Policy effects of the elasticity of substitution across labor types in life cycle models

- This paper studies how modeling assumptions impact the results of policy analysis.
- These assumptions are explored in a long lived agent overlapping generations model.
- We relax the assumption that skilled labor and unskilled labor are perfectly substitutable.
- Our findings are put in the context of a social security reform and an income tax reform.
- We find that ignoring production complementarity may impact conclusions of policy analysis.

This paper investigates how the production function elasticity of substitution across different labor types impacts the results of policy analysis in multiperiod lived agent overlapping generations models. We critique and investigate the popular structure that simply assumes that workers with different age, experience or education are perfectly substitutable in production. This structure is inconsistent with empirical evidence of production complementarities. We couch our findings in the context of two types of policy reforms: a social security reform and a tax reform. These reforms were chosen in part not only because of the large interest in them, but also because of their differing effects on life cycle decisions. We find that ignoring production complementarity may influence the conclusions of policy analysis.