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

Klaus Schmidt-Hebbel

Working Papers Central Bank of Chile from Central Bank of Chile

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? 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.

Date: 1997-03
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