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


  • Klaus Schmidt-Hebbel


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? Yes, as shown by the simulations for a representative economy reported in this paper, based on the stady-state solution of a twosector 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. Is this outcome empirically likely? No, as suggested by reviewing 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.

Suggested Citation

  • Klaus Schmidt-Hebbel, 1997. "Pension Reform, Informal Markets and Long-Term Income and Welfare," Working Papers Central Bank of Chile 04, Central Bank of Chile.
  • Handle: RePEc:chb:bcchwp:04

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    Cited by:

    1. Laurence J. Kotlikoff & Kent Smetters & Jan Walliser, 2001. "Finding a Way Out of America's Demographic Dilemma," NBER Working Papers 8258, National Bureau of Economic Research, Inc.
    2. Jung, Juergen & Tran, Chung, 2012. "The extension of social security coverage in developing countries," Journal of Development Economics, Elsevier, vol. 99(2), pages 439-458.
    3. Sebastian Edwards & Alejandra Cox Edwards, 2000. "Economic reforms and labour markets: policy issues and lessons from Chile," Economic Policy, CEPR;CES;MSH, vol. 15(30), pages 181-230, April.
    4. Solange Berstein & Alejandro Micco, 2002. "Turnover and Regulation: The Chilean Pension Fund Industry," Working Papers Central Bank of Chile 180, Central Bank of Chile.

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