Time averaging meets Heckman, Lochner, and Taber and Ben-Porath

Abstract

The Heckman et al. (1998a) (HLT) model includes credit markets and within-period labor supply indivisibilities, two essential features of Ljungqvist and Sargent (2006) “time-averaging” models. But by assuming inelastic labor supplies until a mandatory retirement age, it shuts down time-averaging. We activate time-averaging by endogenizing retirement ages. Our addition of a baseline social security system puts all workers at corner solutions of their retirement decisions, letting our model reproduce most outcomes in HLT's model. By dislodging workers from those corners, social security and tax reforms raise the aggregate labor supply elasticity and can bring about a “dual labor market.” HLT's Ben-Porath human capital technologies generate steeper earnings profiles for college-educated workers that in our model make their labor supplies more resilient to tax and social security reforms than high school workers' labor supplies. But nonconvexities inherent in the Ben-Porath technologies can bring “tipping points” at which tax increases cause workers who at lower tax rates had chosen long careers and made substantial human capital investments to jump discretely to choosing much shorter careers and doing much less on-the-job human capital accumulation.