Jens Matthias Arnold
Aida Caldera
Paula Garda
Alberto González Pandiella
Expanding Social Protection and Addressing Informality in Latin America
Abstract
The reforms advocated in the preceding chapter would imply a significant re-design of social protection systems and finding the necessary political consensus will face challenges and opposition. While millions of informal and largely unprotected workers stand to gain from social protection reform, potential implementation challenges and opposition from specific groups will need to be considered. An additional key challenge is to finance such reforms as reducing social security contributions for low-wage earners requires raising additional tax revenues or reallocating expenditure, without which the reduction in contributions will not be possible.
The reforms advocated in this paper are not small reforms; they would imply a significant re-design of social protection systems. Large reforms are usually only justified by large challenges, but the extent and persistence of informality in Latin America, and the exclusion from adequate social protection it implies, is a large challenge.
Finding the necessary political consensus for a significant redesign of social protection in the region will face challenges, that will differ from country to country. One of these relates to the tax system. Reducing social security contributions for low-wage earners will inevitably require raising additional tax revenues or reallocating spending. Raising additional tax revenues and reducing social security contributions has proven challenging for most Latin American countries, most of which are characterised by low tax revenues relative to their GDP, with the notable exception of Argentina and Brazil. Most countries in the region have scope for expanding tax revenues and to improve the efficiency of spending. However, if countries are not able to compensate the reduction in social security contributions that the reform would require by raising sufficient additional tax revenues to finance basic social protection, the reforms proposed in this paper will not be feasible, or there is a risk is that social protection is weakened overall or remains weak, which is not desirable. To ensure fiscal sustainability, it will be crucial to ensure that these reforms effectively generate the needed revenue when committing to permanent increases in spending. Increasing social spending should proceed only gradually once permanent revenues are available. Countries would need to set up a clear and detailed reform agenda linking tax reforms with social protection reforms.
A second challenge is that once non-wage labour costs are lowered significantly for those earning the minimum wage, there may eventually be a wage range above the minimum wage where marginal contribution rates will be high. This may make it more costly for firms to raise wages, possibly giving rise to low-wage traps, especially in countries with high minimum wages. This has been discussed at length in some OECD countries, including France, where social contributions for low-wage workers saw considerable reduction in the recent past. At present, this issue seems less pressing than the need to get more people into formal jobs in the first place, but it is something to bear in mind for the future.
Reforming social protection systems, although necessary, will not be enough to fully tackle informality. Better enforcement of tax and labour laws, simpler labour and businesses regulations and lower perceived benefits from informal employment and more investment in human capital, improved rule of law and policies to raise productivity in informal and small firms will also be needed. An upside and a reason to start with reforms to social protection is that they could have a more immediate impact on informality if accompanied by stronger enforcement of labour and tax laws than other reforms, such as policies to strengthen education and productivity that typically take longer to bear fruit.
A key question, and precondition for the successful implementation of the reforms advocated in this report, is how to raise the substantial amount of additional tax revenues that are needed to finance them. For example, estimates suggest that in Colombia such reform would cost 1% of GDP (OECD, 2022[1]). There are significant differences across countries in the region in tax burdens and levels of taxation so the specific tax reforms would vary from country to country. Overall, the most important sources of tax revenue in the region, as in most countries around the world are value added, individual income, and corporate income taxes. Corporate tax revenues in LAC are higher than in the advanced countries, relative to overall tax revenues. Corporate tax rates are often high, but compliance is typically low, and higher rates may lead to further evasion. One way to make collection of corporate taxes more efficient would be to streamline collections and eliminating exceptions, to reduce the nominal burden (lower the rate) while broadening the base. Improving tax administration and enforcement capacity is also essential to raise tax collection.
The relatively low contribution of personal income taxes makes income taxes one key element of a possible source of new revenue. LAC countries’ low individual income burden is due to low coverage, rather than low rates on top earners. In most countries, only the top 20 percent of citizens pay any income tax, so the tax burden is unusually concentrated. One reason is that personal income tax systems are generally characterised by high income thresholds as of which households start paying taxes, also referred to as basic allowances (Figure 3.1). These are often a multiple of the minimum wage, leaving the incomes of a large part of the upper and middle classes with incomes in between the current basic PIT allowance and the minimum wage untaxed. Moreover, in many countries, there are numerous personal income exemptions and tax expenditures, often to the benefit of more affluent taxpayers (IMF, 2019[2]; OECD, 2020[3]; OECD, 2018[4]; OECD, 2022[1]). Reforms could focus on broadening the personal income tax base by lowering exemption thresholds. Caution is needed in lowering the personal income tax exemption as there could be possible negative impacts on labour market participation and hours worked, as well as increases in informality. Those that would start paying personal income tax would need to have incomes far above those for whom social security contributions would be lowered, so the combined effect of higher personal income taxes and lower social security contributions is progressive overall, and to ensure a reduction in non-wage labour costs in the relevant lower income ranges where informality is most prevalent.
