Designing pension programs to strengthen formal labor markets in developing countries: The case of Indonesia

Abstract

Pension systems in developed countries, where labor is concentrated in formal production sectors, are likely to differ from those in developing countries, where labor is more concentrated in informal sectors. Governments have few tools for implementing fiscal policies (taxes and subsidies) in respect of firms and labor in informal sectors. This research develops a comprehensive, multi-dimensional approach to setting up pension systems in developing countries in general and Indonesia in particular. The pension system suggested comprises a short-run consumption tax policy to finance a defined-benefit plan to meet the minimum physical needs of the older population; a medium-run labor income tax policy to finance a defined contribution, fully funded savings plan for individuals and a long-run skilled labor-creation plan through university education to allow more individuals to finance their own pension savings, under the fully funded savings plan. The defined-benefit plan serves as a redistribution tool and the defined-contribution plan as a savings tool. The skilled labor-creation plan is a supporting tool to make the pension program sustainable in the long run. An overlapping generation computable general equilibrium model is calibrated for the Indonesian economy, with heterogeneity in households introduced through the inclusion of skilled and unskilled labor. The model is used to analyze the impact of consumption taxes and pension taxes on labor supply, and to calculate the equivalent variation of the distribution of the consumption tax burden across generations and labor groups. For comparison, a consumption tax to finance defined-benefit pension cash transfers of US$1, $2 and $3 per person per day is found to impose a lower burden on skilled than on unskilled labor. Introducing a consumption tax to finance a $1 cash transfer creates an incentive for the highest amount of labor (both skilled and unskilled) to work in the formal sector, and to compensate for consumption tax costs through higher income. Increasing the consumption tax to support $2 and $3 cash transfers reduces labor supply to the formal sector, however, with skilled labor supply decreasing more than unskilled in the $2 case and the reverse in the $3 case. My theoretical contributions are that, given the existence of both formal and informal labor and production sectors in an economy, and the latter being dominant: (1) taxation of expenditures is preferred to taxation of income because the former may induce labor to work in the formal sector; and (2) there exists an optimal level of consumption tax that provides incentives for the largest supply of labor, both skilled and unskilled, to the formal sector.