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* Professor, Department of Economics, California State University, Long Beach

Working Paper No. 132

Payroll Taxes

by

Alejandra Cox Edwards*

April 2002

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PAYROLL TAXES1

Alejandra Cox Edwards California State University, Long Beach

Draft 3 – January 2002

1 Prepared for the Conference “Labor Market Reforms in Latin America,” Stanford University - Center for Research on Economic Development and Policy Reform (CREDPR) November 9-10 2001. I am thankful to the commentaries by John Shoven, Gabriel Martinez, Carmen Pages, and those of other Conference participants.

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I Introduction

In the Latin America region the average payroll tax is roughly 25% of gross wages. This is

similar to the average for other developing countries, and below the 30% that characterizes the

OECD group. At first sight, payroll taxes as a percentage of gross wages show a relatively small

dispersion, particularly when compared to the more documented variation in other labor market

policies across countries or across regions. 2 However, what is generally known as a payroll tax

is truly a payroll contribution towards one or more programs, such as pensions or health care

benefits. The true dimension of the payroll tax cannot be established without a more detailed

understanding of the link between payroll contributions and their associated benefits.

Several Latin American countries have reformed their social security systems in the 1980s and

1990s. This paper discusses the potential impact of such reforms on the payroll tax, using the

case of Chile –the earliest reformer—as a model.

Table 1: Payroll Tax as a percentage of the gross wage: Selected LAC countries

2 See for example Lazear (1990); Nickel (1997); Heckman and Pages-Serra (2000)

Argentina 36.4 Bolivia 20.0 Brazil 33.6 Chile 19.0 Colombia 19.4 Ecuador 20.0 Mexico 24.0 Nicaragua 17.0 Peru 26.0 Venezuela 23.8

Note: Data for the mid 1990s. This calculation adds employer's contributions to a taxable wage of 100 to estimate the gross wage, and subtracts the worker's contribution from the 100 base to estimate the net wage. The tax rate is the difference between gross and net over the gross wage.

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Mandated payroll contributions and the potential payroll tax associated to them is of interest to

empirical researchers for a number of reasons.

• Mandated payroll contributions are a major source of funding for pension programs. If

workers perceive that the contributions paid are equivalent to a deferred compensation,

then there is no real tax and no efficiency effect. A measure of the link between

contributions and benefits and individuals’ perception of this “money’s worth” ratio is

therefore, of public policy interest.

• Pension programs have liabilities that tend to grow with population aging, creating a

trade-off between actuarial balance and labor market efficiency. A measure of the labor

market impact of an increase in contributions and the potential consequences on the

payroll tax is also of interest for public policy.

• Payroll contributions are relatively easy to collect and administer, but payroll taxes are

more elusive and they can be regressive. A measure of the distributional impact of the

payroll tax is therefore of interest for public policy.

• A better understanding of the tax extent, and distributional and efficiency effects of

alternative ways of funding pension programs is an indispensable tool to evaluate policy

options.

• The centralized financing of social services through payroll contributions has effects on

the organization of the financial and health care industry. There are a number of

additional economic effects derived from this financial choice that come to light as

reforms of these systems have been attempted in Latin America and other regions (see for

example, Maceira and Murillo (2001)).

The paper proceeds as follows. Section II presents a simple model of a labor market impact of a

required payroll contribution towards social security. Section III looks at payroll contributions

and the associated social security programs in Latin America in the early 1990s, and describes

the type of reforms that have been put in place since. Section IV assesses the direction in which

the various reforms have changed the real labor tax. Section V provides an estimate of the

current payroll tax in Chile.

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II The labor market before and after Payroll Contributions

Figure 1 presents a simple demand and supply model of the labor market. Employment is

measured on the horizontal axis, and the wage rate is measured on the vertical axis. This model

is simple enough to assume that all labor is homogeneous and belongs in the same market, but it

is useful as it illustrates the labor market reaction to a policy tool. The upward-sloping curve S0

represents the supply price of labor, or the minimum wage at which workers are willing to

supply various quantities of labor. The downward-sloping curve D0 represents the value of the

marginal productivity of labor, or the maximum wage that employers are willing to pay for

various quantities of labor. In the absence of any taxes, the equilibrium level of employment will

be E0, and the equilibrium wage will be w0.

A payroll contribution equivalent to t percent of the gross wage can be represented by a

downward shift of the labor demand to D1, where D1= D0*(1-t). This shift will tend to reduce the

equilibrium level of employment, and distribute the tax burden between employers and workers.

Thus, the gross wage would go up, by less than t% and the net wage will fall somewhat.

However, the analysis would not be completed if the labor market effects of the benefits

associated to the payroll contribution were ignored.3 In effect, if there are benefits directly

linked to the payroll contributions—i.e. social security, workers will recognize that the

compensation associated to their job includes a take-home pay plus a “social security” benefit.

In other words, the payroll contribution and its associated benefit, reduces the minimum net

wage at which workers are willing to supply their labor. Consider a parameter v representing the

value for workers of the benefits associated to the payroll contribution. The parameter v is also

measured as a % of the gross wage.

The combination of the effect of the payroll contribution on labor costs with the effect of

workers’ valuation of the associated benefits on the labor supply, leads to a new equilibrium.

The upward-sloping curve S0 represents the supply price of labor, or the minimum wage at which

workers are willing to supply various quantities of labor. The parallel upward-sloping curve S1 =

S0*(1-v) represents the net wage workers are willing to accept once the value of benefits

3 See for example, Musgrave (1959) and Summers (1989).

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associated to the payroll contribution (v*S0) are subtracted from the gross wage. The

downward-sloping curve D0 represents the value of the marginal productivity of labor, or the

maximum wage that employers are willing to pay for various quantities of labor, and D1

represents the net wage that employers are willing to pay giving that they are making a payroll

contribution of t%. The equilibrium level of employment E1 will be determined by the

intersection of D1 and S1.

