Capital income taxation and reforming social security in an OLG economy

Abstract

Reforming social security can improve efficiency and reduce future fiscal strain, emerging with the rising old-age longevity. However, it generates transitory fiscal cost and reduces insurance against income risk, which is embedded in current US social security. We show that if that transitory fiscal cost is financed through increased capital income taxation, the efficiency gains can be amplified sufficiently to outweigh the costs of the reform. Our result stems from the Ramsey rule: rising old-age longevity makes capital less responsive to tax hikes. We reconcile our results with the existing literature. Our results are of policy relevance for many advanced economies which currently feature redistributive and increasingly unbalanced social security due to rising old-age longevity.