Figure 5.1 Correlation across Countries between the Size of the informal Sector and the Ease of Doing Business
Source: Loayza and others 2005.
Note: *** = 1% significance level.
SUMMARY: Widespread informality implies that large portions of the workforce are not protected against old age, disability, and, often, health risks. Although the need to address these vulnerabilities provides a clear rationale for government intervention, the actual drivers of informality should inform policy levers and choices. Many institutional constraints determine the labor market segmentation that underpins informality in MENA, such as the design of pension systems, business and labor regulation, incentives and pay in the public sector, and the design of interventions to improve skills upgrading. This chapter analyzes these institutional constraints and presents a related set of policy interventions to effectively expand coverage and promote the creation of better quality jobs. First, the chapter discusses the importance of a healthy business environment that fosters competition and facilitates firm entry. Easing certain provisions of the labor legislation and keeping the cost of labor at a realistic level can help employment creation and reduce informality, especially if coupled with reforms geared toward protection of workers’ transitions. Realigning the pay and benefit package that is offered by public sector employment can reduce important distortions. Moreover, the low productivity dimension of informality, a phenomenon that is particularly relevant among the poorest countries in the region, calls for productivity-enhancing interventions, including those that aim to improve access and realign training and skill-upgrading programs to the needs of the informal sector. Second, the chapter discusses how reforms in the design of the social insurance system in MENA are critical for addressing informality. Limited legal coverage, the short minimum vesting requirements, generous early retirement provisions, and the use of an average wage measure from the final years before retirement for pension benefit calculation all contribute to limited coverage. Addressing the coverage gap will require governments to look beyond reforming the existing social insurance system to seek special coverage extension schemes targeted to the informal sector and to those with limited savings capacity.
This chapter is organized in two parts and addresses five distinct and complementary policy angles, each linked to the drivers of informality in the MENA region. Part 1 discusses institutional barriers to formality in MENA, including (1) the business environment, (2) labor market regulations, and (3) public sector employment bias, and provides relevant policy options. Part 1 also discusses the need for (4) addressing the productivity trap faced by informal workers, particularly through training and skills-upgrading interventions. Part 2 of this chapter focuses on (5) the social insurance system and presents barriers to coverage linked to the incentive design of pension systems in MENA. It presents policy options and recommendations for coverage extension through both improving the design of existing social insurance systems and introducing new special schemes targeting informal workers.
Although growth materialized in the last decade in MENA, not enough good jobs were created. Instead, informal employment grew, characterized by lower pay, lack of access to training, worse working conditions, and lower job tenure than formal employment. These conditions affect the vast majority of workers, whereas relatively few “insiders,” including those employed in the public sector, benefit from privileged circumstances. Reforms aimed at decreasing informality can potentially affect two aspects of this process: (1) by generating direct productivity gains and increasing job creation (increasing the “size of the pie”) and (2) by improving how equitably rents and benefits from the development process are redistributed. In this sense, many of the policy options discussed here can have an impact both on employment creation as well as on formalization and moving toward fulfilling work for all. Because of the multidimensionality of informality, it is important to acknowledge that a complex set of policy interventions might be needed to effectively overcome barriers to formality in a sustainable manner and help the growth process to become progressively more inclusive. Here, too, the mechanism through which formalization is achieved matters greatly for its effects on employment, efficiency, and growth. If formalization is based purely on enforcement, it will likely lead to unemployment and low growth. If, on the other hand, it is based on improvements in both the regulatory framework and the quality and availability of public services, it is likely to bring about more efficient use of resources and higher growth.
Certain features of the regulatory framework in MENA, encompassing the business environment, set of labor regulations, and nature of employment in the public sector, pose barriers to formality. Informality appears to be strictly intertwined with the development process and can be largely explained as a suboptimal private sector response to restrictive regulation. The first part of this chapter describes institutional barriers to formality and provides relevant policy options that extend beyond mere enforcement. In particular, this section addresses the need for a conducive business environment, the importance of less restrictive labor regulations, and, at the same time, more effective protection of workers’ income during employment transitions. Moreover, the first part of this chapter argues that the preference for public sector jobs in many MENA countries affects informality outcomes, requiring a realignment of incentives to limit queuing for these jobs. Finally, recognizing that many informal workers face a low-productivity trap because of their limited access to relevant skill acquisition, numerous skills-upgrading interventions are explored for specific MENA context.
Having to obey more stringent regulations may imply lower flexibility in firms’ employment and production decisions, and therefore, lower profits and productivity (Almeida and Carneiro 2005).
Excessive entry regulations and high taxes matter for informality and growth. Across countries, a significant correlation is found between the size of the informal sector and the ease of doing business (figure 5.1). Barriers to firm entry give discretion to public officials to exclude or advantage specific investors (World Bank 2009) and thus continue to perpetuate a dual model of development in which a few “protected” firms thrive and share rents while many small firms strive to survive. These barriers work as an impediment to growth, especially for the most productive among these outsiders, who might be excluded from important opportunities (or alternatively, who might have to divert resources from productive activities to rent-seeking activities). In parallel, corporate taxes are also systematically identified as a constraint to business and formalization. These constraints are particularly powerful in MENA. As highlighted in chapter 3, many firms in MENA never formalize, and even those that eventually register still operate informally for a significant amount of time. The region has the developing world’s highest share of firms that start out as informal (one-fourth) and the longest operating period before formalization (four years) among registered forms. The following discussion focuses on two main margins along which business environment reform can promote a more inclusive and dynamic private sector: (1) regulation of entry and (2) corporate tax reform.
Figure 5.1 Correlation across Countries between the Size of the informal Sector and the Ease of Doing Business
Source: Loayza and others 2005.
Note: *** = 1% significance level.
Could reforms in the regulation of entry improve firms’ incentives to formalize? Regulation is understood to be an important determinant of formalization. First, monetary and administrative registration costs (for example, a high number of procedures requiring extensive time and effort) increase formalization costs. After LAC, MENA is the region with the highest average number of procedures to start a business. Economies such as Algeria and Djibouti and the West Bank and Gaza economy stand out as places where the registration process is particularly cumbersome, requiring more than 10 procedures and an average of between 20 to 80 days to start a business (see chapter 3). Second, discretion in the application of these procedures (for example, with connected firms potentially benefiting from less strict enforcement) increases barriers to formalization for those firms that, quality-wise, would have the potential to compete on a larger scale and fully within the regulatory framework. Thus, uneven enforcement sustains an equilibrium where few connected firms thrive, a large number of firms operate informally, and new entrants face the choice of either investing in rent seeking to secure the benevolent eye of the bureaucracy or being virtuous and thus bearing the disproportionate brunt of taxation and regulation.
Reforms to the regulation of entry have been shown to have had positive, albeit moderate, effects on formalization. Interventions include (1) reducing the costs of registration, number of procedures, and minimum capital; (2) providing information and training to entrepreneurs (such as filling out forms); and (3) facilitating registration by establishing one-stop shops for registration. No experimental evidence exists in MENA on the likely impact of these reforms. In Mexico experiments were conducted and the impact evaluated (Bruhn 2011; Kaplan and others 2011). Broadly, these studies found that simplifying the process of business registration had a moderate impact on formalization of existing firms. In contrast, they indicate that the intervention increased formalization because of more creation of new businesses by former wage earners (Bruhn 2008). Another potential reason for the limited impacts on formalization of existing firms is that results might take time because of uncertainty about reform reversal, which is not captured by these analyses. Finally, the effect of these policies tends to depend on how many firms are at the margin of formalizing. Given the differences between MENA and LAC in this domain, the effects of this type of intervention could be significantly larger in the MENA region.
High taxation burden was the constraint to formalization most widely identified by micro- and small firms in Egypt and Morocco (figure 5.2). High taxes imply high costs of regulatory compliance if a formal business. Morocco’s corporate tax rate is one of the highest among developing countries: In 2007, it was second only to Pakistan and remained significantly above the average for developing countries in 2008. It is interesting that in Egypt (where corporate tax rates are below the developing countries average), a significantly smaller share of firms than in Morocco identified tax rates as being a major obstacle to formalization. The country’s profit taxes are also high relative to countries with similar income levels.1 Similar results were also found in countries such as Mexico, Brazil, and Bolivia. Lowering the corporate tax rate can affect tax revenue through three main channels: (1) existing formal firms may invest more and earn more income on which they pay taxes, (2) existing informal firms may be induced to formalize and start paying some taxes, and (3) new firms might be induced to operate formally. Evidence from other regions suggests that the net effect is likely to depend on whether a reduction in the tax rate is accompanied by additional enforcement and a reduction in exceptions. The short-run impact may also be negative; for example, Turkey lowered its corporate tax rate from 30 to 20 percent in 2007 and experienced a drop in overall tax revenues (Otonglo and Trumbic 2008).2 However, the converse happened in Egypt: When its corporate tax rate was lowered from 42 to 20 percent, it was accompanied by a significant increase in overall tax revenues. An experimental study in Brazil evaluated the impact of a reform that combines business tax reduction (of up to 8 percent among eligible firms) and regulation simplification and found interesting results. The emerging evidence indicates that the reform led to a significant increase in formality along several dimensions (Fajnzylber and Reyes 2010). In particular, the reform consisted of implementing a new simplified tax system for micro- and small firms, referred to as “SIMPLES.” The new national system consolidated several federal taxes and social security contributions into one single monthly payment, varying from 3 to 5 percent of gross revenues for micro-enterprises, and from 5.4 to 7 percent of revenues for small firms. Program eligibility excluded some sectors. This intervention suggests that this type of program can increase levels of registration and government revenues. Enforcement matters too. Overall, and not surprisingly, more frequent inspections are associated with lower underreporting of workers and sales (Almeida and Carneiro 2009). In MENA, firms report an average of four tax inspections per year (the highest regional average in the world). Such strict enforcement appears to be accompanied by widespread corruption, because informal payments were requested in 17 percent of inspections, significantly above the 7 percent reported in the LAC and ECA regions.
Figure 5.2 Obstacles to Formalization in Egypt and Morocco
Source: Calculations using informal ICA surveys from Morocco 2008 and Egypt 2010.
In the MENA region, investment climate reforms have accelerated in many countries in recent years. The evidence suggests that the implementation of reform matters greatly to private sector development. The recent MENA Development Report From Privilege to Competition (World Bank 2009) estimates that in response to previous reforms, private investment in the MENA region increased by only 2 percent of GDP, compared with between 5 and 10 percent in Asia, Eastern Europe, and Latin America. The same report estimates that the number of registered businesses per 1,000 people in MENA is less than one-third that in Eastern Europe and Central Asia, and with less entry and exits of firms, the average business is 10 years older than in East Asia or Eastern Europe. Close to 60 percent of business managers surveyed did not think that the rules and regulations were applied consistently and predictably, whereas policy uncertainty, unfair competition, and corruption were identified as major concerns for investors. Discretionary enforcement of regulation is a strong deterrent to small entrepreneurs who start their businesses informally but are then forced to stay small to escape controls. Staying small may, in turn, make it prohibitively costly to formalize over time.3 Overall, the paucity of existing data on firms’ dynamics has not yet allowed identification of which margins matter most to promote formalization in the context of MENA. This is an important area where experimental evidence can effectively inform policy making.
Labor policies can affect informality through three main channels. First, excessive labor costs, whether due to labor regulation (such as high minimum wages, severance costs, or labor taxes) or strong worker bargaining power, can depress labor demand in the formal sector. Second, legislation can create incentives for workers to voluntarily work informally if perceived contributions exceed the benefits. Third, labor market institutions can impact productivity growth. Productivity gains arising from adoption of new technologies and production processes account for half of the differences in levels of economic development (the most important determinants of informality), not to mention long-run worker productivity and welfare more generally (World Bank 2007). Yet excessive restrictions on job reallocation or layoffs for economic reasons, or state- or union-induced inflexibilities, may reduce the adoption of such innovations.
Across countries, there is debate whether overly rigid employment protection legislation (EPL) is an important determinant of the labor market segmentations underlying informality. EPL is the set of rules governing the hiring and firing process that is provided through both labor legislation and collective bargaining agreements (box 5.1). Strong evidence suggests that overly rigid EPL tends to not only discourage hiring and firing but also may slow down adjustment to shocks, impede the reallocation of labor, and promote informality (OECD 2010). Recently, Fialová and Schneider (2010) established a statistically significant effect of EPL on the size of the informal sector in European Union (EU) countries. In the countries that have the most rigid EPL, the share of the informal sector is estimated to be about 3.5 percentage points higher than in countries that have the most flexible EPL. This result supports the view that unduly strict EPL leads some employers to hire workers informally to avoid costs imposed by the EPL. Specifically, strict EPL typically makes it harder for certain groups, including youth, women, and displaced older workers, to enter or reenter the labor market, at least on an open-ended contract.
Perceptions of employers. The extent to which labor regulations are perceived by employers as a constraint to expanding their formal employment varies among MENA countries but in general is higher than in other regions. According to ICA surveys, labor regulations and mandatory contributions are considered by firms as a factor that constrain many enterprises from expanding formal employment. Table 5.1 shows the percent of firms indicating employment regulations and skills and education of labor are a major or severe obstacle. The MENA region has the highest share of employers dissatisfied with the existing labor regulations, although it should be noted that the skills and education of the labor force are a more significant problem for all regions than employment regulations. In Egypt, Lebanon, and Syria, labor regulations are perceived by firms as a major constraint to expanding formal employment, although this is true to a lesser extent in Algeria, Jordan, Morocco, and the West Bank and Gaza economy (figure 5.3). Manufacturing firms, service firms, and hotels in Egypt report that they would hire a net of 21 percent, 9 percent, and 15 percent more workers, respectively, if there were fewer restrictions on hiring and firing workers (Angel-Urdinola and Kuddo 2010). Similarly, according to enterprise surveys, firms in Lebanon would be willing to hire more workers (by an average of more than one-third of the workforce) in the absence of existing restrictions on labor regulation. The results of the enterprise survey analysis support those of previous studies (Pierre and Scarpetta 2006), showing that firms in countries with more stringent employment regulations are more likely to report labor regulations as a major or very severe obstacle, even after controlling for other factors such as GDP and unemployment. Overall, EPL as an obstacle to business growth tends to be more pronounced in countries that are more likely to enforce it (including through court challenges) and less of a problem in countries where the capacity of labor market institutions is weaker.
Table 5.1 Employment Regulations and Skills and Education of Labor as a Major or Severe Obstacle for Expanding Employment
Region |
Employment regulations |
Skills and education of labor |
Eastern Europe and Central Asia |
18.7 |
43.2 |
Africa |
17.3 |
32.6 |
East Asia and Pacific |
14.5 |
33.8 |
Latin America and the Caribbean |
29.5 |
42.5 |
South Asia |
19.0 |
24.8 |
Middle East North Africa |
36.2 |
Source: BEEPS 2008 and Enterprise Surveys.
Figure 5.3 Share of Firms Identifying Labor Regulations as a Major Constraint in Doing Business in MENA (%)
Source: World Bank: www.enterprisesurveys.org.
In most MENA countries, labor regulation is a key mechanism for protecting workers’ rights, because collective bargaining is not widespread. Trade unions in MENA rarely represent many workers effectively (although exceptions are found, as in Tunisia, where unions are influential social partners). Moreover, workers have limited ways of challenging private employers; for instance, in many countries in the region, strikes remain illegal. Thus, labor regulations have an important role to play in protecting workers (Angel-Urdinola and Kuddo 2010). Below, key aspects of EPL that can affect informality are explored, including (1) hiring regulations and contract types, (2) minimum wage, (3) firing regulations, and (4) tax wedges.
