Health Care Costs, Taxes, and the Retirement Decision: Conceptual Issues and Illustrative Simulation

Rudolph G. Penner Richard W. Johnson

WP#2006-20

Abstract

Soaring health costs are squeezing government and household budgets. Rising public costs are also likely to boost future tax burdens. This study considers how rising tax burdens and out-of-pocket health care costs will affect the timing of retirement. Conceptually, the impact of taxes depends on which particular taxes are raised. How well people anticipate future increases in taxes and health care costs, and how they react at younger ages, will crucially affect retirement impacts. If households are farseeing rational planners, higher health costs and tax burdens will likely induce more saving and harder work while young, muting effects on retirement decisions.

To gauge the potential importance of rising taxes and health care costs to the retirement decision, the study compares projected retirement income for prototypical workers under two sets of assumptions about future tax and health care burdens. The results show that a moderate-income couple would have to work an additional 2.5 years under the scenario with high health care costs and tax burdens to receive as much income in the first year of retirement — net of taxes and out-of-pocket health spending — as they would receive under the low-cost scenario. The low-income couple would have to delay retirement under the high cost scenario by about 2.4 years to offset income lost from higher taxes and health costs, and the high-income couple would have to work an additional 2.8 years.