Implicit Pension Taxes over the Life Cycle: Efficiency Costs and Tax Smoothing

This paper studies the efficiency cost of pay-as-you-go pension systems. The return on pension contributions – typically average income growth – is lower than the market return on capital. Because the gap between these returns compounds over the life cycle, early-career contributions have a higher implicit tax rate. I develop a sufficient-statistics framework in which the deadweight loss depends on the age profile of implicit tax rates. Deadweight loss is minimized when the implicit tax rate is constant, mirroring the logic of tax smoothing. I then propose an implementation within a notional defined contribution design: contributions are valorized at a higher, market-based rate of return, while a lower fraction of contributions is credited to notional accounts and the remainder treated as a pure tax. Finally, I apply my deadweight loss formula to OECD PAYGO pension systems. Under the assumed parameter values, the deadweight loss averages 19 percent. I find that only 0.2 percentage points is attributable to the uneven timing of implicit taxation.