The Effect of Future Pension Benefits on Labor Supply in a Developing Economy

Abstract

This paper provides causal estimates showing that in developing economies, future pension benefits influence workers’ decisions with respect to choice of employment sector. From the perspective of a worker, a formal job (i.e., a job that complies with government regulation) offers long-run gains because it increases the worker’s expected pension benefits in the future. If workers take those gains into account when they search for formal jobs, the pension system affects formal labor supply. Using a cohort-based pension reform undertaken in Colombia, I show that a reduction in future pension benefits generated a reallocation of labor supply from taxable (formal) to nontaxable (informal) jobs as early as 9 years before the minimum retirement age was reached. Moreover, this reduction did not affect labor force participation. The estimated effect is heterogeneous, and it is concentrated among workers for whom the minimum qualifying conditions are binding and among workers with higher expected pension gains. The results presented here suggest that pension reforms have the potential to create offsetting costs, an effect that should be considered when designing pension programs.