Hiring regulations and contract types. Hiring regulations in MENA are generally aligned with international standards, and MENA countries are joining the international trend in increasing the prevalence of fixed-term work contracts. In general, MENA countries do not have strict hiring regulations compared with international standards. In reforming labor legislation in the region, most attention is paid to relevant arrangements associated with fixed-term employment, which in the past was deemed to be an exceptional form of employment, conditioned by the nature of work or other objective conditions. In recent years, fixed-term work has been increasing not only in EU15 countries4 but also in MENA (table 5.2).5 Fixed-term contracts are heavily concentrated among young people and other new labor market entrants, such as the formerly unemployed and those with lower education levels, that is, among people who have weaker bargaining power. For these workers, fixed-term work can provide a bridge to formal employment and an opportunity to gain experience and skills. Among MENA countries, Morocco has the most restrictive laws: Fixed-term contracts are prohibited for permanent tasks, the duration is limited to 12 months, and renewal is prohibited. At the other end of the spectrum, no restrictions or limits are placed on the use of fixed-term contracts in Bahrain, Egypt, Jordan, Kuwait, Oman, and the Republic of Yemen.
Table 5.2 Arrangements for Fixed-Term Contracts around the World in 2010
Source: Doing Business 2011 database.
Fixed-term employment contributes to more flexible labor markets. It provides a buffer for cyclical fluctuations in demand, allowing companies to adjust employment levels without incurring high firing costs. Fixed-term work also allows companies to reap market opportunities by engaging in projects of short duration without bearing disproportionate personnel costs. This is especially important in labor markets where permanent employment is protected by strict regulations and high firing costs. To counterbalance the latter, some countries have established a minimum service length of one to three years with the same employer for a worker to be eligible to claim severance pay, making short fixed-term contracts less attractive.
Although temporary jobs can be useful for promoting employment opportunities, they can also lead to undesirable labor market outcomes and informality. From the firm’s perspective, temporary jobs can provide a “screening” device, allowing the firm to evaluate workers’ ability or adequacy for the job. They can also act as a buffer, facilitating a firm’s adjustment to temporary demand shocks, thereby avoiding costly adjustments to its “core” labor force (European Commission 2010). Conversely, temporary contracts can simply be a convenient way for firms to reduce labor costs. From the workers’ perspective, fixed-term jobs are subject to higher turnover and pay lower wages on average. Estimates show that in the EU, temporary workers earn on average 14 percent less than workers on open-ended contracts after controlling for a number of personal characteristics. Temporary workers also tend to have reduced access to training provided or subsidized by firms. Labor market reforms are met with resistance by the segments of the society benefiting from the status quo, and so it is likely that fixed-term contracts will become more and more common. From the perspective of improving coverage, more temporary work contracts are desirable if they provide access to basic social risk management tools to workers.
Minimum wage and wage rigidities. Minimum wages affect informality through at least two channels. First, if the minimum wage is set higher than what employers are willing to pay for an unskilled worker, the latter’s employment is likely to be undeclared. Second, minimum wage policy can reduce tax evasion where underreporting is a problem (World Bank 2008) (see box 5.2 for a brief overview of minimum wages).
Although the evidence of the impact of statutory minimum wages on informality is limited, a large body of empirical literature, albeit inconclusive, exists on the impact of statutory minimum wages on worker flows, particularly in the United States. In the United States, although early studies tended to find a negative impact of minimum wages on job retention for individuals at, or close to, the minimum wage, more recent studies have generally found no significant impact (Abowd and others 2005; Zavodny 2000). Draca and others (2008) found that the introduction of a minimum wage in the United Kingdom in 1999 led to insignificant changes in firm entry and exit patterns (OECD 2010). Evidence from other countries is limited. Abowd and others (2005) found no impact of real minimum wages on entry into employment in France, but a strong positive impact on exit from employment. By contrast, Portugal and Cardoso (2006), exploring a specific Portuguese reform that in 1987 dramatically lifted minimum wages for very young workers, found that raising minimum wages had a significant negative effect on both separations and hirings. The effect of introducing a higher minimum wage appears to be large and negative in Colombia and small or negligible in Costa Rica and Mexico. In Brazil, evidence was found of a positive effect of an increase of minimum wage on employment; however, this was mainly the result of changes in the composition between hours worked and number of jobs (Maloney and Medez 2003).
Less is known about the impact of minimum wages on informal employment, but some findings show that a rise in the minimum wage has a positive impact on wages in the informal sector, through what is known as the “lighthouse” effect—as workers in the informal sector use the minimum wage as a reference for their own wages. Although minimum wages are not legally binding in the informal sector, they still seem to influence informal sector wage distribution. From the labor supply side, the minimum may be a benchmark for “fair” wages. On the demand side, employers may pay a wage comparable to the formal sector market wage for a particular occupation so that employees will not leave for a similar job in the formal sector, or employers may not be willing to provide all legislated labor benefits but at least will pay the minimum wage. In particular, Lemos (2004) found adverse effects of higher minimum wages on employment in both the formal and informal sectors in Brazil. Based on data from Costa Rica, a country with a complex minimum wage policy, Terrel and Gindling (2002) found that employers responded to a minimum wage increase by increasing the hours of full-time workers and decreasing them for part-time workers, who, in turn, switched to self-employed work in the informal sector. The subsequent increase in supply of workers in the informal sector then placed downward pressure on wages in the informal sector.
About half of all MENA countries do not have a legal minimum wage; those that do set them with considerable variation. Djibouti and the West Bank and Gaza economy are examples of MENA members that have no minimum wage in practice (Angel-Urdinola and Kuddo 2010). In countries with minimum wages, settings vary, complicating cross-country comparisons. For example, minimum wages are set at a monthly rate in Egypt, Jordan, Lebanon, and Tunisia, whereas Morocco has a minimum hourly wage. Figure 5.4 presents the ratio of minimum wages to average value added per worker in selected countries. In countries that have minimum wages in some form, the ratio of minimum wage to average value added per worker varies from 1.80 in Zimbabwe and 1.17 in Mozambique to 0.05 in Burundi and Gabon. In the reviewed MENA countries, the ratio varies from 0.11 in Egypt to 0.72 in Morocco. A high minimum wage can be damaging in some low-paid sectors and regions with below-average wages; it is also typically more damaging for small and medium enterprises (SMEs) because these enterprises tend to be more labor intensive and financially weaker. This likely contributes to keeping many SMEs smaller than they might otherwise be and gives them an incentive to remain informal. In Egypt, despite the relatively low minimum wage, a significant number of workers earn below the minimum wage, which suggests low levels of enforcement. However, the wage distribution for both formal and informal workers in Egypt seems quite centered (and compressed) close to the minimum wage; this suggests that the minimum wage may serve as a benchmark wage for new entrants in the labor market (figure 5.5).
Figure 5.4 Ratio of Minimum Wages to the Average Value Added per Worker in elected Countries in 2010
Source: Doing Business 2011 database.
Note: Because of a lack of consistent cross-country data on average earnings, the average gross national income per capita is used as a proxy for average earnings. This ratio is adjusted to represent the percentage of population of working age as a share of the total population.
Figure 5.5 Hourly Wage Distribution and Minimum Wages in Egypt, the Republic of Yemen, and Morocco
Source: Calculations using Egypt’s 2006 Labor Market Panel Survey.
Note: The vertical line illustrates the level at which the minimum wage is set; only wages in urban areas are considered.
Overall, minimum wages do not appear to be binding in most MENA countries. In most MENA countries, minimum wages are rather low, and sanctions for noncompliance with minimum wage rules are weakly enforced. Independent of how high or low the minimum wage is relative to average wages, the extent to which minimum wage policy affects employment outcomes and the wage distribution depends on its enforcement. Although most MENA countries with defined legal minimum wage have regulations on enforcement, enforcement is rather weak, inspections are rare due to a lack of resources, and fines are rarely imposed. A fairly significant mass of workers (those to the left of the vertical bar in figure 5.5) report wages below the minimum wage, which indicates that the minimum wage is unlikely to be a significant constraint to formal employment in most MENA countries. Centralized wage setting can, however, be an important determinant of informality. In Tunisia, in parallel to the general minimum wage, employer and employee representatives negotiate a pay scale based on professional levels in each sector; the differences are significant in some sectors. In reality, a relatively high minimum wage for university graduates is institutionalized, which likely contributes to the high graduate unemployment. The bargaining process is such that on the employee side, wages are monopolistically negotiated by unions whose members are all employed, thus possibly resulting in artificially high wages. This especially affects first-time job seekers. Those who cannot afford to wait for a formal job at or above the minimum wage will tend to accept lower wages in informal jobs.6
Firing arrangements. The strictness of firing regulations and the associated cost can affect the incentives of firms to keep workers informal. In general, the procedures for dismissal often require notification or even approval by unions, workers’ councils, the public employment service, a labor inspector, or a judge (table 5.3). Some countries also mandate retraining and reassignment to another job and establish priority rules for dismissal or reemployment of redundant workers. In Tunisia, companies must notify the labor inspector of planned dismissals in writing one month ahead, indicating the reasons and the workers affected. The inspector may propose alternatives to layoffs. If these proposals are not accepted by the employer, the case goes to the regional tripartite committee comprising the labor inspector, the employers’ organization, and the labor union. The committee decides by a majority vote: If the inspector and union reject the proposal, no dismissal is possible. The committee may also suggest retraining, reduced hours, or early retirement. Only 14 percent of dismissals end up being accepted. As a result, annual layoffs occur in less than 1 percent of the workforce, compared with more than 10 percent in the average OECD country. In Egypt, the employer has the right to close down or downsize the establishment, but it is a cumbersome process. Currently the employer may pay terminated workers one month of salary for each of the first five years of service, and one and a half month’s salary for each year after that, one of the most generous severance payments in the world. Eliminating or limiting some or all of the associated firing restrictions would give employers greater flexibility in responding to market fluctuations. Employers must have reasonable freedom to dismiss employees or they will be reluctant to hire and more inclined to operate in the informal sector.
Most countries mandate severance pay with layoffs but differ in important details including extent of coverage, eligibility conditions, cause of dismissals, generosity of benefits, and level of benefits associated with seniority. Some countries require a minimum number of years worked before a worker is entitled to severance pay. In MENA severance pay for redundancy dismissal (for workers with 10 years of job tenure) is the highest in Egypt with 27 weeks of salary paid, followed by the Islamic Republic of Iran, the West Bank and Gaza economy, and the Republic of Yemen, at 23 weeks each (figure 5.6). In general, firing costs in poor countries are 50 percent higher than in rich countries. Some argue that this is justified because governments in poor countries do not have enough resources to provide unemployment insurance, so the cost should be borne by businesses. However, heavy regulation of dismissal is also associated with more unemployment, so those who want to work in poor countries frequently get neither a job nor unemployment insurance (World Bank 2004).
Figure 5.6 Severance Pay for Redundancy Dismissal (Average for Workers with 1, 5, and 10 Years of Tenure, in Salary Weeks)
In labor markets with less rigid and less costly firing regulations, appropriately designed unemployment insurance (UI) schemes can provide adequate protection to workers. This allows firms to discontinue unproductive employee–employer relationships, while maintaining adequate income protection through UI, a powerful support for creating higher productivity, good quality (formal) jobs. According to many (including Auer 2007; Auer and others 2004; Grazier 2007), legislative focus should be shifted from protection of jobs to protection of transitions, so that the individual risk of unemployment and income loss is reduced, while the potentially negative effects of job protection are avoided.
Workers themselves feel better protected by a support system for unemployment than by EPL (European Commission 2006). This is particularly important in a world characterized by the gradual disappearance of lifelong jobs and an increasing need for job mobility. Only a few countries in the region have UI systems, namely, Algeria, Bahrain, Egypt, the Islamic Republic of Iran, and Kuwait (table 5.4). Even in countries with UI systems in place, such as Egypt, systems are underutilized because of a lack of public awareness about UI benefits among plan members, restrictive eligibility conditions, the difficulty of and the stigma attached to documenting a “just-cause” firing decision, and low overall layoff risks among covered open-ended contract employees (Angel-Urdinola and Kuddo 2010). The shift from rigid firing rules to less restrictive regulation accompanied by unemployment insurance creates the precondition for a more efficient allocation of resources. In simple terms, the easier it is for firms to discontinue a formal employment contract tomorrow, the more likely the firm will create that job today. This is especially true in sectors exposed to a volatile product market. Of course, the argument for economic efficiency should not justify reducing worker protection to inadequate levels, but rather shifting the form of protection from protecting jobs to protecting income for workers in transition through UI. By contributing to UI, employees and employers share the social costs of unemployment, but not in a manner that forces firms to maintain unproductive employment in downturns or to limit their incentives to open up vacancies when demand is stronger (World Bank 2008).
Table 5.4 Existence of Unemployment Protection Legislation around the World
Source: Doing Business 2011 database.
Tax wedge. Labor taxes create a wedge between the labor cost to the employer and the worker’s take-home pay. Studies suggest that a higher tax wedge reduces both employment and economic growth (World Bank 2007). For example, a 10 percent reduction in the tax wedge (the difference between the cost of labor and take-home pay) could increase employment between 1 and 5 percent (Kugler and Kugler 2003; Rutkowski 2003). The literature for developing countries and emerging markets economies is limited, but a World Bank study on Turkey concluded that labor tax cuts would not have a major impact on formal employment (Betcherman and Pages 2007). An across-the-board reduction of 5 percent in pension contributions paid by employers would bring about a 0.8 percent increase in employment overall and would reduce the unemployment rate by about 0.2 to 0.3 percent. The effect could be stronger (an increase in employment of almost 1.5 percent) if the reduction in pension contributions was targeted at workers younger than 30 years old, who have less bargaining power to capture most of the tax reduction in higher wages.
Labor taxes in countries such as Morocco (where they account for about 39 percent of total labor cost) and Egypt (37 percent) are as high as the average for OECD countries. In Egypt, Jordan, and Lebanon, social security contributions are the dominant component of labor taxes (table 5.5). Social security contributions in these countries (paid by both the employer and the employee) account for the bulk of the tax wedge. In all reviewed MENA countries, social security contributions are paid largely by the employer; employees pay only a minor part. Table 5.5 shows the calculation of the tax wedge in some MENA countries, and figure 5.7 shows the tax wedge in various countries.
Table 5.5 Contribution Rates for Social Security Programs, 2009/2010, and Tax Wedge on Average Wages in Private Sector
Source: Calculations based on SSA and ISSA (2008, 2009, and 2011).
a. Data refer to effective rates on average wage.
b. The tax wedge is calculated as a sum of social security contributions paid by the employer and the employee, and the personal income tax is expressed as a percentage of total labor cost. Total labor cost is gross wage plus employers’ social security contributions. Gross wage is net wage plus employees’ social security contributions and the personal income tax.
