Financing Universal Social Protection: The Relevance and Labour Market Impacts of Social Security Contributions

It is often argued that informal employment structurally limits the ability to organize social protection systems primarily on the basis of contributory social insurance. The prevailing view is that a mix of funding sources through social security contributions and taxes is needed to achieve universal coverage. The composition of that mix, however, is highly contested. Recently, international organizations and academics have suggested reducing or even abolishing social security contributions and replacing them with general taxation. The argument is to create incentives for the formalization of the economy. Misguided policies in this respect could potentially lead to adverse distributional outcomes and threaten social protection systems' sustainability by constraining one of their most relevant and stable flows of resources.

The objective of this paper is to evaluate the validity of these arguments by bringing together existing evidence on the impact of social security contributions on labour markets, insights from public finance theory and experiences of countries that have reduced social security contributions in an effort to increase formal employment. This paper shows that social contributions are one of the main sources of financing for public policy, and have remained a stable source of financing in the 21st century. The available evidence does not show a clear pattern between contribution rates and informal employment.

The literature suggests that the reduction of informality does not depend primarily on the magnitude of contributions. Instead, it requires a broad and coherent set of measures that support the creation of new formal jobs and the registration of informal workers. Most empirical studies find that contribution cuts fall mostly on workers’ wages. Thus, there are no significant employment or formalization gains in reducing contribution rates. At the same time, any reduction in social security contributions creates an effective loss in government revenue in the short term, limiting the fiscal space for implementing public policies that aim to reduce poverty and inequality. Moreover, since informality makes it difficult to collect employment-linked taxes, replacing contributions with other taxes (such as income or value-added tax) could be regressive and lead to greater imbalances on the macroeconomic front, as illustrated by many of the cases reviewed in the paper.