The closer is the value v to the tax rate t, the smaller is the labor market impact of the mandated

contribution. In effect, if workers valued the payroll contribution at face value, they would be

willing to accept a net wage (or take-home pay) equal to w1 – t. In Figure 1, it is assumed that

v<t. The labor market will reach equilibrium with a gross wage equal to wg and a net wage equal

to wn. The labor compensation as seen by employees is wc = wn + v . The payroll contribution

in excess of v is therefore, a true labor tax. The labor market distortion caused by the payroll

contribution is a function of t-v.

This simple model has a very strong implication for the analysis of the welfare effect of payroll

contributions. Payroll contributions distort the labor market equilibrium to the extent that the

programs funded by them are not fully valued by contributors. Therefore, any analysis of the

labor market effect of payroll taxes must begin with an assessment of the value of contributions.

As described in section III, in all Latin American countries, payroll contributions are earmarked

to fund programs that, at least in theory, benefit workers. However, there are significant

variations across countries in system’s design and in the degree to which individual contributions

are tied in to individual benefits. Therefore the labor market effects of relatively similar payroll

contribution rates are potentially very different.

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FIGURE 1

wage

Employment E1

W0

Wg

Wc

Wn

E0

S0

S1 = S0 *(1-v)

D0

D1 = D0 *(1- t)

TRUE PAYROLL TAX = t - v

Wg – Wn = Payroll Contribution

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III Payroll Contributions and Social Programs in LAC in the 1990s

In the Latin America region, there are typically four different programs intertwined in the so-

called social security system: (1) old-age pensions; (2) disability and survivors pensions; (3)

health care; and (4) occupational accidents. These programs are funded primarily through payroll

contributions.

Mesa-Lago (1991) examined the state of social security contributions and benefits in LAC

countries after the crisis of the 1980s. He organized countries according to the historical

evolution of their social insurance systems and provided a dismal evaluation of the state of these

systems. By the late 1980s, there was no actuarial connection between contributions and benefits

--except in Chile and Peru; and the percentages of social security revenue and expenditure over

GDP were “the highest among developing countries.” In spite of the high percentage of payroll

contribution, social security “endures actuarial disequilibria in most LAC countries and financial

or accounting imbalances in at least half of them, particularly since the 1980s.” (pg xi and xii).

IIIa Reforms to Social Programs funded through Payroll Contributions A number of Latin American countries reformed their pensions systems in the 1980s and 1990s.

Chile launched a full reform in 1981; Argentina and Colombia in 1993; Costa Rica and Peru in

1995; Uruguay in 1996; Mexico in 1997; Venezuela in 1998. These reforms have typically

redefined the role of the state as provider of old-age income security, and encouraged private

systems that either replace or complement the public one in pensions, disability, and health.

There are important variations across countries in the elements of pension’s reform introduced.

These include: strengthening the financial health of the public system (Costa Rica, Uruguay,

Chile); the introduction of an obligatory but complementary savings program (Mexico); phasing

out the public defined-benefit program (Chile); introducing a required defined-contribution

program (Chile); introducing an optional defined-contribution program on top of a reformed

public defined-benefit program (Argentina, Uruguay); introducing the choice between a defined-

benefit program and a privately managed defined-contribution program (Colombia, Peru).

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Generally speaking, the reforms have attempted to add sustainability to the systems, delaying

retirement age, improving individual incentives to contribute, and making benefits a tighter

function of contributions. The Chilean reform reduced the overall payroll contribution from

about 45% of taxable wages to 20%. At the same time, created a very strong link between

individual contributions and benefits, as it transformed social security from “defined benefit” to a

“defined contribution” plan, and introduced competitive forces in the market for social security

funds administration.

From the point of view of the labor market, one should focus on the reform’s effects on the

individual valuation of contributions, which depends on the link between contributions and

benefits at the individual level. In addition, one should differentiate cases where there are

choices associated to the type of contributions (Chile, Colombia, Peru), implying that workers

can sort themselves to the program that maximizes their net present value of income from labor.

Using the case of Chile, in the next section I describe one of the reformed system’s design and.

in particular, the factors that affect expected benefits. In section IV I use micro data for Chile to

estimate the marginal valuation of contributions, and estimate the extent of the payroll tax

reduction in this case.

IIIb The Chilean Reform

The Chilean reform reduced the overall payroll contribution from about 45% of taxable wages to

20%. It established a set of common rules for all contributors; restricted the mandated programs

to pensions, disability and life insurance; and health insurance; and introduced competitive

forces in the market for these products. The new system requires employees to make a 10%

contribution towards pensions and a 7% towards a health program. The self-employed are not

required to contribute, but they can do it if they wish. Pension Fund Administrators -AFPs must

insure their affiliates against the risk of income loss associated to invalidity and death. All

civilian contributors are subject to the same rules, except for the fact that income base for social

security contributions is capped at maximum of 60 UF (Unidad de Fomento -- an indexed unit

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that adjusts to inflation) per month and is subject to a minimum equal to the minimum wage4.

Affiliates can also make voluntary contributions over and above the required 10%, which as in

the case of required contributions, are exempted from income taxes.

The first element of competition is the choice of AFP--or retirement fund administrator. Each

AFP manages a fund that yields a rate of return and at the same time, offers a variety of

information services to its affiliates.5 Each AFP charges a fee for services, which funds the

administration of individual accounts, the management of investments, information and

consultation services, and the insurance premium towards a death and disability insurance. The

market-determined fee currently varies between 2.36 and 2.95% of taxable wages, plus a fixed

amount, which can vary between $0 and $1,000. In the case of hazardous occupations, workers

are required to make an additional contribution of 2% to cover the higher risk. Upon retirement,

the obligation to provide death and disability insurance ceases and in practice AFPs stop

charging the administrative fee. 6

The requirement to contribute towards a health program introduces a second choice. Affiliates

can stay in the public health system (Fonasa), or may opt out. Those that opt out must apply 7%

of their taxable wage (additional coverage is optional) to buy a health insurance package from a

private health care insurer or Isapre--Instituto de Salud Previsional. Isapres, in turn, offer

various health care packages with variable costs, generally more expensive than the basic public

(Fonasa) program.7

Employees cannot be contributors to the pensions program without making contributions

towards the health care program. It is the responsibility of employers to make the appropriate

transfers of funds. Employers deposit contributions towards pension benefits at the respective

4 The data analysis will focus on November 1994. The minimum wage was 52,150 pesos per month, and the UF (unidad de fomento) was 11,463.72. Given the value of the dollar at that time (413.45 pesos/dollar), the minimum contribution base was equivalent to US$ 126 and the maximum to US$ 1,663.6. 5 The conventional wisdom is that the choice is primarily influenced by AFPs’ marketing techniques, presence of sellers and the like. 6 For a discussion on the economics of this fee, and in particular, the implicit cross-subsidies on the financing of the workers’ compensation insurance, see Valdes and Navarro (1992). 7 The choice of health care provider is highly influenced by income and health status (see Sapelli and Torche, 1998).

