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Trade-Offs in Means Tested Pension Design

  • Chung Tran

    ()

  • Alan Woodland

    ()

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.

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File URL: https://www.cbe.anu.edu.au/researchpapers/econ/wp550.pdf
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Paper provided by Australian National University, College of Business and Economics, School of Economics in its series ANU Working Papers in Economics and Econometrics with number 2011-550.

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Length: 37 Pages
Date of creation: Aug 2011
Date of revision:
Handle: RePEc:acb:cbeeco:2011-550
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