Life Cycle, Financial Frictions and Informal Labor Markets: The Case of Chile

In this paper we study the implications of economic policies that affect household’s income. We focus on Chile after the massive demonstrations against the existing standard of living observed in 2019. Using a search model with life-cycle features and survey data, we found that an equivalent change in labor tax rates and non-contributary pensions have opposite effects on labor markets, specifically on informality and unemployment duration. Non-contributary pensions offers a milder trade-off as it produces a second order increase in informality. However, due to the presence of informal labor markets and financial frictions, non-retired agents increase their current consumption only after a tax cut. That is, in this framework, a positive wealth shock can reduce consumption. Thus, when we take into account the impact on welfare, as households are assumed to value only consumption, cutting taxes seems to be preferred. We characterize labor market and consumption-savings decisions. We found 2 effects operating simultaneously and in opposite directions: substitution and wealth. Due to the presence of risk averse agents and incomplete capital markets, the latter prevails suggesting that the life cycle aspects of the labor market are critical to understand policy trade-offs.