Expanding the reach of the personal income tax system could be a valuable objective, as authorities would also gain more information for operating the social protection system, which is currently based on social registries (see Box 2.5). People with incomes below the basic allowance could be required to file simple tax returns. But caution is needed not to affect non-wage labour costs in the lowest income range close to the minimum wage, and not to raise compliance costs for those same low-income people the reform is trying to help by expanding basic social protection.
Income threshold where single taxpayers start paying income tax, measured as a multiple of the average wage
Note: Data refer to the year 2024 for Peru (calculations are based on a monthly average labour income PEN 1,765.9 at national level in 2024; the threshold to start paying personal income taxes is PEN 37,450 annually), to the year 2020 for Argentina and Brazil, and to the year 2022 for other countries.
Source: OECD Taxing Wages 2023.
In addition to reforms to personal income taxes, property taxes, inheritance taxes and broader VAT bases can play an important role. Many Latin American countries have low property tax collection. Improving, updating and completing property registries and ensuring accurate property valuation systems are common challenges and can help raise revenues. Building the capacity of local governments to manage and administer property taxes effectively should be also part of the strategy. Many countries in the region have also margin to raise compliance and limit the scope for exemptions and reduced rates in the VAT while compensating the poorest households through the transfer system. A priority could be to reduce those exemptions that primarily benefit the better-off. This reform could increase VAT revenues, while reducing distortions and addressing equity concerns. Inheritance taxes could be used far more in Latin America and are typically very progressive. Considering that for some LAC countries energy subsidies represent high percentages of their GDP, reducing them and adopting a carbon tax would generate revenues of relevance. Modernising tax administrations, starting with improvements in human capital, information systems and the use of advanced technologies, systematically crossing information from different sources and improving electronic invoicing could also help to raise additional revenues.
Greater efforts to increase spending efficiency can contribute to create the fiscal space to finance the reforms. This could be achieved by making a more systematic use of spending reviews including tax expenditures, cost-benefit analysis, improving means testing mechanisms and social registries and public procurement processes. More systematic evaluations of social policies and more rigorous and transparent cost-benefit analysis of infrastructure projects could also help to boost efficiency.
Identifying potential obstacles to the political implementation of a major social protection reform such as the one advocated here implies identifying those who would win and those who would lose from the reform.
The first question has a straightforward answer: The main winner would be the most vulnerable households in Latin American societies, given that expanding social protection would foster more equal societies and more social inclusion. Among individual groups, the greatest benefits of social protection reform would be the millions of Latin Americans that currently lack access to pensions and/or basic protection against poverty. These are the most vulnerable segments of the population, but they may not be the ones with the strongest political voice.
Beyond low-income households, there would also be large potential benefits for society at large, as widespread informality is negatively linked to productivity (Levy and Cruces, 2021[5]; Maloney, 2004[6]; Amin and Okou, 2020[7]). In the past, favourable demographics and high commodity prices have allowed several Latin American countries to grow without much productivity growth. Now, as less and less young people join the labour force, the population will begin to age rapidly over the next decades. In Latin America as a whole, demographics will turn into a drag on growth rather than supporting it as in the past in about ten years from now, and in some countries in the region, that process is set to start much earlier. In this changing scenario, productivity growth will also need to become the basis for sustainable improvements in wages and living standards. That will hinge on policy reforms that can raise productivity, and incentivising more workers and firms to join the formal economy could play a significant role in this context.
By contrast, groups with a less obvious payoff would include those who are already in the formal labour market. Among formal workers, those with incomes close to the minimum wage may not be the ones who would lose out. After all, their take-home pay would probably rise due to the reduction of social security contributions, while their future pension benefits would in most cases not be lower than under the current setup.
