Nonseparable preferences and optimal social security systems

In this paper, we consider economies in which agents are privately informed about their skills, which evolve stochastically over time. We require agents’preferences to be weakly separable between the lifetime paths of consumption and labor. However, we allow for intertemporal nonseparabilities in preferences like habit formation. We show that such nonseparabilities imply that optimal asset income taxes are necessarily retrospective in nature. We show that under weak conditions, it is possible to implement a socially optimal allocation using a social security system in which taxes on wealth are linear, and taxes/transfers are history-dependent only at retirement. The average asset income tax in this system is zero. Kocherlakota acknowledges the support of NSF 06-06695. We thank Arantxa Jarque, Ned Prescott, Adam Slawski, Hakki Yazici, and participants in seminars at various institutions for their comments. The views expressed in this paper are those of the authors and not necessarily those of the Federal Reserve Banks of Minneapolis and Richmond or the Federal Reserve System.