Pension design, labor supply distortions and human capital investment Fabian Kindermann ∗ University of Würzburg and Netspar Najat El Mekkaoui de Freitas University Paris-Dauphine March 2011 preliminary version, do not quote Abstract This paper studies the optimal design of a PAYG pension system in the presence of endoge- nous human capital formation. We therefore construct a large scale OLG model in the spirit of Heckman, Lochner and Taber (1998) and Gallipoli, Meghir and Violante (2008) in which individu- als can decide about both their schooling level and about how much to invest into human capital formation on the job. Labor supply is endogenous and labor income is due to idiosyncratic shocks. In this model we try to find the optimal pension system with respect to progressivity and the number of years that should be used to calculate pension benefits. Our simulations indicate that a progressive pension system only comes at efficiency costs, since the distortive effect of pen- sion progressivity on both labor supply and human capital investment outweighs the gains from income insurance. In addition, we find that efficiency is reduced if pension benefits are only cal- culated from the last year of income rather than from a full income history. JEL Classifications: C68, H55, J24, J26 Keywords: stochastic OLG model, pension reform, tax-benefit linkage, human capital formation Research support by the Deutsche Forschungsgemeinschaft (grant FE 377/ 5-1) and University Paris- Dauphine is gratefully acknowledged. ∗ Corresponding author: Address: Department of Economics, University of Würzburg, Sanderring 2, D-97070 Würzburg, Phone: +49 931 82975 Email: kindermann.fabian@uni-wuerzburg.de