Accounting for a Positive Correlation between Pension and Consumption Taxes

We attempt to account for a puzzling comovement between pension level and the consumption tax rate observed in the OECD data. First, using a standard overlapping generations model with lifetime uncertainty, we can find a set of optimal policy combinations of taxes and pension, but they cannot account for the data. Second, to resolve this puzzle, we consider welfare states where pension level is higher than the optimal level due to external and/or institutional reasons. In this setting, our analysis of optimal tax mix demonstrates that strengthening consumption taxation (relative to income taxation) can improve welfare, i.e., accounting for the proposed puzzle. Third, we also find that population aging further boosts the role of consumption taxation, reinforcing our main findings. Finally, our results lend support to recent pension reforms: when expanding welfare benefits, most countries tend to resort to consumption tax financing.