Tax incentives can encourage older people to delay retirement and work longer

Developed countries are facing a problem. Increasing life expectancy, coupled with low fertility, is leading to a rapidly ageing population. Countries that have publicly funded old age pensions are likely going to face challenges to their continuing affordability, because there will be fewer working age taxpayers for each pension recipient (what economists refer to as a lower 'support ratio'). The options available to policy makers include increasing the age of eligibility for pensions (as several countries have done in recent years), decreasing the real value of pensions (such as by not adjusting them for inflation), or shifting from universal pensions to means-tested pensions (where older people with high income or wealth would not be eligible to receive the pension).

All of these changes are politically tricky to implement, because as the population ages, older people (and those soon to become eligible for the pension) become an even larger share of the voting population. Also, reducing the real value of pensions (or delaying eligibility for them) may lead to increases in poverty among older people. Another alternative that may reduce these poverty concerns, is to encourage older people to delay retirement, working until they are older and, depending on the pension rules, potentially delaying their receipt of pension benefits (even when the age of eligibility has not changed). One way to encourage people to work more is to allow them to keep more of their labour earnings, such as by lowering the tax rate on labour income.

A reasonable question, then, is how much difference can a tax change make to the labour market behaviour of older people? This 2017 article by Lisa Laun (Institute for Evaluation of Labour Market and Education Policy, Sweden), published in the Journal of Public Economics (open access) provides some indication. Laun uses linked Swedish data from the "Income and Tax Register (IoT), the Longitudinal Database on Education, Income and Employment (LOUISE) and the Employment Register", which allows her to track nearly 190,000 people who turned 65 years old within three months either side of the year end, between 2001 and 2010. Importantly, there were two changes in the tax regime that occurred at the start of 2007, as Laun explains:

The first labor tax credit studied in this paper is an earned income tax credit that reduced the personal income tax on labor income only. It was introduced on 1 January 2007 for workers of all ages, with the purpose of increasing the returns from working relative to collecting public transfers. Motivated by the particular importance of encouraging older workers to remain in the labor force, the tax credit is substantially larger for workers aged 65 or above at the beginning of the tax year...

The second labor tax credit studied in this paper is a payroll tax credit for workers aged 65 or above at the beginning of the tax year. Like the earned income tax credit, it was introduced on 1 January 2007... The payroll tax rate for workers above age 65... was reduced from 26.37% in 2006 to 10.21% in 2007. Since then, it only includes pension contributions. The payroll tax credit thus reduced the payroll tax rate for older workers by 16.16 percentage points.

Laun evaluates the effect of the combination of these two tax rate changes on the labour market participation of older people. Specifically, she looks at the impact on the 'extensive margin' -whether older people work or not (as opposed to the 'intensive margin' - how many hours they work, if they are working). She essentially compares workers who are aged similarly, but on either side of the January date on which their tax rate changes. She finds that there is:

...a participation elasticity with respect to the net-of-participation-tax rate of about 0.22 for individuals who were working four years earlier.

In other words, a one percentage point decrease in the tax rate increases labour force participation by 0.22 percentage points. Given that the employment rate just before age 65 appears to be about 63 percent, and the tax rates dropped by around 20 percentage points, the effect of the Swedish tax change amounts to about 4.4 percentage points of additional labour force participation, or an increase of about 7 percent. The results are robust to various other specifications, and are similar to results from other countries in other contexts not related to retirement. Laun also shows that the retirement hazard (essentially similar to the probability of retirement) decreases by a statistically significant amount as a result of the tax change.

However, pension receipt does not change - people are just as likely to receive the pension after the tax change as before. Interestingly, in Sweden pension receipt is voluntary (but universal and not tied to  whether or not an older person is working or to their earnings, similar to the case in New Zealand), and delaying the pension allows a higher amount to be claimed later (a feature of pension systems that many countries have, but New Zealand does not). So, if working longer led to a delay in eligibility for pensions, you can bet that the effect of the tax change would be much smaller (and potentially zero).

The take-away from this paper is that incentives do matter. It is possible to incentivise older people to work longer, even when they remain eligible for the old age pension. However, this sort of change isn't going to make pensions any more affordable unless the value of pensions in real terms is reduced as well. If people are working more, then the pension could potentially be less generous without substantially increasing poverty among older people. However, that doesn't make any changes in this space any easier to introduce politically.