Fiscal Policy and Informality

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Countries differ from each other in aspects that need to be considered when designing fiscal policy. The size of the informal sector is a case in point. Should fiscal policy be identical in OECD economies, where “… 5% or less of work is […] undeclared”[1], and in Honduras, where the share of the informal sector exceeds 73%?[2] The answer is no.

Informality significantly narrows the tax base, and thus builds pressure to increase tax rates and social security contributions.[3] It also jeopardizes the effectiveness of fiscal policy.

Take pension systems as an example. As only formal workers are covered by social insurance, informality reduces contributions and thus lowers replacement rates (pension entitlements / pre-retirement earnings).[4] Moreover, informality and low coverage rates disproportionally affect the poor, exacerbating inequality.

Chile provides an illustration. The country’s replacement rate stood at 38% in 2012,  lagging behind the 63% OECD average.[5] Moreover, income distribution is highly skewed: whereas the richest 20% captures 54% of total income, only 5% goes to the poorest 20% (Figure 1). The distribution of pension income is even more unequal: while the bottom quintile gets 2%, the top one receives 63% of the pie (Figure 2).

Figure 1. Composition of Income by Quintile, 2015

Figure 2. Income from Pensions by Quintile, 2015

 

Source: Own calculations based on LAC Equity Lab, http://www.worldbank.org/en/topic/poverty/lac-equity-lab1/income-inequality/composition-by-quintile.

Informality triggers pensions’ coverage issues, but also affects their potential remedy.

Governments worldwide aim to increase replacement rates through retirement savings policies. Some of these measures, e.g. raising social security contributions, lift savings automatically. Others, such as tax exemptions for savings, rely upon individuals taking action. Using Danish data, Chetty et al. (2014) show that policies which depend on active choices are less effective: whereas 85% of savers do not react to tax subsidies, the remaining 15% do respond, but mainly by shifting assets between accounts, leaving overall savings unchanged.

Chile’s decision to eliminate the opt-out option for self-employed workers in 2018, and thus to make social security contributions mandatory, seems aligned with this insight. As recommended, the policy would not require active choices to increase coverage rates. However, Denmark and Chile are different. In Chile, informal workers account for 36% of the total, and 69% of them are self-employed.[6] Hence, unexpected “rebound-effects” could arise if formal self-employed individuals that previously opted-out of social security choose to jump to informality instead of start contributing. Such a move could be explained by the perception of contributions as a tax associated with formality rather than a future benefit, as well as by a large informal sector, which – combined with capacity constraints in the tax administration – reduces risks and moral concerns linked to informality.

Best practices and international standards are crucial for the design of fiscal policy. However, the characteristics of the countries implementing the policy are equally decisive to build an effective fiscal system.

 

References

Chetty, R., Friedman, J., Leth-Petersen, S., Nielsen, T. and Olsen, T. (2014). “Active Vs. Passive Decisions and Crowd-Out in Retirement Savings Accounts: Evidence from Denmark.” The Quarterly Journal of Economics 129 (3), pp. 1141–1219.

CIEDES (2016). “Boletín Informalidad Noviembre 2016”, Corporación de Investigación, Estudio y Desarrollo de la Seguridad Social (CIEDES).

Fabrizio, S., Furceri, D., Garcia-Verdu, R., Li, B., Lizarazo, S., Mendes Tavares, M., Narita, F. and Peralta-Alva, A. (2017). “Macroeconomic Structural Policies and Income Inequality in Low-Income Developing Countries”, IMF SDN/17/01, International Monetary Fund.

Levy, S. (2017). “The Great Failure: Retirement Pensions in Latin America”, Vox LACEA.

OECD (2004). “OECD Employment Outlook 2004”, OECD Publishing.

OECD (2015). “Pensions at a Glance 2015. OECD and G20 Indicators”, OECD Publishing.

[1] OECD, 2004.

[2] Key Indicators of the Labour Market (KILM), ILO.

[3] Fabrizio et al., 2017.

[4] Levy, 2017.

[5] OECD, 2015.

[6] CIEDES, 2016.