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

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? This paper provides a positive answer to this question by reporting simulations for a representative economy based on the steady-state solution of a two-sector 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. Empirically this outcome is not likely as suggested by 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