The extension of social security coverage in developing countries

Individuals in developing countries face a shortage of formal risk-sharing instruments and therefore rely largely on informal cash transfers from family members for insurance purposes. This paper studies the effects of introducing a social pension program to elderly informal sector workers in developing countries who lack formal risk-sharing mechanisms against income and longevity risk.

The authors find that:

• the introduction of a social pension program for informal sector workers results in significant economic distortions on capital accumulation and resource allocation between the formal and informal sectors
• for this reason, the extension of retirement benefits to informal sector workers results in efficiency losses
• nevertheless, despite these losses, recipients of social pensions experience welfare gains as the positive insurance effects attributed to the extension of a social insurance system dominate
• yet, these welfare gains crucially depend on the skill distribution between formal and informal sectors, private intra-family transfers and the specific tax used to finance the expansion

Consequently, the paper draws the following policy implications:

• a consumption tax with its broad tax base is the least distortive and generates the largest welfare gains for recipient households
• capital taxes, with their strong direct distortion of capital accumulation, generate the worst welfare and efficiency outcomes

All things considered, the authors conclude that the role of public insurance in an environment that lacks formal private and public insurance mechanisms to insure against demographic and lifetime income shocks is considerably determinant. This is especially true for elderly informal sector workers.