition, we find that efficiency is reduced if pension benefits are only calculated from the last year of income rather than from a full income history.