WORLD BANK LATIN AMERICAN
AND CARIBBEAN STUDIES
40008
Informality
Exit and Exclusion
Guillermo E. Perry William F. Maloney
�
Omar S. Arias Pablo Fajnzylber
�
Andrew D. Mason Jaime Saavedra-Chanduvi
�
INFORMALITY:
EXIT AND EXCLUSION
THE PRINCIPAL AUTHORS OF THIS BOOK ARE AS FOLLOWS:
Overview: Guillermo E. Perry and William F. Maloney
Chapter 1: William F. Maloney and Jaime Saavedra-Chanduvi
Chapter 2: William F. Maloney and Omar S. Arias
Chapter 3: Omar S. Arias
Chapter 4: William F. Maloney and Mariano Bosch
Chapter 5: Pablo Fajnzylber and William F. Maloney
Chapter 6: Pablo Fajnzylber
Chapter 7: Andrew D. Mason
Chapter 8: Jaime Saavedra-Chanduvi
INFORMALITY:
EXIT AND EXCLUSION
Guillermo E. Perry
William F. Maloney
Omar S. Arias
Pablo Fajnzylber
Andrew D. Mason
Jaime Saavedra-Chanduvi
Washington, D.C.
�2007 The International Bank for Reconstruction and Development / The World Bank
1818 H Street, NW
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1 2 3 4 10 09 08 07
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ISBN-10: 0-8213-7092-8
ISBN-13: 978-0-8213-7092-6
eISBN-10: 0-8213-7093-6
eISBN-13: 978-0-8213-7093-3
DOI: 10.1596/978-0-8213-7092-6
Library of Congress Cataloging-in-Publication Data
Perry, Guillermo.
Informality : exit and exclusion / Guillermo E. Perry and William F. Maloney ; Omar S. Arias ... [et al.].
p. cm.
Includes bibliographical references.
ISBN-13: 978-0-8213-7092-6
ISBN-10: 0-8213-7092-8
ISBN-13: 978-0-8213-7093-3 (electronic (13))
ISBN-10: 0-8213-7093-6 (electronic (10))
1. Informal sector (Economics) I. Maloney, William F. (William Francis), 1959- II. Title.
HD2341.P43 2007
330--dc22
2007013736
Cover photo: "Fen�meno" (1962) by Remedios Varo � 2007 Artists Rights Society (ARS), New York / VEGAP, Madrid.
Cover design: Naylor Design.
Contents
Foreword xi
Acknowledgments xiii
Abbreviations xv
Overview: Informality: Exit and Exclusion 1
The raz�n de ser of the informal sector: Adding exit to exclusion 1
Workers: A mix of opting out and exclusion 4
Firms: Little gain, high costs, or weak enforcement? 9
Need for more effective and legitimate institutions 12
Summing up: Policy implications of the report 13
Informality and the development agenda 19
Note 19
References 19
Chapter 1: The Informal Sector: What Is It, Why Do We Care, and How Do We Measure It? 21
Introduction: What is informality? 21
Informality and the relationship between the individual and the state 22
Three margins of informality 25
Measuring the informal sector 28
Correlations among measures and trends over time 35
Conclusions 37
Annex 39
Notes 39
References 40
Chapter 2: The Raz�n de Ser of the Informal Worker 43
Informal work: Adding exit to exclusion 43
The sectors of informal labor: Characteristics and dynamics 48
Motivations for participation in informal work 62
Conclusions 74
Notes 74
References 75
Chapter 3: Informality, Earnings, and Welfare 79
Compensating differentials, comparative advantage, and informal work 80
The question of equal pay for equal work in the informal and formal sectors 85
Informality and self-rated welfare 92
Conclusions and policy implications 98
Notes 99
References 99
v
C O N T E N T S
Chapter 4: The Informal Labor Market in Motion: Dynamics, Cycles, and Trends 101
Informality through the lens of gross labor force dynamics 102
Drivers of the increase in informality 112
Conclusion 125
Notes 127
References 128
Chapter 5: Microfirm Dynamics and Informality 133
Conceptual framework: Firm dynamics and institutional development 134
Microfirm dynamics in Latin America 140
Informality among microfirms 148
Conclusions 153
Notes 154
References 154
Chapter 6: Informality, Productivity, and the Firm 157
Informality among registered firms 158
Firm-level determinants of informality 160
Impact of informality on firm productivity and economic growth 171
Conclusions 175
Notes 177
References 177
Chapter 7: Informality, Social Protection, and Antipoverty Policies 179
Informality and social protection: Why policy makers should care 179
The state of social protection in Latin America and the Caribbean 184
Private risk management and rationale for public social protection 190
Challenges for social protection in the face of informality 193
Reengineering social protection to protect all citizens 199
Potential costs of social protection reform: Financing essential cover 204
Managing the transition from here to there 206
Conclusion 208
Notes 210
References 211
Chapter 8: The Informal Sector and the State: Institutions, Inequality, and Social Norms 215
Social norms, the state, and informality 217
The tax side of the social contract in Latin America 223
Inequality, taxes, and transfers 235
Informality: A reflection of a broken social contract? 239
Conclusions 244
Notes 245
References 246
Boxes
Overview
1 Informal workers in Latin America and the Caribbean: Their profile, motivations, earnings, and welfare 4
2 Government failures in the design of social protection systems in Latin America and the Caribbean 8
Chapter 1
1.1 The ILO definition of informality 27
1.2 Indirect methods of estimating informality 34
1.3 Schneider and Enste in the new world: Checking MIMIC estimates against Mexican data 35
Chapter 2
2.1 Home-based work: Exploitation or flexible work arrangement? 52
2.2 Data from rotating panels in Argentina, Brazil, and Mexico 56
2.3 Informal self-employment: Risky and informal, or risky because informal? 60
2.4 Special informal employment surveys: What can we learn from them? 64
vi
C O N T E N T S
Chapter 4
4.1 Conceptual issues in gross worker flows 103
4.2 Simulated effects of labor market legislation on the size of the informal sector 106
Chapter 5
5.1 Patterns of entry and exit in industrialized countries 137
Chapter 7
7.1 Social protection--strengthening people's abilities to manage risk and promoting long-term productivity,
growth, and development 180
7.2 The comprehensive insurance framework--providing guidance on social protection policy making 182
7.3 Extending health insurance coverage by correctly aligning risk-pooling instruments 201
7.4 Old-age protection in the new millennium: Chile's proposed pension reform 203
7.5 De-linking health coverage from employment status: Spain's shift to general-revenue financing of essential
social insurance 207
Chapter 8
8.1 The extreme of informality and exclusion: Being undocumented 219
8.2 Local taxation and social norms 229
8.3 Tax compliance, social norms, and trust in the state: The contrasting cases of Chile and Argentina in the
late 1990s 231
8.4 Earned income tax credits: Transfers that encourage formal employment 234
8.5 Expansion of private security services in Managua 242
8.6 Negotiating tax reform and the start of the social contract, Chile, 1990 243
Figures
Overview
1 Labor market informality and income per capita 2
2 Trends in informality, by various definitions 3
3 Probability of transition between formal salaried and self-employment in Mexico 6
4 Rate of urban employment across sectors, by age in Brazil, 2002 7
5 Informal workers across firm size 9
6 Male entry into and exit from self-employment 10
7 Advantages of formalization reported by IFC-surveyed firms 11
8 Underreporting of tax and social security contributions, by firm size 11
9 Economically active population contributing to the pension system 12
10 Informality versus inequality 13
11 Tax morale and state capture 14
12 Self-employment and quality of institutions (governance) 14
Chapter 1
1.1 Margins of informality 25
1.2 Methods for measuring the informal sector 28
1.3 Selected measures of informality 29
1.4 Informality and gender: women versus men (ages 25�64) 31
1.5 Informal salaried workers (legal definition) across firm size and time 32
1.6 Distribution of manufacturing sector firms according to worker registration in Mexico 33
1.7 Distribution of manufacturing sector firms according to tax compliance in Mexico 33
1.8 Global correlation of measures of informality with GDP 37
1.9 Trends in informality by various definitions 38
Chapter 2
2.1 Relative sector sizes and wages under a nominal wage rigidity 44
2.2 Relative sector sizes and wages in the presence of a labor tax 48
2.3 Rate of urban employment across sectors, by age 53
2.4 Probabilities of transition among sectors of employment 54
2.5 Absolute mean duration of labor force status 57
2.6 Propensity to move to self-employment from different sectors 58
2.7 Transition between self-employment and out of labor force, by gender 61
2.8 Employment sector allocation by gender, marital status, and parental status in Mexico 61
vii
C O N T E N T S
2.9 Propensity to move to informal salaried status from different sectors 62
2.10 International comparison of desired and actual self-employment rates 65
2.11 Earnings gain from voluntary movement to informality in Mexico 68
Chapter 3
3.1 Propensity to informal employment by firm size and economic sector, 2005�06 82
3.2 Propensity to informal employment by education and tenure, 2005�06 83
3.3 Propensity to informal employment by age, gender roles, and work preferences, 2005�06 84
3.4 Distribution of hourly earnings for workers in urban areas of Argentina and Bolivia, 2005�06 86
3.5 Earnings cost of informality in urban areas of Argentina, Bolivia, and the Dominican Republic 89
3.6 Fraction of workers who are income-poor and self-rated poor, by education and occupational group 93
3.7 Impact of informality on self-rated poverty 94
3.8 Direct impact of having access to social protection through a family member on self-rated poverty 95
3.9 Differences between actual labor incomes and the level of income needed to avoid self-rating poverty
in Argentina 97
Chapter 4
4.1 Formal share of the labor force and unemployment, Brazil and Mexico 102
4.2a Probability of transition between formal salaried and self-employment, Brazil and Mexico 104
4.2b Probability of transition between formal salaried and informal salaried, Brazil and Mexico 104
4.3 Involuntary transition to self-employment in Mexico 105
4.4 Searching while employed, Mexico 105
4.5 Decreased availability of formal sector jobs without segmentation 106
4.6 Probability of transition to unemployment (separation rate), Brazil and Mexico 108
4.7 Probability of transition from unemployment (job-finding rate), Brazil and Mexico 109
4.8 Informal employment reaction to the business cycle 111
4.9 Relative sector shares and earnings, real exchange rate 112
4.10a Variation of informality rate (social protection definition) 114
4.10b Variation of informality rate (productive definition) 115
4.11 Decomposition of changes in informality (social protection definition) for urban salaried workers 115
4.12a Labor force participation, rate of formality, and unemployment, Brazil 116
4.12b Labor force participation, rate of formality, and unemployment, Colombia 116
4.13 Actual and predicted size of the industrial formal sector, Brazil 117
4.14 Informality rate for salaried workers in Greater Buenos Aires 118
4.15 Informal salaried versus formal salaried, Mexico, relative earnings and sector size 118
4.16 Evolution of informality across age groups 120
4.17 Labor legislation and related variables, Peru 123
Chapter 5
5.1 Entry and exit into self-employment among men 141
5.2 Entry and exit into self-employment among women 142
5.3 Job creation and destruction in Colombia, 1977�82 144
5.4 Job creation and destruction by entering and exiting versus continuing firms in Colombia, 1977�82 145
5.5 Employment growth of microenterprises in Nicaragua 146
5.6 Size distribution of microenterprises in Mexico and Nicaragua 147
5.7 Informality among Mexican microenterprises by number of paid workers and time in business 150
5.8 Effect of doubling labor productivity on probability of being informal 153
Chapter 6
6.1 Unreported sales and workers, by firm size 159
6.2 Effect of doubling employment size on underreporting rates 159
6.3 Effect of having started informally on underreporting rates 160
6.4 Effect of doubling labor productivity on underreporting rates 160
6.5 Advantages of formalization reported by IFC-surveyed firms 162
6.6 Disadvantages of formalization reported by IFC-surveyed firms 162
6.7 Impact of changes in costs and benefits of informality 163
6.8 Labor regulations described by firms as biggest obstacle to hiring workers 169
6.9 Estimated impact of informality on growth 172
6.10 Estimated impact of informality on labor productivity 173
viii
C O N T E N T S
6.11 Effects of a 10 percent increase in tax and social security evasion at the industry/region level
on individual firm productivity (pooled sample) 174
6.12 Productivity difference between tax-paying Mexican microfirms and informal firms with similar characteristics 175
6.13 Productivity and paid employment effects of exogenous increase in formality driven by Brazil's
SIMPLES program 175
Chapter 7
7.1 Pension coverage rates in Latin America and the Caribbean 184
7.2 Social security coverage and GDP per capita 185
7.3 Coverage rates in Latin America and the Caribbean, mid-1990s to early/mid-2000s, by quintile of per
capita income 186
7.4 Pension coverage rates in Argentina, by quintile of per capita income 187
7.5 Pension coverage among the elderly in Latin America and the Caribbean, contributory and
noncontributory programs 188
7.6 Coverage of two poverty-targeted assistance programs in Mexico: Oportunidades and Seguro
Popular (by decile, 2004) 188
7.7 Public social protection spending in Latin America and the Caribbean 189
7.8 Public spending on social insurance and social assistance in Latin America and the Caribbean, early 2000s 190
7.9 Nonpoor population who fell below the national poverty line due to out-of-pocket health expenditures 191
7.10 Distribution of Mexican workers' years insured by IMSS, 1997�2005, for low- and high-wage
workers in IMSS in 1997 195
7.11 Density function for years of formal sector work among 60-year-olds in Uruguay (accumulated ages 18�60) 196
7.12 Cumulative distribution of years of formal sector service among 60-year-olds in Uruguay
(accumulated ages 18�60) 196
Chapter 8
8.1 Informality and government effectiveness 220
8.2 Informality and corruption 220
8.3 Share of firms confident that the judiciary will enforce contractual and property rights 220
8.4 Share of firms that consider the court system fair, impartial, and uncorrupt 221
8.5 Informality and state competence indicators 221
8.6 Central government tax revenue and GDP per capita 224
8.7 Tax revenue of Latin America and Caribbean countries 226
8.8 Average tax rate of Latin America and Caribbean countries 226
8.9 Average VAT and income tax productivity in Latin American countries 227
8.10 VAT productivity and informality indicators 227
8.11 Tax morale, state capture, and perception that the government spends taxpayers' money wisely 228
8.12 Tax morale and informality indicators 232
8.13 Social spending and taxation by income quintiles 238
8.14 Informality and inequality 239
Tables
Chapter 1
1.1 Correspondence of the "productive" and "legalistic" definitions of informality 31
1.2 Correlations across measures of informality 36
1A.1 Comparisons of ILO and Gasparini-Tornarolli measures of self-employment 39
Chapter 2
2.1 Distribution of formal salaried, informal salaried (social protection/legal definition), and self-employed in
urban areas of Latin America (percent) 49
2.2 Distribution of informal salaried, self-employed, and unpaid workers, by firm size (percent) 50
2.3 Characteristics of informal salaried employees in Mexican microfirms 51
2.4 Informal employment and work-life occupational history, Dominican Republic and Argentina (percent of workers) 63
2.5 Preference for independent employment (percent of workers) 64
2.6 Distribution of the motivations/reasons for being in the current job as an independent worker (percent) 66
2.7 Reported reasons to be informal self-employed in Mexico (percent of workers) 67
