Pension reform in economies with large informal sectors: The case of Ukraine

What kind of pension reform is best for a country with a large informal sector, such as Ukraine? Answering this question requires designing a pension system that creates incentives for increasing formal-sector labor participation, initially under conditions of poorly developed capital markets and government regulatory capacity. A neo-classical, general-equilibrium, overlapping-generations (OLG) stylized model, in which individuals live two-period lives, defines the framework for the analysis. Introduction of an informal sector yields the result that a "debt-financed" transition from a Pay-As-You-Go (PAYG) to a fully-funded (FF) pension system (in which part of the transition cost is financed by issuing debt that is paid off by subsequent generations) can lead more quickly to a higher growth path than a "tax-financed" reform (in which the entire cost of the transition is paid from taxing current generations). This happens if labor-market efficiency gains are greater than the crowding-out losses associated with issuing debt. Such a result reverses the usual conclusion obtained in models without a large informal sector. Debt-financing can allow for slightly lower tax rates during the transition period, which might lead to a substantial shift in labor from the informal to the formal sector. Such a transition can be Pareto-superior to a tax-financed reform. A predominantly PAYG system is not financially sustainable in the long-run in Ukraine, given unfavorable demographic trends. The outstanding pension liability of Ukraine (and other large post-Soviet countries) is relatively small compared to other countries, such as Poland, implying that the transition costs of comprehensive reforms would not be onerous. A predominantly FF system with a limited government supplemental role can be consistent with the goal of risk diversification. The analysis includes a discussion of a number of implementation issues regarding the laws, regulations, tax incentives, and institutions needed for building a sound, credible system. Enterprise privatization could be incorporated into the pension reform process, giving the elderly an income from return on capital that they normally would have had in a functioning market economy.