The Unequal Protection of Social Security in the Presence of Informality: Theory and Evidence from Chile
In the presence of high employment informality, public pension systems are dysfunctional: they provide little average retirement protection, and the protection is unequally given; concentrated on high-income households. In this paper, I study theoretically and empirically how high informality influences the optimal design of public pensions on its two core attributes: the pension contribution rate and the relationship between lifetime formal earnings and benefits. I start with a novel framework that gauges the welfare effects of reforms to these attributes, which are characterized by the trade-off between social insurance and efficiency. Employing Chilean administrative data merged with a panel survey and two quasi-experimental variations on the pension system design, I empirically estimate this trade-off. On the one hand, I find that increasing the benefits of workers with low lifetime earnings --by flattening the earnings-benefit link-- improves the social insurance provided by the system because these workers are the most vulnerable and the least protected; reducing their consumption upon retirement thrice as much as that of high earners. On the other hand, I find that flattening the earnings-benefit link generates significant efficiency costs by distorting workers' formal earnings and their private savings for retirement. However, the trade-off weighs in favor of more progressive benefits. In the presence of workers with low formality, there are large social gains of making the earnings-benefits link weaker.