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AFPs, and contributions towards health insurance at Fonasa or the respective Isapres. Retirees

and beneficiaries for disability are also required to buy a health insurance plan, which can be

public or private. In these cases, retiree’s contributions towards a health care program (also

equivalent to 7% of the monthly pension) are subtracted directly from their pension benefit. The

self-employed, who are not required to contribute, must make arrangements directly with AFPs

and Isapres.

In the new system, retirement benefits are a function of the accumulation of funds, with a tight

matching between contributions and benefits, except for a guaranteed minimum pension financed

by the central government budget. Men can opt for a pension at age 65 and women at 60. Both

have also the option to start a pension earlier, if they have accumulated enough funds to finance

an annuity equivalent to 50% of average annual income of the last 10 years of contributions

(indexed according to the consumer price index), and the annuity is no less than 110% of the

minimum pension.

Pension beneficiaries have another choice. Their accumulated funds can be withdrawn in three

alternative modes: (1) they can opt for a programmed monthly withdrawal; (2) an immediate

transformation of their accumulated fund into a stream of steady monthly payments or annuity

(through a contract with a private insurance company); or (3) a combination of a deferred

annuity and a programmed withdrawal. Unlike annuities, programmed withdrawals vary year

after year as a function of the remaining fund (which varies with returns and initial withdrawals),

and life expectancy (which varies with age).8 The remaining funds are invested as part of the

AFP’s portfolio, and have market returns.

Old-age benefits are not a function of the division of labor within the household

Old age pensions are calculated on the basis of the accumulated fund in the individual account,

the life expectancy of the affiliate, and of the individual’s family members who will be

beneficiaries of the “survivors’ pension.” By law, any affiliate generates a benefit towards

his/hers legal dependents of a survivors’ pension. This mandatory bequest becomes available to

8 By 1997 there were already 250,000 pensioners under the new system. Of these, approximately one half had opted for annuities, and one half for programmed withdrawal.

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survivors at the active affiliate’s time of death, or at the retired affiliate’s time of death. In the

case of an active affiliate’ death, his/her survivor will receive the accumulated fund plus any

benefits that would apply in case of work-related accident covered by insurance. Naturally, the

legal obligation to provide funding towards a “survivors pension,” establishes a financial

constraint that reduces the affiliate’s own pension in any of its three modalities.

Married men are required to make provisions for their wives survivor’s pensions9, while married

women are required to make provisions for their husbands --only when the husband is disabled.

Parents are required to make provisions for dependent children. Any unused portion of the

accumulated fund, in case of death of an active worker without survivors, or in case of death of a

retiree that opted for a program of annual withdrawals, becomes part of the beneficiaries’

inheritance.

No penalties for pensioners that choose to work

Men and women may choose to continue working after starting their respective pension. Their

time allocation has no effect on their pension benefits. In addition, once an employee becomes a

pension recipient, he/she is exempted from the obligation to make the 10% contribution towards

pensions (they can make voluntary contributions), although he/she must continue to make the

contributions towards health. It is important to note, however, that the obligation to make

contributions towards the health care also continues for non-working pension recipients.

Incentive effects of the minimum pension guarantee

In the reformed system, the State plays a fundamental role in the regulation, and monitoring the

operation of the system, and also guaranteeing a minimum pension to individuals that have been

active contributors for at least 240 months. This guarantee can increase the expected pension

above the actuarially fair amount for some individuals but does not do it at the expense of

reducing the pension amount for others, since pensions are determined by individual

accumulation of funds. Any shortfall between the self-financed benefit and the minimum

guaranteed pension is financed by the central government budget.

9 The surviving wife must have been married to the contributor for at least six months before his death and for at least three years if the wedding took place with a male pensioner.

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In short, every peso put into the system towards the retirement fund increases the expected

pension benefit, except in the case of contributors that are bound for the minimum pension

guarantee. In those cases, the minimum pension acts as a floor as well as a ceiling because the

marginal benefit of a peso of contributions falls to zero once the individual has accumulated 20

years worth of contributions.

Extent of Chile’s New Social Security System Coverage

Table 2 presents summary data, for 1994, on the coverage of Chile’s privately managed social

security system. These data correspond to those individuals in the sample that had a paying job

at the time of the survey, and have been organized by urban-rural sectors, age and gender.

“AFP” refers to the percentage of individuals in that particular group that made contributions to a

privately managed retirement fund (an AFP). “Other” refers to the percentage of individuals that

made contributions to other retirement systems, including the old pay-as-you-go system and the

armed forces retirement fund; “No” refers to those individuals that had not made contributions to

any retirement system.

In 1994 the coverage rate of the formal retirement systems was 60.2%. Urban males have the

highest coverage – defined as contributing to any retirement scheme --, at 69.9 percent. The

lowest coverage corresponds to males in the rural sector, with 47.2%. It may also be seen that,

with the exception of rural males, those in the 16 to 39 year-old have the highest degree of

coverage. Data from the CASEN survey also suggest that there is a very high degree of

compliance with respect to required contributions. More that 95% of employees with an

employment contract make contributions, as required by law, to a retirement system.

Opting out of the public health system

According to the Chilean Ministry of Health, in 1993 73% of the population received health

services from the National Health Service System, 21% from the Isapre and 6% were under a

parallel public system that serves the military and public enterprises. (see World Bank, 1995).