Policy implications for MENA. MENA countries could ease certain provisions of labor legislation to achieve more compliance and improved employment outcomes, while shifting from protection of particular jobs to protection of transitions. Overall, even though certain provisions in labor legislation in some MENA countries might be rigid de jure, de facto they are widely evaded. It is unlikely that merely improving enforcement would result in reducing informality. As discussed in this section, the rigidity of certain labor regulations in some countries contributes to the prevalence of informality (for example, hiring arrangements in Morocco, and firing arrangements in Tunisia and Egypt). A shift toward a richer and more flexible set of labor contracts (including more fixed-term contracts and fewer open-ended contracts), despite their drawbacks, would provide opportunities for young workers and new entrants to join the formal sector through flexible working arrangements with social insurance coverage. Such policy reforms that ease regulations and make them more realistic to comply with should be supported by a reform of social protection systems to better protect the income position of workers and their employment transitions.7 For example, recent experience shows that moderately strict EPL, when combined with a well-designed system of unemployment benefits and a strong emphasis on active labor market programs, can help create a dynamic labor market while also providing adequate employment security to workers (OECD 2008). Adequate safety nets could also play an important role in protecting workers from sudden job loss, help them transition between jobs, and prevent more people from slipping into poverty. The newly legislated unemployment insurance schemes in Jordan and Egypt provide an example to be considered by other countries in MENA.
Keeping the cost of labor at a realistic level via affordable social security contributions in MENA and relaxing wage rigidities are likely to reduce informality. In general, institutionalized minimum wages in MENA are neither high (with the exception of Morocco) nor binding. Yet centralized wage setting mechanisms, such as those discussed in the case of Tunisia, contribute to informality by artificially setting high wage floors for certain occupations and skill levels. In addition to keeping minimum wages at low levels that can be realistically enforced, wage-setting mechanisms in MENA should benefit from some kind of quantitative anchor to provide an objective baseline measure on changes in productivity. In countries where minimum wages are high (whether economy wide or sector specific), and where it is not politically feasible to reduce them, governments could consider reducing the minimum wage for youth to at least improve transitions of new entrants into formal employment, while maintaining the higher-level minimum wages that protect well-established workers. This section has also shown that the cost of labor attributable to labor taxes is not very binding in MENA, with the exception of Morocco and Egypt. In general, tax wedges could be reduced through social insurance reforms that reduce the social security contribution rates (as already legislated in Egypt) or by shifting a portion of the labor taxes toward other general revenue taxes such as consumption taxes.
Engaging in a more inclusive social dialogue is key to sustaining these types of reforms. Important political economy aspects to labor market reform are found. In particular, the traditional tripartite structure that convenes government actors, trade unions, and employer representatives is likely to show a bias for the status quo of protective regulation for employed, unionized workers. Including representation from the outsiders, informal workers, youth, and the unemployed would likely rebalance the dialogue toward facilitating entry in labor markets, improving mobility, and promoting a more equitable redistribution of returns across different strata of the population.
The widespread preference for public sector jobs in many MENA countries has important implications for informality. The presence of large public sectors has been explained as the consequence of an implicit social contract in the Arab region that promised well-compensated public sector jobs to those reaching higher levels of educational attainment (Yousef 2004). Recently hiring has slowed, and in practice, public sector jobs are offered only to those who are sufficiently patient to queue for them. Yet the preference for public employment is very widespread. For example, according to the 2010 youth survey in Egypt, 70 percent of youth say it is best to work for the public sector. This preference for public sector jobs is grounded in a rational evaluation of costs and benefits. On average, public sector jobs (1) are better compensated than similar private sector jobs; (2) offer full job security, good fringe benefits, and solid social status; and (3) tend not to require as much effort as private sector jobs. Jordan, Syria, and Egypt have the highest proportion of the workforce in the public sector in the region (30 percent in each of Jordan and Syria and 39 percent in Egypt). In Syria, the average public sector wage is 32 percent higher than the average private sector wage (representing both formal and informal workers). Even in Egypt, where public sector pay is considered low, the average wage in the public sector is 6 percent higher than the average wage in the formal private sector.8 The public employment bias and the queuing phenomena also exist in Jordan, where public sector wages are on average 20 percent higher than private sector wages.9 Bodor and others (2008) show that in Morocco public sector employees, regardless of the level of education, have better career paths, in terms of wages and pension benefits, than those working in the private, formal nonagricultural sector and the informal agricultural sector.
The existence in some countries of a distinct single registry for those seeking public sector jobs indirectly contributes to the prevalence of informality. In Jordan and Syria, those who wish to work in the public sector must register with an agency. This registry is the institution of the “queue”; once registered, an individual does not need to exert any effort to procure a public sector job, he or she just needs to wait for his or her turn in the queue. In Syria, the total number of registered jobseekers was over 1.7 million persons in 2009. When the Syrian government attempted to use this registry to offer training, with the opportunity for private sector placement upon conclusion, it found that those in the registry were typically unwilling to accept the prospect of formal private sector employment. They believed that presence in the social insurance agency’s administrative records would lead to deletion from the public sector job queue. Therefore, only a quarter of those offered formal jobs took them.10 In contrast, informal employment was acceptable to the same individuals; many of them were already engaged in informal employment.11
In the short run, MENA governments should consider eliminating institutionalized public sector employment queues. In the medium and long run, a reform of civil service by realigning incentives is needed. Modernized public employment and placement services should require active job search effort from applicants. Placement services should place workers based on their interests, training, and skills, instead of an expressed preference for public or private employment. Workers currently in formal private sector jobs should not be disqualified from moving into public sector jobs later in their careers. In the long run, civil service reforms should establish stronger performance evaluation measures, linking worker compensation to performance. Further, public sector wage scales should be rationalized so they no longer constrain flow of talent into the private sector.
The productivity dimension of informality is especially predominant in the poorer countries, in rural areas where low-skilled workers are engaged in micro-entrepreneurship and low-yield agricultural work. Programs aiming at increasing productivity in the informal sector are potentially important interventions to promote inclusive growth and avert a productivity trap. However, effectively tackling productivity improvements in the informal sector, particular in rural areas, is a complex agenda, which involves not only effectively upgrading skills, but also creating opportunities that would allow for returns to training to materialize. As such, complementary investments in infrastructure and access to markets are needed. An exhaustive analysis of policies to increase productivity is outside the scope of this report; this section focuses on policy and program options that improve access to training opportunities and realign training programs to the needs of informal workers.
Improving access to training. Informal workers have limited opportunities to benefit from training provided by governments, employers, and private training providers. Active labor market programs (ALMPs), which include training and skills-upgrading programs, are interventions provided by the government or by nongovernmental organizations that aim at increasing workers’ employability. In MENA, government provision of such programs is mainly directed to the unemployed. This may be because of the belief that the unemployed are more vulnerable and worse off than the employed, regardless of job quality. However, the working poor could actually be worse off than certain groups of the unemployed in some countries. Workers from higher income households might be able to afford to be unemployed and queue for better quality jobs, whereas those from poor households are forced to take available low-quality and low-wage informal sector jobs. Figure 5.8 shows that unemployment is lowest among those with the lowest skill levels. This would suggest that those who can afford to stay in the education system could also be those who can afford to stay unemployed and wait for better jobs. In addition to government provision, the private sector plays a large role in providing fee-based training programs in MENA. However, an evaluation of privately provided ALMPs targeting young people in MENA revealed that the informal sector rarely has access to such programs: 80 percent of beneficiaries are educated males from middle- or high-income groups in urban areas (Angel-Urdinola, Semlali, and Brodmann 2010). It is also worth mentioning that only 5 percent of all surveyed training programs target rural areas, where a large share of informal workers reside. Finally, as shown in chapter 3, informal salaried workers working in informal firms or small firms are less likely to receive on-the-job training where they work.
Figure 5.8 The Relationship between Educational Attainment and the Unemployment Rate in Urban Egypt and the Republic of Yemen
Source: Egypt 2006 Labor Market Panel Survey, the Republic of Yemen 2006 Household Budget Survey.
To address low access to training, as well as to provide incentives for firms and workers themselves to pursue training, governments may extend their provision of ALMPs to informal sector workers through direct targeting (for example, through training cooperatives or vouchers). Training vouchers can be used to empower recipients to buy training in the open market and thereby promote competition between public and private providers of training and the efficient delivery of training services. The Jua Kali program in Kenya, which offered training vouchers to those working in the informal sector in the mid-1990s, provides an interesting perspective on the response of public training institutions to the demand for skills created by the vouchers. The Jua Kali vouchers produced a positive supply response to the demand created for skills, but mainly from master craftspersons in the informal sector and nongovernmental organizations (NGOs). Programs were tailored to the needs of voucher recipients and offered in off-hours to fit work schedules. The Jua Kali voucher program was successful in its pilot stage in expanding the supply of training to workers in the informal sector. Evidence was also noted of its positive impact on the earnings of participants as well as strengthened capacity of local Jua Kali associations responsible for distribution of the vouchers (Steel and Snodgrass 2008). A commonly used policy intervention to address the underprovision of training by firms is the establishment of training funds, financed through general revenue or some payroll taxes. However, financing training through general revenues is regarded as less distorting to employment outcomes than through payroll taxes (and thus preferable). Training funds can be used to target firms with low levels of training, such as SMEs. For example, in the Republic of Korea, all firms pay a training levy, but the government provides reimbursement to employers who offer training. When the government found that mostly larger firms were actually providing training and benefiting from the reimbursement, they provided additional incentives to SMEs to establish a training consortium through which they could collectively mobilize resources for training while benefiting from a higher reimbursement rate and a subsidy to hire financial managers (Lee 2009).
Tailoring training to informal workers’ needs. Traditional training programs generally require a minimum level of literacy and proficiency and do not adequately address the need for a general and flexible set of skills that is typical of informal employment, especially in rural areas. General literacy skills are a barrier to productivity as well as a barrier for informal workers to access and benefit from training programs, especially in rural areas. Although the expansion of the basic education system in MENA has been remarkably successful in initially enrolling almost all children in rural and urban areas, the dropout rates are still high, and education quality often lags behind in rural areas, leaving rural agricultural workers with low levels of literacy.12 This is especially important given the evidence that literacy is associated with increased productivity. An often cited example is that literacy improves the use of fertilizers when workers can adequately read and comply with directions written on the labels. General education reforms addressing the low literacy and quality of education, particularly among rural workers, are necessary conditions for improved productivity in the medium term. However, in the shorter run, rural workers could benefit from training programs that are made accessible to them, and for which literacy is not a necessary precondition. Such training should also be associated with support for micro-entrepreneurship and accessing markets, so as to broaden the set of available opportunities.
How training is delivered matters too. Training programs for the informal poor need to offer clear, concrete, and immediate reasons to motivate enrollment and ensure that individuals participate and benefit from the program. Many informal workers are too poor to take time off from work to participate in daytime training. Thus, programs should provide opportunities to combine earning and learning as well as flexible schedules. If alternative schedules are offered, such as evenings and weekends, beneficiaries can then continue to contribute to household income and/or take care of their children during regular hours, thereby increasing beneficiary retention (Singh 2005). Moreover, experience shows that nonformal training programs should be adapted to the work context surrounding the beneficiaries, that the teaching methods should be participatory, and that some of the program instructors should ideally come from the neighborhood itself, because they bring with them insights on community needs. Unless the training is provided in the rural villages or is hands-on at the homes of the informal workers, it can be difficult to attend for several reasons: lack of transportation, insufficient infrastructure, and lack of lights along roads. Women face additional challenges because they may not be allowed to travel without male company.
Although school dropouts constitute a majority of informal workers in many MENA countries, very few “second-chance” programs are aimed at providing learning in a nonformal manner. Second-chance programs can provide enhancement of an individual’s literacy, work skills, equivalency education, and life skills training, crucial characteristics that facilitate integration into society. Education equivalency programs are designed for those who have missed opportunities for early and traditional education and are unlikely to return to a formal learning environment. People who have dropped out of school at an early age are generally poor and very vulnerable. Second-chance programs are usually provided in a nonformal manner (often via accelerated learning) because this increases the likelihood of reaching informal and vulnerable workers. Life skills include social and coping skills, and improving relations with family, community members, and authority figures, while increasing the beneficiary’s own self-confidence. They can also include counseling and mentoring and components related to risky behaviors. Participants are more likely to benefit from work skills training once life skills and coping mechanisms are included in the general training (Angel-Urdinola and Semlali 2010).
The traditional approach to training programs in the MENA region is not well suited for the informal sector. Training appears to be associated with a positive impact on labor market outcomes when offered as part of a comprehensive package. According to the survey of privately provided ALMPs in MENA, about 70 percent focus solely on hard skills and are provided in classrooms, less than 20 percent provide some type of practical experience and/or apprenticeships, less than 35 percent focus on soft skills, and only 14 percent provide some type of employment services and/or labor market intermediation (Angel-Urdinola, Semlali, and Brodmann 2010). Country-specific evidence confirms that similar approaches also prevail among publicly provided ALMPs. Many countries, particularly in the OECD and Latin America, have moved toward a comprehensive training model that includes provision of classroom and workplace training, monitoring, job search and placement assistance, and soft skills training. Evaluations of “comprehensive” youth programs from Latin America indicate that programs can have a significant positive impact on employment and earnings of program participants, especially for women, if they are organized with flexible schedules, based on public-private partnerships (that is, demand driven), combined with internships and practical experience (in addition to in-class training), provide a combination of soft and hard skills, and are monitored and assessed for impacts. In many Latin American economies, youth unemployment rates soared during the late 1990s. To address this, the Chilean government designed what is known as the “Chile Joven” program, which offered comprehensive “demand-driven” training programs to unemployed youth. The program was so successful that similar models were customized in Argentina, Colombia, the Dominican Republic, Panama, Paraguay, Peru, and República Bolivariana de Venezuela. Depending on the specific needs identified, these programs can be targeted to either the general unemployed youth population or to specific marginalized groups.
If improved and combined with theoretical knowledge taught by Technical and Vocational Education and Training (TVET), traditional apprenticeships13 could contribute to more productive employment within the informal sector in MENA. Traditional apprenticeships are distinct from formal apprenticeships, which are registered with a government agency and administered by employers. The flexibility of traditional apprenticeships in combining hands-on training, work and learning, their affordability and self-financing, their connection with future employment, and their generally low entry standards make them attractive to disadvan-taged informal workers. However, master craftspersons rarely provide theoretical knowledge alongside practical experience and often teach outdated technologies, and there are few market standards available for judging the quality of the training provided. Traditional apprenticeships suffer from the low education of those being trained, and the choice of trades tends to follow gender biases (Johanson and Adams 2004). If public financing for TVET institutions shifted to focus on outcomes (such as success in serving target populations of master craftspersons and apprentices) rather than financing inputs (such as classrooms, courses offered, or instructors hired), both apprenticeships and TVET could be made more relevant. Performance-based budgeting for public institutions could provide incentives to upgrade technical skills for master craftspersons and improve their pedagogy (Ziderman 2003). More attention and accountability could be given to these institutions in partnership with apprenticeships for addressing the low levels of basic education that handicap training of apprentices and master craftspersons and for providing the complementary theoretical training needed to accompany the practical training of apprenticeships (Van Adams 2008).
Training programs targeted toward the low-skilled, self-employed, and micro-entrepreneurs among informal workers, or those individuals with the inclination to become self-employed, could help informal workers transition into higher productivity and higher value-added self-employment. The great majority of participants in informal self- or household-based enterprises have had little formal education or training when entering self-employment. Some, especially woman entrepreneurs, may have had none at all. The knowledge and skills used in their businesses have likely been acquired from parents and other relatives in family enterprises. The self-employed can benefit from both technical training specific to their industry, such as on the use of modern production techniques in agriculture, as well as general entrepreneurship and business skills training. The latter could include bookkeeping, financial literacy, marketing, communication, life skills, and simple risk management. International experience has shown that a comprehensive package offering a set of services that both includes training and facilitates access to credit can be successful in improving entrepreneurial ventures. Moreover, micro-franchising programs are an emerging approach that entails helping individuals replicate an existing business rather than starting an original one. Box 5.3 presents two case studies of productivity-enhancing programs from Egypt and Jordan.
