Trade-Offs in Means Tested Pension Design

36 Pages Posted: 6 Oct 2011

See all articles by Chung Tran

Chung Tran

Australian National University (ANU) - School of Economics

Alan D. Woodland

University of New South Wales

Date Written: August 1, 2011


Inclusion of means testing into age pension programs allows governments to better direct benefits to those most in need and to control funding costs by providing flexibility to control the participation rate (extensive margin) and the benefit level (intensive margin). The former is aimed at mitigating adverse effects on incentives and to strengthen the insurance function of an age pension system. In this paper, we investigate how means tests alter the trade-off between these insurance and incentive effects and the consequent welfare outcomes. Our contribution is twofold. First, we show that the means test effect via the intensive margin potentially improves the insurance aspect but introduces two opposing impacts on incentives, the final welfare outcome depending upon the interaction between the two margins. Second, conditioning on the compulsory existence of pension systems, we find that the introduction of a means test results in nonlinear welfare effects that depend on the level of maximum pension benefits. More specifically, when the maximum pension benefit is relatively low, an increase in the taper rate always leads to a welfare gain, since the insurance and the positive incentive effects are always dominant. However, when maximum pension benefits are relatively more generous the negative incentive effect becomes dominant and welfare declines.

Keywords: means-tested pension, Social Security, optimal policy, overlapping generations, dynamic general equilibrium

JEL Classification: D9, E2, E6, H3, H5, J1

Suggested Citation

Tran, Chung and Woodland, Alan D., Trade-Offs in Means Tested Pension Design (August 1, 2011). Available at SSRN: or

Chung Tran (Contact Author)

Australian National University (ANU) - School of Economics ( email )

Arndt Building 25B
Canberra, Australian Capital Territory 0200

Alan D. Woodland

University of New South Wales ( email )

School of Economics
Sydney, NSW 2052
61293859707 (Phone)
61293136337 (Fax)

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