2.8 Reported reasons to be informal self-employed in Brazil (percent of workers) 67
2.9 Distribution of the motivations/reasons for being in the current salaried job (percent) 69
ix
C O N T E N T S
2.10 Reported reasons to be informal salaried in Brazil (percent of workers) 69
2.11 Principal reason for working without monetary compensation in the Dominican Republic (percent of workers) 70
2.12 Main reasons why the informal do not contribute to social security (percent of workers) 71
2.13 Main reasons why workers do not contribute to health insurance (percent of workers) 73
Chapter 3
3.1 Unconditional hourly earnings gaps (percent difference in earnings) for formal employees, informal employees,
and independent workers in urban areas in Argentina, Bolivia, and the Dominican Republic, 2005 87
3.2 Impact of informality on earnings in Argentina, estimated log-earnings differences and treatment parameters 91
3.3 Correlation between income and self-rated poverty 92
3.4 Impact on the propensity to self-rate poor and be income poor (normalized logit regression coefficients) 95
3.5 Job satisfaction and informal employment in the Dominican Republic 96
3.6 Job satisfaction and informal employment in Colombia 97
Chapter 4
4.1 Evolution of informality across firm size and time: Distribution of informal and self-employed workforce 119
4.2 Subcontracting in Mexico, 1992�2002 (percent) 119
Chapter 5
5.1 Entry probabilities into Mexico's self-employment sector (percent) 140
5.2 Exit probabilities from Mexico's self-employment sector (percent) 143
5.3 Growth and contraction probabilities of Mexican microfirms (percent) 146
5.4 Employment size distribution of firms, selected countries (percent) 147
5.5 Employment size distribution of firms with employees, selected countries (percent) 148
5.6 Reasons for starting up, firm prospects, and firm licensing in Brazil 149
5.7 Informality among Mexican and Brazilian microenterprises by age, education, and previous
activity of the owner 149
5.8 Informality among Mexican, Brazilian, and Colombian microenterprises by paid employment and
time in business 151
5.9 Informality among Mexican, Brazilian, and Colombian microenterprises by age, education, and previous
activity of the owner 152
Chapter 6
6.1 Firm-level correlates of sales and employment underreporting 167
Chapter 8
8.1 Long-run informality relationships 222
8.2 Indicators of informality and institutional indicators 223
8.3 Comparative perspective of tax burdens and structures (percent of GDP) 224
8.4 Tax structure by region, selected years, 1975�2002 (percentage of total tax revenue) 225
8.5 Tax exemptions in Latin America (percent of GDP) 227
8.6 Comparative efficiency and corruption in tax administration: Survey evidence for 2005�06 233
x
Foreword
I NFORMALITY IS A WAY OF LIFE IN LATIN countries more generally is partly due to the low opportunity
America and the Caribbean, no matter how we cost of opening a microbusiness, the gamut of measures to
measure it. In some countries, the majority of the increase formal sector productivity (improving the business
workforce is not covered by labor protections; the climate, fomenting innovation, and so forth) and to
ubiquitous microenterprises found on every street increase workers' skills is important. Labor market reform
corner are often not registered with authorities and only is also essential because part of the rise in the share of work-
partially comply with other regulations; and tax evasion by ers uncovered by labor protections in the 1990s appears to
rich and poor alike is the norm. Although these features be due to the increased burden of labor costs and restric-
of the Latin American and Caribbean landscape are not tions in several countries. But reform also needs to extend
new, their striking increase in some countries has given to remedying the poor design of many social protections
new life to the debate concerning what informality tells us that workers find of poor quality, inefficient, and of little
about how our economies are functioning. value. Hence, shifting workers' cost-benefit analysis toward
Informality: Exit and Exclusion, the ninth in our series of engagement with the institutions of the state--both
regional flagship reports, explores this very heterogeneous through improving the benefits of being formal and
sector from a variety of perspectives ranging from a concern through better monitoring--is critical to reducing their
with the protection of workers, to the productivity of firms, often voluntary entry into informality. Relatedly, although
to the determinants of tax evasion. The report accepts and experiments reducing the costs of registering businesses
sheds more light on the exclusionary character of much have led to relatively little formalization of existing busi-
informality, which leaves citizens outside formal institu- nesses, the impact on those few businesses appears substan-
tions. However, it especially highlights that there is an tial and progress in this area appears important. All of these
important "exit" dimension that has been understressed in reforms need to take place in a context of improving the
the literature: workers, firms, and families, dissatisfied with perception of fairness and efficiency of the state, which is
the performance of the state or simply not finding any ben- often seen as serving the needs of particular elites rather
efit to interacting with it, opt into informality. Hence, the than the needs of the population. In the long run, this is
discussion ranges from the purely economic analysis of the only way to change social norms of compliance and
microeconomic incentives to reflection on the soundness of reduce the "culture of informality."
the "social contract"--shorthand for how citizens of the This is a topic that the Latin America and the Caribbean
region relate to the state and to each other. Region of the World Bank has been working on in a sus-
It is not surprising, then, that the analysis gives rise to tained way through various regional studies and reports
recommendations that span many dimensions of the policy for more than 10 years. The present volume builds on this
agenda. Because the high level of informality in developing work, introduces original data sources collected for the
xi
F O R E W O R D
project and new statistical techniques to analyze them, Chief Economist for the Latin America and the Caribbean
and brings together research done in our partner coun- Region of the World Bank.
tries. Both its findings and its policy recommendations are
thus grounded in detailed analysis of the reality of the
region.
As a final note, this Flagship is the last undertaken
under the direction of Guillermo E. Perry, and I would like Pamela Cox
to thank him for his leadership, insights, and enthusiasm as Vice President for Latin America and the Caribbean
The World Bank
xii
Acknowledgments
I NFORMALITY: EXIT AND EXCLUSION IS THE PRODUCT OF A COLLABORATIVE EFFORT BY A NUMBER
of professionals from within and outside the Bank. The report was prepared under the direction of
Guillermo E. Perry by a core team comprising William F. Maloney, Omar S. Arias, Pablo Fajnzylber,
Andrew D. Mason, and Jaime Saavedra-Chanduvi.
Background papers were prepared by Rita Almeida (World Bank), James Alm (Georgia State University),
Guillermo Beylis (World Bank), Mariano Bosch (London School of Economics and Political Science [LSE]
and University of Alicante), Karla Breceda (World Bank), Monserrat Bustelo (World Bank), Dante Contreras
(Universidad de Chile), Barbara Cunha (University of Chicago), Wendy Cunningham (World Bank), Norbert
Fiess (University of Edinburgh), Marco Fugazza (United Nations Conference on Trade and Development
[UNCTAD]), Sebastian Galiani (Washington University in St. Louis), Rodrigo Garc�a-Verd� (World Bank),
Leonardo Gasparini (Centro de Estudios Distributivos Laborales y Sociales [CEDLAS] and Universidad
Nacional de La Plata), Edwin Go�i (World Bank), Melanie Khamis (LSE), Fernando Landa (Unidad de An�lisis
de Pol�ticas Sociales y Econ�micas [UDAPE], Bolivia), Santiago Levy (Brookings Institution), Norman Loayza
(World Bank), Leonardo Lucchetti (University of Illinois at Urbana-Champaign), Jorge Martinez (Georgia
State University), David McKenzie (World Bank), Truman Packard (World Bank), Esteban Puentes (Univer-
sity of Chicago), Jamele Rigolini (World Bank), Gabriel Montes Rojas (University of Illinois at Urbana-
Champaign), Lucas Ronconi (University of California at Berkeley), Claudia Sanhueza (Universidad de Chile),
Mariano Tommasi (Universidad de San Andr�s), Leopoldo Tornarolli (CEDLAS and Universidad Nacional de
La Plata), Federico Weinschelbaum (Universidad de San Andr�s), Chris Woodruff (University of California,
San Diego), and Patricia Ya�ez (UDAPE, Bolivia).
The report has also benefited from specific contributions or comments by Juliano Assun��o (Pontif�cia Uni-
versidade Cat�lica [PUC], Brazil), Tito Cordella (World Bank), Jean Jacques Dethier (World Bank), Maria
Victoria Fazio (World Bank), Gary Fields (Cornell University), Alvaro Forteza (World Bank), Vicente Fretes
Cibils (World Bank), Marcelo Giugale (World Bank), Gustavo Gonzaga (PUC, Brazil), Ricardo Furman (Inter-
national Finance Corporation [IFC]), Luke Haggarty (IFC), Mary Hallward-Driemeier (World Bank), Marco
Hernandez (Oxford University), Tom Kenyon (IFC), Peter Lindert (University of California at Davis), David
McKenzie (World Bank), Carolina Mejia (Fedesarrollo), Ezequiel Molina (CEDLAS and Universidad Nacional
de La Plata), Carmen Pages (Inter-American Development Bank), Georgina Pizzolito (World Bank), Kristtian
Rada (IFC), Lauro Ramos (Instituto de Pesquisa Econ�mica Aplicada [IPEA], Brazil), Jose Guilherme Reis
(World Bank), Helena Ribe (World Bank), Rafael Rofman (World Bank), Jose Scheinkman (Princeton
University), Pablo Suarez (Brown University), Judith Tendler (Massachusetts Institute of Technology),
Gabriel Ulyssea (IPEA, Brazil), and Evelyn Vezza (World Bank); and by our peer reviewers Jesko Henschel
xiii
A C K N O W L E D G M E N T S
(World Bank), Pierella Paci (World Bank), Stefano Scarpetta (Organisation for Economic Co-operation and
Development [OECD]), and Simeon Djankov (World Bank).
The project benefited from a data collection grant from the World Bank Development Economics Group
Research Support Board to undertake surveys in Bolivia, Colombia, and the Dominican Republic, building
on the 2005 survey conducted in Greater Buenos Aires, Argentina, by the Ministry of Labor, Employment,
and Social Security and the National Institute of Statistics and Census of Argentina, with support from the
World Bank. We very warmly thank Clara Else for her guidance and help in shepherding through the pro-
posal and Fran�ois Bourguignon for his support. Invaluable collaboration to develop these surveys is
acknowledged to Carlos Ignacio Becerra (Departamento Administrativo Nacional de Estad�stica [DANE],
Colombia), Dilia Cruz (Central Bank of the Dominican Republic), Olga Diaz (Central Bank of the Domini-
can Republic), Pedro Jos� Fern�ndez (DANE, Colombia), Eduardo Freire (DANE, Colombia), Rolando
Guzman (PARETO Consulting Group), Oscar Lora (Instituto Nacional de Estad�stica [INE], Bolivia),
Gabriel Loza (UDAPE, Bolivia), Juliana Martinez Cuellar (Departamento Nacional de Planeaci�n [DNP],
Colombia), Jos� Ramirez (UDAPE, Bolivia), Carmen Julia Reyes (Central Bank of the Dominican Repub-
lic), Guillermo Rivas (DNP, Colombia), Norberto Rojas (DNP, Colombia), Luz Magdalena Salas (DNP,
Colombia), Mauricio Santamaria (DNP, Colombia), Romilda Santana (Central Bank of the Dominican
Republic), Johnny Suxo (INE, Bolivia), Mar�a Fernanda Tellez (DNP, Colombia), and Mar�a Eugenia
Villamizar (DANE, Colombia).
We are also grateful to Mauricio Cardenas (Fedesarrollo) and Sebastian Edwards (University of California,
Los Angeles); to participants at the National Bureau of Economic Research workshop on Informality in
Bogota; to Hartmut Lehmann (University of Bologna and Institute for the Study of Labor [IZA]) and
Stefano Scarpetta (OECD); to participants at the World Bank/IZA Conference on Informality in Bertinoro;
and to participants at the annual conference of the Latin American and Caribbean Economics Association for
helpful feedback on background work for this report.
Finally, Patricia Da Camara, Catherine Russell, and Elena Serrano coordinated the report's publication
and dissemination activities, working closely with Dina Towbin, Andr�s Meneses, and Shana Wagger in the
World Bank's Office of the Publisher.
xiv
Abbreviations
ATE average treatment effect LDC least developed country
AUGE Acceso Universal para prestaciones integrales LSMS Living Standards Measurement Survey
y Garant�as Expl�citas (Plan of Universal MAROP Mecanismo de Ahorro para el Retiro
Access with Explicit Guarantees) Oportunidades
BONOSOL Bono solidario MIMIC Multiple Indicator�Multiple Cause
BPS Banco de Previsi�n Social Model
DANE Departamento Administrativo Nacional MPG Minimum Pension Guarantee
de Estad�stica OECD Organisation for Economic
ECINF Pesquisa Economica Informal Urbana Co-operation and Development
EITC earned income tax credit OLF out of the labor force
ENAHO Encuesta Nacional de Hogares PASIS Pensi�n Asistencial
ENAMIN Encuesta Nacional de Micronegocios PNAD Pesquisa Nacional por Amostra Domicilios
ENEU Encuesta Nacional de Empleo Urbano PPP purchasing power parity
F-I formal to informal RN Renovaci�n Nacional
FONAHPO Fondo Nacional de Habitaciones RTS simplified tax regime
Populares SARE Sistema de Apertura R�pida de
FONASA Fondo Nacional de Salud Empresas
F-SE formal to self-employed SE-F self-employed to formal
GDP gross domestic product SENA Colombian Training Institute
ICBF Colombian Institute for Family Welfare SIMPLES Sistema Integrado de Pagamento de Impostos
ID identity e Contribucoes as Microempresas e Empresas
I-F informal to formal de Pequeno Porte
ILO International Labour Organization SME small and medium enterprise
IMSS Mexican Social Security Institute TT treatment on the treated
INEGI Instituto Nacional de Estad�stica, TU treatment on the untreated
Geograf�a e Inform�tica (National VAT value-added tax
Statistical Institute [Mexico]) WDI World Development Indicators
ISSSTE Social Security Institute for Mexican WFTC working families tax credit
civil servants at the federal level WGI Worldwide Governance Indicators
xv
OVERVIEW
Informality: Exit and Exclusion
There are two main types of activist reactions to discontent with organizations to which one belongs or with which one does
business: either to voice one's complaints, while continuing as a member or customer, in the hope of improving matters; or
to exit from the organization, to take one's business elsewhere. --Albert O. Hirschman (1981, p. 246)
I NFORMALITY HAS GAINED INCREASING analysis, we hope, will serve as a foundation for more effective
attention as a possible drag on growth and rising public policies.
social well being, and as a force corrosive to the
integrity of our societies. In fact, informality is not The raz�n de ser of the informal sector: Adding
especially higher in Latin America and the exit to exclusion
Caribbean than in other developing countries of similar per The report sees informality as a manifestation of the rela-
capita income, according to two popular measures (figure 1). tionships between economic agents and a state that the
However, given the long-standing negative connotations of economic literature should play an important role in reme-
informality--inferior working conditions, low-productivity dying market failures, coordinating the provision of public
firms, disrespect for the rule of law, to name a few--it is not goods, and maintaining a level and equitable playing field.
