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Despite many studies of the pension systems in developed countries, little work has been done on how to apply a sustainable pension system in developing countries. The set-ups of pension systems in developed versus developing countries are expected to be different because in developing countries much labor is concentrated in informal production sectors, while labor in developed countries is more fully located in formal production sectors. Informal production sectors are sectors where the government has few tools to implement fiscal policies (taxes and subsidies) on firms and labor. This research develops a comprehensive system on how to set up pension policies generally in developing countries and specifically in Indonesia. The basic set-up of the pension system suggested in this dissertation is multidimensional: a short run consumption tax policy to finance a defined benefit plan to support minimum physical needs of the older population, a medium run labor income tax policy to finance individuals defined contribution fully funded savings plan, and a long run skilled labor creation through university education so that individuals are able to self-finance their own pension savings through the fully funded savings plan. The defined benefit plan is important because it serves as a societal redistribution tool, while the defined contribution plan serves as a household savings tool. In addition, the skilled labor creation serves as a supporting tool so that the pension program can be sustained in the long run. A theoretical model is developed from Auerbach and Kotlikoff that utilizes an overlapping generation (OLG) computable general equilibrium (CGE) model, calibrated for the Indonesian economy by introducing heterogeneity in households including skilled and unskilled labor. We apply a mathematical programming system for general equilibrium analysis (MPSGE), developed by Thomas Rutherford. Some parameters used in the model are estimated by using econometric methods. The OLG-CGE model is applied in order to analyze the impact of consumption taxes and pension taxes on labor supply and also to calculate the equivalent variation of the distribution of consumption tax burden across generations. Meanwhile, the impact of skilled labor creation on economic growth is calculated by applying linear algebra. The main macroeconomic data are taken from the Indonesian social accounting matrix (SAM) for the year 2000. Labor data are taken from the Indonesian labor condition 1998-2003. The main findings in this dissertation are several. For the equivalent variations, the consumption taxes for USD 1, USD 2, and USD 3 cash transfers per day per person give more benefit to skilled labor than to unskilled labor. The consumption taxes for USD 1 cash transfer give incentives to the largest amount of labor, both skilled and unskilled labor, to work in the formal sector. The amount of labor after the consumption taxes for USD 1 cash transfer is higher than the initial condition. Increasing the consumption taxes for the USD 2 cash transfer decreases the amount of labor in the formal sector, with the amount of skilled labor decreasing more than unskilled labor. In addition, increasing the consumption taxes for the USD 3 cash transfer would also decrease the amount of labor in the formal sector, with the amount of unskilled labor decreasing more than skilled labor. We also find that the elasticity of government education expenditures with respect to skilled labor creation is roughly 0.3. This means that, if the Indonesian central government would like to eliminate the informal sector by 25 percent within 20 years or an average 1.25 percent annually, they must increase government education expenditures to 8 percent of total annual government budget. Finally, we show that the increase of skilled labor would contribute positively to the Indonesian economic growth, while the consumption taxes and the fully funded pension taxes would likely reduce the current economic growth but increase the future one. The theoretical contributions are se eral. First, given dual formal and informal labor sectors present in an economy, where the latter is dominant, taxation of expenditures is preferred to taxation of income because the first may induce labor to work in the formal sector. Second, given dual formal and informal labor sectors present in an economy, where the latter is again dominant, there exists an optimal level of consumption taxes that provides incentives for the highest amount of labor, skilled and unskilled labor, to work in the formal sector.
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