Pension Reform, Informal Markets, and Long-Term Income and Welfare

Posted: 9 Oct 1997

Abstract

It is well known that a pay-as-you-go (PAYG) pension system lowers saving, income, and welfare of future cohorts in a one-sector economy because it entails a transfer to the first cohorts of PAYG pensioners. Is the opposite result possible in a two-sector (formal-informal production) economy? This paper provides a positive answer to this question by reporting simulations for a representative economy based on the steady-state solution of a two-sector two-period overlapping-generations model. A PAYG system can raise long-term saving, income, and welfare in a two-sector economy if the formal sector (forced to pay mandatory PAYG taxes) is more capital intensive than the non-taxed informal sector, causing higher wages and lower interest rates. Empirically this outcome is not likely as suggested by the stylized features of real world pension systems and formal-informal market structures. Therefore, replacing PAYG by a fully-funded pension system is still more likely than not to raise long-term saving, income, and welfare levels.

JEL Classification: E2, H55

Suggested Citation

Schmidt-Hebbel, Klaus, Pension Reform, Informal Markets, and Long-Term Income and Welfare. Available at SSRN: https://ssrn.com/abstract=35438

Klaus Schmidt-Hebbel (Contact Author)

Central Bank of Chile ( email )

Agustinas 1180
Santiago
Chile
(56-2) 670-2386, 670-2586 (Phone)
(56-2) 670-2836 (Fax)

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