erasing the "formal/informal" distinction at least as it pertains to retirement income security. By tightening the link between contributions and retirement benefits, reforms that introduce individual retirement accounts cut the pure-tax component of payroll deductions, reduce the cost of hiring incurred by employers, discourage early retirement of experienced workers, and increase the flexibility and cross-sector movement of labor (World Bank, 1994, James 1996, James, 1997). Detractors argue that since they involve little if any redistribution between generations or between high and low-earning workers of the same generation, systems based primarily on individual retirement accounts lead to greater social inequity. PAYGO systems that usually pay benefits according to a defined formula, pool the risk of interrupted careers and periods of low earnings over the covered population, while the new systems shift the burden of these risks onto the individual (Diamond, 1998, Queisser, 1998). The new systems are further criticized for imposing high administrative costs (Diamond, 1993), and exposing workers' retirement security to the relative volatility of financial markets. Finally, contrary to the efficiency benefits touted by reform advocates, critics argue that it is unclear whether individual retirement accounts have made the labor market more or less efficient (Diamond, 1998).

Theory suggests that a transition away from a purely public, PAYGO regime and toward individual retirement accounts will effect the labor market through two channels. First, reforms can often entail a reduction in the payroll tax rate which reduces the cost of labor and/or increases net wages, encouraging greater participation in the labor market and the creation of regulated employment (Cowell, 1985). Second, systems based on individual retirement accounts tie benefits directly to contributions, reducing the portion of mandated contributions that are perceived as a pure tax (World Bank, 1994). These claims point to a shift in the incentives faced by firms and workers in their resource allocation decisions following a reform, as mandated contributions are more directly linked to future benefits. This shift in incentives is important to the extent that workers who may have evaded coverage in the past, choose to participate in national social security systems after reforms.

# **IIL. The Transition to Individual Retirement Accounts: A Two Sector Model**

In most developing countries only a small share of workers sell their labor in a regulated, "formal" sector, subject to a mandated minimum wage and _covered_ by a social security system. The remainder work in an unregulated, _uncovered,_ "informal" sector where wages are determined by the market and workers and employers escape the mandate to contribute to social security. A country's social security institutions can affect the allocation of labor between the sectors. Social security contributions are one of the main components of non-wage labor costs, thus "informalizing" production allows firms to reduce their costs. In Latin America, the costs imposed by social security are estimated to be as high as 20% of the operating expenses of small firms (Tokman 1992, Tokman and Martinez, 1999).

Theory suggests that, at the margin, a higher contribution rate for social security distorts labor allocation if workers do not consider their contributions "appropriable" in the future at the market rate of interest (Corsetti, 1994, Schmidt-Hebbel, 1998). When the link between mandated contributions and perceived benefits is ambiguous, social security 4