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 in which 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 un-taxed 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: those low-productivity workers who are retired at the time of the reform and those high-productivity workers within 5 years of retirement at the time of the reform. The presence of informality has two conflicting impacts: (1) including an outside option to formal work leads to smaller long-run transfers as government revenue is lower due to substitution from the formal to the informal sector, and (2) the privatization of the Social Security system causes wage growth that informal workers can receive without facing the distortions of any remaining taxation. Quantitative results indicate that these conflicting effects roughly cancel one another out and lead to long-run welfare gains that are similar to those in an economy without informality.