Finally, moving toward more integrated and innovative social safety net systems that link income support to the poor with strategies to foster productivity should be considered in the context of MENA. The “Chile Solidario” Conditional Cash Transfer Project provided the poor with the means to attend training while linking them to employment opportunities. This well-targeted social protection project assisted extremely poor families, mostly in Chile’s rural areas. A social worker worked with anyone in the family in need. Each individual’s needs were evaluated and the social worker then linked the person to the appropriate services, including literacy classes, soft skills training, help with job searches, links to internship opportunities/subsidized employment opportunities, or self-employment assistance programs. The connection to the social worker was important for understanding the needs of the client and for accurately informing the client of available opportunities, because many poor are not aware of the services available to them. Conditional Cash Transfers in the form of a stipend were provided conditional upon training participation. Without this stipend, the poorest would not have been able to participate (Angel-Urdinola and Semlali 2010).
Numerous barriers to formality exist in MENA, requiring a complex set of policy interventions. Restrictive business and labor market regulation, the prominent role of the public sector as employer in a number of countries, and the productivity gap facing informal workers are all important barriers to inclusive growth and formalization. Although different and complementary policy interventions that relax these barriers can be effective toward this goal, the process of formalization matters, and policy interventions to address informality should extend beyond mere enforcement and should aim to reduce informality in a sustainable manner while helping the growth process become progressively more inclusive.
A healthy business environment and labor regulations that foster more mobility in labor markets, while protecting workers during job transitions, are important. The evidence suggests a negative correlation between the ease of doing business and the size of the informal sector. In MENA, barriers to entry, high taxes, and discretionary enforcement of regulation all collude to promote informality. Simplifying entry regulation, reducing compliance costs, and moving toward a fairer implementation of regulation are all necessary, and emerging evidence from other countries suggests that these interventions can be effective to move beyond informality. A large portion of employers in MENA perceive labor regulations as a major obstacle to business development and more employment growth. In some MENA countries, certain labor regulation provisions are rigid, including hiring arrangements in Morocco and firing arrangements in Tunisia and Egypt. Rigid EPL promotes informality, because firms can respond to rigid labor regulations by reducing overall employment or shifting employment into conditions of informality. Easing certain provisions of labor legislation to achieve more compliance, supported by a reform of social protection systems to better protect the income position of workers and their employment transitions (for instance, through the introduction of unemployment benefits and a strong emphasis on active labor market programs), can decrease informality and promote employment creation. In parallel, it is also important to keep the cost of labor at a realistic level, including through affordable social security contributions. The generosity of public sector employment conditions (including pay, benefits, and job security) in some countries also contributes to higher informality and important segmentations, making the need for a reform of civil service even more pressing.
Many informal workers face a productivity trap. Especially in the poorer countries and in rural areas, the low productivity of jobs is the predominant aspect of informal employment. Low productivity is a result of different factors, including poor skills and limited opportunities, particularly in rural areas. The evidence shows that informal workers consistently have limited access to training and skills-upgrading opportunities. Although complementary investments in infrastructure and access to capital and markets will be necessary to increase the returns associated with skills upgrading, targeting such programs to informal workers can be one effective way to address the productivity trap. Providing incentives to firms (such as through training cooperatives for small firms) and workers (such as with vouchers) to engage in training will address some of the determinants of underprovision of these programs. To make these interventions more effective, reorienting and tailoring the delivery and design of training toward the particular needs of informal workers is necessary. Second-chance programs, traditional apprenticeship, and training specifically designed for the self-employed and micro-entrepreneurs are examples of interventions that are likely to be effective in the context of MENA.
Lack of social insurance coverage exposes workers and their families to important risks and vulnerabilities. In MENA, these vulnerabilities loom large, with about 67 percent of the labor force not protected against a plethora of social risks, of which loss of income in old age may be the most pressing. Government interventions that effectively expand access to risk management instruments can be beneficial both from the perspective of individual/household welfare and for society as a whole, because evidence exists that private markets are likely to underinsure social risks, such as loss of income-generating capacity due to old age, disability, health conditions, or layoffs. This is particularly true for the poor, who might engage in suboptimal strategies, such as selling productive assets or withdrawing children from school, to respond to shocks. From a societal point of view, important negative externalities can be found from having too much uninsured risk, including an adverse impact on productivity. If the rationale for government intervention is clear, assessing what drives lack of coverage is key to informing which policies are most likely to succeed in expanding it. For example, if most workers are observed to voluntarily opt out of social security systems because of a rational cost-benefit analysis, then improving the perceived quality of public service, including outreach and communication about benefits, would be needed. Specific design features of pension systems, including vesting periods, early retirement, and legal coverage provisions, might also provide different incentives for workers to contribute to social insurance. Furthermore, a significant portion of the population might not possess sufficient saving and contributory capacity to pay for the true cost of the socially optimal degree of protection against these risks, which would justify government intervention to improve coverage with some level of subsidy beyond traditional contributory mandatory social insurance schemes. A complex set of reforms is likely to be needed, which includes moving beyond a sole focus on enforcement of mandatory social insurance rules (especially under existing designs and lack of financial sustainability) toward a coverage extension strategy that acknowledges the realities of the informal economy in MENA.
Part 2 of this chapter introduces a conceptual framework for social insurance coverage extension policies. In this context, it discusses design features of pensions systems in MENA, with special attention to the need for improving the design and incentive structure of existing formal sector pension schemes as a precondition for feasible and successful coverage extension efforts. Following that, a structured description of alternative coverage extension strategies is presented, including a set of guiding principles to select such strategies for specific vulnerable population groups. Finally, it concludes with a section on how the often disregarded evidence from the emerging field of behavioral economics could support better designed social insurance coverage extension policies.
Although the costs and benefits to informality have been discussed, the vulnerability associated with informal employment is a social concern requiring government action. The main objectives of this section are to describe (1) how the design of social insurance systems affects incentives to be informal and (2) the policies governments should consider to alleviate the social problems caused by informality. In line with the emphasis of this report on informal employment, policies aimed at extending social insurance coverage are the focus of the following discussion, because they provide a means for individuals to reduce vulnerability and excessive exposure to social and economic shocks, and to ultimately improve social welfare.
The ultimate objective of coverage extension policies is to improve social welfare by providing individuals with access to the risk management tools of social insurance systems. A framework for social insurance/coverage extension policies is illustrated in figure 5.9. Social insurance systems provide protection against certain social and economic risks, such as the loss or sudden reduction in income (generating capability) due to old age, disability, work-related injury, death of an income-generating family member, sickness, loss of income due to maternity, or loss of a job.14 The realization of any of these risks, at least temporarily, undermines an individual’s employment income-generating capacity, and in some cases a medical care-related expense shock is incurred as well (for example, with sickness, disability, and work injury). The social insurance system is designed to intervene in such cases to at least temporarily provide income support and cover a significant portion of the shock’s expenses. These interventions are in line with the underlying objectives of (1) consumption smoothing (limiting the extreme fluctuation of individual and household consumption and welfare), (2) poverty alleviation (preventing social and economic shocks from forcing individuals or households into poverty), and (3) preserving investment in human capital (in the cases of health insurance, disability, and work injury benefits, there is a direct objective to prevent the—further—deterioration of health). In a broader social insurance context, temporary income support measures are justified as an attempt to prevent households from reducing their investment in human capital (such as spending on education) when social and economic shocks occur.
Figure 5.9 A Framework for Social Insurance/Coverage Extension Policies: Objectives, Social and Economic Risks, Policies, Instruments, and Behavioral Impacts
Source: Adaptation of the broader framework presented in Robalino and others 2010.
Social insurance programs typically entail a combination of risk pooling, (mandatory) saving, and explicit redistributionary transfer mechanisms (Holzmann and Koettl 2010). The optimal choice of a policy instrument depends on the nature of the risk. In general, low-probability shocks with potentially devastating impact are best protected against through risk pooling. In contrast, the loss of income-generating capacity in old age is a high-probability (thus predictable) event; therefore (mandatory) saving-type pension schemes are more appropriate. Saving and risk pooling are, in theory, contributory mechanisms ensuring the financial sustainability of the social insurance systems and ensuring that any redistribution among plan members happens based only on the ex ante unknown realization of risks (that is, in a random manner). The discussion to follow defines a necessary role for redistributionary transfers, especially for ensuring protection to low saving capacity individuals (and households) who cannot afford to pay the true cost of a universally guaranteed social insurance package. Such transfers play an especially critical role in coverage extension policies.
Understanding behavioral impacts is especially important for the design of coverage extension policies given the need to induce voluntary compliance and enrollment. Given the nature of informality, relying only on enforcement of mandates is not sufficient and can be counterproductive. Economic actors respond to incentives. For example, self-employed individuals decide to register and enroll in social insurance schemes based on whether they find their participation beneficial given the information they have and the level of effort required. Firms make employment offers with or without associated enrollment in the mandatory pension system dependent on factors such as the related additional cost of labor. Employees and employers may negotiate over a worker’s enrollment as part of a total compensation package. Households may optimize social insurance participation of one household member based on the degree of protection offered to the entire household. A focus on expected behaviors is necessary for understanding the true effect of policy interventions. Later in this chapter it will be shown that the lessons learned from behavioral economics about bounded rationality can significantly inform the design of coverage extension policies.
The link between pension design and coverage: A review of key options. This section describes an array of pension system designs and their features as related to coverage. The designs of old-age pensions vary greatly in achieving wide coverage, and few systems manage to provide access specifically to informal sector workers. In their simplest form, old-age pension systems are mandatory saving schemes that prevent myopic undersavings for old age and curb intentional undersavings and abuse of often generous social safety nets that redistribute income to those in need.
Earnings-related pension schemes (see panel 1 of figure 5.10) provide old-age pension benefits dependent on individual contributions; they work, in effect, as saving mechanisms from the perspective of the individual and can be designed as defined benefit (DB) or defined contribution (DC).15 In MENA, pension benefits are determined through a set of parameters taking into account the individual’s contribution performance over the active life cycle (such as number of contributory periods, and some average wage measure reflecting earnings before retirement or over the entire contributory life span). These are known as DB schemes. The expected value of pensions may be quite different than the value of lifelong contributions. If the pension benefits are systematically higher than the value of contributions, contingent government liabilities emerge, giving rise to implicit pension debt. Mandatory pension schemes in MENA tend to be pay-as-you-go (PAYG), as opposed to “funded,” in their underlying financing mechanism, with pension benefits financed by the contributions of active age plan members.16 Pure earnings-related mandatory pension schemes are rare and lack the minimum old-age income feature that most modern pension schemes possess in one way or another. By definition, mandatory earnings-related pension schemes in general, regardless of their design or financing mechanism, do not offer protection to informal sector workers; these schemes typically require that employers register their employees with the social insurance authority, report their earnings. and pay wage-proportional employee and employer contributions, while earnings of informal sector workers are rarely observed. Later in this section, the specific design features of PAYG pensions systems in MENA that pose challenges to participation are explored.
Figure 5.10 Old-Age Pension Design and Coverage: Options Ranging from Pure Earnings-Related Pensions to Pure Noncontributory Flat Pensions
In contrast to earnings-related pension schemes, noncontributory basic (flat) pension schemes do not take into account an individual’s income position before retirement to determine his or her benefit amount. Such schemes assume a social responsibility for providing everyone with a minimum standard of living at old age regardless of their saving capacity before retirement (see panel 4 of figure 5.10). As such, they have limited scope for controlling myopic behaviors, a disadvantage over earnings-related pension schemes. Although earnings-related pension schemes attempt to smooth consumption patterns between an individual’s active and retired life, flat noncontributory pensions do not necessarily prevent a radical drop in consumption in retirement but offer wider coverage. By design, noncontributory pensions rely on general revenue financing and cover formal and informal sector workers, as well as those outside the labor force. Noncontributory pension schemes can provide 100 percent coverage in exchange for government spending as low as 1 to 2 percent of GDP.17 The most commonly cited universal flat pension scheme is in New Zealand, where no other pension program is offered by the government.18
Establishing a minimum pension floor in an earnings-related pension scheme improves income protection compared with a pure earnings-related design but does not improve the potential for coverage. Additionally, it can undermine contribution incentives. The minimum pension is a redistributory feature of earnings-related pension schemes, which ensures an income floor in old age to anyone with an acceptable lifetime contribution effort (for example. with a sufficiently large number of contributory years), regardless of what the earnings-related pension benefit determination would yield (see panel 2 of figure 5.10). The cost of a minimum pension (that is, the “top-up” over the earnings-related pension) is financed from general revenues or redistribution from other plan members. Its potential to increase coverage is limited because it does not extend benefits beyond the Bismarkian (earnings-related) scheme for the formal sector. Moreover, it may create incentives for individuals to hide income, move certain employment activities into informality, or save outside the system, so that lower levels of observed income and contributions will create eligibility for the top-up.
A recent innovation that addresses the flaws of the minimum pension combines an earnings-related pension scheme with a universal (flat) basic pension. One policy option is to combine a pure earnings-related scheme with a universal basic (flat) pension without any connection between the two components. This solution provides smooth income patterns across active and retired life for formal sector workers and establishes an income floor in old age for everybody. The criticism of this solution is its overall high cost, involving uniform general revenue-financed universal pension benefits to those with already high earnings-related pensions. An innovation over this simple unlinked combination is the so-called “universal basic pension with claw-back,” which attempts to combine the high coverage of the universal basic pension with the incentive design of a pure earnings-related pension, by gradually phasing out the universal basic pension component as old-age income from the earnings-related pension increases (see panel 3 of figure 5.10).19 This mechanism provides complete old-age income protection coverage while avoiding the contribution incentive trap of the minimum pension. Under the latter, for a class of low-income workers, any contribution that will not eventually elevate earnings-related pensions above the minimum pension is a sunk cost. In contrast, the claw-back feature reduces the marginal benefit from contributions among low-income contributors but does not eliminate it. Universal basic pensions with a claw-back are always cheaper than an otherwise identical flat universal benefit scheme because of the built-in targeting mechanism and benefit reduction. However, a universal pension with a claw-back is more expensive than an otherwise identical earnings-related pension scheme with a minimum pension because it covers more individuals using general revenue funding and the top-up is larger, as apparent in figure 5.10. This innovation was recently enacted (but has yet to be implemented) in Egypt and already exists in Chile and South Africa.