The National Health Fund (Fonasa) is responsible for administering and distributing financial

resources of the National Health System, including government allocations towards health and

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the mandatory 7 percent payroll deduction earmarked for health from active and pensioned

salaried workers who are not Isapre affiliates.10

Table 3 describes the patterns of contribution among workers and the average probability of

opting out of the public system (or be an Isapre affiliate) by schooling in 1994. Seven out of ten

urban workers respond affirmatively to the survey question “Are you contributing to the social

security system?” and three of them choose to opt out of the public health care system. The

fraction of contributors and the percentage of contributors that opt out of the public system

increase with the level of schooling. 11

Isapre affiliates pay a monthly premium that varies according to the cost of the health plan

chosen. In 1992, the average monthly premium per subscriber was approximately US$40. The 7

percent contribution is applied to the cost of the premium and affiliates with relatively low wages

or high premium plans must make additional out-of-pocket payments. Clearly individuals

attribute a value to their payroll contribution towards health care. In particular, those that opt out

of the public health system cash in the full 7 percent of the taxable wage, and apply it towards

their private health care premium. In these cases, the marginal value of the contribution is equal

to the nominal amount.

In a separate means-tested program, the elderly poor may qualify for the PASIS subsidy. This is

a poverty-targeted transfer program, financed by the central government budget, and

administered at the regional (intendencias) level. In 1994, 14% of elderly men and 23% of

elderly women in rural areas received the PASIS benefit. These percentages are 6 and 3% in

urban areas. The high incidence of PASIS in rural areas along with the generally lower wages

suggests that the perception of the reformed social security system is quite different in rural

compared to urban areas. In particular the strong link between contributions and benefits that is

10 The ISAPRE option is subsidized through tax rebates to employers who contribute an additional 2 percent of payroll to complement the compulsory 7 percent salary deduction for low income employees or those with large families. 11 The new system has brought about an increase in coverage, with the fraction of workers covered increasing from 58% in 1985 to 67% in 1990. The fraction of employees covered has increased from 79% in 1985 to 92% in 1990. Self-employed workers still have a low rate of participation.

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being argued for the case of urban areas is more distorted in rural areas. The analysis that

follows is therefore restricted to urban workers, which represent more than 80% of the labor

force.

To sum, Chilean reforms to the pension system and the obligatory contribution towards health

care insurance represent a significant increase in the individual valuation of these contributions

at the margin. The next section uses micro data to estimate the implicit tax component of social

security contributions in post-reform Chile.

IV. Estimating Individual Valuation of Payroll Contributions: the case of

Chile If social security contributions were a deferred compensation, individuals that are enrolled in the

system would be willing to accept, for an equivalent job, a lower take-home pay than those

individuals that do not participate in the social security system. If, however, social security

contributions are considered to be fully a tax, those enrolled in the system will demand, for an

equivalent job, the same take-home wage than those that are not subject to this tax. The

magnitude of the “compensating differential,” for otherwise equivalent jobs will, then, provide

an estimate of the proportion of the contribution that is actually perceived as a tax by labor

market participants. In principle, this implicit tax can be obtained by estimating a wage rate

equation that includes a “compensating differential” for individuals that participate in the social

security system. The empirical challenge is to isolate the “compensating differential” associated

to social security contributions from all the other factors that distinguish those that contribute

from the ones that do not.

The basic data set is the CASEN (Caracterización Socioeconómica Nacional) national survey

for 1994. Using 1994 has a number of advantages. First, it is a fairly “normal” year, when Chile

was neither facing a recession or serious disturbances from abroad. Second, it is a year when

the democratic system was being consolidated, and thus the country was not subject to serious

political disturbances. And third, in 1994 the privatized social security system had already been

operational for some time, and was entering into a mature phase. The CASEN survey collects

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information on demographics, education, type of dwelling, health care, labor force status, and

income. Individuals that identify themselves as workers are asked a series of questions regarding

their occupation, sector of employment, hours, take-home pay, system’s affiliation and

contributions towards to social security.

One may be tempted to estimates a Mincer-type wage equation for the entire sample and use a

dummy variable to estimate the effect of social security contributions. However, the

corresponding coefficient would not be a consistent estimate of the marginal effect of social

security contributions on net wages. Most likely, individuals choose whether to make

contributions, and the error term of the model that gives rise to this choice is correlated with the

error term in the wage equation. In particular, individuals that have more attachment to the labor

force are more likely to make contributions, and other things equal, earn higher wages.

A better specification of this econometric problem requires two elements: an equation that

captures the decision to contribute in the social security system (See Maddala 1983, for the

details of this type of model), and a wage equation that uses the “predicted” probability of

contributing as an independent variable (see Edwards and Edwards 2001).

(1) log w j = x j β + γ C j + µ j

1, if C* j > 0

(2) C j =

0, otherwise

(3) C* j = y j α + ε j .

Equation (1) is the wage equation. log w j is the log of take-home wages for individual j; x j is a

vector of traditional determinants of real wages that include, among other, education, experience,

size of firm, gender, and geographical location of the job; C j is an endogenous dummy variable

(i.e. the treatment variable) that takes a value of one if individual j participates in the retirement

system, and zero if he does not. µ j is an error term, whose properties are discussed below. β and

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γ are parameters to be estimated. The decision to contribute to the social security, described in

equation (2) is assumed to be the result of an unobserved latent variable C* j, which is assumed

to depend linearly on vector y j. α is a parameters’ vector to be estimated, and ε j is an error

term. Error terms µ j and ε j are assumed to be bivariate normal, with a zero mean and a

covariance matrix given by:

σ ρ

(4) ρ 1

If the wage and contribution equations are independent, the covariance term ρ in equation (4)

will be zero.

The model given by equations (1) - (4) can be estimated simultaneously using a maximum

likelihood procedure. Parameter γ in equation (1) measures the (average) value that individuals

attach to participating in the privatized social security system with a negative sign, since it would

reflect the wage cut that contributors are willing to accept. Chile’s social security law requires

individuals to make contributions to the retirement system (at 10% of taxable wages), the health

system (7%) and to a mandated life insurance program (about 3%). Total contributions for this

“package,” then, stand at 20% of taxable wages. As explained in section II, the reformed social

security system is designed in a way that allows individuals to opt out. This is likely to generate

a significant marginal valuation of contributions.

