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Impact of Informality on Consumption

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Published: Tue, 20 Mar 2018

Abstract

By using a simple model, it will be analyzed the impact that informality has in the amount of consumption of the workers during their life cycle. This paper deals with the interconnections of under-reported earnings, savings and old-age pension. The workers sampled for this analys have been divided into three groups: 1. Low income emloyees, 2. Higher income employees who declare all incomes, 3. Employees who under-report their incomes .In this paper the analysis is based on two pension models: the model that calculates pension in conformity with the incomes (proportional model) and the basic model, whose objective is poverty reduction for the “third age”. The major result is as follows: Given the fact that the basic pension system favors employees that under-report their incomes and the fact that the impact of informality is greater in the basic system than in the propotional pension system, the application of basic pension system in the Albanian might be problematic.

KEY WORDS: informality, pensions, proportional model, basic model, Albania

  1. Introduction

There are many examples around the world, how different countries have adapted their pension system in comformity with the important changes they are experiencing. However what works well in a country does not necessarly work well in an other country. Pension reforms should be in accordance with the economic, political and social characteristics of the country. The issue referring to the appropriate scheme to be implemented in Albania has been the concern of the governments. . In such circumstances, when the “Pay-As-You-Go” system is failing every day, the problem of a reform seems as urgent as it is necessary.

Pension systems have been one of the serious issues, which all Albanian governments have been facing. They have been a constant source of criticism from international bodies and are one of the schemes that aggravate the state budget a lot, therefor impeding the development of the Albanian economy (Treichel, 2001)

As a result of a misconception of this scheme since the beginning, the current system has generated high evasion and informality, distorting effects on the labor market and not providing a long term solution for the pensions. The main problem has to do with the amount of contributions and incentives to pay these contributions.

Using a simple model, it will be given an idea about the impact that informality has in the amount of the workers consumption during their life cycle. For this reason two pension models have been analyzed: the model that calculates pension in conformity with the incomes and the basic model, whose objective is poverty reduction for the “third age”. Augusztinovics, (2005) concludes that increasingly social tensions can be reduced by e replacing the pension system related to incomes with a basic pension system.

Given that this topic presents a great complexity and at the same time is so current and present in our daily lives, it would be interesting to treat it in order to provide an alternative for solving such a so sharp problem.

2Proportional pensions

In recent years, the Hungarian Economists of the Academy of Sciences have conducted a series of empirical studies regarding pension systems, especially in the countries of Central and Eastern Europe. The assumptions used in their model, have a lot in common with the Albanian reality.

According to (Simonovits, 2008), the assumptions of the model are:

• The population is taken unchanged

• The young population is active in the labor market

• Every elder person has retired

Consequently, R is the number an employee working years and S, the years of an individuals’ retirement. Dependency rate, expressed as the ratio of pension years to those of work, is marked with μ = S / R. Although, the difference between the contribution rate of employers and employees is clear in the current pension system clear, in this analysis, this difference is not taken into account. The total salary, which represents the total cost of the work, is marked by w. Individual contribution, paid to the pension system, is calculated at the rate t, of the total reported salary. Health insurance contributions and income tax impacts have been left out of the model. To be closer to the Albanian reality, it is assumed that the rate of employed persons who declare their exact income, are not directly related to the pension system. The system is suposed in equilibrium; the revenues of the system are equal to its expenditures.

The scale of the informal economy in Albania is one of the highest in the Central and Eastern Europe countries. The informal economy is assumed at 34 percent according to (Schneider, Buehn, & Montenegro, 2010). For this reason, it is foreseen to classify the employees in three different groups:

1. Low income emloyees, who are marked with (U)

It is presumed, that employees who do not fully declare their income are part of the second group. For this group, it is made the following subdivision:

2. Higher income employees who declare all incomes, who are marked with (P)

3. Higher income employees who under-report their incomes, who are marked with (N)

The frequency of these employees is: ƒU, ƒP and ƒN. These frequencies are positive numbers, the amount of which shall be equal to 1. Considering all the employment as a unit, the number of employees is marked by 1.

In special cases it may occur that one of the frequencies is equal to 0, as it is the case of economies where informality is in very low levels near 0.

In this model, it is assumed that pensioners receive their pensions, in proportion to the income declared, which are marked with *, (t*, is the rate of the contribution to the system). The current income of workers according to salary levels, are: wP = wN and wU. While the benefits from the system during the retirement period, are: bP* and bN* =bU*. Based on the above assumptions, the benefits are commensurate with the income declared; bP* = β* wP and bN* = β* wU, where β* is the replacement rate of the pension system related to income (proportional). As it is observedou, wU represents the minimum wage and any potential changes will affect the overall level of formal employment. This problem will not be considered, because of the complexity that it presents.

