Tax Incentives, Turnover Costs and Private Pensions

October 1981
Southern Economic Journal;Oct81, Vol. 48 Issue 2, p365
Academic Journal
In this paper I examined the role that turnover costs and the income tax play in getting pensions included in a labor contract. The most important results are derived by comparing the optimal contract with and without income taxes. Without income taxes it seems unlikely that a pension will be included in a contract.[14] If a firm wants to reduce costly labor turnover, it could simply increase the slope of the wage profile. However, when an income tax is introduced into the model, the expected present value of lifetime income may be increased by deferring a portion of wages until retirement. Therefore, at least in a competitive market the tax incentives explain the existence of private pensions. Although the tax incentives are necessary for pensions to exist, the level of turnover costs play a key role in determining the level of benefits.[15] When turnover costs are minimal, a pension may not be worth the administrative costs in spite of the tax incentives.
A brief examination of historical evidence gives some support to the hypothesis that the tax incentives are the driving force behind getting private pensions included in labor contracts. Prior to the institution of the income tax laws in 1913 there were very few pension plans in the United States. In its early years the income tax affected only a small proportion of the population [8], and pension coverage did not expand very rapidly. In 1940 about 4.1 million workers were employed in firms with pension plans [5], and these plans were concentrated in large non-competitive industries such as railroads, public utilities and steel.[16].


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