When wages are well above the minimum, employers may offer a contract (with the obligation to

pay social security contributions) or pay cash wages. Employees, in turn, have to evaluate if a

contract –with the corresponding payroll deduction-- is a better package than the cash wage.

Thus, if two workers are undistinguishable and are applying to the same job, the employer would

offer the same total compensation. The one that chooses to make contributions would earn

approximately γ less than the other. The exact compensation negotiated will be subject to market

conditions.

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If the (average) value attached to social security contributions is zero – that is, if contributions

are fully considered a tax --, the estimated coefficient should not be significantly different from

zero. If, on the other hand, contributions are fully valued by those that make them, the observed

take-home pay of contributors should be 20% below that of non-contributors. This means that

the estimated value of parameter γ is in the range of zero to – 20%.

If one observes individual characteristics and job specifications, the wage difference due to

“contributing” can be isolated, and the parameter γ can be estimated. Therefore, a good

specification of the model is central. The decision to contribute is assumed to be a function of

individual characteristics that determine the value of the benefits involved (pensions and health

coverage). The key factors that are expected to be positively associated to this value are

schooling and age. In addition, employers are more likely to encourage workers to contribute if

other workers in the firm are doing so, and the administrative cost of handling this obligation is

relatively low on a per-work basis. Similarly, if the worker has been on contract before, it is

relatively cheaper to continue to handle these contributions. Thus, a set of dummy variables

controlling for firm size is added to this equation, as well as a dummy for “has sometime in the

past signed a formal employment contract with the current employer.”

As is traditional in labor economics, the key variables that capture individual characteristics are

schooling and potential experience (age-years of schooling – 6). This variable is expected to

measure the value of human capital associated to experience in the labor market. In the absence

of a true measure of labor market experience, it is acceptable practice to use potential experience.

This estimate of experience is a fairly good approximation for men, who tend to enter the labor

market after finishing school, and stay in the market afterwards. Women, on the other hand, are

more likely to have career interruptions, and accumulate labor market experience at a lower pace

relative to men. For this reason, one should not expect the variable “experience” to measure the

same thing in the case of women relative to men. This leads us to estimate separate regressions,

or to allow for the coefficients of experience to differ across gender. The regional dummies were

added to control for differences in regional amenities, and the firm size variables were the only

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available variables that could be added to control for job specifications.12 In short, it is assumed

that two individuals that have the same schooling and experience, that work in the same region,

and in firms with the same size, will receive equal wages, except for a difference associated to

being or not a contributor.

How to handle the minimum wage range?

The typical wage distribution of a labor market where the minimum wage is binding shows

“bunching” of observations at that wage. This phenomenon is indirect evidence that the wage

received by workers is only part of the total compensation. If the wage received reflected the full

compensation, a binding minimum would cause the wage distribution to have a drop in

frequency just below the minimum. If, on the other hand, the monetary wage were part of a

larger compensation package, employers forced to pay a minimum wage, would reduce other

components of the compensation package to get to a desired total compensation. In fact,, some

workers earn just the minimum wage, and many earn additional fringes (lunch, clothes,

vacations, etc) over and above the minimum. These additional fringes may also include social

security contributions, leading to a situation where the distribution of take-home wages shows

two “bunching” points.

In November of 1994 (the reference period for this survey), the monthly minimum wage was

$52,150 for all workers except those in domestic service, where a lower minimum wage of

$39,113 applied. 13 Workers that were paid the minimum wage (and no additional fringes)

would receive a take-home pay $41,720 – or $52,150*(1-.2). Figure 2 presents the wage

distributions below the median for urban men and women (civilian full-time workers). In both

cases, there is more bunching at $50,000 than at $40,000. One may think that this result is driven

by a large fraction of workers receiving the minimum wage in cash and not making contributions

to social security. However, this is not the case. The fraction of contributors among those with

12 Typically, there is a premium associated to large establishments. 13 The minimum wage for domestic workers is close to $40,000, and while they are subject to the same general rules regarding social security contributions, they are treated differently in case of dismissals. The labor legislation establishes an employer liability equivalent to one-month wages per year of service (up to 11 months) in case of dismissal for all employees except those hired on a short-term contract or domestic workers. The employer liability in case of dismissal of a domestic worker is the accumulated fund in an account built for the individual worker, with monthly contributions equivalent to 4.11% of the taxable wage. In other words, the overall contribution towards fringe benefits is 24% in the case of domestic workers, compared to 20% in the general case.

19

Figure 2: A close look at the lower end of the wage distribution Fr

actio

n

Men wages below the median ($85000)monthly wage in pesos

40000 50000 60000 70000

.05

.1

.15

.2

Frac

tion

Women wages below the median ($70000)monthly wage in pesos

40000 50000 60000 70000

.05

.1

.15

.2

20

take-home wages in the $45,000 to $55,000 range is twice as large than among those earning

wages below $45,000.

The observed “bunching” at $50,000 with a high incidence of contributors in that range suggests

that any equilibrium condition that drives the wage differential between take home wages of

contributors and non-contributors breaks down near the minimum wage. For this reason, the

estimates reported in Table 5A and 5B restrict the sample to all men and women that report take-

home wages above the minimum wage (rounded to $40,000 for domestic-service workers and

$50,000 for all other workers).

The data

Our data consists of civilian workers in the urban sector that held a paying job, worked more

than 35 hours a week, were paid on a monthly basis, and did not receive retirement benefits at

the time of the survey. Our sample excludes individuals with a salary that exceed the maximum

amount subject to social security contributions, because the payroll contribution rate for them is

effectively lower; and men and women that report take-home wages below the minimum wage

(rounded to $40,000 for domestic-service workers and $50,000 for all other workers). The final

sample has 22,592 observations (15,996 men and 6,596 women).14

Table 4 presents the final sample averages for the most important variables. To be noted:

• The fraction of contributors is fairly constant across genders (at 80%).

