The Hayek Pension: An efficient minimum pension to complement the welfare state

A means tested minimum income for old age creates an incentive for some not to save for old age and instead to free ride. Recent literature is undecided to what extent this inefficient savings distortion should be addressed by a compulsory pension system because resulting labour-leisure distortions could be even worse. In a simple optimal taxation framework we show that it is Pareto improving to fully eliminate the savings distortion by means of a compulsory pension termed “Hayek pension” that decreases with after-tax lifetime earnings, with zero pension benefits for middle and high incomes. A combination of the Hayek pension and the contribution dependent Bismarck pension is found to be superior to the tax financed flat benefit Beverage pension.