The most recent innovation for incentive-compatible pension coverage extension is the matching defined contribution (MDC) design. MDCs are voluntary defined contribution saving mechanisms, offering old-age or other social insurance benefits, where the government or employer provides incentives to enroll by matching individual contributions at a given rate and threshold. MDCs increase the incentive to save through matching contributions, effectively increasing the return on savings. Many employer-sponsored pension programs, such as the 401(k) scheme with employer matching in the United States, already have this feature. In panel 5 of figure 5.10, the dark gray columns show the income level–dependent subsidies, and the light gray columns show the income level–dependent contributions under a general MDC design. The figure reflects a further extension to MDCs, combining the matching mechanism with a targeting mechanism (such as means testing or proxy means testing) to induce participation by those with limited saving capacity, without regressively offering higher matches to individuals with higher income or savings capacity. This feature makes MDCs suitable for coverage extension. It is conceivable that a significant number of households desire social insurance services, but their income position does not allow them to pay for the true cost of their social insurance coverage in the form of contributions (see box 5.4 for an example of a targeted MDC in the case of health insurance in Lebanon). The MDC innovation demonstrates that targeting mechanisms often used to reach the poorest and most disadvantaged households can also be used to target those above the extreme poverty level, but below the income level that would allow them to enroll in the contributory social risk management mechanisms. In fact, the relative income status of households can be used to determine the amount of matching subsidies for which households are eligible if they are willing to enroll in the related social insurance mechanism. The MDC scheme is likely more affordable than universal basic pensions due to the targeting mechanism and the consequently reduced inclusion error. However, MDCs do not ensure complete coverage as well as universal schemes do; their potential to increase coverage can only be met if (1) the matching design adequately motivates contributions at all income levels, (2) the transaction cost of enrollment is small, and (3) lessons learned from behavioral economics on irrational behavior are used in the program design (discussed later in this chapter.)20
Box 5.4 proposal for expansion of Health Insurance in Lebanon through a Targeted MDc
The government of Lebanon has embarked on reforms to expand health insurance coverage to individuals who are not covered by the National Social Security Fund (NSSF) and other contributory schemes. The NSSF, which covers about 40 percent of the population, provides health insurance to formal sector workers in the private sector and to civil servants through earnings-related contributory schemes. For those not covered by the NSSF, the Ministry of Public Health acts as the insurer of last resort. These are mostly poor or near poor, low-income self-employed, and informal wage earners. The recent reforms (Health Card Initiative) launched by the government entail subsidizing the low-income population who cannot afford the premium to be covered. Figure B5.4.1 is an illustration of how the consolidation of the health plans can be achieved if the government chooses to use a targeting strategy offering three plans (a basic plan, an intermediate plan, and the more comprehensive NSSF plan) and allocates subsidies based on the level of earnings. As shown in the figure, a universal subsidy is provided to all individuals regardless of income that covers externalities and public goods. Additional subsidies are allocated based on the income quintile to which beneficiaries belong. The proxy means testing system currently being developed under the National Poverty Targeting Program could be used to indicate beneficiaries’ income brackets. As income increases, subsidies decline, and the required individual contributions rise. Thus, individuals with some savings capacity would contribute to the cost of the plan to receive the subsidy. Individuals who can afford to pay additional contributions can finance more “generous” health packages.
Figure B5.4.1 Subsidized and Individual Contributions by Income Quintile
Source: World Bank 2010.
Note: BP = Basic Plan ; NSSF = National Social Security Fund.
The key issues with increasing coverage through noncontributory (or heavily subsidized) special schemes are the potential unintended consequences in the form of behavioral responses; such schemes may reduce willingness to participate in the contributory mechanism among those who are able to and could ease the path for firms to offer jobs without social insurance coverage. Clearly, the easiest way to extend coverage is through universal general revenue–funded noncontributory transfers such as the universal basic (flat) pension. In addition to the higher costs of a universal program, the availability of noncontributory benefits may create incentives for current contributors (and some uncovered who otherwise would exert effort to contribute) to transition to the noncontributory scheme. Even if the services of the noncontributory system are of lower quality, this argument still holds as long as the services are valuable and include a higher subsidy component than the contributory benefit alternative. Levy (2006) provides evidence in this regard, indicating that the availability of subsidized social insurance programs for uncovered workers may unintentionally allow firms to shift employment into contractual relationships not covered under the formal social insurance scheme or into self-employment. The macroeconomic result of such a shift may be that aggregate labor is overemployed in the informal sector and underemployed in the formal sector. This increases labor costs in the formal sector, and thus these programs can have an economy-wide negative effect on productivity competitiveness, and potentially on growth. Alterido and others (2009) have shown that expansion of a noncontributory health insurance program in Mexico (Seguro Popular)21 has a moderate downward influence on participation in the formal contributory social insurance scheme covering health insurance as well as pension and unemployment benefits. The authors show that 65 percent of Seguro Popular beneficiaries are nonpoor. Overall, the availability of noncontributory special schemes is likely to decrease incentives to participate in contributory social insurance mechanisms. In addition, access to noncontributory schemes allows employees and firms to collude by not incurring the cost of enrolling the employee in the contributory social insurance system to share the emerging surplus. In cases of weak bargaining power on the side of employees, the availability of noncontributory schemes can give rise to firm behaviors that shift the creation of new jobs to informality, justifying this by the access of workers to the noncontributory benefits. Theoretically, the MDC design would not suffer from this problem if the matching subsidy were truly aligned with the income position of the contributor. In particular, the better the targeting in assessing saving capacity, the less likely that undesirable behavioral responses would emerge.
Design of pension systems in MENA and determinants of coverage. Universal social insurance coverage is a relatively modern policy goal; current coverage patterns in MENA reflect a history of social security provision initially limited to the civil service, without the ambition of universality. Most social insurance systems in MENA were born in the late 1960s or early 1970s through the establishment of schemes specific to civil service employees. In fact, worldwide, public sector employees were usually the first to be covered by pensions and other social insurance schemes sponsored by governments in their role as employers.22 Gradual expansion to formal private sector employees and other groups took place at later stages. In MENA, though expansion of pension schemes beyond the civil service has been achieved in all countries, it has happened in a fragmented manner. As shown in figure 5.11, the share of MENA countries that have already integrated civil service schemes within larger schemes that cover workers in other sectors (such as the private sector) is lower than in the ECA and LAC regions, comparable to EAP, and greater than in SSA and SAR.23 Currently, 11 of the 19 MENA countries still operate a separate or only partially integrated scheme covering civil servants and private sector workers. Concerns regularly surface regarding the legacy costs of integrated civil service schemes in countries where the integration has already been implemented (such as in Jordan and Syria). None of the countries operate one single national scheme that covers all types of workers. The fragmentation of the system poses various problems, especially as MENA economies seek efficient and productive resource allocation across sectors. First, if benefits are not portable across schemes, labor mobility across sectors with different schemes is constrained (box 5.5). Moreover, generous sector specific schemes (such as civil service schemes) may crowd out labor supply in other sectors (such as the private sector) and create inequities (Robalino 2005). The following sections discuss three features that are common to many MENA pension systems and that are problematic for informality: legal coverage, early retirement, and calculation of benefits.
Figure 5.11 Path Dependency in the Evolution of Pension Systems: Degree of Integration of Civil Service Pension Schemes in MENA and Other Regions
Source: World Bank pension systems database.
Note: Integration refers to integration of civil service pension schemes within schemes covering workers in other sectors, including the formal private sector. ECA = Europe and Central Asia; EAP = East Asia and Pacific; LAC = Latin America and the Caribbean; SA = South Asia; SSA = Sub-Saharan Africa.
Outside the public sector, pension system coverage in MENA is still limited, and legal provisions for covering the self-employed and agricultural workers are sporadic. MENA social insurance schemes reflect the traditional view that coverage is associated with a formal employment relationship, and they rarely accommodate special employment status categories. In several MENA countries, certain types of workers are legally excluded from coverage. Thus, in some cases, coverage extension may need to start with expansion of “legal coverage,” as was done recently for workers of agricultural cooperatives in Morocco. Traditional social insurance coverage implies that the self-employed are excluded from coverage by default. Only half of the MENA countries offer mandatory or voluntary coverage for the self-employed (table 5.6; see Robalino 2005; SSA 2009, 2010). However, integrating the coverage of the self-employed under the current DB pension schemes in MENA is challenging because it would put a significant burden on the often low-productivity self-employed. Moreover, the existing pension schemes in the majority of MENA countries exclude a large portion of rural workers; at best, workers in large agricultural organizations such as cooperatives can enroll. As for unpaid family workers, coverage relies exclusively on household members accessing social insurance benefits (such as survival pensions or health insurance) through covered family members. Temporary and casual workers are excluded from coverage in the Republic of Yemen and Syria. Another example of legal exclusion from coverage is in Syria, where employees in firms with fewer than five employees receive coverage limited to work injury only. In Lebanon, all private sector employees are not eligible for pensions, but rather receive a lump-sum end-of-service indemnity.
Table 5.6 Legal Coverage for Self-Employed Workers and Agricultural Workers in Non-GCC MENA Economies
Further contributing to the fragmentation of pension systems and labor markets in MENA, various countries have established specific occupational schemes that are usually not subject to government regulation. Occupational schemes exist in the Islamic Republic of Iran, Morocco, Egypt, and Tunisia. Tunisia’s experience in expanding coverage to the self-employed is based on the development of an income estimation system for different occupational groups. Based on the estimated lowest income bracket assigned to each occupational group, the required personal contributions are identified. Workers can choose to contribute more, or they can contribute less if they prove that their real income is lower than the bracket assigned to them. This kind of approach suffers from challenges of financial sustainability and inaccuracy of estimated income. Although specific mandatory occupational schemes have been used as a gradual approach to expanding coverage, and have been sought in countries such as South Africa, Korea, and Costa Rica (Von Ginneken 2009), their potential as an approach to increase coverage (especially compared with more wide-scale extension of coverage strategy) is very much affected by whether the groups are large and sufficiently homogenous (Olivier 2009; Robalino and Palacios 2009). Arguably, such a coverage extension approach increases the segmentation of the social insurance system and could ultimately undermine integrated coverage extension efforts that attempt to attract voluntary participation regardless of the nature of workers’ employment status.
In terms of design, mandatory earnings-related pension schemes in MENA all follow the DB pension system design. Figure 5.12 illustrates the relative share of each of four mandatory pension design types (DB, DC, notional defined contribution [NDC], and provident fund [PF]) that exist around the world. In MENA, DB systems dominate. The widespread design weaknesses of these schemes in MENA contribute to the observed high degree of informality. Modern versions of DB pension design are capable of creating favorable participation incentives similar to those of DC schemes. In fact, it has been proven that DB and DC design can be identical if the DB design (1) adjusts the benefit level in an actuarially fair manner for early or delayed retirement before or after the statutory retirement age, (2) has an automatic mechanism to change the statutory retirement age in line with changing life expectancy, and (3) uses an average wage measure in the benefit formula, which incorporates the wage level of all contributory periods in a revalorized manner.24 However, the mandatory DB schemes in MENA do not meet these criteria. In addition to the problem of financial sustainability, MENA’s DB schemes have flaws in many of the critical design features, such as the minimum vesting period, early retirement provision, and average wage measure in the benefit formula, that provide disincentives to participate in the system.
Figure 5.12 Mandatory Pension Design Types across Regions of the World
Source: Pallares-Miralles and others forthcoming.
Note: ECA = Europe and Central Asia; EAP = East Asia and Pacific; LAC = Latin America and the Caribbean; SA = South Asia; SSA = Sub-Saharan Africa; DB = defined benefit; DC = defined contribution; NDC = notional defined contribution; PF = provident fund.
Minimum vesting period: Minimum vesting periods can promote informality. Table 5.7 summarizes some of the design parameters of mandatory pension schemes in MENA. With the exception of the recently modernized Iraqi pension system, none of the featured MENA countries require individuals to contribute for longer than half of a potentially 35- to 45-year active life cycle (that is, between a labor market entry age of 15 to 25 years and retirement at the age of 60) to qualify for full pensions. Primarily, a short vesting period causes either unsustainability or inadequate income protection. In many cases, the length of the minimum vesting period is close to or less than the length of time for receiving pension benefits, even without taking advantage of early retirement provisions. Theoretically, this can be sustainable only at prohibitively high contribution requirements or very low benefits. Low benefits would not protect against poverty in old age, so that the protection offered is not adequate. Another consequence of a short vesting period is that individuals provide only what is required from them in terms of system participation and exert a significant portion of their income-generating effort in some form of informality hidden from the social insurance system. The best strategy for workers is to limit the length of contributions to the minimum necessary to draw full benefits (see further below). Gaming the pension system with strategically shortened life-cycle contributions not only undermines sustainability but also increases informality. Conversely, a long minimum vesting requirement would exclude from pension eligibility those who cannot contribute sufficiently long in the formal sector.
Table 5.7 Pension Design Parameters of Mandatory Formal Sector Schemes in MENA Retirement Age, Minimum Vesting Period, and Early Retirement Provisions
Sources: Pallares-Miralles and others forthcoming; SSA 2009, 2010.
Note: — = not available.
Under DC schemes, no need for a required minimum vesting period is required, and thus such schemes can be considered more “coverage friendly” than DB schemes. With funded DC or NDC25 pension designs, the saving effort during the active life cycle is measured only by the actual amount of the saving. Furthermore, the earnings-related DC mechanism could be augmented with a minimum old-age income guarantee feature (see the summary in the previous section), and the eligibility of the pensioner for a subsidy could be determined based on the annuity level he or she receives given his or her saving effort and age. Such a scheme would avoid gaming behaviors that are prevalent under the vesting period requirement of DB design. The minimum vesting period requirement also puts upward pressure on informality through another channel. Jobseekers with access to temporary formal employment who are uncertain whether they can maintain formal employment status for the minimum required DB vesting period may decide to stay informal since any contributions could eventually become a sunk cost to them.26 Conversely, under DC schemes, no sunk cost risk is found for engaging in formal sector employment for those who are uncertain about the stability of their formal employment status. Overall, DC design can be considered as the desirable “coverage friendly” system benchmark (as long as it is augmented with some minimum old-age income guarantee) under which there is no need to use proxies for contribution performance that are prone to be abused. The path dependency reality suggests that DB will continue to be the dominant design in MENA in the foreseeable future. However, it is possible to incorporate features into a DB design pension to approximate the advantages of a DC scheme, although doing so is more difficult than taking advantage of the DC design’s simplicity. For example, under a still uncommon but theoretically interesting DB design solution, the flaws associated with a minimum vesting period could be overcome. The requirements for drawing full pensions or accessing the minimum pension top-up could be conditioned on age and the true value of past contributory effort (see box 5.6 on recent Jordanian pension reform).
Early retirement provisions: Generous early retirement provisions cause problems similar to those of the short minimum vesting period by radically undermining financial sustainability and encouraging people to reduce the length of their formal sector employment. Providing a degree of flexibility in determining the actual individual age of retirement is a logical feature of pension systems. In good practices of pension design, such flexibility is achieved through an actuarially fair adjustment of benefits. In particular, those who decide to retire before the statutory retirement age should compensate the pension system, in the form of reduced pension benefits, for their shorter contributory period and their longer term of benefit receipt. An upward adjustment should also be allowed for those who delay retirement beyond the statutory age and therefore contribute longer and receive benefits for a shorter period. MENA pension schemes are lax in defining the age at which individuals can start drawing benefits, and it is the exception rather than the rule that the actual benefit amount is less than that defined by the benefit formula.27 In many MENA countries, the actual age of retirement is not constrained at all. For example, in Algeria, males must complete 32 contributory years; in Djibouti, 25; in Egypt, 20;28 in the Islamic Republic of Iran, 35; and in Syria, 25. An individual who starts a formal sector job at the age of 20 could retire with a full pension at the age of 40 in Egypt or 45 in Syria, in other words, at ages still suitable for economic activity. Many of these individuals do decide to start drawing pension at this age, stop contributing to the pension system, and seek other informal employment income while officially retired. These “noncontributing active age pensioners” are then counted as uncovered in widely used coverage definitions. Even when the pension system actually imposes an age floor, the set ages are still considered suitable for economic activity; for example, in Iraq, Jordan, and Tunisia, the floor is age 50 for men. The flip side of this practice is that no incentive is given for delayed retirement. To the contrary, mandatory retirement-age rules are set at or close to the statutory retirement age, especially in the public sector. It is likely that this practice is related to the bias toward public sector employment. Without mandatory retirement, many would “overstay” in their relatively well-compensated and low-effort public sector jobs. Allowing early retirement for the public sector–dominated formal employees may be viewed as making room for the many young graduates who queue for public sector jobs, a situation exacerbated by the ever lengthening queue associated with the youth bulge and expansion of the higher education system. High informality rates among those 55 and older have been observed in the data used herein. If these are early retirees, they are already covered by pensions, and the vulnerability argument does not apply to them.
