Faced with aging populations, tax rates on labor income rose in most industrial countries in the 1970's and 1980's, in large part to fund burgeoning social-security systems. The growth of the welfare state coincided with increased returns to education, and thus broader wage differentials between workers with relatively high levels of skills or education and those without. This paper provides a theoretical framework which connects these phenomena. We show that the aging of the population and the return to education both affect the politicaleconomy determination of tax rates and the generosity of transfers in a democratic framework. Using panel data on the United States and nine European countries, we provide supportive empirical evidence.

Data for the United States and countries in western Europe indicate a negative correlation between the dependency ratio and labor tax rates and the generosity of social transfers, after other factors that influence the size of the welfare state are controlled for. This occurs despite the increased political clout of the dependent population implied by the aging of the population. This paper develops an overlapping generations model of intra‐ and intergenerational transfers (including old‐age social security) and human capital formation that addresses this seeming puzzle. We show that with democratic voting, an increase in the dependency ratio can lead to lower taxes or less generous social transfers.