• The women sample is slightly younger and with one extra year of schooling than the

men’s sample.

• The average male-female wage differential –based on take-home pay-- is about 16%.

• Women are more likely to work in retail and services.

• Women are more likely to work in micro enterprises (firm size of 5 or less employees)

The results 14 Sixty five percent of the observations eliminated by the minimum wage correspond to individuals employed in micro enterprises, where total employment is five workers or less, and where enforcement of the labor laws is weaker.

21

In the wage equation (1) the dependent variable is the log of take-home wage. I estimate Mincer

type wage equations controlling for schooling, potential experience and its squared, geographical

location of the job, and size of the firm where the individual is employed. The variable

“Contributor” is the endogenous dummy variable that indicates if the individual makes

contributions to the system. In the estimation of equation (2) I assume that the decision on

whether to make a contribution depends on schooling, age, size of the firm, gender, and whether

the individual “has sometime in the past signed a formal employment contract with the current

employer.” The equation was estimated for the entire sample, and also in separate models for

men and women, which are reported here.

The results obtained from the joint estimation, using a maximum likelihood procedure, of the

model given by equations (1) - (4 ) are presented in Table 5A and 5B. The Wald test statistic for

independence of equations (1) and (2) (for the covariance term ρ being equal to zero) suggests

that both equations should indeed be estimated jointly. Table 5A corresponds to the estimates

for men table 5B reports the estimates for women.

The estimated coefficients for the traditional variables – schooling, experience and experienced

squared – are along the line of what is expected, and are consistent with previous estimates for

Chile and other emerging economies. Both schooling and experience have significant and

positive coefficients; as expected, experience squared has a negative and significant coefficient;

and there are regional and firm size significant wage differentials. The most important result, for

our purpose, is that the estimated coefficient of the social security contribution variable is

significantly negative, as expected.

The treatment equations shown in 4A and 4B indicate that the decision to contribute to the social

security system is affected in a positive way by schooling, experience (although at a declining

rate), and the size of the firm. As expected, those that have had an employment contract have a

(very) high probability of contributing.

Less expected is the finding that the estimated coefficient is –0.0824 in the case of males and -

.19 in the case of women. The finding suggests that, on average and for equivalent jobs, men

22

that contribute to the social security (cum health) system have a take-home wage that is almost

8% lower than their counterparts that do not contribute to the system. Women that contribute to

the social security system seem to fully value their contribution, since they earn a take-home

wage that is 19% below that of their non contributing counterparts. Since the mandatory

contribution is 20% of the taxable wage, this means that the marginal payroll tax in the case of

men is 12 points of the contribution, while the marginal tax in the case of women is 1 point.

Further examination of the data suggests an alternative –perhaps complementary—explanation

for the gender difference in the estimated value of the parameter γ associated to the non-observed

job characteristics that vary by gender. One of these non-observed characteristics is tenure. One

may speculate that there is a positive correlation between total compensation and tenure, and that

one element of the total compensation is the social security contribution. In other words, when

we compare two men with the same schooling and experience, and one is a contributor and the

other is not, the contributor is more likely to also be a person with longer tenure, and be

receiving part of his compensation in the form of social security contributions. In fact, if the

model is estimated separately for men in retail and for men in other sectors, the estimated

parameter γ turns out to be much closer to 20% in the case of retail than in the rest of the sectors.

Since there is a lot more rotation in retail compared to other sectors, this finding is consistent

with the explanation suggested above.

The most important result reported in this section is that workers assign a non-trivial value to

social security contributions in Chile. This finding is based on micro data that compares take-

home wages of those that contribute to the social security system with the non-contributors.

V Final Comments and Suggested Work

There is no doubt that social security reforms have been primarily motivated to avoid bankruptcy

and bring sustainability to these systems. Yet, there are important microeconomic effects

associated to the specific rules that link contributions to benefits. In particular, pay-as-you-go

systems are a combination of a payroll tax and an entitlement to a benefit through a formula;

while fully funded or defined contribution systems are closer to a forced savings program. Yet,

23

as this paper describes, the real difference is in the details because, if individuals do not fully

value the amounts set aside as forced savings, a fully funded system may also operate as a tax.

This paper suggests that social security reforms that pay close attention to individual’s choices,

in an effort to create a strong link between contributions and perceived benefits, can lift a major

burden from the labor market as it can reduce the payroll tax.

The Chilean reform reduced the overall payroll contribution from about 45% of taxable wages to

20%. In addition, estimates presented in this paper indicate that current payroll contributions

have a high value component, with more than 8 points of the 20 being perceived as a fringe

benefit by men. Women value their mandated contributions almost entirely. Clearly, the payroll

tax saw a sizeable reduction after the social security reform. The fast employment expansion

that Chile saw in the late 1980s and 1990 is consistent with an environment of a significant

reduction in the labor market tax burden. 15

This work can be extended to measure the payroll tax in other countries of the region. A careful

examination of each country’s social security reform is the first requirement to design an

empirical strategy to measure the payroll tax in relationship to the mandated contribution rate.

Subsequently, it is possible to improve labor market efficiency through a more careful design of

mandated contribution programs. This would lead to more jobs and higher incomes, possibly the

most important policy goal for the region.

15 For a more detailed analysis of the impact of other labor market reforms on the labor market see, Edwards and Edwards (2000).