Formal workers in the higher income ranges may oppose the reform to the extent that more of them would be paying personal income taxes than before. Since most of these have incomes significantly above those of low-income households that currently struggle to join the formal sector, the reform would have a progressive distributional effect overall. Some of these higher income formal workers may also benefit from special pension schemes that deliver better actuarial value than the standard pension regime, for example civil servants, teachers, members of the judiciary or others. To the extent that these -often costly- special regimes would be integrated into the general system, this could trigger additional political opposition. But it would also improve further equity and fairness of the pension system, especially considering that these special regimes are often more a legacy of power struggles of the past than of rational policy design.
Social security administrators may oppose any reform that shifts part of the financing burden to taxes, fearing revenue losses. That may have political weight when thinking about private pension funds, but in countries where these are large and are generally perceived to function well, there is no reason why they should not play a strong role in the design of the contributory pension pillar.
A wider concern may be a general mistrust in the capacity of the state to use additional tax revenues for the benefit of the population. In some countries, even where tax revenues are low, some citizens tend to oppose giving government a greater role for fear of these resources being lost in corruption or embezzlement. People are more likely to support policies if they trust that public institutions are competent, act in the public interest and implement policies effectively and fairly (OECD, 2025[8]). Enhancing trust in the government will be fundamental for successfully designing, approving, and implementing reforms that increase the resources administered by the public sector. Mistrust of government is high in much of Latin America, reducing support for tax reforms to finance education, social protection, policing and redistribution (Keefer, Scartascini and Vlaicu, 2018[9]). Reducing corruption and increasing transparency and government accountability can increase trust in government (Scartascini and Valle Luna, 2020[10]).
To boost feasibility of the proposed reforms, a policy debate to reach the necessary consensus is essential. This policy debate should be evidence-based and should not shy away from a clear identification of the winners and losers of the reforms, quantification of the costs and possible impact on different population groups. An analysis of the sequence and timing of the reforms will also play a very important role. Having a clear mandate and political leadership from the government showing the will and commitment to act would also be important (Tompson, 2009[11]).
An effective communication strategy on the need for the reforms and their impact on different population groups and the society in general will be essential to lead to acceptance by the population and avoid misperceptions on the impact of reforms. An effective communication strategy can include the provision of information, as well as consultation and dialogue with stakeholders. To reap its full potential, however, authorities can establish a two-way dialogue with the public (OECD, 2020[12]). People are more likely to support reforms when they understand their objectives and mechanisms. Misunderstandings about policy details can significantly reduce support—even when the reform would benefit them (OECD, 2025[8]). Acceptability increases when policies include visible compensation for those who lose out in the short term, and when reforms are introduced gradually with clear timelines. Trust in government varies by demographic group and is often lower among those most affected by reforms. Therefore, targeted communication strategies are needed to address different concerns and values across the population (OECD, 2025[8]).
Another key aspect for the successful adoption and implementation of some of these reforms is to incorporate gradual transition mechanisms, which can reduce resistance to proposed changes (CAF, 2020[13]). A clear sequencing and gradual implementation of tax reforms will be necessary to make them politically viable. This is also the case for pension reforms. Changing the pension system requires a prolonged period of transition, in which those close to retirement and those already retired are not affected. These individuals would hardly be able to make decisions in the short term that could cushion the impact that such reforms may potentially have on their incomes. The reform recommendations in this chapter can be implemented gradually, but in a coordinated manner, applying a whole of the government approach. In the past, small patches to punctual problems have often failed to consider the broader picture, and often created as many new challenges.
Tackling informality also requires a stronger enforcement of the rules, especially when these rules aim to strengthen formalisation incentives. One key challenge for governments will be to ensure that no abuses of the existing legislation are committed, as would be the case when companies falsely classify workers as self-employed or use service contracts to escape regulatory and tax commitments. Authorities should also step-up enforcement efforts to make sure that workers, including the self-employed, and firms pay their taxes. Although the region has made significant efforts to reduce tax evasion, including continued improvements to the tax authority’ digital system and electronic invoicing, there remains scope for further improvements in tax administration. Continued efforts to ensure sufficient resources to institutions tasked with the enforcement of labour laws, which should count with well-trained inspectors and the capacity to collect and analyse relevant data and information. Streamlining the penalty enforcement and improving its presence in rural areas are also open agendas in many LAC countries.