surprising that the rise in informality over the 1990s across Of the many lenses through which informal workers have
several measures (figure 2) is viewed with concern and as been viewed, the most influential lens has focused on their
meriting closer investigation. exclusion from critical state benefits or the circuits of the
This said, the mere fact that we need to employ multiple modern economy. This exclusion can be seen as occurring
measures of informality capturing distinct approaches to along three margins, or borders, between formality and
the sector suggests that we are not clear on exactly what it is informality. First, a long tradition in the labor literature sees
and what we should be studying. In all likelihood, we are segmentation in the labor market as preventing workers
dealing with several distinct phenomena under this conve- from leaving their holding pattern in informality and
nient, but arguably unhelpful, umbrella term. For a report taking jobs in the formal sector that offer state-mandated
on informality in Latin America and the Caribbean this benefits. Second, de Soto's (1989) seminal work argues that
clearly poses special challenges. Fortunately, recently avail- burdensome entry regulations prohibit small firms from
able data sets and the development of new techniques to crossing the line into formality and thriving. And, third,
analyze them have made possible more solidly grounded some larger firms faced with excessive tax and regulatory
analysis of the underlying heterogeneity and reasons for being burdens may remain partially informal as a defensive
of the sector, the factors driving its evolution across different measure and, as a result, they forgo potential growth and effi-
countries, and its social and economic ramifications. Such an ciency gains. This report finds that these exclusion factors
1
I N F O R M A L I T Y
FIGURE 1
Labor market informality and income per capita
Share of labor force not covered by a pension scheme Share of labor force self-employed
Percent Percent
100 60
90
50
80
70
40
60
50 30
40
20
30
20
10
10
0 0
0 0 0 0 0 0 0 0 0 0 0
5,000 10,000 15,00 20,00 25,000 30,000 35,00 40,000 45,00 5,000 10,000 15,00 20,00 25,000 30,000 35,00 40,00 45,00
2005 GDP per capita, purchasing power parity (PPP) adjusted 2005 GDP per capita, purchasing power parity (PPP) adjusted
Latin America Advanced countries Rest of the world
Sources: Loayza and Rigolini 2006; World Development Indicators 2006.
are indeed important, documents their negative impact on wages, may find that what they expect to get in the formal
productivity and welfare, and discusses some of the reforms jobs for which they are qualified does not outweigh the for-
necessary to mitigate them. gone current consumption or the greater flexibility and
However, the report also highlights a second lens earnings they may get as informal workers. This is espe-
through which to view informality. This lens is more akin cially true when they have social protection alternatives
to Hirschman's (1970) exit: many workers, firms, and fami- through access to universal or noncontributory programs,
lies choose their optimal level of engagement with the or through private means. Larger firms or skilled profes-
mandates and institutions of the state, depending on their sionals may decide to underreport their operations and
valuation of the net benefits associated with formality and incomes, balancing private gains from tax evasion with low
the state's enforcement effort and capability. That is, they detection risks resulting from poor enforcement.
make implicit cost�benefit analyses about whether to cross These two lenses, focusing, respectively, on informality
the relevant margin into formality, and frequently decide driven by exclusion from state benefits and on voluntary exit
against it. This view suggests that high informality results decisions resulting from private cost�benefit calculations, are
from a massive opting out of formal institutions by firms complementary rather than competing analytical frame-
and individuals, and implies a blunt societal indictment of works. First, individual countries differ greatly in history,
the quality of the state's service provision and its enforce- institutions, and legal frameworks, so exclusionary mecha-
ment capability. nisms may be more important in some and exit may be more
This view leads to important divergences with many important in others. Second, the informal sector is tremen-
popular stylized facts about the informal sector. Microfirm dously heterogeneous, and arguably, then, there is a contin-
owners with little intention or potential to grow may see uum in the relative importance of exclusion and exit among
insignificant benefits from engaging with unhelpful regula- individual workers and firms within countries. Third, in
tory and tax institutions. Interpreting Hirschman literally, some cases the two can be virtually indistinguishable. A
they take their business elsewhere, knowing that they will microentrepreneur concluding, through a cost�benefit
fall below the radar screen of enforcing authorities. analysis, that formality is not worth the high registration
Unskilled workers, who partially pay for social protection costs may be explicitly excluded or self-excluded--either
benefits directly and implicitly through lower formal way, the effect is much the same. A poor worker, excluded
2
I N F O R M A L I T Y: E X I T A N D E X C L U S I O N
FIGURE 2
Trends in informality, by various definitions
Self-employed workers: ILO (% of employed workers) Lack of pensions (% of labor force)
Colombia 1992�2005 17.3 Ecuador 1990�2004 12.8
Bolivia 1990�2000 6.9
Argentina 1992�2004 10.3
Dominican Republic 1991�2005 4.7
Nicaragua 1993�2001 8.1
Chile 1996�2005 0.1
Costa Rica 1990�2004 3.8
Costa Rica 1990�2005 1.4
Jamaica 1997�2005 2.3 Venezuela, R.B. de 1995�2004 3.8
Panama 1991�2005 2.4 Chile 1990�2003 2.7
El Salvador 1995�2004 2.7
Uruguay 1995�2004 2.2
Honduras 1996�2005 3.4
Colombia 1996�1999 0.6
Argentina 1996�2005 3.7
Brazil 1992�2002 0.5
Peru 1996�2005 6.9
Mexico 1991�2005 8.6 El Salvador 1995�2003 4.3
10 5 0 5 10 15 20 15 10 5 0 5 10 15
% of employed workers Percent
Informal workers: Productive definition Informal salaried workers: Legalistic definition
(% of employed workers) (% of salaried workers)
Venezuela, R.B. de 1989�2003 18.5 Argentina 1992�2005 11.9
Uruguay 1992�2004 7.0
Honduras 1992�2002 6.8 Venezuela, R.B. de 1995�2003 7.7
Panama 1995�2003 5.4 Brazil (metropolitan) 1992�2002a 6.2
Colombia 1996�2004 4.8
Peru 1997�2003 4.6 Nicaragua 1993�2001 5.9
Jamaica 1996�2002 3.4
Peru (metropolitan Lima)1990�2000 4.5
Dominican Republic 1996�2004 3.1
Paraguay 1997�2003 2.6 Mexico 1990�2004b 4.0
Mexico 1996�2002 2.4 Chile 1990�2003 1.1
El Salvador 1991�2003 2.2
Argentina 1995�2005 1.9 Ecuador 1994�1998 0.7
Bolivia 1997�2002 1.5 Brazil 1990�2003 0.8
Ecuador 1994�2003 1.1
Costa Rica 1992�2003 0.4 Paraguay 1997�2003 0.9
Nicaragua 1993�2001 0.9 Colombia 1996�1999 2.4
Brazil 1992�2003 3.3
Chile 1990�2003 5.2 El Salvador 1991�2003 12.0
10 5 0 5 10 15 20 15 10 5 0 5 10 15
% of employed workers % of salaried workers
Sources: Gasparini and Tornarolli 2006; International Labour Organization (ILO) Labor Statistics Database 2006;
World Development Indicators 2006.
Note: Although global data is available only for the definitions of informality as self-employed workers and workers not covered by a pension
scheme, two other measures are calculated here based on regional data sources. In the "productive" definition, a worker is considered informal
if he or she is unskilled self-employed, a salaried worker in a small firm, or a zero-income worker. In the "legalistic" definition, a salaried worker
is informal if he or she does no have the right to a pension linked to employment upon retirement.
a. Percent of workers without carteira (work card).
b. Based on the balanced panel sample (common municipalities) for the period 1990�2004.
from health care services because he or she lives in a remote can play different roles across different dimensions: a
rural area or a poor urban neighborhood, may see little point microfirm owner unlicensed because of high registration
in being formal and paying labor taxes for services to which costs may be de facto excluded from desired formal credit
he or she has no access. circuits while opting out of contributing to poorly designed
Finally, informality is a multidimensional phenomenon: state pension funds on behalf of his or her workers. The
agents interact with the state along some dimensions and findings of the report indeed support the use of both lenses
not others, creating a large gray area between the extremes to fully understand and address the causes and consequences
of full compliance and noncompliance. Exit and exclusion of informality in the Latin American and Caribbean region.
3
I N F O R M A L I T Y
Workers: A mix of opting out and exclusion significantly in both their motivations and their relative
This report examines informal labor using the vast set of levels of job satisfaction.
regular household surveys conducted in most countries First, on average, independent workers--the self-
of the region, together with recent special modules on employed or those owning microfirms--in the countries
informality collected by statistical agencies in Argentina, surveyed (with the exception of Colombia) report being as
Bolivia, Colombia, and the Dominican Republic, in well-off as they would be in jobs they are qualified for in
collaboration with the World Bank and line ministries. the formal sector. As a consequence, the majority are not
The analyses shed light on the characteristics of informal looking for formal jobs. Most of these informal workers
workers, their motivations, and their preference for the appear to choose their occupations according to their indi-
benefits and nonpecuniary characteristics of jobs (for vidual needs (especially their desire for flexibility and
example, flexibility, autonomy, stability, mobility) by autonomy) and abilities (their comparative advantage in
examining their remuneration, self-rated welfare, and job terms of entrepreneurship). In fact, when asked, a majority
satisfaction. The findings (summarized in box 1) show of workers state that they prefer the independence of being
great heterogeneity within and across countries. They also self-employed. In Mexico, they were overachievers in
indicate, however, that the informal sector can generally salaried work, earning relatively high wages, given their
be thought of as comprising two large groups who differ human capital. Many women, in particular, report forgoing
BOX 1
Informal workers in Latin America and the Caribbean: Their profile, motivations, earnings, and welfare
Who are the informal?
Informal employment encompasses a diverse range of
FIGURE 1. B.1
people. While the report considers numerous common
Distribution of informal workers in urban areas contributing to
criteria to define informal employment, it focuses on the a social security system in Latin America
social protection definition. Based on whether the job is a
Percent
salaried relationship and unregistered with social secu-
80
rity, informal employment accounts for 54 percent of
70
total regional urban employment and it comprises two
60
groups: (1) informal independent workers, making up
50
24 percent of total urban employment (ranging from
40
20 percent or less in Argentina, Brazil, Chile, and
30
Uruguay to more than 35 percent in Bolivia, Colombia,
20
the Dominican Republic, Peru, and the Rep�blica
10
Bolivariana de Venezuela), and (2) informal salaried
0
workers who account for roughly 30 percent of total
05 1
regional urban employment and more than half of all 2003 2004 2003 20 2003 2003 2002 2006 2002 2006 200 1998 2005 2002
de ia
Peru
informal work (ranging again from 17 percent in Chile to Chile Brazil lvadorR.B. Mexico
Uruguay Sa Republic EcuadorBoliv
Argentina
El Guatemala
Colombia
Nicaragua
more than 40 percent in Bolivia, Ecuador, Guatemala,
Mexico, Nicaragua, Paraguay, and Peru) (figure 1.B.1) Venezuela, Dominican
The informal independent work sector includes
Informal salaried Informal independent
microfirm owners and self-employed professionals, as well
as artisans, handymen, construction laborers, taxi drivers, Source: Author's estimates, based on household surveys.
and street vendors. The informal salaried work sector Note: In Ecuador, Mexico, and Rep�blica Bolivarina de Venezuela,
coverage of independent workers is proxied by having a tertiary
largely comprises domestic employees, unpaid family education. Argentina denotes Greater Buenos Aires.
4
I N F O R M A L I T Y: E X I T A N D E X C L U S I O N
workers, microfirm workers, and those who work in larger still significant for many of the people in this subsector
firms under informal labor arrangements. The characteris- (for example, youth and unpaid family workers). Infor-
tics more strongly correlated with informal employment mal workers state they do not contribute to social
are firm size (10 employees or fewer), education (comple- security and health insurance plans mainly because of
tion of schooling below the secondary level), industry low incomes and also because of their employer's deci-
sector (construction, agriculture, retail, and transport), sion not to offer benefits (in the case of most informal
tenure (less than one year), age (youth predominantly infor- salaried workers); because they lack information on the
mal salaried, self-employed mostly older workers), and benefits and functioning of social protection programs;
women's household status (married women with children). and, in the case of health care, because they resort to
other means of coverage, including coverage through
What are their motivations, earnings, and welfare? other family members and universal services.
Evidence from workers' patterns of mobility, reported For both groups of informal workers, there is sub-
motivations, and self-rated welfare and job satisfaction stantial heterogeneity of motives and demographic
indicate that (1) the majority of independent workers characteristics. For instance, in Argentina, the informal
(approximately two-thirds) entered their jobs voluntar- self-employed report being as well-off as formal salaried
ily, attach significant value to the nonpecuniary benefits workers, but the informal salaried appear worse-off (fig-
of autonomous work, and choose to "exit" formal social ure 1.B.2); in the Dominican Republic, both informal self-
protection systems; (2) on the contrary, the majority of employed and in-formal salaried workers are as well-off as
informal salaried workers appear to be excluded from formal employees (figure 1.B.2); and, in Colombia, both
more desirable jobs, both as formal salaried and as informal groups report much lower levels of satisfaction
independent workers, although voluntary motives are with current jobs.
FIGURE 1. B.2
Impact of informality on self-rated poverty
Argentina Dominican Republic
Propensity to self-rated poverty Propensity to self-rated poverty
Independent Independent
large firm large firm
Independent Independent
formal salaried formal salaried
Independent Independent
permanent contract permanent contract
Microfirm worker Microfirm worker
large firm large firm
Informal salaried Informal salaried
formal salaried formal salaried
Temporal salaried Temporal salaried
permanent contract permanent contract
0 0.5 1.0 1.5 2.0 0 0.5 1.0 1.5 2.0
Odds ratio Odds ratio
Source: Ar�as and Luchetti (2007), based on household surveys, 1997 and 2004.
Note: Self-rated poverty is based on household survey responses.