24

References

Edwards, Sebastian and Alejandra Cox Edwards (2001): “Social Security Privatization Reform and Labor Markets: The case of Chile.” (forthcoming Economic Development and Cultural Change) Edwards, Sebastian and Alejandra Cox Edwards (2000): “Economic reforms and labour markets: policy issues and lessons from Chile,” Economic Policy 30 (April): 183-229. Heckman, James and Carmen Pages-Serra (2000): “The Cost of Job Security Regulation: Evidence from Latin American Labor Markets,” Economia 1 #1 Fall: 109-54. Lazear, Edward (1990) “Job Security Provisions and Employment,” The Quarterly Journal of Economics 105, 3 :699-726. Maceira and Murillo (2001) : “Social sector reform in Latin America and the role of unions,” InterAmerican Development Bank Research Department - Working paper series # 456. Maddala, G.S. 1983. Limited Dependent and Qualitative Variables in Econometrics, Cambridge University Press, Cambridge, U.K. Mesa-Lago, Carmelo (1991): Social Security and Prospects for Equity in Latin America. World Bank Discussion Papers Series # 140. Washington D.C.: The World Bank. Musgrave, Richard A. (1959) The Theory of Public Finance. New York: McGraw Hill. Nickel, Stephen (1997): “Unemployment and Labor Market Rigidities: Europe vs. North America,” Journal of Economic Perspectives 11: 55-74 Sapelli, Claudio and Arístides Torche (1998) “El Seguro Previsional de Salud: Determinantes de la elección entre seguro público y privado: 1990-1994,” Cuandernos de Economia, 35 # 106: 383-404 Summers, Lawrence H (1989): “Some Simple Economics of Mandated Benefits,” American Economic Association Papers and Proceedings, 79: 177-83. Torche, Arístides and Gert Wagner (1997). “Prevision Social: Valoracion Individual de un Beneficio Mandatado”. Cuandernos de Economia, 34 # 103, pp. 363-390. Valdes Prieto, Salvador and Eduardo Navarro Beltran (1992) “Subsidios Cruzados en el Seguro de Invalidez y Sobrevivencia del Nuevo Sistema Previsional Chileno” Cuadernos de Economia 29, #88, pp. 409-41. December. World Bank, 1994. The Old Age Crisis, Washington, D.C.

25

Table 2: Workers by Contributing Status and Institution: Urban and rural, by age and gender

16 to 39 40 to 59 60 plus Total URBAN Males

INP 1.38 6.18 16.52 4.14 AFP 68.87 60.01 35.02 63.36 Capredena 1.38 2.55 0.95 1.76 Other 0.33 1.11 1.48 0.68 No 28 30.15 46.04 30.03 No answer 0.04 0 0 0.02 Total 100 100 100 100

URBAN Females INP 1.94 7.88 16.22 4.75 AFP 66.56 52.89 24.57 59.63 Capredena 0.4 0.81 0.14 0.53 Other 0.12 0.58 0.36 0.29 No 30.98 37.6 58.71 34.72 No answer 0 0.24 0 0.08 Total 100 100 100 100

RURALMales INP 2.09 10.62 13.21 5.83 AFP 44.85 39.12 21.02 40.79 Capredena 0.28 0.35 0.07 0.28 Other 0.28 0.36 0.19 0.3 No 52.49 49.56 65.51 52.8 No answer 0.01 0 0 0.01 Total 100 100 100 100 RURAL Females INP 1.37 6.02 12.91 3.38 AFP 48.79 41.69 17.83 44.93 Capredena 0.13 0 0 0.09 Other 0.09 0.23 0.72 0.17 No 49.62 52.06 68.54 51.44 Total 100 100 100 100

Source: Casen 94

26

Table 3: Contributory behavior among urban workers and choice of health care provider: by

schooling

Did you contribute to social security?

Incompl Primary

Incompl Secondary

Secondary up to 4 years Post Sec

more than 4 years Post sec

TOTAL

Yes 55.02 65.24 76.69 80.35 89.84 70.58 with FONASA health plan 25.65 30.27 28.33 21.6 11.85 25.64 with ISAPRE health plan 9.06 18.1 32.53 48.14 68.2 29.2 with alternative plan 20.31 16.87 15.83 10.61 9.79 15.74

No 44.97 34.76 23.31 19.65 10.16 29.43 Total 100 100 100 100 100 100 Source: Casen 94

27

Table 4: Sample Means – Urban Data :civilian paid workers, full-time, with take-home wages above minimum wage threshold

Full Sample 22,592 obs. Men 15,996 obs Women 6,596 obs. Variable Mean Std. Dev. Min Max Mean Std. Dev. Mean Std. Dev. age 36.357 11.403 16 89 36.880 11.570 35.257 10.963 years of schooling 10.870 3.772 0 19 10.537 3.739 11.570 3.744 potential experience 19.508 12.876 0 75 20.363 13.014 17.711 12.391 s.s. contributors 0.803 0.398 0 1 0.799 0.401 0.812 0.390 Metro and V regions 0.613 0.487 0 1 0.593 0.491 0.654 0.476 Regions II, VIII, XII 0.176 0.381 0 1 0.186 0.389 0.154 0.361 Regions III, IV, VI, VII 0.123 0.328 0 1 0.129 0.336 0.109 0.312 Region IX, X, XI 0.089 0.284 0 1 0.091 0.288 0.083 0.276 Agriculture 0.041 0.199 0 1 0.051 0.221 0.020 0.139 Mining 0.022 0.148 0 1 0.031 0.174 0.003 0.058 Industry 0.189 0.391 0 1 0.214 0.410 0.135 0.342 Utilities 0.009 0.096 0 1 0.012 0.109 0.004 0.059 Construction 0.100 0.300 0 1 0.143 0.350 0.011 0.106 Retail 0.189 0.392 0 1 0.173 0.378 0.225 0.417 Transportation 0.087 0.282 0 1 0.114 0.318 0.030 0.172 Finance 0.077 0.267 0 1 0.067 0.250 0.099 0.299 Services 0.274 0.446 0 1 0.185 0.388 0.461 0.498 firm size1_5 0.352 0.478 0 1 0.335 0.472 0.386 0.487 firm size6_9 0.066 0.247 0 1 0.064 0.246 0.068 0.252 firm size10_49 0.258 0.438 0 1 0.257 0.437 0.262 0.440 firm size50_199 0.154 0.361 0 1 0.162 0.368 0.137 0.344 firm size_200+ 0.170 0.376 0 1 0.182 0.386 0.147 0.354 Had contract 0.744 0.437 0 1 0.729 0.445 0.775 0.418 monthly wage 133,932 94,991 42,000 550,000 139,843 97,833 121,517 87,440 log(monthly wage) 11.622 0.571 10.645 13.218 11.666 0.572 11.529 0.558 Source: Casen 1994