Average wage measure in the DB pension formula: Another design flaw of MENA pension schemes is that the wage measure used in the DB formula does not represent full career wages; this feature provides incentives to report only high income in the years before retirement. If the average wage measure used in the DB pension formula represents all contributions throughout the active life cycle where past wages are revalorized to the changes in the average wage levels over time, then DB systems could have desirable incentive effects similar to those of DC systems. Table 5.8 summarizes the average wage measures applied in the national DB schemes of MENA; they tend to use an unrevalorized average wage measure of the last few years before retirement. As a result, individuals tend to avoid reporting low earnings in these critical years and artificially inflate wages during the same period through side agreements with the employer. The average wage measure effects of the DB MENA pension schemes are stronger from a sustainability or a general equity perspective but can also contribute to gaming of earnings for reporting contribution purposes.
Table 5.8 Average Wage Measures in the Pension Benefit Formula in Selected MENA Countries
Country |
Average wage measure |
Algeria |
Maximum of the average of the wages of five last years and the average of five best years without revalorization |
Djibouti |
average of the wages of the last 10 years/last month’s wage |
Egypt, Arab Rep. |
convoluted combination of unrevalorized average basic wage of the last two years and unrevalorized full career average variable wages |
Iran, Islamic Rep. |
average of unrevalorized wages in the last two years |
Iraq |
gradually expanding to revalorized full career average wages in public sector/unrevalorized average of last three years of wages in private sector |
Libya |
average of unrevalorized wages in the last three years |
Syrian Arab Republic |
average of last year’s unrevalorized wages with wage increase not to exceed 15 and 30 percent in the last two and five year periods, respectively |
Tunisia |
average revalorized wages in the last 10 years in main scheme; different rules in four other national schemes |
Yemen, Rep. |
last month’s salary |
Sources: Pallares-Miralles and others forthcoming; SSA 2009, 2010.
What are optimal life-cycle pension system participation strategies? Pension systems in MENA are extremely generous and have a high internal rate of return for contributors. Given the existing design, individuals often have the incentive to contribute for the minimum period required and still draw generous pensions once retired. MENA pension schemes are excessively generous and, not surprisingly, financially unsustainable. For anyone able to find formal employment and registered with the pension administration, it is worthwhile to enroll in the pension system, although the optimal strategy is not necessarily to contribute all the time. Figure 5.13 shows that in Egypt and Jordan (before the recent reforms) and in Syria, contributing to the pension system yields real returns in the ranges of 6 to 10.5 percent, 7 to 17 percent, and 7 to 14 percent, respectively, much higher than the risk-less 2 to 4 percent real return one could achieve through saving outside the pension system.29 Figure 5.13 also illustrates that returns and contribution length are inversely related under the flawed design of MENA DB pension schemes. The highest return is associated with just completing the minimum vesting period necessary to draw full pensions, with contributions completed either early in the career (for example, a “frontloading strategy,” taking advantage of the generous early retirement provisions) or very late in the career, to raise the average wage measure with the highest wages reached during a career (for example, a “backloading strategy”). Note that limiting the number of contributory years, if they are nearly evenly distributed between the years of labor market entry and the statutory retirement age, does not increase the return on contributions; the constant contribution density strategy (that is, a “homogeneous life-cycle strategy”) is suboptimal from the perspective of the individual. If individuals are in a position to move income between the formal and informal sectors, or if they strategically plan their life-cycle formal employment participation behavior, they further undermine the sustainability of the pension schemes and increase observed informality. The patterns of the derived optimal contribution strategies can explain some of the coverage patterns observed at the aggregate level.
Figure 5.13 Internal Rate of Return under Various Pension System Participation Strategies in Egypt, Jordan, and Syria
Source: di Filippo and Bodor forthcoming.
Reforms toward DC pension design (regardless of the financing mechanism) or improvements in DB scheme design would address the adverse incentives of the current MENA pension schemes. Figure 5.14 illustrates the changing internal of rate of return profile under the recently legislated NDC of a funded DC pension reform in Egypt and a hypothetical DB reform in Syria. The Egyptian legislature passed a complex pension reform in 2010, which changed the PAYG pension scheme from DB to NDC design, and introduced a smaller funded DC mandatory pension component, as well as a universal basic pension for all, while reducing the tax wedge imposed by the pension system. One of the goals of this reform was to reinstate the pension system’s financial sustainability, so it is not a surprise that the current system’s extreme generosity is reduced (as evidenced by the lower internal rate of return). It is also notable that the rate of return differential across various contribution lengths and strategies of “frontloading,” “backloading,” or keeping contribution density nearly constant is diminished; the pension system no longer provides incentives to work informally during the work career. Similar results can be achieved under a well-designed DB architecture as well. The second panel of figure 5.14 shows that the payoff for short career contribution (and system participation) strategies disappears if an actuarially fair benefit reduction for early retirement is introduced and is combined with an average wage measure that represents all career contributions in a revalorized manner. (These reform features are combined with reduced accrual rate,30 increased retirement age to improve sustainability, and a reduced contribution rate/tax wedge to reduce the system’s burden on the economy.)
Figure 5.14 Internal Rate of Return Patterns of the Egyptian Pension System before and after Recently Legislated Pension Reform and of Hypothetical DB Reform in Syria
By design, pure DC pension schemes promote desirable incentives and are financially sustainable, yet on their own they cannot provide adequate income protection in old age for those who could not save enough during their active life period. As the name “defined contribution” suggests, benefits are solely dependent on the contributions/savings. The implications of this design are especially problematic among those who save too little, not because of a lack of effort, but rather because of labor market conditions and the marketability of their skills. That is why DC pension schemes are almost always augmented with some feature guaranteeing a minimum income level in old age. In this case, the minimum guarantee could be conditional on contributory effort rather than the value of contributions. Moreover, the income guarantee could be a top-up subsidy to augment the saving in the DC scheme, a broader noncontributory social pension, or a combination in the form of a social pension claw-back based on the DC saving.
The discussion in the previous subsections on the various distortions created by the design features of MENA DB pensions implies that the observed informality in the form of the coverage rate is likely to overestimate vulnerability, at least when it comes to access to old-age benefits. Box 5.7 discusses how the coverage rate overestimates the informality-related vulnerability problem when it comes to accessing social insurance benefits that are based on life-cycle contributions, even without strategic behavioral responses to the rules of the social insurance (pension) systems. The flawed DB design of many of the mandatory MENA pension schemes further contributes to reducing the observed coverage rate and increasing the gap between the informality measure provided by the coverage indicator and the actual access to old-age income benefits. It should also be stressed that this usually comes at the cost of financial sustainability and, as such, has implications for intergenerational equity.
In the previous section, the primary focus was on how pension system rules affect informality outcomes in detail, but a variety of other social insurance risk management mechanisms may have similar effects. With the notable exception of Lebanon, mandatory national pension schemes in MENA offer old-age pension benefits in the form of pension payments until death. The old-age pension benefits are almost always augmented with survivor and disability pension benefits. Eligibility for survivor benefits in MENA tends to be generous; significant anecdotal evidence suggests household-level strategic planning around fully utilizing survivor pensions. Work injury coverage, almost always bundled with old-age pensions, can be more extensive than that of old age. For example, in Syria, registered workers of firms with fewer than five employees are covered only for this risk. Work injury coverage for private sector workers in Morocco is mandatory (a unique case), but employers need to purchase coverage for their employees from competing private insurance providers. A survey from Syria31 suggests that employees value this social insurance component more than others, such as family or survivorship benefits, but less than old-age benefits and perceived job security due to coverage. In any case, it is unlikely to significantly drive informality. Workers’ behaviors are more likely to be affected by health insurance coverage, but in MENA, broad access to health insurance is ensured through public provision of heavily subsidized but often low-quality health services, and privately or publicly provided health insurance benefits typically augment this or offer access to higher quality care (for example, as in Iraq for private sector scheme members). Last, UI schemes in MENA rarely meet the international standards of UI provision, are hardly effective in ensuring the unemployment risk, and are unlikely to drive social insurance system participation decisions. However, recent UI reforms in Jordan and Egypt, which not only offer services to those laid off but also return the savings not used during periods of unemployment to the individual upon retirement, have the potential to make this a valued social insurance component.
Bundling or debundling coverage for the various social insurance components may influence informality outcomes. The bundling of benefits under a single social insurance package may exert downward pressure on coverage through mandating contributions for components widely viewed as less valuable. The Syria employer-employee survey showed that old-age coverage is significantly more valued than any bundled components, although health insurance is not provided through social insurance. On the other hand, in Lebanon, where old-age coverage in the traditional sense of pensions does not exist (only a lump-sum end-of-service indemnity), the health coverage component is viewed as the most valuable. The “price elasticity” of coverage is dependent on what services are provided under the coverage umbrella. If employees and employers are forced to pay for social insurance components that are less valued because of the bundled access to social insurance services, participation may be reduced under the formal sector social insurance scheme. At the same time, bundling of important social insurance components that are not valued by some workers because of myopia and the lack of immediate benefits (such as old-age income security compared with health insurance whose benefits could be immediately experienced) may improve coverage of such insurance types. Often benefits that are not associated with social risks are also financed through the social insurance mechanism, which increases the cost of participation without underlying theoretical justification. For example, in Syria, heating subsidies and family allowances are financed through the social insurance contributions of employees and employers. Such social benefits may be legitimate social benefits categories in a particular country context, but no reason exists to mix their financing with the financing mechanisms of protection against the realization of social risks such as old age, disability, or death of income-generating family members. Social support toward families is not an insurance service per se; this would be better matched with general revenue financing.
In summary, the set of risks covered by the social insurance mechanism should be linked to the underlying exposure to social risks and productivity of formal sector employment, so that a bundle of protection against the truly relevant risk is provided at an appropriate cost. Such bundling decisions should be revisited as MENA governments are now considering introducing unemployment insurance to protect against layoff risk in formal sector employment. This was less of a relevant risk in the past, but one that is getting increasingly more relevant given the private sector–driven growth path. It should be noted, however, that the limited existing evidence does not support the hypothesis that bundling significantly affects the participation decision in Morocco. There the chance of having a formal job was found to increase if another member of the family had a formal job. With health insurance extended to spouse and dependents, the “bundling” hypothesis would generate a negative correlation of formal jobs within the household. Instead, an explanation relying on networks and privileged access to formal jobs seems more plausible.
The coverage of social insurance (pension) systems in MENA is historically low. Coverage extension is required to provide tools to individuals and households to protect against various critical social risks including, but not limited to, health and unemployment risks and diminishing income-generating capacity in old age. Well-designed social risk management mechanisms increase welfare, but it is crucial that their design ensures adequate, affordable, and sustainable benefits in a manner that offers coverage to a large and increasing share of the population, without causing massive economic and labor market distortions. The first step in coverage extension is bridging the legal coverage gaps: coverage is rarely offered, for example, to the self-employed or agricultural workers. Beyond that, rethinking the design of existing MENA pension schemes should be a precondition for further coverage extension efforts. Vesting requirements, early retirement provisions, and average wage measures used for pension benefit calculation all contribute to reduced observed coverage. In general, the MENA pension systems provide high returns to those who have the chance to enroll, but paradoxically, this return can be made even greater by reducing the contribution length to a minimum and by taking advantage of the generous early retirement or by gaming representation of career wage by wages immediately before retirement. In addition to improving sustainability of the pension system and protecting against a wider array of social risks, social insurance reform is critical for addressing informality in MENA. Important political economy aspects to coverage extension can be identified. Given the generosity of existing systems and their financial unsustainability, current contributors have the incentive to extend coverage now to stave off reform. Without reestablishing financial sustainability first, extending coverage under the same conditions of existing pension systems is likely to magnify considerably the financial sustainability problem (box 5.8). Nevertheless, even if the existing formal sector pension schemes were reformed to match best practices, full, or even near full, coverage would still be an issue in MENA. Because many of informal workers have limited ability to save, it is unlikely that coverage extension can be achieved effectively without special subsidized social insurance features.
This section addresses how governments can develop coverage extension program strategies for their country-specific needs, assuming that the incentive design issues in existing earnings-related schemes are addressed in line with the discussion above. The following discussion acknowledges that informality is a persistent reality, and that access to innovative social risk management tools needs to be developed and provided to the informal sector, as well as to those outside of the labor force.
Governments that opt to extend social insurance coverage beyond the existing mandatory social insurance system by targeting groups of informal workers are faced with a set of decisions related to strategy, design, and implementation of new schemes. Although modernization of social insurance systems is expected to contribute to improved coverage, certain groups are likely to remain vulnerable/excluded. For example, consider the case of workers with nontraditional jobs that have no easily identifiable employment relationship defined by a single employer, duration, frequency, and wage, and who experience high mobility between jobs and recurrent unemployment spells. It is difficult, if not impossible, to mandate such workers to enroll under the formal earnings-related social security system. Moreover, some groups of informal workers are likely not to be able to afford any contributions required by the social insurance system and the transaction costs associated with enrolling. Extending coverage to such groups of workers requires the introduction of one or more types of special coverage extension schemes. This section discusses the various decisions facing governments when introducing such schemes (figure 5.15). For example, schemes could be based on either a universal strategy, where all individuals in the broad population group are eligible to benefit from a certain scheme, or on a targeted strategy, where only a portion of individuals within the broad population group is eligible, based on some kind of means test or categorical differentiation. Additionally, the scheme might or might not require contributions on the part of the beneficiaries. Examples of contributory schemes include MDC schemes in which the matching for the employee’s contribution may be financed by the government or by employers. Noncontributory schemes include social pensions and free health insurance (figure 5.10 illustrates these types of schemes in the context of pensions). Governments may even consider introducing different schemes serving distinct homogenous social groups and/or different objectives. This section also presents guiding indicators that can be used to assess the relevance of different strategies in light of existing country conditions. The indicators are chosen based on evidence from international literature and experience on different social insurance schemes. Based on the decision framework presented, this section also provides policy implications specific to MENA countries regarding the relevance of different types of coverage extension strategies.
Most countries are not starting with an empty slate when it comes to social insurance. The first step of decision making requires an assessment of the existing system with the objective of identifying possible reasons for low coverage outcomes resulting from implementation shortcomings. Palacios (forthcoming) presents a framework that can be used to identify gaps in social protection programs based on five main implementation “tasks,” presented as different layers of the pyramid in figure 5.16: (1) identification, (2) targeting, (3) enrollment, (4) benefit definition, and (5) management information systems. This framework suggests that a rough estimation can be made of the share of the eligible population that did not receive a certain social protection benefit due to shortcomings in each of the five main tasks. This then provides guidance on improving the implementation of existing programs as well as on the design and implementation of new programs. Figure 5.16 also presents examples of indicators associated with each of the five tasks in the framework.
Figure 5.16 A Framework for Implementing Social Protection Programs
Sources: Based on Palacios forthcoming.
