Tax Incentives for Private Life Annuities and the Social Security Reform: Effects on Consumption and on Adverse Selection

In a two-period model with uncertainty about life expectancy, we analyze several measures that are typically included in a social security reform: tax incentives for private life annuities, a cut in the social security benefits, and an increase in the social security tax. First, we look at the demand side and study the effects on old-age provision for a given annuity price. It is shown that tax incentives for life annuities indeed stimulate annuity demand, if a cut in the supply of public goods to finance the tax incentives does not influence the private consumption choice. In this case, such incentives counteract the negative effects on old-age consumption of the other two reform instruments adopted to maintain long-run solvency of the social security system. However, when considering an increase in the income tax to finance the tax incentives, the positive effect on annuity demand is smaller and may even turn negative for some individuals. Second, we assess the effects of the reform measures on the equilibrium price, in view of an adverse-selection problem in the private annuity market. We find that a cut in the social security benefit rate reduces the adverse selection and consequently the equilibrium price, while an increase in the social security tax raises the equilibrium price. The effect of a tax incentive for life annuities is ambiguous and depends on the degree of risk aversion of the individuals. Adverse selection is mitigated if the coefficient of relative risk aversion does not exceed a critical value, which is shown to be higher in the case when the tax incentives are financed by a reduction in public goods than in the case when they are financed by an increase in the income tax.