So far the economic literature has concentrated on analyzing the income tax and pension scheme in isolation. The present paper asks how both transfer schemes should be optimally designed in a society where individuals differ in productivity and rationality. Rational agents (if not liquidity constrained) smooth consumption over lifetime while myopic agents suffer from self-control problems and overconsume in young age, even though, ex post they regret their earlier decisions. The government’s aim is twofold. On the one hand, it wants to redistribute income from high- to low-productivity agents. On the other hand, it aims to secure old-age consumption possibilities for myopic agents. Analytical and numerical results show that, redistribution of the income tax scheme is increasing in society’s prevalence of self-control problems while it is decreasing in the pension scheme. The two transfer schemes are perfect substitutes when individuals do not suffer from self-control problems.
