Flexible Retirement and Optimal Taxation

Abstract

Raising the retirement age is a common policy response when social security schemes face fiscal pressures. We develop and estimate a dynamic life cycle model to study optimal retirement and tax policy when individuals face health shocks and income risk and make endogenous retirement decisions. The model incorporates key features of Social Security, Medicare, income taxation, and savings incentives and distinguishes three channels through which health affects retirement: nonconvexities in labor supply due to health-dependent fixed costs of working, earnings reductions, and mortality risk. We estimate our model to match US microdata and show that labor supply nonconvexities play a dominant role in driving early retirement, making rigid increases in the retirement age welfare reducing. In contrast, more flexible policies, such as increasing the dependence of Social Security benefits on the claiming age, can improve welfare and pay for themselves with a fiscal surplus. We map a range of policy reforms to their marginal values of public funds (MVPFs), showing that certain incentives to delay claiming offer MVPFs of infinity while broad-based retirement age increases have negative willingness-to-pay. These findings offer novel retirement policy prescriptions and challenge the prevailing emphasis on raising the retirement age.

Keywords: Retirement, Social Security Reform, Medicare, Life cycle model, Health

JEL Classification: H21, H55, J26, D15