PENSION DESIGN WITH A LARGE INFORMAL LABOR MARKET: EVIDENCE FROM CHILE

Abstract

This article investigates the fiscal and welfare trade‐offs involved in designing a pension system when workers can avoid contributing by working informally. Using a life‐cycle model of labor supply and saving decisions, I structurally estimate preferences and earnings opportunities in the formal and informal sectors using data on Chilean households. I find limited support for formal jobs rationing. Instead, mandatory pension contributions significantly encourage informality. Policy experiments show that Chile could lower minimum pension spending by 23%—while guaranteeing the same income to retirees—if the minimum pension's implicit tax rate was increased to 60%.

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