28

TABLE 5A Wages and Social Security Contributions -Males (Maximum Likelihood Simultaneous Estimation)

Treatment effects model -- MLE Number of obs = 15996 Wald chi2(11) = 6371.61 Log likelihood = -15215.914 Prob > chi2 = 0.0000 ------------------------------------------------------------------------------ | Coef. Std. Err. z P>|z| [95% Conf. Interval] -------------+---------------------------------------------------------------- Dependent variable = log(monthly salary) schooling | .0844811 .0011852 71.28 0.000 .082158 .0868041 experience | .0257859 .0009791 26.34 0.000 .0238669 .0277049 experience2 | -.0002268 .0000187 -12.12 0.000 -.0002635 -.0001901 Metro and V reg | .0573433 .0138063 4.15 0.000 .0302834 .0844032 Reg. II, VIII, XII | -.0106307 .0148673 -0.72 0.475 -.0397701 .0185088 Reg. III, IV, VI, VII| -.0268287 .0153688 -1.75 0.081 -.056951 .0032936 Firm size 6_9| -.0045475 .0162299 -0.28 0.779 -.0363575 .0272624 F.size 10_49 | .0484508 .0113177 4.28 0.000 .0262684 .0706331 F size 50_199| .1171859 .0130814 8.96 0.000 .0915468 .1428251 F size_200+ | .2522021 .012871 19.59 0.000 .2269754 .2774289 Contributor | -.0827705 .0165905 -4.99 0.000 -.1152872 -.0502538 _cons | 10.3142 .0240682 428.54 0.000 10.26702 10.36137 -------------+---------------------------------------------------------------- Contribution Probability schooling | .0340942 .0040895 8.34 0.000 .026079 .0421094 age | .0239146 .0068948 3.47 0.001 .0104011 .0374282 age2 | -.0002242 .0000833 -2.69 0.007 -.0003874 -.000061 Firm size 6_9| .066209 .0569569 1.16 0.245 -.0454245 .1778424 F.size 10_49 | .312927 .040786 7.67 0.000 .2329878 .3928661 F size 50_199| .4212094 .0536511 7.85 0.000 .3160553 .5263636 F size_200+ | .5841931 .0579812 10.08 0.000 .470552 .6978342 Had contract | 1.927414 .0339957 56.70 0.000 1.860784 1.994044 _cons | -1.328927 .144408 -9.20 0.000 -1.611962 -1.045893 -------------+---------------------------------------------------------------- /athrho | .1916468 .0234905 8.16 0.000 .1456063 .2376874 /lnsigma | -.7540773 .0056922 -132.48 0.000 -.7652338 -.7429207 -------------+---------------------------------------------------------------- rho | .1893345 .0226484 .1445859 .2333102 sigma | .4704445 .0026779 .4652252 .4757224 lambda | .0890714 .0107641 .0679742 .1101685 ------------------------------------------------------------------------------ LR test of indep. eqns. (rho = 0): chi2(1) = 67.60 Prob > chi2 = 0.0000 ------------------------------------------------------------------------------

29

TABLE 5B Wages and Social Security Contributions - Females (Maximum Likelihood Simultaneous Estimation)

Treatment effects model -- MLE Number of obs = 6596 Wald chi2(11) = 2880.12 Log likelihood = -5853.7659 Prob > chi2 = 0.0000 ------------------------------------------------------------------------------ | Coef. Std. Err. z P>|z| [95% Conf. Interval] -------------+---------------------------------------------------------------- Dependent variable = log(monthly salary) Schooling | .0854444 .0018533 46.10 0.000 .081812 .0890768 Experience | .0176242 .0014438 12.21 0.000 .0147944 .020454 Experience2 | -.0001128 .0000308 -3.66 0.000 -.0001732 -.0000524 REG1 | .0616717 .0199922 3.08 0.002 .0224878 .1008557 REG2 | -.0281751 .0225614 -1.25 0.212 -.0723947 .0160444 REG3 | -.0928951 .0230718 -4.03 0.000 -.138115 -.0476751 Firm size 6_9| .0417252 .0235126 1.77 0.076 -.0043586 .0878091 F.size 10_49 | .1136677 .0160158 7.10 0.000 .0822774 .145058 F size 50_199| .1851391 .0193689 9.56 0.000 .1471767 .2231016 F size_200+ | .2458762 .0196998 12.48 0.000 .2072653 .284487 Contributor | -.1882781 .0227042 -8.29 0.000 -.2327775 -.1437787 _cons | 10.28635 .0353268 291.18 0.000 10.21711 10.35559 -------------+---------------------------------------------------------------- Contribution Probability Schooling | .0392099 .0066605 5.89 0.000 .0261556 .0522642 age | .0503859 .0117614 4.28 0.000 .0273339 .0734378 age2 | -.0005626 .0001491 -3.77 0.000 -.0008548 -.0002705 Firm size 6_9| .1431084 .0916455 1.56 0.118 -.0365134 .3227302 F.size 10_49 | .4199402 .0669001 6.28 0.000 .2888184 .5510619 F size 50_199| .4488038 .0898692 4.99 0.000 .2726634 .6249442 F size_200+ | .4969377 .0923881 5.38 0.000 .3158604 .6780149 Had contract | 1.973855 .0508161 38.84 0.000 1.874257 2.073452 _cons | -1.988713 .2321016 -8.57 0.000 -2.443623 -1.533802 -------------+---------------------------------------------------------------- /athrho | .2907195 .034564 8.41 0.000 .2229754 .3584637 /lnsigma | -.7967497 .0089672 -88.85 0.000 -.8143251 -.7791743 -------------+---------------------------------------------------------------- rho | .2827969 .0317997 .2193521 .3438601 sigma | .4507918 .0040424 .4429381 .4587847 lambda | .1274825 .0146607 .0987481 .156217 ------------------------------------------------------------------------------ LR test of indep. eqns. (rho = 0): chi2(1) = 72.07 Prob > chi2 = 0.0000 ------------------------------------------------------------------------------