Moreover, reforms require regular monitoring and evaluations of their impact, to ensure that progress is made towards the reform’s objectives. A robust monitoring and evaluation framework would increase trust in the reform and support the social protection system, while offering the most productive tool to simultaneously assess the programme’s effectiveness and provide guidance for improvements. Colombia, for example, already has an advanced monitoring and evaluation framework of public policies in place, and so do several other countries in the region. Continuous efforts to enhance this process, stronger links between planning, budgeting and evaluation, more frequent and faster links between results and decision-making, and better quality of data from the beginning of the programme implementation would help improve social policy implementation and increase feasibility of reforms.
Finally, there is also a question of finding the right timing for undertaking large reforms. The strong negative impact of the Covid-19 pandemic on social inclusion and potential growth may have generated momentum for reform. Not only is there extensive literature showing that structural reforms, including those related to social protection, may be more easily undertaken in times of economic difficulties (Sturzenegger and Tommasi, 1998[14]; Drazen and Grilli, 1993[15]). The Covid-19 pandemic has also triggered an unprecedented level of emergency support to citizens, including many new or expanded social benefits. In light of the significant policy support that most governments in the region and the world have provided during the pandemic, citizens may now be more inclined to turn to the state when they are in severe need, and the expectations about the state’s role and capacity to provide social protection may be much higher now than only a few years back.
All these considerations provide a strong rationale for moving forward towards a social protection system that is compatible with low incentives for informality, providing benefits to all those in need. Building social protection systems in Latin America was a long and arduous task, but it eventually happened, despite all the unresolved challenges in its design. Now is the moment to reform the system to achieve better material living standards and more inclusive societies for all Latin Americans.
References
[7] Amin, M. and C. Okou (2020), “Casting a shadow: Productivity of formal firms and informality”, Review of Development Economics, Vol. 24/4, pp. 1610-1630, https://doi.org/10.1111/RODE.12697.
[13] CAF (2020), Los sistemas de pensiones y salud en América Latina. Los desafíos del envejecimiento, el cambio tecnológico y la informalidad, http://scioteca.caf.com/handle/123456789/1652.
[15] Drazen, A. and V. Grilli (1993), “The Benefit of Crises for Economic Reforms”, American Economic Review, Vol. 83/3, pp. 598-607.
[2] IMF (2019), Brazil: Boom, Bust, and Road to Recovery, INTERNATIONAL MONETARY FUND, https://doi.org/10.5089/9781484339749.071.
[9] Keefer, P., C. Scartascini and R. Vlaicu (2018), Shortchanging the Future: The Short-Term Bias of Politics, Inter-American Development Bank, https://flagships.iadb.org/en/DIA2018/chapter-10-shortchanging-future-short-term-bias-politics.
[5] Levy, S. and G. Cruces (2021), “Time for a New Course: An Essay on Social Protection and Growth in Latin America”, UNDP Latin America and the Caribbean Working Paper Series, No. 24, United Nations Development Programme, https://www.latinamerica.undp.org/content/rblac/en/home/library/human_development/time-for-a-new-course--an-essay-on-social-protection-and-growth-.html (accessed on 21 September 2021).
[6] Maloney, W. (2004), “Informality Revisited”, World Development, Vol. 32/7, pp. 1159-1178, https://doi.org/10.1016/J.WORLDDEV.2004.01.008.
[8] O. (ed.) (2025), Getting the Public on Side: How to Make Reforms Acceptable by Design, OECD Publishing, Paris, https://doi.org/10.1787/262255fd-en.
[1] OECD (2022), OECD Economic Surveys: Colombia, OECD Publishing, Paris, https://doi.org/10.1787/25222961.
[12] OECD (2020), Communicating Open Goverment. A How to Guide., https://www.oecd.org/gov/Open-Government-Guide.pdf.
[3] OECD (2020), OECD Economic Surveys: Brazil 2020, OECD Publishing, Paris, https://doi.org/10.1787/250240ad-en.
[4] OECD (2018), OECD Economic Surveys: Brazil 2018, OECD Publishing, Paris, https://doi.org/10.1787/eco_surveys-bra-2018-en.
[10] Scartascini, C. and J. Valle Luna (2020), The Elusive Quest for Growth in Latin American and the Caribbean: The Role of Trust, Inter-American Development Bank, https://doi.org/10.18235/0002522.
[14] Sturzenegger, F. and M. Tommasi (1998), The Political Economy of Reform, The MIT Press.
[11] Tompson, W. (2009), The Political Economy of Reform: Lessons from Pensions, Product Markets and Labour Markets in Ten OECD Countries, OECD Publishing, Paris, https://doi.org/10.1787/9789264073111-en.