5
I N F O R M A L I T Y
formal salaried work to better balance home and work counterparts, about one-third of the self-employed (over
responsibilities. half in Colombia) appear to be so largely involuntarily;
Moreover, even though the desired flexibility associ- they would prefer formal jobs.
ated with self-employment and microfirm ownership is There is also considerable variation across countries in
often associated with low income and little security, those the plausible causes of job segmentation for those groups
jobs are still considered better options than the corre- of informal workers who report being involuntary. For
sponding jobs that the workers could get in the formal example, in Brazil, Colombia, and Peru, the evidence
economy, given their minimal human capital, access to points to an impact of increasing labor costs and rigidities
other assets, and the low aggregate productivity in the on the expansion of informality in the 1990s. In other
economy. In other words, many self-employed workers countries, such as Argentina, the introduction of tempo-
opt for informality because their options in the formal rary contracts and subsequent weakened enforcement of
sector are at least equally poor. Furthermore, they have tax and labor regulations seem to have played a role in the
the possibility of using informal mechanisms or freely observed increases in the share of the labor force without
available (noncontributory) social protection programs to social security contributions. In most countries, trade
substitute, in part, for formal social security benefits that liberalization appears to have had modest or no effects on
they would otherwise have to pay for, explicitly or implic- informality trends.
itly, via (sometimes steep) payroll taxes. In summary, The presence of both exit and exclusion factors in
most of the self-employed do not appear to be "excluded" informal labor markets--apparent in informal workers'
from the formal sector; rather, after implicitly making a subjective motivational responses and self-rated welfare
cost�benefit analysis, they opt out of formality. measures reported above--is corroborated by the
A different picture emerges, however, for the majority observed patterns of labor market dynamics, an important
of informal salaried workers in the countries studied. analytical tool introduced in this report. Indeed, evidence
Indeed, most of the informal salaried appear to be queuing from Mexico (figure 3), suggests that, during good times,
for more desirable jobs in either the formal salaried sector the number of workers who leave the formal sector to
or as self-employed workers (with Mexico and the Domini- become self-employed or take an informal salaried job is
can Republic being notable exceptions). For many of these nearly equal to or sometimes even greater than the num-
workers, informality largely reflects the decision of the ber of those who transit from the informal to the formal
firms for which they work, especially microenterprises, to sector. This is a major piece of evidence supporting the
operate outside the realm of government regulations. view of integrated labor markets in which workers are
On average, these workers are not choosing to opt out of freely choosing between formal and informal jobs.
formal contracts and social security institutions, and they
would much prefer an equivalent job in the formal sector.
In these cases, exclusion rather than exit from formality
FIGURE 3
appears to be the driving force behind their present
Probability of transition between formal salaried and
informal status. self-employment in Mexico
However, considerable heterogeneity exists even within
.08
these two subsectors of the informal sector, with both
.18
voluntary and involuntary entrants and a great variety of .07
Formal to
.16
workers' life trajectories found in each. For example, self-employment
.06 (left scale)
while, on average, salaried workers in microenterprises .14
appear to want a formal sector job or self-employment, .05
.12
approximately half of the employees of Mexican microen- Self-employment
.04
to formal .10
terprises turn out to be unpaid family members whose (right scale)
.03 .08
presence in the sector probably reflects a mix of profes-
1987q1 1991q1 1995q1 1999q1 2003q1
sional and personal considerations. Similarly, while, on
Source: Bosch and Maloney 2006.
average, independent workers are as well-off as their formal
6
I N F O R M A L I T Y: E X I T A N D E X C L U S I O N
However, although initially following a pattern similar to informal salaried work is a point of entry to the labor mar-
that of Mexico, after the constitutional reform in Brazil ket for many of the young, and, as they accumulate experi-
the flows from informal to formal salaried employment ence or simply queue, they are more able to find a job in the
became significantly lower than the flows in the reverse formal sector or fulfill a surprisingly common desire to be
direction even in boom times--suggesting a significant self-employed. Informal salaried employment is also an
degree of market segmentation. Consistent with the liter- option for many older workers who lack the skills or capital
ature focused on the U.S. economy, it is also true that for- to become self-employed or get a formal salaried job, or
mal sector hiring comes almost to a halt during bad who opt out of informality because, for example, they will
times, perhaps reflecting more binding downward wage never accumulate enough years to secure a meaningful pen-
rigidities. Hence, many entrants have no choice but to sion. The fact that participation in self-employment rises
join less desirable occupations in the informal sector. As a with age is, again, similar to that of the United States, and
consequence, the performance of labor markets is asym- similarly may be partly explained by voluntary entry
metric throughout the business cycles in most countries: delayed by credit or human capital constraints.
labor markets tend to behave more as segmented markets The findings discussed above have critical implications
during downturns and recessions, and more as integrated for policy design. Whether because of outright exclusion
markets during booms. and market segmentation or massive voluntary opting out
Finally, both the more exclusionary and exit dimensions of formality, informality may lead to a suboptimal social
of informal salaried work are suggested by workers' life- equilibrium in which many workers go unprotected from
cycle employment trajectories. In most countries, young health and employment shocks and from poverty in old
workers, especially the less educated, are more likely to be age. In either case, the imperative for reform is strong.
informal employees than formal salaried workers, and very However, our findings caution against one-size-fits-all
few are informal self-employed. Meanwhile, middle-aged solutions. Again, whereas labor markets in Mexico and the
and older workers are more likely to be found in the formal Dominican Republic show a high degree of integration--
sector or to be self-employed, although many still end up for example, most informal workers choose to be
as informal employees (see figure 4). This suggests that informal--except, perhaps during crises--labor markets in
Argentina, Colombia, and, to a lesser extent, Brazil show
many signs of segmentation. Thus, it is very useful to clar-
ify the relative importance of alternative drivers of infor-
FIGURE 4
Rate of urban employment across sectors, by age in Brazil, 2002 mality so that strategists may devise the most suitable
policy changes.
Percent
50 For example, if labor informality were essentially
45 driven by inadequate labor legislation leading to labor mar-
Formal
40 ket segmentation, then the key to reducing informality
35 would be to engage in (politically demanding) labor market
reform. If, however, expected low benefits and high costs of
30
Self-employed social security contributions relative to other forms of
25
protection against shocks are prominent in driving many
20
workers to opt for informality, reform of the design and pro-
15
vision of social protection benefits must be an additional
10
Informal component of the policy package to reduce informality.
5
Indeed, this report finds that there is significant room for
0
15 19 23 27 31 35 39 43 47 51 55 59 63 67 improvements in the area of social protection program
Age design (box 2). Further, when considering the case of infor-
Sources: Cunningham et al. 2007; author's estimates, based on mal salaried workers, it is also key to understand and
Pesquisa Mensal de Emprego, September 2002.
address the factors that lead firms to be partially or entirely
Note: Considers the availability of a carteria de trabajo.
informal, as we discuss in the next section.
7
I N F O R M A L I T Y
BOX 2
Government failures in the design of social protection systems in Latin America and the Caribbean
There are high human costs associated with the lack of rise to benefits for many formal sector (or potential
access to appropriate risk management instruments, such formal sector) workers.
as health insurance and old-age security. In addition, � Rigid, one-size-fits-all approaches to mandated social
missing insurance markets and other market failures-- security programs: For example, spouses and sec-
such as negative externalities associated with the absence ondary household workers who opt to enter formal
of health treatment or unsupported poor elders--create a employment generally would have to pay for
clear rationale for public intervention to ensure basic health coverage to which they already have a right
access to social protection. Therefore, a key challenge fac- through the household head's affiliation. This dou-
ing policy makers in Latin American and Caribbean coun- ble payment for a single benefit creates a powerful
tries is to ensure that their citizens have suitable access incentive to choose informal jobs. Furthermore,
to social risk management instruments, even in the face social security systems rarely account for different
of significant informality in the region. However, ill- needs and preferences among workers at different
designed interventions actually may serve to make things stages of the life cycle, and, as a consequence, high
worse. They not only hinder people's ability to access basic initial payroll contributions create a significant dis-
services or to manage risk, but also distort economic incentive for young workers who have other invest-
incentives that may have adverse effects on productivity ment priorities (such as education and housing) to
and long-term economic growth, for example, by creating join the formal sector
strong incentives for many workers to remain informal. � Weak accounting for workers' mobility into and out of the
Indeed, in Latin America and the Caribbean there is formal sector during their careers and across their life
ample evidence of "government failure" in the design and cycles: In particular, lengthy pension vesting periods
implementation of social protection, and that failure needs make many workers ineligible because of the high
to be addressed as part of any actions to strengthen risk mobility between formal and informal sectors, and
management among the region's citizenry. This report thus creates, ex ante, a major disincentive to choos-
documents these issues in detail. At the level of specific ing formal jobs. Furthermore, lack of portability
programs, design problems raise the costs of participating often leads to intermittent health insurance cover-
in social security, relative to the benefits of participation, age gaps for workers who shift from formality to
causing some workers to opt out of the system. Design informality and vice versa.
deficiencies also impede some workers' access to benefits.
Moreover, recent efforts of a number of governments in
At the level of social protection systems--the constellation
the region to use noncontributory or subsidized assistance
of contributory social security and noncontributory social
programs to compensate for low social security coverage
assistance schemes--programs often compete, creating
inadvertently may have complicated the quest to
adverse labor market incentives and outcomes.
provide effective social protection to a broader swath of
Among the key weaknesses in the design of the
the region's population. Indeed, the evidence suggests
region's social security programs we find the following:
that programs offering informal workers services on a
� High payroll contributions relative to the expected bene- noncontributory or highly subsidized basis actually may
fits and quality of service: Evidence shows that high "compete" with formal social security programs that
contributions can act as a disincentive to formal workers have to pay for through payroll tax contributions,
employment. thereby creating additional incentives for informality.
� Excessive "bundling" of multiple benefit packages: For Addressing these design weaknesses will be important
example, packages in some countries include not not only to ensure broader access to effective risk man-
only health care, worker risk, life insurance, and agement instruments by the citizens of Latin America
pensions, but also housing, child care, and sports and the Caribbean, but also to make social protection
and recreation. Some of these components represent programs consistent with increased productivity and sus-
"pure taxes" rather than contributions that give tained economic growth in the future.
8
I N F O R M A L I T Y: E X I T A N D E X C L U S I O N
Firms: Little gain, high costs, formality can be seen as an input in the production process
or weak enforcement? for which small firms have little need. Formality increases
Labor informality is primarily a small firm phenomenon rapidly with firm size and productivity. As an example,
with the vast majority of workers who are unregistered whereas 86 percent of Mexican microfirms with only one
with social security administrations found in firms of paid employee do not pay social security contributions,
fewer than five workers (figure 5). Hence, understanding 71 percent of those with five paid workers report paying
the rationale behind small firms' decisions to register their social security for at least some of their employees.
firms and their workers, to pay taxes, and so forth is funda- In Brazil, 76 percent of microfirms do not have an operat-
mental to understanding the phenomenon of informality. ing license and 94 percent do not pay taxes. Those rates
The report shows that, in nature and dynamics, these fall to 33 and 23 percent, respectively, among firms with
microfirms are closely related to their advanced-country five paid workers.
counterparts and should not be treated as a pathology pecu- However, the large majority of microfirms remain too
liar to developing countries. As figure 6 shows, the patterns small to benefit sufficiently from formality to overcome its
of entry, exit, and participation in self-employment are various costs. In Brazil, for instance, 87 percent of all
very similar, suggesting that the high levels of self-employ- microfirms have no paid employees. In Nicaragua, less than
ment seen in figure 1 may not reflect a fundamentally dif- 7 percent of microfirms have more than two employees
ferent phenomenon but simply much more of it. This may after three years of operation. Most of these firms have no
arise precisely because the lower labor productivity of the potential to grow (turnover is extremely high in this sub-
formal sector in developing countries implies a lower sector), and thus their credit needs may be marginal. They
opportunity cost of participating in independent work, have a limited number of clients and with most of those
which worker surveys suggest is as highly regarded in Latin clients they have personal relationships, so they would not
America and the Caribbean as it is in countries of the benefit much from greater access to the organized imper-
Organisation for Economic Co-operation and Development sonal markets and courts usually associated with formality.
(OECD). It is not surprising that a survey of informal Mexican
In this light, although a sizable body of literature microfirms reveals that nearly 75 percent of the microfirms
sees these firms' lack of registration with the authorities report the main reason for not registering with the author-
through an exclusionary lens, this report argues that ities is that they are just too small to make it worth their
FIGURE 5
Informal workers across firm size
Argentina (Greater Buenos Aires) Mexico (urban areas)
% informal and self-employed workers % informal and self-employed workers
50 50
1980
45 45
2004
40 40
35 35
2003
30 30
25 25 1994
20 20
15 15
10 10
5 5
0 0
1 2�5 6�25 26�100 101�500 501 1 2�5 6�10 11�15 16�50 51�100 101�250 250
Firm size (number of workers) Firm size (number of workers)
Source: Author's calculations, based on Encuesta Nacional de Empleo Urbano (Mexico) and Encuesta Permanente de Hogares (Argentina).
9
I N F O R M A L I T Y
FIGURE 6
Male entry into and exit from self-employment
Mexico United States
Percent Percent
60 60
50 Self-employment rate 50
40 40
Exit rate Exit rate
30 30
20 20
Entry rate Self-employment rate
10 10
Entry rate
0 0
20 35 55 �65 �65
18� 21�25 26�30 31� 36�40 41�45 46�50 51� 56�60 61 18�20 21�25 26�30 31�35 36�40 41�45 46�50 51�55 56�60 61
Age Age
Sources: Evans and Leighton 1989; Fajnyzlber, Maloney, and Rojas 2006; and author's calculations, using Encuesta Nacional de Empleo Urbano.
while. In contrast, only 2, 8, and 4 percent of surveyed The firm-level evidence reported here presents a mixed
firms, respectively, answer that the main reason is the high record on the above hypotheses. The microfirm evidence
costs and time required to register or the high costs of oper- suggests that firms choosing to register do have better per-
ating as registered businesses. The same appears true in the formance or, alternatively, the firms that started operations
Dominican Republic, although prohibitive registration red being registered exhibit, on average, higher levels of labor
tape seems to be of greater import in Argentina. In most productivity than their equivalent unregistered peers. In
cases, the degree of formality increases with firm size, sug- particular, programs in Brazil and Mexico to reduce the
gesting that as firms grow, their demand for the services costs of becoming formal have had a positive impact on the
associated with formal institutions increases, as does the performance of those firms that decided to cross the frontier
probability of detection by authorities. from informality to formality. The evidence on the effect of
Having so much of the workforce in microfirms and these programs on the aggregate levels of informality and
having so many of these microfirms unplugged from the productivity through time remains inconclusive (as will be
formal economy in all likelihood extract some productivity discussed in chapter 6). Further, evidence from the invest-
costs. First, there may be scale economies or externalities ment climate reports suggests that firms surrounded by
arising from employment in large firms. To the extent that complying firms have higher rates of productivity. How-
informality is associated with a preponderance of small ever, there is evidence that, in some cases, informality
firms and that increasing returns to scale are relevant for reflects defensive evasion of possibly excessive regulation.
their size range, informality could lead to considerable effi- All evidence considered, the report concludes that
ciency losses. Second, unfair competition from informal tilting the cost�benefit analysis toward formality for a sub-
firms could slow down the process of creative destruction stantial percentage of informal firms requires a fair combi-
by which inefficient firms are replaced by their more nation of "carrots" and "sticks." As an example, in Brazil
efficient competitors, and could negatively affect the and Mexico, microfirms constrained at the frontier coexist
incentives of formal firms to innovate and adopt new tech- with entrepreneurs who show no demand for the presumed
nologies. Third, if reducing the costs and increasing the benefits of formality and for whom reducing registration
benefits of formality allow previously informal firms to costs would not lead to formalization under present condi-
gain increased access to markets and services, the result tions. Similarly, evidence for the Dominican Republic sug-
could be increased aggregate productivity growth. gests that many informal firms perceived more gains from
10
I N F O R M A L I T Y: E X I T A N D E X C L U S I O N
staying under the state radar, including not only the tax have a significant number of employees without social secu-
savings but also the avoidance of interaction with the state rity contributions, and the fraction of underreported sales for
bureaucracy altogether. Further, a large fraction of firms tax purposes is quite high--even as high as in small firms, in
that become formal allegedly do so to avoid fines and some cases (see figure 8). Firms again appear to undertake a
bribes, according to surveys of many countries in the region careful cost�benefit analysis, weighing the "private" benefits
(see figure 7). Thus, interventions to address regulatory
constraints faced by small firms or to reduce tax rates
might not be enough to achieve a major change in their FIGURE 8
Underreporting of tax and social security contributions, by firm size
levels of formality. Such a goal would also require improv-
ing the positive incentives for joining the formal sector, Number of employees
including improvements in private and public services 5
6�10
available to formal firms (for example, credit, contract 11�20
Panama
21�50
enforcement, technical assistance, and the like), and 51�99
enhancing the level of enforcement to increase the opportu- 100
5
nity cost of remaining informal. 6�10
11�20
Nonetheless, the low aggregate productivity in the for- Brazil
21�50
mal sector would put some limits on the overall effect of 51�99
100
even well-designed, integrated programs to induce infor- 5
6�10
mal firms to become formal. Hence, a large chunk of the 11�20
Mexico
efforts to reduce informality must focus on policies to 21�50
51�99
enhance productivity and growth in the formal sector, 100
5
which would increase the perceived benefits of formality, 6�10
along with the opportunity cost of remaining informal. 11�20
Bolivia
21�50
Finally, in many countries in the region, even large firms 51�99
100
show considerable tax evasion and labor informality. They 5
6�10
11�20
Argentina
21�50
51�99
FIGURE 7 100
Advantages of formalization reported by IFC-surveyed firms 5
6�10
11�20
Colombia
21�50
Avoid paying fines 51�99
100
Compliance 5
with the law 6�10
11�20
Uruguay
21�50
Avoid paying bribes
51�99
100
Gain new clients 5
6�10
11�20
Improved Peru
21�50
access to credit
51�99
100
Operation on
a greater scale 5
6�10
Legal power to 11�20
demand contracts Chile
21�50
is upheld 51�99
0 1 2 3 4 100
0 10 20 30 40 50
Mean of firms with no employees
Mean of firms with at least one employee Unreported sales Unreported workers
Source: Investment climate surveys 2006. Source: Investment climate surveys 2006.
