Social Desirability of Earnings Tests

Abstract. In many countries, pension systems involve some form of earnings test; i.e. an individual's benefits are reduced if he has labor income. This paper examines whether or not such earnings tests emerge when pension system and income tax are optimally designed. We use a simple model with individuals differing both in productivity and in their health status. The working life of an individual has two 'endings': an official retirement age at which he starts drawing pension benefits (while possibly supplementing them with some labor income) and an effective age of retirement at which professional activity is completely given up. Weekly work time is endogenous, but constant in the period before official retirement and again constant (but possibly at a different level), after official retirement. Earnings tests mean that earnings are subject to a higher tax after official retirement than before. We show under which conditions earnings tests emerge both under a linear and under a non-linear tax scheme. In particular, we show that earnings tests will occur if heterogeneities in health or productivity are more significant after official retirement than before.