An Endogenous Growth Model of Social Security and the Size of the Informal Sector

Abstract

Fully-funded pension systems are claimed to be less distortionary of labor allocation decisions than pay-as-you-go systems. This paper explores this issue in the framework of an overlapping generation model of endogenous growth where capital has an external effect on labor productivity and workers move from a formal to an informal sector in response to social security reforms. The two main features of the model are the following. First, as the social return on capital is sufficiently bounded away from zero, the economy can never be dynamically inefficient due to overaccumulation, but the private rate of return on capital may well be lower than the rate of growth. Labor market distortions determining the size of the informal sector are not necessarily lower in a fully funded system. Second, to the extent that a pension reform increases the share of output produced in the formal sector, both productivity and the rate of return on capital rise. Because of conflicting income and substitution effects, the change in consumption and growth cannot be determined unambiguously. Nonetheless, simple numerical exercises show the potential importance of the effects under consideration.