Nonlinear Means-Tested Pensions : Welfare and Distributional Analyses

Several countries, including Australia, have a means-tested public age pension. Means testing the age pension can reduce the overall fiscal burden relative to a universal pension, but can also distort households’ incentives to work and save. Policymakers can influence the sizes of these distortions by adjusting the structure of the pension function (e.g., the withdrawal rate of the pension). In contrast with the standard piece-wise linear means test, we introduce a class of non-linear means tests that contain the standard linear test as a special case and allow for progressive or regressive tests in which the withdrawal rate respectively increases or decreases as means increase. To identify the socially optimal nonlinear income-tested pension function, we develop an overlapping generations model of a small open economy with heterogeneous agents with stochastic wage and mortality profiles. We find that the optimal nonlinear income test is strongly regressive with a low average withdrawal rate as income increases