Moving from a Pay as You Go to a Defined Contributions Pension Scheme: Does it Boost Participation in the Formal Labour

This article exploits the wide variation in the incentives individuals face towards formal work introduced by the Chilean pension reform of the early 80s. Through a non-lineal random effects dynamic model that allows for state dependence and unobserved heterogeneity we estimate the effect of pension system design on individuals' labour market formality decisions. Results indicate that individuals in the new pension scheme are 23 percentage points more likely to be formal than those in the old scheme at any one period t. State dependence is even more important indicating that labour market past decisions do affect future ones. The unobserved heterogeneity is also high and significant but its magnitude is only a fifth of the state dependence. The results on state dependence and initial condition suggest there is scope for public policy to affect formality decisions. Since the outcome variable is discrete and given the findings on state dependence, a change in pension system should have a lasting effect on formality. We perform simulations that take into account the dynamics of the model to look at the extent of this persistence. Indeed, we find that the boost in formality caused by the reform lasts throughout the life cycle. The simulated individual in the new pension scheme is 34 percentage points more likely to be formal than the one in the old pension system at the end of the working life..