A robust and integrated national identification system is an important prerequisite. In MENA, although a national identification (ID) system exists in all countries and national IDs are mandatory for adults, the robustness and integration of these systems across various public agencies and service providers vary among countries but remain underdeveloped in most. Moreover, exclusion from the ID system is heavily dependent on income level. Morocco, the Republic of Yemen, and Djibouti have recently taken steps to develop a multiuse biometric national ID system. The national ID in Egypt is used for receiving various public services as well as for employment and some private transactions. In other countries, the use of national IDs is limited to election purposes. Overall, modernization of national ID systems is underway in the region, although completion may take time, and program-specific IDs can be used, with an outlook toward future development of an integrated unique ID. With respect to the second layer of the pyramid, targeting/eligibility, the key question for governments is whether some people are being excluded because they cannot prove their eligibility or because of the quality of the targeting system. It is also important to determine if ineligible people are erroneously included as well. The upper levels of the pyramid consider the need to assess the procedures through which potential beneficiaries enroll in the system and evaluate the effectiveness of the benefit delivery processes and the accuracy and maturity of the management information systems.
Existing country conditions can serve as a good guide for governments to assist in making design decisions when introducing coverage extension strategies. Current country-specific conditions (such as the level of income of the target group, existing coverage patterns, government effectiveness, and effectiveness of existing programs and their supporting infrastructure) can be used to assess the relevance of each type of scheme in a specific country context. Various guiding indicators are collected in the score card presented in table 5.9. It summarizes considerations and examples of relevant indicators that can be used to evaluate existing country-specific conditions for guiding decisions on coverage extension strategies. The conditions are described in turn below. It is worth mentioning that although current country conditions will ultimately guide the decisions to be made when introducing new schemes, governments’ future objectives and the projected enabling environment of a country, as envisioned by various reforms, should be taken into account. For example, although current country conditions may motivate the introduction of temporary programs or temporary design features, a different form of the system may be anticipated under more developed conditions. The key is that design features applied under current conditions should not serve as constraints toward future modernization.
Table 5.9 Existing Country Conditions Guiding Indicators (Score Card)
Universal vs. Targeted strategy |
||
Universal |
Targeting |
|
1. Level of income and poverty in the country |
||
A. GDP per capita |
+ |
|
B. Share of rural population |
+ |
|
C. Share of “no” and “low” savings capacity population |
+ |
|
D. Incidence of poverty among elderly |
+ |
|
2. Effectiveness of existing social assistance programs and systems |
||
E. Existence and effectiveness of social assistance programs |
+ |
|
F. Existence and quality of means or proxy means testing |
+ |
|
3. Government’s ability to reach different population groups |
||
G. Mobile/Internet penetration |
+ |
|
H. Local government presence/strength |
+ |
|
Noncontributory vs. Contributory Scheme |
||
Noncontributory |
Contributory |
|
4. Level of income and poverty in the country/target population |
||
A. GDP per capita |
+ |
|
B. Coverage rate |
+ |
|
C. Share of “no” to “low” savings capacity population |
+ |
|
5. Transaction costs (bureaucratic transaction costs) |
+ |
|
6. Trust in government (government accountability) |
+ |
|
7. Financial literacy |
+ |
|
Note: GDP = gross domestic product.
Deciding between a universal or a targeted strategy:
(1) Level of income and poverty: The richer the country, the more likely that a universal strategy will result in higher inclusion errors; that is, more middle- and high-income individuals with no need for government support are likely to benefit from the scheme. This group would otherwise be excluded from a means-tested targeted scheme. Thus, a universal scheme would be both more regressive in nature and more costly in richer countries. In addition, because income is more likely to be observable in richer countries, both inclusion and exclusion errors will be less significant under a targeted scheme. Indicators to consider under this category include GDP per capita, the share of rural population, and the savings capacity of the population. Finally, with respect to old-age benefits in particular, a higher share of elderly among the poor strengthens the argument for universal schemes.32
(2) Effectiveness of existing social assistance programs and systems: In countries with well-established, effective, and high-coverage social assistance programs, a universal scheme implies that individuals are likely to receive multiple benefits. Moreover, effective social safety net programs often rely on well-developed targeting systems, on which governments can depend when introducing a targeted coverage extension strategy. Relevant indicators to be considered under this category include scope, coverage, and impact of social assistance programs and the existence/quality of means or proxy means testing systems in the country (see box 5.9 for a discussion of targeting methods).
(3) Government’s ability to reach different population groups: In less urbanized countries with little government representation in rural and remote areas, a targeting strategy may be very costly. Examples of indicators that can be considered when assessing the government’s ability to reach different population groups include local government presence/strength and mobile or Internet penetration rates.
Although a higher share of rural population may make it more expensive and difficult to use a targeting strategy, the cost may be offset in varying degrees if the majority of people can be reached through mobile phones or the Internet and if the government has a strong local presence.
Besides country conditions, the fiscal implications of each scheme are also important. The average cost of a noncontributory pension scheme is estimated at about 1 percent of GDP, varying between universal and targeted schemes. For example, a means-tested scheme in Bangladesh costs 0.03 percent of GDP, whereas a universal scheme in Mauritius costs 2 percent of GDP. For the MENA region, Palacios and Sluchynsky (2006) estimate that the cost of a universal social pension that provides a benefit equal to 15 percent of GDP per capita at a retirement age of 65 would reach 1 percent in 2025 and 1.5 percent in 2040, depending on demographic evolutions. The cost of a universal scheme may be considered unaffordable for countries with a low tax base and revenues and an aging population. Moreover, capping the number of eligible beneficiaries, restricting benefits to one individual per household (as in Bangladesh), and disqualifying persons who receive other forms of assistance could also contain costs. Countries with means tested social pensions include Bangladesh, rural Brazil, Chile, Costa Rica, India, Moldova, Nepal, South Africa, and Thailand.
Deciding between a contributory and a noncontributory scheme: The choice between a contributory and a noncontributory scheme is, to a large extent, dependent on the ability and willingness of target social groups to contribute to a particular scheme and the extent to which their incentives to do so can be influenced. It is in this context that the following factors are evaluated (recall table 5.9).
(1) Level of income and poverty in country/target population: Indicators including GDP per capita, coverage rate of existing contributory schemes, and the ratio of “no” to “low” savings capacity population can be considered. If a large portion of the target population has no savings capacity, the take-up rate of a contributory scheme is likely to remain very moderate even when the government or employers offer to subsidize a portion of contributions. Moreover, if coverage of existing mandatory schemes is low (for example, below 20 to 25 percent), incentives are likely to play a less significant role compared with situations where coverage is higher (for example, above 50 percent). GDP per capita and coverage rates are correlated, and so this is in line with the argument presented earlier.
(2) Transaction costs: The schemes under consideration are by nature voluntary and require beneficiaries to make a conscious choice to enroll, knowing that they will have to incur some transaction cost related to simply registering or also making contributions. Thus, it is very important to consider the level of transaction costs involved and understand how they will influence people’s incentives to enroll. If high transaction costs cannot be overcome or mitigated, noncontributory schemes may achieve higher coverage rates than contributory ones.
(3) Trust in government: People’s trust in the government and its institutions can influence their decision to enroll and contribute to a scheme.
(4) Financial literacy: Contributory schemes require some financial understanding or computation from the individual to assess whether it would be cost effective to contribute. In this context, if financial literacy among the target population is low, it may be difficult to achieve high enrollment rates in contributory schemes.33
Examples of different schemes: Core and supplementary schemes are the two main types of noncontributory schemes that have emerged internationally. In the case of social pensions, core schemes can be found in developing countries such as South Africa, Bolivia, Botswana, Mauritius, Kosovo, and rural Brazil. In this context, social pensions are used as the main tool for addressing the coverage gap, in some cases covering up to 100 percent of the elderly. Larger core schemes are more likely to be found in countries with limited coverage of mandated contributory schemes or no such schemes at all. On the other hand, supplementary social pension schemes are intended to assist the elderly poor who are excluded from the formal system; these are more likely to exist in countries with moderate to large contributory schemes, such as Algeria, Egypt, Colombia, Turkey, Costa Rica, and Uruguay.
MDC schemes are emerging as a potentially viable option for expanding coverage to informal workers. Although MDCs exist in some developed countries such as the United States and Germany, laws establishing MDC schemes have been only recently passed in some middle-and low-income countries, including the Dominican Republic, Korea, China, India, Indonesia, Mexico, Vietnam, and Thailand. Yet only a few countries have recently launched implementation (see box 5.10 for a description of MDC schemes in India, Mexico, and China); thus little systematic evidence is available on their performance and impact. Robalino and Palacios (2009) argue that MDC schemes have numerous advantages for informal workers, namely, their portability across different jobs and their ability to accommodate flexible levels and frequency of contributions. Moreover, MDCs may be a more relevant tool to encourage enrollment among informal workers in middle- and low-income countries compared to other monetary incentives, such as tax deductions or exemptions. First, lower-income informal workers are less likely to pay taxes in lower-income countries, and, second, tax incentives, if applied universally, may be regressive. When MDCs are structured as a flat co-contribution by governments, they cease to be regressive. Furthermore, evidence on the magnitude by which tax incentives affect enrollment and savings levels is mixed, and a debate exists around whether savings induced by tax incentives crowd out existing savings (Antolin and Ponton 2007).
The level of the matching contribution and the elasticities of the take-up and savings rate to the match are critical in determining the success of an MDC scheme in expanding coverage. The take-up rate is affected by both the level of the matching contribution and its magnitude relative to the individual’s income level. Robalino and Palacios (2009) present a method to determine the parameters and costs of an MDC scheme. However, ex ante evidence on the take-up/match elasticity, a critical factor affecting the take-up of MDCs, is fairly limited, and the only evidence comes from U.S. experience in employer-matched 401(k) and individual retirement account (IRA) schemes. For example, a randomized field experiment offered matching incentives for IRA contributions in low-and middle-income neighborhoods in St. Louis, Missouri, at two levels (20 and 50 percent), while a control group was not offered any match. The higher match significantly affected both participation and contributions to the scheme. Take-up rates among the 20 percent match group (8 percent) were almost three times that of the control group (3 percent) and reached 20 percent in the 50 percent match group. Savings were also four and seven times higher in the 20 and 50 match groups, respectively, compared with the control group (Duflo and others 2005). Not all studies are conclusive about the power of matching with respect to increasing participation. Engelhart and Kumar (2006) used administrative data on 401(k)34 participation and estimated that the elasticity of 401(k) participation with respect to the match rate ranged between 0.02 and 0.07; a 25 cent match per dollar of employee contribution resulted in an increase of 3.75 to 6 percent. The savings/match elasticity was also estimated to be modest.
Under contributory schemes, some design features can further improve incentives of target groups to enroll. Allowing flexible contributions and withdrawals are two potentially useful features to encourage take-up rates (Hu and Stewart 2009; Robalino and Palacios 2009). For types of work with volatile income (as in the agricultural sector or other seasonal sectors), it may be important to relax the rules on the regularity of contributions. In Chile, participation of seasonal and temporary workers is encouraged by allowing irregular frequencies of contributions. The Central Provident Fund in Singapore, a mandatory social insurance scheme originally designed to provide old-age income security, eventually allowed members to use their account funds for paying housing mortgages. As withdrawals to fund home ownership increased, concerns about the scheme’s retirement objectives increased (Hu and Stewart 2009). Since liquidity of savings above a certain threshold may be a relevant issue for low- and middle-income countries, schemes could be designed to restrict withdrawals from specific portions of the account and for certain acceptable reasons.
Workers’ preferences and perceptions: Preferences and perceptions of workers in Syria and Lebanon suggest a genuine demand for social insurance and a general willingness to pay for its services.35 In Syria, about one-third of the surveyed workers are informal, 64 percent of which are interested in social insurance coverage. Similarly, 68 percent of informal workers in Lebanon are interested in being covered by social insurance. Figure 5.17 presents results from the survey. The majority of Syrian workers rank old-age benefits as the most important, whereas health insurance is the most important benefit for Lebanese workers, because the social insurance package there does not offer pension coverage. In both countries, preferences for different benefits are similar among formal workers and informal workers demanding coverage. The majority of formal workers in both countries consider the cost of social insurance to be reasonable, which indicates a general willingness to pay for coverage.36 Further confirming a willingness to pay, cost is not identified as the most important reason for lack of interest in social insurance among groups of informal workers. In Syria, individuals’ myopia (56 percent) and lack of knowledge about the system (55 percent) seem to be more important reasons than cost considerations. Cost considerations are also not the main reason in Lebanon either, where reliance on private health insurance as an alternative is most frequently cited.
Figure 5.17 Preferences and Perceptions of Informality among Workers in Lebanon and the Syrian Arab Republic
Sources: Syria Employee-Employer Survey (2011) and Lebanon Employee-Employer Survey (2011).
Among MENA countries, the relevance of contributory and noncontributory schemes (whether targeted or universal) as coverage expansion strategies varies. In Lebanon and Jordan, the existing coverage rates and the development of proxy means testing systems indicate the viability of a targeted-contributory scheme. The countries’ GDP rates, rural population rates, and poverty levels indicate a potential affordability of contributions, for at least some population groups (annex table 5A.1). Governments may consider fully subsidizing contributions of groups with no savings capacity, while matching contributions of groups with limited saving capacity, as determined by the proxy means test. The willingness to pay for social insurance, as implied by the survey results presented earlier, further confirms the potential relevance of a contributory scheme in Lebanon. In Syria, general country conditions (including lower levels of coverage and higher rural population rates) would guide policy choices away from introduction of a contributory scheme. However, the survey results indicate a certain level of demand and willingness to pay for social insurance among informal workers in registered firms. In this case, the government might consider introducing a contributory scheme targeting such workers.
Country conditions (especially high poverty rates) in Djibouti and the Republic of Yemen would point toward universal noncontributory schemes, while acknowledging that limited fiscal space is an important barrier. In Djibouti, although the share of the rural population is low, mobile and Internet penetration are also quite low, poverty is high among the elderly and the rest of the population, and no proxy means testing (PMT) system is in place (see box 5.9 for targeting methods). Although a PMT system exists in the Republic of Yemen, the high share of rural population, low mobile and Internet penetration rates, and high poverty levels favor the relevance of a universal strategy at this time. In Tunisia, coverage patterns and level of income make a contributory scheme viable for at least part of the population, but with no PMT in place, a contributory scheme in the short run may need to be based on a universal flat matching provided by the government.
Implementation arrangements and capacity differ widely in MENA. Some of the key elements for consideration include whether some of the tasks outlined in the pyramid in figure 5.16 can be contracted out to the private sector, while others remain under public management. Another important set of decisions involves how to best leverage existing infrastructure and institutions to implement new schemes. Box 5.11 describes the recent implementation of a new noncontributory health insurance scheme in India. Its implementation arrangements are continually being improved as the scheme evolves, a critical factor of its success so far.
It is also worth mentioning that financial education and generally raising awareness about the value of social insurance can be a useful tool for supporting the implementation of social insurance programs and contributing to higher take-up rates. Evidence from developing countries shows that general awareness about social insurance can be improved. A survey in India shows that about 80 percent of the informal sector did not even know what pensions were. In Chile, the understanding of pensions among citizens is still very limited (rated at 2 on a scale of 2 to 7). Using data from Chile, Fajnzylber and Reyes (2010) show that an improvement in information provided by pension administrators increased the probability of making voluntary contributions by older workers but less so by younger workers. Women responded to the information significantly more than men. Even in developed countries such as the United Kingdom, research has shown that over 25 percent of pension credits remain unclaimed because people do not know they are eligible. Various initiatives can improve awareness and financial education, including training office staff in social insurance agencies (as in China) and community outreach and awareness through household visits to potential plan members (as in the United Kingdom). The recent Chilean pension reforms set up a “Pension Education Fund” to fund awareness-raising initiatives (Stewart 2006). The evidence from Lebanon and Syria also indicates low awareness about pension benefits and pension rights.
