Flexible Retirement and Optimal Taxation

This paper studies optimal income taxes and retirement benefits in a life-cycle model with an intensive margin of labor supply and an endogenous retirement age. The government insures and redistributes resources across individuals who privately observe persistent shocks to their productivity. In this environment, the optimal labor tax is hump-shaped in age, unlike in existing models with no endogenous retirement choice, in which the optimal tax is everywhere increasing. Because of the retirement margin, the total Frisch elasticity of labor supply increases with age. This elasticity effect flattens the labor tax for old workers relative to the model without an extensive margin. In addition, as high-productivity workers retire later than low-productivity workers, the distribution of productivity in the labor force features, over time, a higher mean and lower variance than in the general population. This novel composition effect pushes for a labor tax that declines for old workers. Optimal policy balances these effects with the insurance benefits of taxation, yielding the hump-shape in tax rates. In numerical simulations, the optimum achieves sizable welfare gains that approximately optimal age-dependent taxes fail to capture under the current US Social Security system. Yet, an optimal combination of age-dependent linear taxes with increasing-in-age delayed retirement credits generates welfare gains that are close to those from the optimum.