Optimal Income Redistribution

We study whether redesigning the social security and income tax-transfer systems can deliver significant welfare gains. Our rich quantitative model features both realistic inequality over the lifecycle and the key channels through which redistributive policies can distort aggregate allocations. We find that there are two distinct ways to achieve significant welfare gains. The first prioritizes reducing distortions through a regressive pension system, resulting in higher inequality. The second reduces inequality through progressive pensions, complemented with a less progressive tax system to mitigate the rise in distortions. In both reform types, pension progressivity emerges as a powerful instrument to either manage distortions or redistribute income within generations. Since redistributive instruments turn out to be highly distortionary in our benchmark economy, the policy reducing distortions turns out to be optimal under utilitarian social welfare.