The effect of disability pension incentives on early retirement decisions

I investigate the incentive effects of disability pensions on disability retirement entry as a special type of early retirement. The implicit tax rate on further work is included as a forward looking incentive measure. A substantial change of the disability pension legislation caused exogenous variation in disability benefits in Germany in 2001 and is used to obtain estimates of individual's responses to financial incentives. Benefit levels appear to have no effect on the labour market behaviour. At the same time, there is a sizable and significant disincentive effect of implicit taxes on labour market income, indicating that alleviating such disincentives would likely increase labour force participation. Since the response to financial incentives occurs mainly among those in good health, such a policy might on the other hand imperil the aim of providing insurance against a health‐induced loss of one's working capacity.

► Topic the incentive effects of disability pensions on disability retirement entry. ► Key variable implicit tax rate on work income as forward looking incentive measure. ► Identification exogenous variation in disability benefits by reform in Germany in 2001. ► Result1 benefit levels have no effect on the labour market behaviour. ► Result2 large and significant effect of implicit tax, for those in good health only.