11
I N F O R M A L I T Y
of informality (evading taxes, avoiding burdensome regula- As an example, most countries in the region are charac-
tions) against the "private" costs of informality (risk of terized by "truncated welfare systems," in which those in
penalties and bribes, imperfect access to markets and govern- the formal sector have access to an often generous multidi-
ment services) in choosing their "degree" of formality. mensional package of social security, while those in the
Administrative and tax simplification programs to reduce informal sector have much more limited access to govern-
red tape and compliance costs, regulatory reviews aimed at ment benefits or formal risk management instruments. Not
eliminating laws and regulations that are either anachronis- only has overall progress in increasing social security cover-
tic or privately motivated, and enhanced enforcement are the age been slow in the region, but coverage has actually
key policy responses with respect to the phenomenon of declined in a number of countries throughout the 1990s.
partial informality within large firms. And, in nearly all countries in the region, coverage rates are
significantly lower among low-income than among high-
Need for more effective income workers (see figure 9). Indeed, in many countries
and legitimate institutions the poorest workers and families are practically excluded
Whether informality is an outcome of exclusionary policies from the system. At the same time, although independent
or mechanisms, or a result of cost�benefit decisions by workers can choose to participate in formal social security
firms and individuals that lead them to opt out of formal systems in many countries, very few do it voluntarily.
institutions, it represents a fundamental critique of the Actually, there is evidence that many workers opt out from
Latin American state at several levels. In the burdensome the system once they obtain the right to a minimum pen-
business and labor market regulations, as with the poorly sion (see Gill, Packard, and Yermo 2004).
designed social protection systems, the state is complying The underperformance of Latin American and Caribbean
inadequately with its designated roles. This failure, in con- states may reflect deeper, poorly resolved social tensions that
junction with an abiding lack of confidence in who the may be thought of as constituting a dysfunctional underly-
state represents and serves and in its capacity to enforce the ing "social contract"; in Hirschman's terms, the lack of voice
law, may intensify the tendency of many Latin Americans-- and loyalty. Beyond high informality, this can also be seen
perhaps no more or less than citizens of other emerging in the inability of the state to redress the long-standing
regions--to opt out, rendering the fulfillment of the funda- high inequality, in the weak rule of law, in the sometimes
mental roles of the state all the more difficult. large share of undocumented citizenry, or in the recurrent
FIGURE 9
Economically active population contributing to the pension system
Percent
100
Poorest quintile Second quintile Middle quintile Fourth quintile Wealthiest quintile
90
80
70
60
50
40
30
20
10
0
Peru Colombia Mexico Argentina Chile
Sources: Adapted from Rofman and Lucchetti 2006.
Note: Estimates based on national household surveys from the following years: Peru (2003), Colombia (1999), Mexico (2002),
Argentina (2004), and Chile (2003).
12
I N F O R M A L I T Y: E X I T A N D E X C L U S I O N
(tax privileges and loopholes, weak competition laws, and
FIGURE 10
cumbersome regulations). Those inefficiencies lead to low
Informality versus inequality
tax collections and the abuse of monopolistic power, and they
% of population without a pension further erode state legitimacy and its capacity to provide
40
public goods and services and to enforce the law. Some recent
PER
20 ECU ARG literature has focused on the possibility that Latin America is
MEX PARBOL
NIC DOM GUA
locked, in fact condemned, to a bad social equilibrium where
VEN HON
BRA
0 URU SAL
entrenched elites have no interest in responding to the voiced
COL
petitions of those seeking full participation.
JAM CHI
20 COS
PAN
However, this report is more optimistic about the possi-
40 bilities for incremental reform, despite acknowledging the
vital importance of enhancing the legitimacy of the state.
60
Ironically, this conclusion partly emerges from the study of
coef .72, t 3.5 the distressing increases in informality in many countries
80
20 10 0 10 20 of the region over the 1990s. These increases can be traced
Gini coefficient partly to sharp increases in real minimum wages in some
Source: Author's estimates, based on World Development countries, inadequate macroeconomic policies (that led to
Indicators 2006.
Note: Figure shows partial correlations controlling for GDP artificial booms in nontradable, highly informal sectors) in
per capita at PPP. some countries in the early 1990s, changes in labor market
and social security legislation or weakened enforcement
bouts of macroeconomic instability. For example, high capabilities, and to the increased availability of noncontrib-
inequality of incomes and power is correlated with infor- utory social protection schemes for informal workers. In the
mality (see figure 10) and is often associated with weak meantime, poorly designed social security systems continued
institutions and state capture by both elites and organized to tax heavily workers in the formal sector. Indeed, if infor-
segments of the middle class (see de Ferranti et al. 2004; mality increased in many countries during a decade that
Perry et al. 2006). State capture leads to the generalized per- exhibited modest growth due at least partially to a combi-
ception that the state is run for the benefit of the few, and nation of policy missteps, then a shift toward better policies
thus it reinforces a social norm of noncompliance with taxes at least can reverse these upsetting trends. Furthermore,
and regulations, what might be dubbed a "culture of infor- although it appears that inequality and informality share
mality." Noncompliance is then further compounded by the important causal determinants, Chile shows that strong
suspicion that others are not complying either--an absence and more fair institutions and a fall in informality can be
of what is termed "strong reciprocity--which, in turn, built even in the midst of high income inequality. Quoting
makes enforcement even more difficult." As an example, Hirschman (1971) again, we find a "bias for hope"--good
in the Dominican Republic, 19 percent of small firm owners policies can have important effects.
report that they do not register or contribute to pension
systems because "businesses like them don't." Summing up: Policy implications of the report
At a more aggregate level, after controlling for per capita Achieving significant reductions in present informality
income, informality is negatively correlated with "tax levels will require, first and foremost, actions to increase the
morale"--society's disposition toward tax compliance-- aggregate productivity in the economy. A more enabling
which, in turn, depends inversely on perceptions of investment climate will permit formal firms to expand and
"state capture" (see figure 11) and positively on perceptions pay higher wages. Raising human capital levels, especially
of the quality of public spending. Furthermore, informality for the poor, will permit more workers to find remunerative
measured as the share of the workforce in self-employment is jobs in a more dynamic formal sector. Without such
negatively related to the quality of institutions, as indicated improvements in aggregate productivity, we will continue
in figure 12. This suggests that greater exit to independent to find a very large number of microfirms, characterized by
work accompanies higher distrust of the state. Inequality high turnover, weak growth prospects, and low productiv-
and its correlates then lead to inefficient laws and regulations ity, that would see little benefit in engaging with formal
13
I N F O R M A L I T Y
FIGURE 11 FIGURE 12
Tax morale and state capture Self-employment and quality of institutions (governance)
Tax morale Share of self-employed
0.2 0.3
COS
SAL GUA
0.2
0.1 PAR
BRA
NIC
HON
COL ARG 0.1 VEN
BOL
PER COL
HON
0 CHI GUA JAM
CHI
0 BRA PAN
ECU MEX COS
MEX ARG SAL
URU
PAN
0.1 ECU BOL
PER 0.1
coef .07, t 4.7
coef .88, t 2.8 0.2
0.2 1.5 1.0 0.5 0 0.5 1.0 1.5
0.15 0.10 0.05 0 0.05 0.10 0.15 Government effectiveness
State capture
Sources: Author's estimations, based on World Development
Source: Author's estimates, based on data from World Indicators; Worldwide Governance Indicators, World Bank 2005;
Development Indicators 2006 and Latinobar�metro 2004. and investment climate surveys, 2005.
Note: Figure shows partial correlations controlling for GDP Note: Partial correlations controlling for GDP per capita at PPP.
per capita at PPP. State capture is proxy by an indicator of the Government effectiveness index measures the quality of
perception about the economy being run according to the interests public service provision, the bureaucracy, the competence of civil
of a few. To construct the indicator we ask: In general terms, would servants, the independence of the civil service from political
you consider that the country is governed according to the interests pressures, and the credibility of the government's commitment to
of a few, or is it governed for the benefit of the country? policies. Higher values correspond to a more effective government.
institutions. Without generalized improvements in human labor market segmentation, as evidenced in most countries
capital, many unskilled workers would continue to prefer at least during some periods, need to be reduced. We dis-
self-employment, even if their earnings are low, because the cuss below some policy changes that may be especially
jobs they could find in the formal sector would also deliver promising in particular circumstances.
very low earnings. Such improvements in human capital Achieving a deeper change in incentives also requires
have to be synchronized with those in the investment actions to change the pervasive culture of noncompliance
climate, as stressed in previous studies (particularly, de that we observe in most countries in the region. Because
Ferranti et al. 2003), because otherwise the demand for such social norms are, in part, the result of a lack of trust in
more skilled workers will not grow at the same speed as the effectiveness of the state and the equity of its actions,
the increase in supply--thereby depressing skill premiums overcoming the culture of informality probably requires
(for instance, to secondary education) and further eroding major improvements in the quality and fairness of state
incentives to invest in education. institutions and policies. In short, it requires building an
However, there are many things that can be done to effective and inclusive social contract in which the great
change the balance of incentives for those workers and majority of individuals feel compelled to participate and
small firms whose implicit cost�benefit estimates place comply with state mandates.
them close to the margin between formality or informality.
The same can be said of larger firms that remain partially
informal. To have a significant effect, such actions normally Reforming labor market policies to increase
require a good balance of carrots (reforms and actions to productivity of the formal and informal sectors
facilitate, reduce the costs, and increase the benefits of for- The findings of this report suggest that labor market poli-
malization) and sticks (enhanced, evenhanded enforcement cies are important determinants of informality, working
of such improved laws and regulations). Furthermore, those through three channels. First, excessive labor costs,
excessive regulations and taxes that create some degree of whether arising through labor legislation or unrealistic
14
I N F O R M A L I T Y: E X I T A N D E X C L U S I O N
union demands (such as exaggerated minimum wages, related government- or union-induced inflexibilities, may
severance costs, or labor taxes and contributions), depress have a disincentive effect on technology adoption, which
the number of jobs in the formal sector, often creating the accounts for up to half of the differences in levels of eco-
classic segmented market. Other recent reports from the nomic development. And, as shown in this report, the level
World Bank--"Minimum Wages and Social Policies: of economic development is the most important determi-
Lessons from Developing Countries" (Cunningham nant of observed informality levels.
2007b) and "Job Creation in Latin America and the Overall, the present constellation of often well-intended
Caribbean" (World Bank 2007)--as well as the Inter- but heavy-handed labor regulations poorly serves work-
American Development Bank (IDB) (2006) publication ers and firms, and both could benefit from substantial
Good Jobs Wanted, have investigated in detail the trade-offs reform. In particular, stronger enforcement of a redesigned
encountered in offering strong protections to some work- labor code that combines strengthened safety nets,
ers at the possible expense of excluding others (see also de well-designed worker protections, and worker representa-
Ferranti et al. 2001). Minimum wages in most countries tion with the flexibility that firms need to adapt in a global
are not extremely binding, but in some--such as Colom- economy has the potential to expand formal employment
bia--they seem to be a deeply segmenting force that begs and reduce opting out. Simply tightening the enforcement
for moderation. Higher non-wage burdens on formal jobs of existing laws, particularly in the largely informal
in Brazil, Colombia, and Peru appear responsible for sub- microfirm sector, may just eliminate jobs--many of which
stantial declines in formal employment. Further, the expe- the chapters in this volume will show to be of good quality
rience in the OECD countries suggests that such when measured by the worker's overall welfare. At the
regulations have a heavy exclusionary impact on young other extreme, attempting to reduce the weight of labor
people who are trying to find jobs and who, in Latin legislation by creating special classes of less protective con-
America and the Caribbean, are especially overrepresented tracts can be problematic. When well designed, such con-
among the involuntary informal salaried. Nor does the tracts may offer flexibility that helps young people enter
evidence of a very high degree of integration of the formal the market. However, they can often effectively create a
and informal sectors in some other countries in the region parallel, unregulated "formal" sector that displaces formal
necessarily imply satisfactory labor codes. Latin America's contracting. That can lead to higher job turnover and to
globally very high levels of severance costs, for example, diminished incentives for training and may contribute to
may substantially reduce job creation arising from growth the overall culture of informality. Provisions to accommo-
without necessarily segmenting the market. Furthermore, date different non-wage costs for smaller firms and flexibil-
as in the case of minimum wages, regulations sometimes ity in benefits plans (such as simplified health/pension
can be binding in practice for the informal salaried sector plans) may offer an extension of the overall rubric of labor
and may inhibit job creation there. protections without prejudicing the viability of these firms.
