On the design of an optimal non-linear pension system with habit formation

Abstract

We study optimal lifetime redistributive policy in a two-period model where individuals differ in both productivity and future discounting and where their retirement period utility is dependent of the earlier standard of living, i.e. there is a habit formation effect. We consider both welfarist government respecting individual utilities as well as the case where the government aims at correcting the short-sightedness of the individuals. We assume that both gross income and saving are observable. Hence the pension benefits schemes can be based on both gross income and saving of each type. Analytical results depend on the pattern of incentive constraints. The two sources of imperfect information, wage rate and time discounting, interact, so the effects cannot be separated. To consider closer the tax and pension policy and the effect of the degree of habit formation the problem is also solved numerically. We found support for non-linear pension program.