Social Security Reform in the Presence of Informality

As populations age, countries across the globe are dealing with the issue of how to fund retirement consumption for their workers. The design of Social Security programs is more difficult when the country also exhibits an informal economy where workers avoid the taxation of the government and are not entitled to its benefits. In this paper, I study the example of Chile–a country that transitioned from a pay-as-you-go Social Security system to a system of private, individual retirement accounts in 1981 and also exhibits a significant informal sector–in order to quantify the transitional welfare impact of Social Security privatization when workers have the option to evade the public system through informality. I construct an OLG model which allows households to split working time between a taxed formal sector, an untaxed informal sector, and home production. I find large long-run welfare gains of roughly 10 and 15 percent for low and high-productivity workers, respectively. However, these gains come at the expense of losses for two groups: low-productivity workers who are retired at the time of the reform and high-productivity workers within 5 years of retirement at the time of the reform. The presence of informality leads to conflicting mechanisms: (1) the elasticity channel decreases welfare gains from reform: including informality as imperfectly substitutable with formality in utility decreases labor supply elasticity and renders the pay-as-you-go payroll tax less distortionary, and (2) the market wage channel increases welfare gains from reform: the privatization of the Social Security system causes wage growth which informal workers can receive without facing the distortions of any remaining taxation in the formal sector. Quantitative results indicate the elasticity channel is stronger in the case of Chile, and the inclusion of informality decreases the long-run welfare gains from privatizing Social Security. (Copyright: Elsevier)