Second, legislation can create incentives for voluntary Perhaps more flexible work schedules, or enhanced avail-
informality. The design of social safety nets and labor legis- ability of day care, would keep more women in the formal
lation needs to consider a more integrated view of the labor sector, although care must be taken to avoid measures that
market, taking into account the cost�benefit analysis that might lead firms to discriminate against women in hiring
workers and firms make in deciding whether to interact as a result. Finally, institutional strengthening (staffing,
with formal institutions. High labor taxes or contributions training, technical assistance) of the labor ministries and
that do not correspond to benefits that workers value cause coordinating of relevant public agencies (social security
workers to opt out of the formal labor market. The difficul- administration, enterprise development agencies, and com-
ties of managing work and children under rigid formal petitiveness councils) are needed so that those ministries
work contracts also lead young mothers to opt for informal and agencies can assume their increasingly more complex
independent work offering more flexibility. role of facilitating labor productivity growth.
Third, the effect of labor market institutions on produc- Informality sharply decreases with education, partly
tivity growth has probably been underemphasized. Theory because the opportunity cost of being independent rises.
and anecdotal evidence suggest that excessive restrictions However, the substandard education and training systems
on job reallocation or destruction for just cause, or other in the Latin American and Caribbean region both impede
15
I N F O R M A L I T Y
the growth necessary to generate jobs in the more modern costs on society, there is a case for providing a package of
sector of the economy and reduce workers' attachment to minimum essential direct cover, de-linked from the labor
it. Furthermore, the poor signaling of education quality contract and financed through general taxation. In the case
that results from a lack of uniform certification or accredi- of old-age security, there is also a case to provide essential
tation impedes the entry of young workers into formal cover in the form of a poverty prevention pension targeted
jobs. Remedying these failures, perhaps along with an toward the poor as part of a broader multipillar pension
expansion of intermediation services, may reduce the system that includes provisions for individual retirement
information asymmetries that young workers face. Further savings. The social costs associated with people falling into
discussion of necessary reforms in this area is offered in the poverty in old age create a clear risk management rationale
regional report "Raising Student Learning in Latin for providing minimum old-age support de-linked from
America and the Caribbean: The Challenge for the 21st the labor contract; nonetheless, the high probability of
Century" (Vegas and Petrow 2007). Ongoing upgrading of income loss in old age suggests that saving should play the
the workforce through training, particularly in rapidly main role in earnings replacement during old age.
evolving industries, is a central element of the national For a number of reasons, including those related to fiscal
innovation system, and is critical to developing skills and institutional capacity, movement to provide essential
used in the modern sector of the economy and to promot- cover in health care and old-age security, de-linked from
ing productivity growth. Training systems in the region, the labor market and financed by general taxes, represents a
however, need to be more competitive and responsive to long-term agenda for many countries in the region. It is
market demands. important, therefore, for countries to orient their short-to-
In sum, the high rate of informal employment in some medium-term policy agendas in ways that are consistent--
cases reflects classic segmentation, but in others it simply or at least not inconsistent--with their long-term vision.
reflects the high costs and small benefits of employment in This will be critical if the region's governments are to
the formal sector. Labor regulations need to allow for pro- ensure that the objectives of social policy--and particularly
ductivity growth in both sectors, while revisiting the social risk management--are well aligned with those of
design of regulations and social protection systems that higher productivity and growth.
provide incentives for firms and individuals to become To this end, there will be high returns to governments
informal. in the region undertaking step-by-step reforms to improve
the efficiency of existing programs as well as to establish
Reengineering social protection to cover greater consistency and incentive compatibility across pro-
all citizens grams. Several sets of actions will contribute to short-term
Central to this agenda is the need to rethink and, in fact, improvements in social protection while moving countries
reengineer social protection policy and programs in much in the direction of achieving essential cover over the long
of Latin America and the Caribbean. Poor access to basic term. These actions would include efforts to improve the
risk management instruments, coupled with poor design of cost�benefit ratios of programs in several ways. First, com-
social security schemes, serves workers poorly and provides plex, multidimensional social security benefit packages
an incentive to be informal. Fundamentally, this may should be unbundled to focus on increasing access and
require rethinking the traditional model of social protec- quality of those programs with high public goods content
tion in which protection depends on the specific form of the (for example, health care, old-age security). Second, efforts
labor contract. A broader notion of who has access to basic should be made to improve program quality and benefits
risk management instruments is needed--one based on via microefficiency reforms in health care and country
ensuring the basic protection and welfare of countries' citi- pension systems. Third, program design should be
zens rather than of "workers" as traditionally and narrowly strengthened--for example, by revising overly burdensome
defined. pension-vesting periods, fostering benefits portability,
Drawing insights from the economics of insurance, this eliminating double payments for health insurance, and so
report outlines a long-term vision for social protection on--to account for and enable greater worker mobility.
reform in the region.1 In the case of health care, because Finally, rules, eligibility requirements, and benefits levels
shocks that go "uncovered" can impose significant external across programs and institutions of social security and
16
I N F O R M A L I T Y: E X I T A N D E X C L U S I O N
social assistance should be made consistent and compatible registration costs. Hence, although high entry costs may
with incentives. Such types of measures will provide the keep some entrepreneurs from starting new formal busi-
foundation for more effective social protection for all citi- nesses, the available evidence suggests that just lowering
zens and help strengthen the alignment of social and administrative barriers to business registration may not
economic policy objectives. have a major impact on aggregate levels of informality.
This finding does not imply that those interventions are
Improving opportunities for workers in the not important. First, lower entry costs do induce at least
formal sector while reducing barriers to some entrepreneurs to open new formal businesses, and
business formalization their improved performance probably would be sufficient
As suggested above, the fact that few micro firms grow justification for the corresponding reforms. Second, the
from small informal entities to large formal firms can be impact of administrative simplification programs may
explained in two complementary ways. On one hand, the be larger when accompanied by other complementary
presence of low opportunity costs for entry into the sector measures aimed either at increasing the potential benefits
could be to blame because it would lead to a predominance of joining the formal sector or at reducing the costs of
of low-productivity businesses with low growth prospects regulatory compliance--beyond the facilitation of firm
and high failure rates. In this context, policy makers wish- registration.
ing to reduce informality should focus not only on altering With regard to the first alternative, recent evidence
the direct costs and benefits of formality but also on alter- from randomized experiments suggests relatively high
ing the drivers of formal sector productivity, including returns to capital among very small Mexican microenter-
measures to improve the investment climate and policies prises, and this suggests that considerable increases in
aimed at increasing human capital accumulation. On income could be obtained through measures to increase
the other hand, however, policy-induced barriers to small businesses' access to bank credit and other forms of
formalization could impede microfirms' access to technolo- external finance. Similarly, in principle, formality could be
gies, markets, and government services, and that would made more attractive by improving the provision of busi-
explain at least some of their low growth and job creation ness development and training services available to formal
rates. In this second interpretation, reductions in informal- firms, and by facilitating access to product markets
ity and improvements in microfirm performance could be through public procurement opportunities and supplier
achieved by lowering statutory burdens to formalization development programs aimed at increasing links with
and implementing administrative simplification programs larger private firms. Other ways of making formality more
aimed at reducing the transaction costs associated with attractive include improvements in the quality of legal ser-
operating legitimate businesses. In particular, programs vices available to small businesses so that they may find it
that facilitate business registration--for instance, through less risky to expand beyond local markets, and creating
the use of Internet-based technologies and one-stop- mechanisms to provide information to entrepreneurs wish-
shops--should lead to an increase in formality rates and ing to formalize their businesses (from advisory services on
improved microfirm performance. taxes and regulations to information on financial and nonfi-
In practice, the existing evidence from Brazil and nancial services available to them).
Mexico suggests that administrative simplification pro- As for measures to reduce other costs of operating legiti-
grams do lead to increases in formal firm registration rates, mate businesses, governments should consider performing
with large consequent improvements in the revenue- and comprehensive regulatory reviews aimed at eliminating
employment-generating capacity of the corresponding unnecessary and costly bureaucratic requirements. In this
businesses. However, the number of positively affected respect, the challenge is that of distinguishing relevant from
firms is relatively small in comparison with the overall size anachronistic regulations, as well as identifying those regu-
of the informal microfirm sector. Moreover, at least in the lations that significantly increase the costs of operating pri-
case of Mexico, it appears that most of the newly registered vate businesses and are not justified by legitimate public
firms are new entrants--that is former wage workers who interests, such as the protection of public safety or the envi-
decide to open new formal businesses--rather than exist- ronment. If successful, such regulatory reforms may help
ing informal firms that become formal as a result of lower reduce informality both by increasing job creation in the
17
I N F O R M A L I T Y
formal sector and by reducing regulatory noncompliance tration can be enhanced through better use of third-party
among formally registered, medium-size and large firms-- information (for example, cross-references between tax
for example, tax and social security evasion. Indeed, reporting, social security records, and data from the financial
although cross-country differences in the size of the infor- system). Audits can be made more effective by the adoption
mal sector are largely explained by countries' general levels of modern audit technology, such as has been the case in
of development--which, in turn, are driven partially by the Chile and Spain. In most countries there is scope for reduc-
quality of governance and institutions--there is also evi- ing administrative and compliance costs and increasing
dence that, for given levels of per capita income, informality collections through changes in tax structure, combining
tends to be higher where regulatory burdens are heavier. reductions in marginal tax rates with the elimination of
Moreover, not only the quantity but also the quality of reg- exemptions and privileged regimes that create loopholes in
ulations appears to matter, as is illustrated by the finding value-added, income, and property taxes, and simplification
that firms facing higher levels of corruption are more likely of deductions. Collections can also be increased by facilitat-
to evade taxes and social security. In that context, the objec- ing payments through the banking system, relying more
tive should be to eliminate unnecessary regulations while heavily on source withholding and applying non-harsh
enhancing their evenhanded enforcement and streamlining penalties for noncompliance often and consistently. Finally,
administrative processes to reduce excessive red tape. criminalization of certain tax offenses in combination with
Overall, a wider and integrated approach appears to be a modernized tax administration agency has been credited
necessary to switch the incentives of a large fraction of with playing a key role, among other factors, in Spain's
informal firms in the direction of formality. Such an success in the late 1970s and 1980s in drastically reducing
approach would likely have to combine carrots (such as tax evasion and eventually doubling the ratio of tax revenue
lower costs of formalization, better and more efficient gov- to gross domestic product.
ernment services, and greater access to government- and Second, reforms should also emphasize the "service
market-provided services for formal firms) with sticks (for paradigm" with policies to enhance the role of the tax
example, increasing evenhanded enforcement of regula- administration as a facilitator and a provider of services to
tions and, hence, the expected cost of being caught). The taxpayer-citizens. Promoting taxpayer education and devel-
correct mix of policies, however, is likely to vary across oping taxpayer services in filing returns and paying taxes,
countries and over time, depending on the relative impor- broadcasting advertisements that link taxes with govern-
tance of the various determinants of informality. Moreover, ment services, stimulating voluntary compliance by lower-
policies aimed at reducing firm informality should be con- ing compliance costs, simplifying taxes and their payment,
sidered in conjunction with the labor market and social and promoting a taxpayer--and a tax administrator--"code
protection issues associated with the possibility of large of ethics" have proved to be useful complementary measures
contingents of previously informal workers shifting to to the punishment paradigm to enhance compliance. The
other segments of the labor market. use of semiautonomous revenue authorities has been shown
in several countries to improve tax administration with a
Simplifying tax laws, facilitating compliance, more service-oriented approach to tax enforcement.
and strengthening enforcement The service paradigm fits squarely with the perspective
As mentioned above, underreporting of sales and incomes that emphasizes the role of social norms in tax compliance.
for tax purposes is common even in large firms, although Experience from other countries shows that a government's
the degree of compliance and its relation with firm size vary commitment to evenhandedly enforce the tax laws while
widely among countries. To deal successfully with this facilitating taxpayer compliance can have an important
dimension of informality, there is also a need for an inte- effect on the pervasive culture of noncompliance found in
grated approach consisting of both sticks and carrots. many countries in the region. Disclosure of public expendi-
First, there is substantial room for measures that fall ture information, and the participation of and supervision
within the traditional monitoring and "punishment para- by citizens--that is, "voice"--in the way taxes will be
digm" of tax compliance. In most countries, improvements spent, may also help increase trust in the state and may
are needed in the three main aspects of tax administration: contribute to social norms of compliance. These factors
taxpayer registration, audit, and collection. Taxpayer regis- have been credited with success in increasing tax
18
I N F O R M A L I T Y: E X I T A N D E X C L U S I O N
compliance (and collections) in Chile and Spain, particu- policies emerging from the constitutional exercises that
larly through widespread consensus among political parties strove to be more inclusive. Hence, however well meaning
about the need for the reform of the tax system, improved or inclusive policies may be, they must be well designed.
democratic governance, and highly visible enhancements The inclusive state must also be a competent state.
in social and other public services.
Informality and the development agenda
Enhancing the effectiveness and legitimacy Informality reflects underdevelopment, and this report seeks
of the state to tease out some of the interactions and directions of causal-
Improving the quality of state policy making is one ele- ity between the phenomena of informality and development.
ment in a larger agenda of reducing the culture of infor- There is evidence that, in part, informality is merely a stage
mality that also requires increasing the perceived efficiency, in the development process: the ubiquitous microfirm
fairness, and accountability of the state. To spin it posi- reflects the unattractive options in the small modern sector
tively, a particular policy change (such as greater and more and the traditional reliance on family and community. How-
evenhanded enforcement of adequate and equitable taxa- ever, other evidence suggests that, in part, informality is a
tion laws and other regulations) may reduce informality by canary in the coal mine--the symptom of poor policies and,
more than what would be expected, given individual elas- more profoundly, a lack of confidence in the state and per-
ticities, if it induces a change in the social norm of tax and haps in our fellow citizens. To return to Hirschman, con-
regulatory compliance that permits the state to improve fronted with a lack of voice in and relevance of the state,
the provision of public goods and services and to enforce Latin Americans take their business elsewhere; and, in doing
the law. this, they further undermine the region's growth prospects.
As with informality more specifically, the task of bol- Hence, redressing the causes of high informality is part and
stering the legitimacy of the state involves both carrots and parcel of the broader development agenda.
sticks. Identifying the correct set of carrots to foster a sense
Note
of greater inclusion and responsiveness requires detailed
1. See de Ferranti et al. (2000) for an earlier application of the
analysis of specific country circumstances to detect the
economics of insurance in the region.
"binding constraints" whose removal would cause a shift in
the decision of a large number of firms and workers located References
close to the three borders between formality and informal- Arias, Omar, and Leonard Lucchetti. 2007. "Informal Employment
ity. Adequate sticks require modern enforcement tech- and Self-Rated Welfare: Measuring Compensating Differentials."
niques (for example, many countries in Latin America and Photocopy. World Bank, Washington, DC.
the Caribbean have not yet developed adequate tax- Bosch, M., and W. F. Maloney. 2006. "Gross Worker Flows in the
Presence of Informal Labor Markets. Evidence from Mexico,
auditing systems like those common in OECD countries),
1987�2002." Policy Research Working Paper 3833, World
political resolve, and evenhanded enforcement of laws and
Bank, Washington, DC.
regulations that are perceived as fair. Cunningham, W. 2007a. "Life Trajectories of Latin American
Again, to improve the legitimacy of the state through Workers." Photocopy. World Bank, Washington, DC.
more equitable public policies and programs, it is necessary ------. 2007b. "Minimum Wages and Social Policies: Lessons from
to consider carefully the formality incentives or disincen- Developing Countries." Photocopy. World Bank, Washington, DC.