In the following equations are presented: total real income (WP) and the total income declared (WU).

WP = (ƒP + ƒN)wP + ƒUwU and WU = ƒPwP + (ƒN+ ƒU)wU

Since the system is in equilibrium, then, t * WU = μβ * WU. Consequently, subsequent connection between the contribution fee (t *) and the replacement ratio is:

β* : t* = µβ*

It is assumed that those who declare all the incomes do not save for theretirement period, as they believe that the replacement ratio is sufficiently high. In contrast, people who do not report their total incomes, are supposed to save for the retirement, that hidden amounts. In some cases these rates may be even lower than the rate of social security system, which would make them save for their whole lifetime. So the saving rate is marked with σ, which is: 0 <σ < t* and the annual savings are: σ(wP – wU). It is assume that the hidden savings during the R years of work are used for consumption ρ(wP – wU) during the S retirement years.

For comparative reasons the level of consumption is analyzed during two stages of life (work and pension). This analysis will provide a more complete picture throughout the whole life cycle, of the consumption during the work period, which is labeled “youth consumption” and the consumption during retirement, which is labeled “elderly consumption”.

Based on the above equations, “youth consumption” would be:

cP* = (1 – t*)wP ; cN* = (1 – t*)wU + (1 – σ)(wP – wU) ; cU* = (1 – t*)wU

While the “elderly consumption” would be

dP* = bP* ; dN* = bU* + ρ(wP – wU) ; dU* = bU*

  1. Basic pension system

Some researchers (Augusztinovics & KöllÅ‘, 2008), (Kollo, 2008), (Kertesi G., Bonn 2003) consider the replacement of the proportional pension system with a basic pension system as a way to reduce the increasing social tensions. Since the goal of this system is the reduction of poverty during the “third age”, it is assumed that it is given a definit benefit b0 which is funded by a consumption tax rate î. Each individual pays his/her taxes proportionally after spending money for consumption and for mathematical simplicity it is assumed that the basic benefits are net. Pensions obtained from this system are:

One of the innovations that this model offers is the assumption which does not take into account the possibility of consumption tax evasion, in contrast to the case of non-payment of pension contributions. The implementation of this model faces with some difficulties in our country, such as problems with the informal economy (tax evasion) and the indirectly calculation method of VAT.

In the model analyzed there is no total savings and total consumption is equal to total income. Based on the equation that shows the dependency ratio, the tax equation is as follows:

The decreasing contributions, tw finance only the reduced pensions of employees.

, pra

For comparative reasons, it is assumed that the total costs of pensions are invariable. This assumption is clearly expressed in the following equation:

By substituting î from the previous equation to the new equation the following formula is obtained:

Consequently, the reduced contributions will be as follows:

In order for the contribution to be a positive rate, it should be assumed that: . So,

The “youth consumption” is:

; ;

While the “elderly consumption” is:

; ;

As it can be noticed from the above equations, consumption and benefits of employees who declare all their incomes has decreased, while consumption and benefit of employees with low incomes and workers that under-report their incomes have increased in comparison with the proportional pension system.

4The Albanian Case

For study reasons it is worth presenting a numerical simulation. In the above mentioned models are used features of Albanian pension system.

Based on the Albanian legislation for social security, the working years that an employee must have to obtain a retirement pension, are 35. Consequently, R = 35 years. According to official data from the World Bank (2012), the average of life expectancy for the Albanian population is 77 years. By subtracting from this age the average age of the entry into the labor market, which is 22 years (qualified employees, as well as unqualified have been considered as), it is concluded that the average number of years spent in retirement for every Albanian, is S = 20 years. Dependency rate, which represents the ratio of average years spent in retirement, with the average years spent in work, is μ = S / R = 20/35 = 0.57.

The calculation of incomes is attained based on the data on employment and average salary for each sector of the economy. It is assumed that:

• All employees of public and private sector and non-agricultural privat sector are classified as employees with high average incomes.

• For purposes of analysis, the informal economy is assumed at 34 percent according to (Schneider, Buehn, & Montenegro, 2010). So, 34 percent of private sector employees do not declare their real incomes.

• Employees of the agricultural sector are assumed as employees with low income.

Based on the above assumptions and on the (INSTAT, 2014) data the distribution of workers by sector is:

ƒU = 0.49 , ƒP = 0.39 , ƒN = 0.12

According to INSTAT data (2013), the average salary in the public sector is 52,150 ALL (Albanian lek), the average of high salary in the private sector is 97,000 ALL and in the agriculture sector it is assumed that the salary is equal to the minimum wage 22,000 ALL. Based on these data, the income distribution is:

wP = 4.4 dhe wU = 1

While the average stated salary is:

WU = 2.326

So, the average salary declared, based on the above analysis, is: 2.326 x 22’000 = 51’172 ALL. This indicator has a outcome close to the average salary of 52’150 ALL declared in Albania.