Findings from behavioral economics can complement rational economic models in understanding individuals’ savings choices and behavior.37 Behavioral research has shown that individuals procrastinate when making choices, especially important ones. This is known as “inertia” or “status quo” bias. When the choice involves selection among several options and the need to make complex computations, individuals are even more likely to behave passively. Such behaviors are incompatible with traditional models of economics based on the rationality of economic agents. Another finding is the concept of “loss aversion”; people are more active in avoiding losing something they already have rather than in acquiring new gains (Kahneman and others 1991). Furthermore, behavioral research has shown that altering the description of a certain problem or question (also called “framing”) may result in different choices and judgments (Tversky and Kahneman 1981). To some extent, these findings explain certain savings behaviors, including, for example, the low take-up of voluntary retirement or other social insurance schemes. Figure 5.18 presents a notional framework for addressing individual saving behavior.
Figure 5.18 Implications of Rational and Behavioral Economics Theories Explaining an Individual’s Savings Behavior
In the context of coverage expansion, auto-enrollment and default options in retirement savings schemes (or other types of social insurance schemes) can positively influence savings behavior. Under auto-enrollment, individuals are by default enrolled into a social insurance scheme unless (or until) they chose to opt out. In addition, saving rates are set at a default (usually conservative) rate with a choice to enroll in different saving options if desired. The idea is motivated by the philosophy of libertarian paternalism under which the government can influence an individual’s choices without exerting coercion (Thaler and Sustein 2003). Auto-enrollment in social insurance schemes has been used in various developed countries, including Italy, New Zealand, the United Kingdom, and the United States. Some evidence from 401(k) plan experiments shows that auto-enrollment and default options are effective in increasing take-up of voluntary savings schemes and can even be designed to increase savings. Using data from a large U.S. firm, Madrian and Shea (2001) found that automatic enrollment had a significant impact on enrollment and retirement savings behavior; an enrollment rate of 86 percent was achieved compared with 36 percent without auto-enrollment. Simply framing the question as “Check this box if you would not like to have 3 percent of your paycheck put into a 401(k)” instead of “Check this box if you would like to participate in a 401(k) and indicate how much you’d like to contribute” led to this difference. An interesting auto-enrollment default option scheme that does achieve increased savings is the experimental “Save More Tomorrow” scheme (Thaler and Benartzi 2004). Under this scheme, employees are invited to choose a target level of savings according to which they will automatically start contributing in one year at a low savings rate, with a gradually increasing rate until they reach their target. This feature is usually referred to as auto-escalation or auto-acceleration of savings. Note that it makes a difference if one needs to commit current earnings to saving in the present or commit to saving yet unearned future income.38 Employees have the choice to opt out at any time. Evidence from four years of implementation shows a take-up rate of almost 80 percent; moreover, 80 percent of participants stayed through to the fourth year. Saving rates rose from 3.5 to 13.6 percent over the course of the program.
Overall, coverage extension through the social insurance system is an important yet complex agenda in MENA. This part of the chapter first reviewed the link between the design of social insurance schemes, particularly pensions, and coverage outcomes. With the exception of the recently approved social insurance reform in Egypt, all MENA countries have DB pension systems with design features not in line with best international practices. Many of the existing substandard design characteristics of MENA DB pension schemes contribute to the low observed coverage rates beyond the already well-known concerns over financial sustainability. These flawed design features include limited legal coverage, short minimum vesting periods that promote gaming of the system, generous early retirement provisions that distort participation incentives, and the use of average wages in the last few years of service as a basis of benefit computation. It is crucial that these incentive design issues are addressed through reforms that ensure adequate, affordable, and sustainable benefits, while offering coverage to a large and increasing share of the population.
It is unlikely that in MENA coverage extension will be achieved effectively without special subsidized social insurance schemes targeted to informal workers, or even to those outside the labor force. Although this notion might be considered controversial, social insurance coverage, at least for certain social groups, should be separated from the formal employment relationship without compromising the unified overall logic (integration platform) of the social insurance system most easily established based on DC design features. Even if this is achieved, no homogeneous recipe for success can be offered; country conditions matter significantly. A decision tree approach that MENA governments could follow when deciding on the type of social insurance coverage extension programs was suggested. Once the incentive design of the existing formal sector social insurance scheme in MENA is improved, the key decisions with regard to coverage extension strategies are (1) whether contributory or noncontributory programs are more appropriate and (2) whether universal or targeted subsidies should be used. To support these critical decisions, a stylized set of indicators based on country conditions was developed to help governments assess the relevance of different schemes. Among targeted contributory interventions, piloting a MDC scheme with subsidies conditional to low saving capacity emerges as a viable option to expand coverage in some MENA countries, including Lebanon, Syria, and Jordan. In the short run, noncontributory schemes will still play an important supplementary role in these countries, particularly for those individuals who have already completed their working life and those with no savings capacity. Means-tested noncontributory strategies may have to be used as the main coverage extension strategy in poorer countries such as Djibouti and the Republic of Yemen where contributory schemes are not a strong option given current country conditions. In the case of new contributory schemes, design features and implementation arrangements geared at inducing voluntary participation that include auto-enrollment and auto-escalation of savings could be considered, in addition to complementary financial literacy and general awareness interventions.
It was also emphasized that the ex ante predictions of traditional, agent rationality–based, economic models are not sufficient for determining the subsidies needed to induce voluntary participation, critical in the informality context. The lessons learned from behavioral economics about observed behaviors being irreconcilable with rational agent assumptions should also be taken into account. Such lessons suggest the use of auto-enrollment arrangements and program features responding to loss aversion (as opposed to just risk aversion). The recent innovation of MDC program design for social insurance coverage expansion, especially if combined with a targeting mechanism that assigns subsidies conditioned on the income position of the individual or household, received special attention. Although little empirical evidence exists on the potential impact of such innovations (and virtually no evidence from MENA, other than inferences based on perception surveys), one could confidently argue that successful coverage extension programs would combine (1) a program design predicting subsidy needs based on ex ante predictor economic models of agent rationality with (2) lessons from observed behaviors reflecting bounded rationality put into an implementation environment, which (3) ensures low transactions costs from the perspective of the individual for enrollment and benefit delivery and (4) relies on investments in financial literacy and broader awareness building within the target group of the coverage extension effort.
Annex Table 5A.1 Country Conditions in MENA Countries
Sources:
a. World Development Indicators, World Bank 2009.
b. Specific surveys for the Republic of Yemen, Iraq, Morocco, the Syrian Arab Republic, Egypt, and Lebanon as presented in chapter 2; coverage rates for the other countries are based on 2008 World Development Indicators, pension contributors as percent of labor force.
c. Robalino and others 2009.
d. World Development Indicators, World Bank 2008.
e. The Corruption Perception Index ranges from 0 to 10, 10 being for countries with no perceptions of corruption. From Transparency International 2010.
Note: GDP = gross domestic product; PPP = purchasing power parity; PMT = proxy means testing; — = not available.
1. Note that other taxes also contribute to the tax wedge. For detailed discussion, see below.
2. Note that as pointed out by Otonglo and Trumbic (2008), even in Turkey, the medium-run effect can be an increase in revenues, as the total amount of income declared increased, attributed to less understating of incomes. Importantly, evidence on the short-run effects of the Turkey case study should be interpreted with caution because this study is based on a before-and-after comparison, and many other changes might have occurred in the economy during the same period that also affected overall tax collection rates, making it hard to draw causal interpretations.
3. The fact that Doing Business rankings capture only a small part of the set of complementary reforms that are needed to effectively promote private sector growth can explain the apparent disconnect between the significant improvement in rankings recorded by some of the MENA countries and the continued perceived challenges to an inclusive growth process.
4. The EU15 was the number of member countries in the European Union prior to the accession of ten candidate countries on 1 May 2004 compromising Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, Sweden, and the United Kingdom.
5. The term “fixed-term worker” means a person having an employment contract or relationship entered into directly with an employer where the end of the employment contract or relationship is determined by objective conditions, such as reaching a specific date, completing a specific task, or the occurrence of a specific event.
6. Wage data for Tunisia were not available to produce kernels similar to those depicted in figure 5.5.
7. The ILO, European Union, and OECD have embraced the concept of “flexicurity,” combining flexible regulation, safety nets (such as unemployment insurance), and active social policies. One component of flexicurity policies is flexible and reliable contractual arrangements (from the perspective of the employer and the employee, of “insiders” and “outsiders”) through modern labor laws, collective agreements, and work organization.
8. This is only an indicative data point that does not take into account, for example, the underlying educational attainment composition in the public and private employment sectors. The point is that public sector pay is relatively high even in Arab region countries, where public sector salaries are generally perceived to be low such as in Egypt.
9. Annual Employment and Unemployment Survey, Department of Statistics, 2008.
10. Data were collected from the Public Commission for Employment and Enterprise Development in Syria.
11. The Syrian example highlights distortions introduced by certain labor market institutions; the unintended contribution to the informality phenomenon is just one particular aspect. The public sector job queue consists of a self-selected group of job seekers with a preference for public sector employment; this preference drives their acceptance of informal and refusal of formal private jobs, at least temporarily. The government uses this queue to attempt to identify candidates for its training and private sector placement programs because the alternative registries are of little value; neither employers nor job seekers show up in other government registries because neither party believes in effective matches through such channels.
12. See MENA Education Flagship Report (World Bank 2008).
13. An apprenticeship is an arrangement that allows individuals to receive firm-specific training through a working relationship with an employer. Workers usually receive low wages during the apprenticeship period such that the training costs are shared among firms and workers during the period.
14. The expressions “social insurance system” and “pension system” are used somewhat interchangeably in this chapter. Pension systems are often thought of as a set of social insurance mechanisms, including old-age pension, disability pension, survivor benefit, and work injury benefit components. These are the social insurance components typically introduced at earlier stages of development. Pension systems in this sense are present in all the MENA countries, albeit with often limited coverage. A social insurance system is often thought of as one that incorporates some of the social insurance components typically introduced at higher levels of development, such as unemployment insurance, sickness and health insurance, and maternity benefits. These “second generation” social insurance benefits are typically introduced on top of the already existing pension system components.
15. See Holzmann and Hinz 2005; Holzmann and Palmer 2006.
16. In a funded DC scheme, savings are typically accumulated through investment in actual financial saving instruments.
17. See the discussion on the range of the cost of universal basic pensions later in this chapter based on Palacios and Sluchynsky (2006). A cost benchmark at 2 percent of GDP is what the World Bank projections suggest on universal flat pension expenditures in the case of Egypt.
18. Currently, $NZ318.12 (net, for single persons) is paid to those eligible, as determined by age (65) and residency. Benefits are adjusted annually based on the consumer price index and average wages. The main task of the pension administration is not really administering this simple payment mechanism, but rather building tools that improve financial literacy and communicating to the public that the quality of life in retirement is heavily dependent on individual saving behavior.
19. For example, a claw-back with a basic pension reduction rate of 25 percent yields no reduction in the universal basic pension if no contributions were made during an individual’s active life cycle (for example, this is the benefit for those who spent their entire career in the informal sector), whereas the top-up is completely phased out at an earnings-related pension level equivalent to four times the basic flat pension. The mathematical formula to calculate the pension benefit under the universal basic pension with a claw-back design is p = ERP (y) − max (0, a − b × ERP (y)), where p is the amount of the pension benefit, ERP (y) is the pure earnings-related pension component benefit at life-cycle income measure y, a is the amount of the universal flat pension for those with no earnings-related pension, and b is a parameter reflecting the share of the earnings-related pension reducing the universal pension benefit.
20. For a detailed discussion on MDCs, see Robalino and Palacios (2009).
21. Notionally, participation requires a participation fee based on income, but as income is rarely observable outside of the formal sector, almost no one pays such a fee.
22. See Palacios and Whitehouse (2006) for more information on the evolution of civil service pension schemes worldwide.
23. See Pallares-Miralles and others (2011) for cross-country data on mandatory publicly and privately managed pension systems around the world.
24. Revalorization of past wages in the pension benefit formula means that past wages are taken into account with an adjustment equivalent to proportional changes in the general wage level between the time the pension contribution was paid and when the formula was applied to determine pension levels.
25. NDC schemes are DC schemes where contributions are not funded (that is, invested in financial instruments) and where individual earnings are based on individual contributions (PAYG). See Holzmann and Palmer (2006).
26. The lump-sum payments offered by MENA pension schemes to those who do not fulfill the minimum vesting requirement do not compare to the magnitude of pension payments received until death; contributions for these individuals would remain a sunk cost, for the most part, even with the lump-sum payment.
27. A simplified mathematical representation of the core of a defined benefit pension formula is 
, where T is the number of contributory years, 
is some measure of the wage based on which contributions were made during at least a part of the active life cycle, and a is a parameter called the replacement rate referring to what share of earnings one year of contributions replaced in old age by the DB pension system. Such a formula is calibrated (if at all) for a particular retirement age. Clearly a should be conditional on the actual age of retirement if sustainability matters.
28. In the case of Egypt, this features refers to the pension system before the recent legislated reform.
29. The internal rate of return (IRR) is a concept that creates an intuitive relationship between life-cycle contributions and the pension benefit flow. One can think about the internal rate of return as a real interest rate that, if applied to all career employee and employer contributions, would yield a savings amount by retirement equivalent to the (expected) value of the pension benefit flow until death. The IRR concept makes it easy to assess whether one should save inside or outside a pension system (provided that is a choice).
30. The accrual rate is a critical DB pension parameter. It is the rate by which pension benefits accumulate each year of contribution expressed as a percentage of the final salary.
31. World Bank employee-employer survey on workforce development (2001) conducted under the World Bank MILES program in Syria.
32. For a discussion of universal and targeted social pensions, see Holzmann and others (2009) and Palacios and Sluchynsky (2006).
33. OECD work on financial education and pensions can be found at http://www.oecd.org/document/37/0,3343,en_2649_15251491_25698341_1_1_1_1,00.html.
34. 401(k) plans are widely used retirement savings plans among American workers, where employers often choose to match contributions that workers make into their individual accounts. IRA schemes are provided by an employer and are similar to a 401(k) but offer simpler and less costly administration rules. 401(k) and IRA schemes are DC schemes in design.
35. The firm-based survey in Syria is representative of workers in registered private sector firms in manufacturing and services sectors. The household-based survey in Lebanon is representative of private sector workers more generally.
36. It is worth mentioning that the Syrian Social Insurance system is an unsustainable one because contributions do not cover the cost of services. It is unknown whether workers’ perceptions on the cost of social insurance would change if the contributions to be paid reflected the true cost of the services offered.
37. The field of behavioral economics brings together insights from psychology and economic theory in understanding individuals’ economic choices and decisions, with a focus on bounded rationality of economic actors. For recent experiments and writings on this topic, see Ariely (2008, 2010).
38. This behavior is consistent with the theory of time-inconsistent preferences, a formal and promising modeling attempt to explain certain behaviors in the rational agent environment.
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