Journal of Human Capital 4(2). 2010

Recent theoretical and empirical research has argued that incentives stemming from social security systems influence the worker’s decisions about retirement, investment in human capital and even family formation. The experience of Chile, which radically changed its national system in 1981, offers an opportunity to test this hypothesis. Chile shifted from a defined benefit system to an actuarially fair defined contribution plan, exempted pensioners from the pension payroll tax and tightened early retirement restrictions. Using probit analysis and simulations of the behavior of 50 cohorts followed through 47 household surveys, we estimate the impact of the 1981 pension reform on the probability of dropping out of the labor force for older workers. We also try to disentangle the effects of each reform component. We find large effects: Labor force participation rose dramatically among male cohorts that approached retirement age after 1981 in Chile, in contrast to the decline observed before and the decline taking place in other countries at the same time. The rise was particularly great for pensioners, suggesting that the payroll tax exemption played a large role. Longer working lives and lower implicit and explicit taxes on labor should also lead individuals to invest more in education, job training and other types of human capital that yield a labor market return