The Impact of Pension System Designs in Labor Markets with Informality Restricted; Files Only

Abstract

I examine the impact of pension systems in economies with large informal labor markets using Peru as a case study. In these economies, mandatory participation in contributory pension systems can only be enforced on formal-sector workers.

As a result, the design of the pension system can have an important impact on workers' decisions to work in the formal sector.

Using a 3-period overlapping generations model (OLG) I explain that mandatory contributions to the pension affect the liquidity constraint of workers. I show that, in economies with informal labor markets, mandatory savings for retirement have an impact on workers' optimal decisions to take informal or formal jobs.

Following this finding, I study the decision to work in formal or informal jobs along the worker's life-cycle and in interaction with other factors that affect the attractiveness of formal jobs. I develop a heterogeneous agent life-cycle, OLG model where informality arises endogenously as workers choose their optimal working sector each period. Formal workers choose between a pay-as-you-go and an individual-account pension system, while the government finances a non-contributory means-tested pension for the poor and uncovered elderly. Workers in the economy face earnings and job separation risk. The mandatory contributions formal workers make to the pension system impose a liquidity constraint on lower income workers making them more likely to choose informal jobs. I show that both types of contributory pension systems affect labor decisions and that removing them increases formality and is welfare improving. Without any contributory pension system, the number of elderly individuals receiving the non-contributory social pension expands, but the government has a larger tax base of formal workers to offset financing this increase. Finally, in comparison to having both types of pension system or only an individual-account system, an economy with a PAYG-only system has the highest ex-ante welfare. Such economy has more high-income workers in the PAYG system which increases contributions. In addition, pension outlays are lower because benefits paid are limited to individuals with a minimum number of contributions and capped. With relatively lower cost of the PAYG system, the government can lower income taxes, which further increases formality.

Table of Contents

1 Mandatory Savings for Retirement in the Context of Informality 1

1.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

1.2 Literature Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

1.3 Data and Empirical Findings . . . . . . . . . . . . . . . . . . . . . . . . . . 7

1.4 Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

1.4.1 The Formal Household Problem . . . . . . . . . . . . . . . . . . . . . 15

1.4.2 The Informal Household Problem . . . . . . . . . . . . . . . . . . . . 16

1.4.3 The Government Problem . . . . . . . . . . . . . . . . . . . . . . . . 17

1.5 Numerical Exercise . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

1.6 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

1.7 Supplemental Material . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

1.7.1 Savings and Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

1.7.2 Econometric Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

1.7.3 Robustness Check by Quintile . . . . . . . . . . . . . . . . . . . . . . 28

1.7.4 Mandatory Savings and Wealthy Hand-to-Mouth . . . . . . . . . . . 30

1.7.5 Numerical Results Parameters . . . . . . . . . . . . . . . . . . . . . . 35

2 The Impact of Pension Systems in Labor Markets with Informality 37

2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38

2.2 Case study of Peru . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48

2.2.1 The data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48

2.2.2 Labor Market Facts . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

2.2.3 Retirement Facts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55

2.3 Pension System Design . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56

2.3.1 Peruvian Pension System . . . . . . . . . . . . . . . . . . . . . . . . . 57

2.3.2 Pension System Channels . . . . . . . . . . . . . . . . . . . . . . . . 60

2.4 The Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64

2.4.1 Model Description . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64

2.4.2 The Young’s Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . 68

2.4.3 The Old’s Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76

2.4.4 The Government’s Problem . . . . . . . . . . . . . . . . . . . . . . . 80

2.4.5 Production Technology . . . . . . . . . . . . . . . . . . . . . . . . . . 81

2.4.6 Definition of Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . 82

2.5 Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82

2.5.1 Income Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82

2.5.2 Calibration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87

2.5.3 Goodness of fit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93

2.6 Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95

2.6.1 Impact of contributory pension systems . . . . . . . . . . . . . . . . . 95

2.6.2 Analysis of the Design: PAYG or Individual-Account . . . . . . . . . 107

2.7 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113

2.8 Supplemental Material . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115

2.8.1 Empirical facts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116

2.8.2 Calibration moments and data . . . . . . . . . . . . . . . . . . . . . . 117

2.8.3 Model Features . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119

2.8.4 Results continuation . . . . . . . . . . . . . . . . . . . . . . . . . . . 121

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School	Laney Graduate School
Department	Economics
Degree	Ph.D.
Submission	Dissertation
Language	English
Research Field	Economics, Theory Economics, General Economics, Labor
Keyword	Informality Pensions Latin America Social Security Liquidity
Committee Chair / Thesis Advisor	Karen Kopecky, Federal Reserve Bank of Atlanta Kaiji Chen, Emory University
Committee Members	Juan Rubio-Ramirez, Emory University Mi Luo, Emory University

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