Earning Distribution and Labour Supply after a Retirement Earnings Test Reform
Norwegian administrative data are used to evaluate the impact of a doubling of the threshold in the retirement earnings test. We find almost no impact on the extensive margin, but a positive effect on the intensive margin. This positive effect is uneven over the earnings distribution, and concentrated on workers around the threshold, increasing with exposure to the reform and leading to a decrease in earnings inequality. Individuals who remain active until retirement age respond more to the reform. Conditional on pre-reform earnings, we find little evidence that individual characteristics such as working histories influence the responsiveness to the reform.
One of the measures undertaken by governments around the world to encourage their workforces to delay retirement is to reform or altogether abolish the old age pension earnings test. Among the first to undertake this reform was the US, which exempted workers aged 70- 71 in 1983 and exempted workers above full retirement age from the Social Security earnings test in 2000.
The earnings test in the UK (“the earnings rule”), which implied a 100% withdrawal of pension against earnings in an interval corresponding to roughly between 21 and 35 hours per week at average earnings, was abolished in 1989. Nevertheless, similar policy reforms have been considered and implemented in many other countries.
Considering the potential impact of this particular reform on elderly labour market behaviour, and the theoretical ambiguity of the labour supply response to changes in the earnings test, this type of reform has received remarkably little attention in the literature until recently. To date, most studies have focused on the US reform. The results have varied, as some conclude that there has been little effect on the labour supply (see for example, Gruber and Orszag, 2003), although the general thrust of various analyses suggests that earnings test abolition leads to a quite significant increase in the elder labour supply (Engelhardt and Kumar, 2007; Friedberg, 2000; Friedberg and Webb, 2006; Song and Manchester, 2007). In a recent study of US reforms, Haider and Loughran (2008) utilize both survey and administrative data, and conclude that the US earnings test in operation until 2000 did significantly reduce the earnings of persons over the full retirement age, with the main effect felt for those at the lower end of the age bracket.
Similar evidence is also found in other countries. Disney and Smith (2002) confirm the impact of the earnings test in a study based on UK data for the abolishment of the earnings test in 1989. They estimate an increase of 3-4 hours per week for males, with approximately half that for females after the reform. For Canada, Baker and Benjamin (1999) find shifts from part-time to full-time work, which they tentatively attribute to fixed costs of work or labour market rigidities. In the end, the conclusion that an earnings test depresses work activity still comes through.
In 2002, the exempt threshold in the Norwegian earnings test, above which 40% of earnings were deducted from the old age pension for persons age 67-69, was doubled. In contrast to the US test, the Norwegian earnings test can be unambiguously viewed as an implicit tax on earnings since there is no actuarial adjustment, i.e. future pension benefits will not be adjusted to “compensate” the immediate reduction due to the earnings test. If individuals are forward-looking and behave in a way consistent with the life cycle framework, an actuarially fair earnings test such as that of the US would have little or no effect on the labour supply. Hence, the Norwegian reform provides a better opportunity to study the responses of the elderly to changes in financial incentives.