Cunningham, W., L. McGinnis, R. G. Berdu, and C. Tesliuc. 2007.
tives generated by government programs. Greater inclusion
"The Promise of Youth: Policy for Youth at Risk in Latin America
or a more participatory social contract may not by them-
and the Caribbean." Photocopy. World Bank, Washington, DC.
selves reduce informality. Some countries' laudable de Ferranti, D., G. E. Perry, F. H. G. Ferreira, and M. Walton. 2004.
attempts to extend free social protection services to infor- Inequality in Latin America and the Caribbean: Breaking with His-
mal workers, made without reforming badly designed tory? Washington, DC: World Bank.
social security systems that tax many of its formal contrib- de Ferranti, D., G. Perry, I. Gill, J. L. Guasch, W. F. Maloney, C.
Sanchez-Paramo, and N. Schady. 2003. Closing the Gap in Educa-
utors, have inadvertently reinforced perverse incentives
tion and Technology. Washington, DC: World Bank.
that could actually lead to higher levels of informality. Fur-
de Ferranti, D., G. Perry, I. Gill, L. Serv�n, F. Ferreira, W. F. Maloney,
thermore, the rise in informality in both metropolitan and M. Rama. 2000. Securing Our Future in the Global Economy.
Brazil and Colombia results partially from well-intentioned Washington, DC: World Bank.
19
I N F O R M A L I T Y
de Ferranti, D., G. Perry, D. Lederman, and W. F. Maloney. 2001. ------. 1981. Essays in Trespassing. Economics to Politics and Beyond.
From Natural Resources to the Knowledge Economy. Washington, DC: Cambridge, UK: Cambridge University Press.
World Bank. IDB (Inter-American Development Bank). 2006. Good Jobs Wanted:
de Soto, H. 1989. The Other Path. The Invisibles Revolution in the Third Labor Markets in Latin America. Washington, DC.
World. New York: Basic Books. Loayza, N., and J. Rigolini. 2006. "Informality Trends and
Evans, D. S., and L. S. Leighton, 1989. "Some Empirical Aspects of Cycles." Policy Research Working Paper 4078, World Bank,
Entrepreneurship." American Economic Review 79 (3): 519�35. Washington, DC.
Fajnzylber, P., W. F. Maloney, and G. V. Montes Rojas. 2006. Perry, G., O. Arias, J. H. Lopez, W. F. Maloney, and L. Serv�n.
"Microenterprise Dynamics in Developing Countries: How 2006. Poverty Reduction and Growth: Virtuous and Vicious Circles.
Similar Are They to Those in the Industrialized World? Evidence Washington, DC: World Bank.
from Mexico." World Bank Economic Review 20 (3): 389�419. Rofman, R., and L. Lucchetti. 2006. "Pension Systems in Latin
Gasparini, L., and L. Tornarolli. 2006. "Labor Informality in Latin America: Concepts and Measurements of Coverage." Social Pro-
America and the Caribbean: Patterns and Trends from Household tection Discussion Paper 0616, World Bank, Washington, DC.
Survey Microdata." Photocopy. World Bank, Washington, DC. Vegas, E., and J. Petrow. 2007. "Raising Student Learning in Latin
Gill, I., T. Packard, and J. Yermo. 2004. Keeping the Promise of Social America and the Caribbean: The Challenge for the 21st Century."
Security in Latin America. Washington, DC: World Bank. World Bank, Washington, DC.
Hirschman, A. O. 1970. Exit, Voice, and Loyalty: Responses to Decline in World Bank. 2006. World Development Indicators. Washington, DC.
Firms, Organizations, and States. Cambridge, MA: Harvard Univer- Available at http//:www.worldbank.org.
sity Press. ------. 2007. "Job Creation in Latin America and the Caribbean."
------. 1971. A Bias for Hope. New Haven, CT: Yale University Press. Photocopy. Washington, DC.
20
CHAPTER 1
The Informal Sector: What Is It,
Why Do We Care, and How
Do We Measure It?
SUMMARY: This chapter seeks to unpack our understanding of the term informality, why we may care about it, and
what dynamics may be driving its elements. The number of phenomena it encompasses and the limitations of its measures
are manifold, dictating caution in employing the term. Yet two stylized facts remain: First, however measured, informal-
ity is high in Latin America, although not obviously so for the region's level of development; and it remains an important
phenomenon. Second, in several countries it has experienced striking increases over the last decades. Whatever adverse reg-
ulatory, poverty, growth, or social morale implications "informality" may have, they have become more relevant with time.
Introduction: What is informality? the "urban traditional sector," and so on. These terms
The term informality means different things to different beggar analysis by assuming what has to be demon-
people, but almost always bad things: unprotected workers, strated (Hart 1973, p. 68).
excessive regulation, low productivity, unfair competition,
With this, Hart cautions us against inquiry with exces-
evasion of the rule of law, underpayment or nonpayment of
sively well-informed ideas of what we may find.
taxes, and work "underground" or in the shadows.1 The
Fortunately, the accumulation of rich data sets over the
multiplicity of adjectives from very distinct fields of study
last decades has cast progressively more light on the realm
suggests that we may have a classic "blind men and the ele-
of the informal, permitting us to document the great
phant problem"--everybody touches part of the animal,
heterogeneity of actors and their raz�n de ser. Among them
but understands only the part that they touch. More likely
we find the following:
still, we are exploring several distinct phenomena as we
attempt to describe one ungainly composite "informality." Labor:
To further complicate things, Keith Hart, the purported � workers, particularly the old and young, who would
coiner of the term informality (and one who did not think prefer a job with standard labor protections, but are
the sector was necessarily bad), argued that the source of unable to get one;
our blindness--the undocumented nature of the sector-- � workers who have quit formal sector jobs to start a
left the sector especially vulnerable to being a tabula rasa on microbusiness to be their own boss, make more money,
which analysts projected their particular concerns: and avoid paying social protection taxes; and women
leaving formal salaried jobs for the flexibility of bal-
Most enterprises run with some measure of bureaucracy
ancing home and income-raising responsibilities.
are amenable to enumeration by surveys, and, as such,
constitute the "modern sector" of the economy. The Microfirms:
remainder--that is, those who escape enumeration--are � microentrepreneurs with no intention of or potential
variously classified as the "low-productivity urban sector," for growing, and hence no intention of engaging the
the "reserve army of the underemployed and unemployed," institutions of civil society;
21
I N F O R M A L I T Y
� microentrepreneurs stymied in their expansion by Drag on productivity and growth
excessively high barriers to registering with the gov- Rigidities in either the labor or product market that prevent
ernment and thereby accessing other inputs offered the optimal allocation of workers among sectors generally
by the informal sector. lead to output and welfare losses. Regulatory failures that
lead to higher informality may have a direct impact on pro-
Firms:
ductivity. But beyond this, informality itself has been pos-
� firms and individuals avoiding taxation or other
tulated to have adverse impacts on productivity. As noted in
mandated regulations because everybody else does,
Poverty Reduction and Growth: Virtuous and Vicious Circles
and because enforcement is weak and uneven;
(Perry et al. 2006), workers uninsured against health, old
� firms registering only part of their workers and part of
age, and other risks may have lower productivity and fewer
their sales--or declaring only part of the salary of
incentives to invest in human capital accumulation. Firms
their workers--due to an excessive regulatory burden.
unable to access credit, larger sales/product markets, and
Though far from exhaustive, these three pairs are illus- sources of innovation, and those evading taxes may operate
trative of the variety of types of agents captured under the at a suboptimal scale. Competition with noncomplying
rubric of "informality" and, further, capture three different firms leads to productivity losses at formal firms. At the
margins of informality discussed later. They also suggest aggregate level, a large concentration of workers in small
the reasons we care about informality. firms rather than larger firms may lead to lower productivity
growth.
Why do we care about informality?
Each example above has a different underlying logic and Erosion of the functioning and legitimacy
reason for being and, hence, a reason that we may care of market- and equity-enhancing institutions
about its existence or size from a policy perspective. Noncompliance with tax collection and market-supporting
regulation erodes the rule of law and the integrity of public
Unprotected families institutions, and limits society's ability to address collective
As the regional flagship report Securing Our Future (de needs that range from infrastructure to the mitigation of
Ferranti et al. 2000) noted, while development is often seen inequality. Noncompliance may become a social norm that
as a process of increasing income, in practice we have also increases the costs of enforcing the law, undermines the
seen the emergence of institutions to shelter families from legitimacy of societal institutions, and creates horizontal
adverse shocks, be they loss of job, illness, or natural and vertical inequities (with better-off insiders and worse-
calamity. The presence of a large fraction of the workforce off outsiders). This said, compliance with legal norms may
in Latin America that does not count on formal mecha- be endogenous to the perceptions of the current effectiveness
nisms to hedge or mitigate these shocks is, hence, of intrin- of public institutions and, more profoundly, to the nature of
sic concern. What complicates policy making is that, as the the underlying "social contract."
chapters in this volume will show, workers often choose
jobs that lack such benefits or they willingly leave jobs that Indicators of other problems
offered such benefits, valuing more other characteristics of A sizable body of literature sees informality as arising from
informal jobs. In this case, the worker and his/her family poor regulation or other government failures. To the degree
must be at least as well-off as before, but may still be vul- that this is the case, unusually high or increasing informal-
nerable to some types of misfortune (in particular, health) ity may be suggestive of poor policy regimes.
for which informal protections are few. There also may be
externalities for society in, for instance, the classic case of Informality and the relationship between
families undersaving for retirement. Further, if, as is sug- the individual and the state
gested throughout this report, some informality is due to Implicit in each of the examples above is a relationship
the low valuation of government-provided services com- between the individual or firm and the state. Economic
pared with their implicit or explicit costs to workers, then theory posits a legitimate role of the state in a number of
a choice to be unprotected may point to a dysfunctional and areas. The state redresses coordination failures in the provi-
inefficient social protection system. sion of public goods (for example, roads, defense, public
22
T H E I N F O R M A L S E C T O R : W H AT I S I T, W H Y D O W E C A R E , A N D H O W D O W E M E A S U R E I T ?
security) and in the prevention of social bads (such as on lack of compliance with revenue-raising norms, illegal
pollution). Further, it fills in missing markets--establish- when the sector engages in unsanctioned activities, unfairly
ing courts, property rights, risk-pooling mechanisms--and competitive by those focusing on how industrial structure is
sets the rules in the modern economy. Finally, it concerns affected by such evasion (Capp, Elstrodt, and Jones 2005),
itself with distributional issues and power asymmetries-- unprotected by those thinking about why workers in least-
redistributing from rich to poor, ensuring that labor� developed countries (LDCs) are not covered by labor legis-
capital relationships are not too one-sided or that no firm or lation (International Labour Organization [ILO]), and
group of firms gains too much economic power, and that all subcontracted by those concerned with the potentially
citizens receive equal treatment regarding the provision of exploitative dynamics of globalization (Castells and Portes
key services. To redress the market failures identified above, 1989). Each of those descriptors can be seen as evasion,
the state necessarily requires the power to monitor and broadly construed, of the state's legitimate and efficiently
coerce agents to do things that, privately, they would not executed brief.2 Opportunistic evasion is, of course, the pri-
do. This view of the state has led to seeing the informal mal form of "opting out," despite the fact that "voice"
sector through a lens emphasizing lack of compliance with through the political system may be perfectly adequate.
legal norms. Though this is not the only lens (Hart defines Many of the cases above have an exclusionary comple-
informality simply as "undocumented," an important dimen- ment. Those firms avoiding labor legislation, for instance,
sion taken up in chapter 8), it enjoys currency, particularly may be implicitly creating a dual labor market where their
in the economics field, and will be a central organizing employees would prefer to enjoy the full benefits of the
theme of this report. social protection system, but find themselves, for at least
However, even that fairly narrow definition raises the the present, in inferior jobs.
question of why agents are not in compliance with state
norms. Among the many lenses through which this ques- Defensive evasion and exclusion: Coping with the
tion has been viewed, one of the most influential lenses on imperfect, captured, or informal state
the labor and firm side has focused on their exclusion from However, as a large body of literature has documented, the
critical state benefits and, concomitantly, the circuits of the state often deviates from the economists' ideal. Simply put,
modern economy. However, this report highlights a second the state does its job badly--ranging from poor regulation
lens through which to view informality that is more akin to to oppressive or exclusionary measures, forcing agents, who
Hirschman's (1970) "exit": many workers, firms, and fami- perhaps are inclined toward compliance under the ideal
lies choose their optimal levels of engagement with the state, to cope by defensive evasion. De Soto (1989),
mandates and institutions of the state on the basis of their Djankov et al. (2002), Friedman et al. (2000), Loayza,
valuation of the net benefits associated with formality and Serv�n, and Oviedo (2005), and Schneider (2005), among
the enforcement effort and capability of the state. That is, many others, have stressed the very high registration costs,
they make implicit cost�benefit analyses about whether to the regulatory burden to becoming formal, as well as the
cross the relevant margin into formality and frequently high ongoing costs of fully integrating with the state that
decide against it. Under this view, high informality results drive firms to stay off the state's radar.
from a massive opting out of formal institutions by firms The postulated reasons for this state deviation from
and individuals, and offers an indictment of the state's reg- the ideal range widely both in view of the nature of the state
ulations and services and of its enforcement capability. and in implications for policy. A large body of literature
As a starting point, it is useful to sketch three types of stresses that the bureaucracy may be populated by rent seek-
relationships between the individual and the state and, ers and, in principle, defensive evasion in this case could be
more generally, the institutions of civil society, that capture largely alleviated by regulatory reform. However, in more
these two dimensions. extreme views (Acemoglu, Johnson, and Robinson 2001;
North, Wallis, and Weingast 2005), the state is behaving in
Opportunistic evasion a deliberately and coherently exclusionary manner, manifest-
In the case closest to economic theory's vision of the state, ing an underlying stable political-economy equilibrium
the informal sector is seen as evading legal norms that give where incumbent business and labor elites defend their
rise to additional adjectives: tax-evading by those focusing rents and will find ways to offset and nullify any tinkering
23
I N F O R M A L I T Y
with the costs of doing business. In this spirit, the informal design of its policies and, hence, substantially reducing the
firm, as depicted by de Soto (1989), is excluded from the distortions that both exclude and encourage exit.
benefits of the state and hobbled in its participation in
the market economy; the informal worker is excluded Passive evasion and state irrelevance
from the benefits enjoyed by a privileged caste of workers. This discussion of the limits of the Latin American state
Further, in the absence of a major shock to the political- brings us back to Hart's (1973) emphasis on how multiple
economy equilibrium, they are permanently so. institutional systems coexist within a polity and that
Other, more generous views, (for example, Centeno and the state is only one candidate among many. This may par-
Portes 2003) see weak Latin American states as assigning ticularly be the case for very rudimentary microenterprises
themselves an unmanageable--and usually unenforceable-- that may not consider themselves part of the modern
load of regulatory measures. That is, what we see is less a economy/social order, and whose production requires little
conspiracy to exclude than overwhelmed and poorly coor- in the way of services from the largely irrelevant state.
dinated bureaucracies. However, the exclusionary views do Such firms are described colorfully in Geertz's (1963) semi-
touch on a leitmotif in the political science literature that nal Peddlers and Princes, which traces the social evolution
stresses the informality of Latin American political systems. from the bazaar economy in Indonesia to that of the more
In particular, this literature studies the divergence rational, modern "firm." The premodern or bazaar economy
between the formal structures of democracy and the econ- encompasses a vast number of proto-firms that are not con-
omists' ideal bureaucracy, on one hand, and how gover- strained by access to the benefits that normally are associ-
nance is really done, on the other. O'Donnell (1996) argues ated with formality but, as Hart stresses, operate within
that often behind formal elections and alternation of subsystems of institutions that coexist with, substitute for,
power lies particularistic access to the state with roots in or compete with the "formal" state institutions. In fact,
century-old traditions of patron�client relations. Everyone what is striking in Geertz's description of two Indonesian
"understands the model" of particularistic access, distrust towns is the significant discussion of institutions for
of the state and its evenhandedness is high, tax morale3 managing credit, risk, and collective issues of irrigation,
and the general feeling of social reciprocity are low. but very little about the state.