It is assumed that the amount of benefit in the basic system is equal to half of the benefit of the pension system related directly to income.

b0 = tWU/ 2µ

Also, it is assumed that the worker that does not declare his/her real income, saves half of the money, σ = t/2, which, Social Security, would make the employee save from the income that are not declared.

Table no 1: The Key Indicators

Indicators

Division of employees according to declaration of incomes

The saving rate

ƒP

ƒN

ƒU

Basic Model

0.39

0.12

0.49

0.108

Full Reporting

0.51

0

0.49

0.108

         

Source: Author Calculations

4.1Basic Model

The distribution as per basic assumption is:

ƒP = 0.39, ƒN = 0.12, ƒU = 0.49

In the table below have been presented the characteristics of both pension systems that are being analyzed

Tabel no 2: Characteristics of pension systems

Systems

Contribution Rate

T

Tax Rate

î

Repalcement Rate

β

Proportional pensions

0.216

0

0.38

Basic pensions

0.108

0.092

0.189

Source: Author Calculations

The above characteristics are calculated in the case of Albania, where the contribution rate paid to the social security, is 21.6 percent for the proportional pension system. As it can be observed from the above data, when moving from a proportional pension system to the basic pension system, the contribution rate paid to the pension system is halved. A consumption tax at the rate of 9.2 percent is added to the basic pension system in contrast to the proportional pension system. Refering to the calculations, there is a significant difference regarding the replacement ratio between the two pension systems. In the proportional pension system the value of this ratio is 38 percent, which is reduced to 18.9 percent in the basic pension system.

We see the impact of two pension systems to the amount of consumption for the three groups taken into consideration.

Table no 3. Consumption amount

Systems

youth consumption

elderly consumption

 

cP

cN

cU

dP

dN

dU

Proportional pensions

3.449

3.817

0.784

1.672

0.747

0.380

Basic pensions

3.564

3.843

0.810

1.196

0.946

0.610

             

Source: Author Calculations

By analyzing the above results, it can be observed that:

• The “youth consumption” is the highest in three groups on the basic pension system compared with the proportional pension system.

• As expected, the “elderly consumption” with low income at basic pension system is higher than the consumption of the other system. Characteristic of the basic pension system is the support for people with low incomes.

• The “elderly consumption” with high incomes at the proportional pension system compared with the consumption at the basic pension system is about 50 percent higher.

• A weakness in the basic pension system is that it favors the group of pensioners who under-report their incomes.

4.2Full reporting of incomes

The analys of the “ideal case” where all employees report all their income, although it seems utopian, it is worthwhile analyzing.

Division of employees according to the declaration is:

ƒP = 0.51; ƒN = 0; ƒU = 0.49

Table no 4. Characteristics of pension systems

Systems

Contribution Rate

t

Tax rate

Î

Repalcement Rate

β

Proportional pensions

0.216

0

0.38

Basic pensions

0.107

0.11

0.19

Source: Author Calculations

The rate of contribution to the proportional pension system is 21.6 per cent, as it was in the case of the basic model. As observed from the above table, the characteristics of the basic pension system, has changed in the “ideal case” compared to the basic model. The rate of contribution in the “ideal case” decreased at 10.7 percent compared with 10.8 percent in the basic model. While the tax rate has increased to 11 percent from 9.2 percent in the basic model. Changes in the ratio of replacement are negligible.

We see the impact that the two pension systems have to the consumption quantity of the three groups who have been analyzed.

Table no 5. Consumption amount

Systems

youth consumption

elderly consumption

 

cP

cN

cU

dP

dN

dU

Proportional pensions

3.449

0.784

1.672

0.380

Basic pensions

3.497

0.795

1.264

0.689

             

Source: Author Calculations

By analyzing the results above, we can say that:

• The “youth consumption” and the “elderly consumption” have not changed for the proportional pension system for both cases.

• Into the basic pension system there is a reduction in the consumption quantity at the young age and a very small increase in the consumption during the “third age”.

• So, the basic pension system is more sensitive toward informal economy than the other pension system that is taken into consideration.

5Conlusions

The elementary model.has already been analized. Finally, by analyzing the cases discussed above, it can be concluded that:

  • The consumption and benefits of employees who report all their incomes has decreased in the basic pension system compared to the proportional pensions system.
  • The consumption and benefits of employees with low incomes and those of the employees who under-report their incomes increased in the basic pension system compared to the proportional pensions system.
  • The basic pension system favors employees that under-report their incomes.
  • The impact of informality is greater in the basic pension system than in the proportional pension system.
  • So, in the Albanian reality the application of basic pension system might be problematic.

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