Mandatory retirement savings in the presence of an informal labor market

Abstract

This paper shows how mandating workers to save more for retirement can lead them to work informally and save less. Consider a worker who is more productive in the formal sector but works informally to avoid mandatory retirement contributions. Lowering the contribution rate (the share of wages mandated to be saved) will paradoxically increase her retirement savings. The reason for this is that working informally acts as borrowing against mandatory savings. The implicit cost of such borrowing, and hence the opportunity cost of working informally, rises as the contribution rate drops. This creates a substitution effect favoring formal work, driving the worker towards the formal sector. As her formal income increases, the base for her mandatory contributions rises, expanding her retirement savings. Therefore, the optimal contribution rate is no greater than the highest contribution rate under which the worker prefers to work exclusively in the formal sector.