Further, as chapter 7 will discuss, the state is perceived as Here we find a conceptual kinship with the literature on
providing little: relatively few citizens are covered by what social capital that deals with "informal" relations of trust,
has been called the truncated welfare state--low quality and reciprocity, and the like that exist in the absence of formal
coverage of public social services, such as health care or institutions (see Alesina and La Ferrara 2000; Glaeser,
education, further erode tax morale and prompt opting Laibson, and Sacerdote 2000; Greif 1993, 1998; and Stiglitz
out of the system of taxes and transfers. Hence, a Latin 2000, among others). While, generally, such relations are
American citizen weighing working with a state that considered positively--that is, as ways of solving problems
diverges substantially from the ideal, or employing other of contracting and market failure--they may, in addition, be
"nonformal" ways of solving social problems and market preferable in some dimensions to formal institutions that
failures, may not perceive the informal-formal dichotomy may eventually displace them. Local institutions are likely
as quite so sharp. to be more closely tailored to the relevant market failure and
At a meta level, it may be argued that the underperfor- less subject to moral hazard due to closer monitoring by
mance of Latin American states along these dimensions family or village. As Bentolila and Ichino (2000) argue, the
partly reveals poorly resolved social tensions and manifests informal safety nets in southern Europe cushion families
what we might use as conceptual shorthand--a dysfunc- against employment shocks better than the formal unem-
tional underlying "social contract." Beyond high informal- ployment insurance schemes of northern Europe. Studying
ity, this can also be seen in the inability of the state to financing in Chicago migrant communities, Bond and
redress the long-standing high inequality, in the weak rule Townsend (1996) conclude, "We are inclined to view the
of law, or in the recurrent bouts of macroeconomic instabil- small role played by the formal sector as stemming, at least
ity. Difficult as these phenomena have been to manage in in part, from community disinterest as opposed to formal
the region, the report is generally optimistic about the sector negligence" (p. 24) due to the insufficient flexibility of
possibilities of improving the quality of the state and the formal institutions. With some caution, they suggest that
24
T H E I N F O R M A L S E C T O R : W H AT I S I T, W H Y D O W E C A R E , A N D H O W D O W E M E A S U R E I T ?
"formal sector institutions attempt to create more flexible
FIGURE 1.1
financial instruments by either using or mimicking existing
Margins of informality
informal and semi-formal structures" (p. 24). In sum, infor-
mal institutions cannot be ruled out ex ante as suboptimal, Share of labor force (percent)
35
given the type of enterprises operating within them and the
Intersectoral margin (labor)
level of development of the state. 30
The demand for formal institutions increases with the
25
sophistication of the firm and, more generally, of society. Microfirms Modern firms
20
Geertz's peddlers become organized firms whose growth
will require access to an increasingly sophisticated set of 15 Intersectoral margin
(firms) de Soto
socially provided inputs. In line with de Soto's anecdote of
10
the Peruvian street vendors who sought to pay taxes so they Intrafirm
margin
5
would be granted de facto property rights over their
pitches, participation in formal institutions can be seen as a 0
"normal" input, increasing with firm size or sophistication 1 2 3 4 5 9 10 25 50 100 250 500
1,000
(see Levenson and Maloney 1998). This is entirely consis- Firm size (number of workers)
tent with the logic, postulated in the social capital litera-
Formal Informal
ture, that individuals optimize their investment in informal
networks with a view toward long-run returns, except that Source: Maloney 2006.
here the "networks" include formal institutions.
At the economywide level, the reach and density of for- and Maloney 2001; Fields 1990; and Henley, Arabsheibani,
mal institutions are almost certainly endogenous to the and Carneiro 2006). But policy demands that we identify the
complexity of the society, and, as Stiglitz (2000) suggests, most germane interactions, and this, in turn, requires identi-
we may expect a greater need and density for formal institu- fying the critical margins along which individuals and firms
tions with development--a natural evolution from informal are making calculations about or facing constraints to becom-
to more formal institutions.4 At each point along the course ing formal. Maloney (2006) sketches three such margins and
of this process, the state makes its own cost�benefit analysis suggest what types of agent�state interactions are at play (fig-
on what size firm is worth monitoring and taxing to finance ure 1.1): (1) the intrafirm margin where firms are partly formal
its mandate, and what size is not worth doing so, thus leav- and partly not, (2) the intersectoral margin between informal
ing the institutional space free for the kind of institutions and formal firms, and (3) the intersectoral margin of formal and
discussed above. Tendler (2002), in fact, describes a "devil's informal workers operating through the labor market. These
deal" in Brazil between the state and the informal sector margins are not exhaustive, nor are they unrelated to each
implicitly on the boundaries of this space. More generally, other. However, they do capture much of the relevant activity
there is an equilibrium where small firms find nonstate solu- covered in the informality discourse and help us isolate the
tions to their needs, and the state occupies itself with firms most relevant areas on which to focus.
above its enforcement threshold. In this view, informality is
neither cause nor result of underdevelopment, nor is it nec- The intrafirm margin
essarily pathological; rather it is a normal phase in the Firms across the size spectrum are often partially informal
development process--a lack of formalization of enterprises across several dimensions. Underreporting of sales is com-
and the dominance of local institutional systems that com- mon globally. As chapter 6 will show, the investment cli-
plement, compete with, or substitute for those of the state. mate surveys conducted by the World Bank find that the
It is not so much "exiting" as never really "entering." percentage of sales reported by Brazilian firms ranges
between 60 percent in microfirms and 80 percent in very
Three margins of informality large firms. Survey and anecdotal evidence from Latin
In all likelihood, all these agent�state interactions can be America suggests that medium-size to large firms will
found among the phenomena lumped under what is commonly have a substantial share of their operations,
clearly a very heterogeneous informal sector (see Cunningham including workers, off the books. In Argentina, roughly
25
I N F O R M A L I T Y
15 percent of workers will receive pay partly "en blanco" on close to the margin of becoming formal? Alternatively put,
the books and partly "en negro"�off the books�without the how relevant is de Soto's story in explaining informality?
corresponding labor taxes paid by either worker or firm. As Second, how binding are the impediments at this margin?
discussed later, firms can often be fully compliant in one Chapters 7 and 8 will take up both these questions.
dimension--perhaps paying taxes--and not in others--
registering workers in social security. The intersectoral margin (workers)
The labor literature has long focused on the relationship
The intersectoral margin (firms) and flows between workers in the formal sector, covered by
The growing informal firm is on the border of registering labor legislation, and those in the informal microfirm
or complying with the labor or tax laws. To formalize the sector who are not covered. The latter are often considered
classic de Soto story, we can follow Lucas (1978) and think the most disadvantaged of the urban labor market, as they
of steady-state firm size as determined by its underlying are precarious, often termed subsistence, and thought to be
cost structure that reflects the ability of the entrepreneur, the rump end of the global value chain. A large informal
among other characteristics. The resulting heterogeneity of sector has also been seen as evidence of a labor market seg-
costs gives us the distribution of firms across the size spec- mented by acute formal sector rigidities arising from exces-
trum, whether a mom-and-pop store or a Wal-Mart or sively high minimum wages or union bargaining (see, for
Mexican Elektra. And, as Jovanovic (1982) argues, entre- example, Esfahani and Salehi-Isfahani 1989; Mazumdar
preneurs have a rough idea of what their ability is, but only 1976; and Rauch 1991).
upon actually opening the business can they make that However, evidence has been mounting that a sizable
estimate precise. Some will find out they are unprofitable share of entrants into the informal sector do so because
and quit; others will find their profits surprisingly high they will become better-off. The report will use the term
and seek to expand. At this point, the latter group may voluntary to denominate entry yielding higher or equal lev-
need the services of the state, or of collateral services that els of welfare. This does not imply that they are not poor
require being recognized by the state. or that they are happy--only that this is the better of two
In the de Soto (1989) view, the costs of becoming formal options, given their lower human capital and the low pro-
are too high and firms are effectively excluded from the ductivity of the economy. Returning to Lucas (1978), we
formal realm and forced to remain suboptimally small. may argue that, in fact, at low levels of aggregate produc-
Banerji and Jain (2006), following Rauch (1991), argue that tivity, the opportunity cost of becoming self-employed is
lack of monitoring below a certain size threshold produces such that more workers with a comparative advantage in
size dualism, where small firms take advantage of the wage operating a small business will actually do so. This may
differential, in the former case, to produce lower-quality explain an important part of self-employment and
goods for the poorer section of the consumption market.5 microentrepreneurship in many countries in the region.
However, there are also firms whose underlying produc- The idea that entry into informality occurs for various rea-
tivity is so low that they will never demand the services of sons is not new. Hart (1973) never saw the informal sector
the state. Going back to Geertz's (1963) study of the bazaar as intrinsically bad, and Fields (1990) noted that there is
economy in Indonesia, he describes entrepreneurs who, in an "upper tier" to informal employment that does very
fact, lack the organizational skills to function as a modern well. The critical empirical question is, What share of the
firm, let alone grow to a large size. Very poorly educated sector corresponds to those who would prefer formal jobs
workers, many less than a generation away from subsistence versus those who are as well-off as they would be in the
farming, would also, on average, have low ability levels in formal sector? Gregory (1986) and Maloney (1999, 2004)
running a firm. Alternatively, women may choose to oper- argued that, for Mexico, the evidence of segmentation is
ate as independents to better balance home and income- weak, the majority of the sector is "voluntary," and the
earning roles, with no plans to expand (Cunningham unprotected/exploited view of informality seems an inap-
2001). Further, we do not know how unsubstitutable for- propriate lens.6 The next three chapters confirm this find-
mal inputs are for less formal ones. ing for Mexico and the Dominican Republic, as well as for
Hence, there are two central open questions surrounding the majority of the informal self-employed workforce
this margin. First, how many informal firms are actually across the region. They also reveal that, in most countries
26
T H E I N F O R M A L S E C T O R : W H AT I S I T, W H Y D O W E C A R E , A N D H O W D O W E M E A S U R E I T ?
BOX 1.1
The ILO definition of informality
The three margins discussed in the text are fully consistent five employees). As such, the table below shows that total
and useful for analyzing informality, both as the ILO tradi- employment in the informal sector includes self-employed
tionally defined it, based on what might be called the "pro- (3); own-account workers, with or without family workers
ductivity view" (rows in the table below) that focused on (5); microentrepreneurs (4); and their employees (6).
the type of production unit (rows); and the newer focus on Under this definition, understanding the logic of the pro-
informal employment defined according to the "social protec- duction would have required focusing most on the second
tion" or "legalistic" view by job status (columns). In the for- and third margins--how microfirms become formal and
mer definition, the informal sector enterprises are defined as the nature of flows between those people working in such
production units operated by single individuals or house- firms and those in the "modern" sector of the economy. The
holds that are not constituted as separate legal entities more recent shift to a "legal" definition of informality rec-
independent of their owners and in which capital accumu- ognizes that "informal employment" can be found both
lation and productivity are low. This includes "family within and outside the small-firm sector. Consequently,
units" (those operated by nonprofessional own-account informal employment now includes informal contractual
workers with or without contributing family workers) and arrangement in firms that are otherwise formal, (1) and (2),
"microenterprises" (productive units with no more than and hence would now include the intrafirm margin.
ILO conceptual framework: informal employment
Job by status in employment
Production Contributing Members of
Own-account
unit by type Employers family Employees producers'
workers
workers cooperatives
Informal Formal Informal Formal Informal Informal Formal Informal Formal
Formal sector
1 2
enterprises
Informal
sector 3 4 5 6 7 8
enterprisesa
Householdsb 9 10
Source: Hussmanns 2004.
Note: Cells shaded in dark gray refer to jobs, which, by definition, do not exist in the type of production unit in question. Cells shaded in light
gray refer to formal jobs. Unshaded cells represent the various types of informal jobs.
Informal employment: cells 1�6 and 8�10. Employment in the informal sector: cells 3�8.
Informal employment outside the informal sector: cells 1, 2, 9, and 10.
a. As defined by the Fifteenth International Conference of Labour Statisticians 1993 (excluding households employing paid domestic workers).
b. Households producing goods exclusively for their own final use and households employing paid domestic workers.
of the region, informal salaried workers appear to corre- compatible, with the latter spanning all three margins. Con-
spond more to the traditional queuing view. cerns with better enforcement of tax codes or "corruption,"
Framing the informality "decision" as one occurring more generally, are likely to focus primarily on the first mar-
across three distinct margins focuses the diagnostic and pol- gin. The World Bank's Doing Business measures focus pri-
icy discussion on the relevant set of individuals and consid- marily on the second de Soto margin, as might those
erations, and is general enough to encompass most existing concerned with access to credit and informal microfirm pro-
frameworks as well. For instance, the ILO definition of infor- ductivity more generally. Traditional concerns with seg-
mality, both traditional and more recent (box 1.1), is fully mented labor markets focus primarily on the third margin.
27
I N F O R M A L I T Y
Measuring the informal sector
FIGURE 1.2
The previous sections have suggested how difficult it may
Methods for measuring the informal sector
be to present a picture of informality, even if we had the
data to see clearly the component elements--data that, Voluntary
surveys
almost by definition, we do not have. Which aspect are we Direct
methods
interested in? Large firms evading taxes? Microfirms that
Tax audits
will manage through family and community mechanisms
and not bother with the state? Workers rationed out of for- Discrepancy between
aggregate income
mal jobs? Or women quitting jobs with benefits to stay and expenditure
with their children and work independently? This hetero-
geneity is clearly the manifestation of multiple social and Discrepancy between
total labor force and
economic phenomena that have given rise to a cacophony of Classes of formal employment
methods
characterizations and measurement attempts. The next sec- Velocity of
tions discuss a subset of these measures, what they may or Indirect circulation
methods approach
may not be capturing conceptually and in practice, and Monetary
Transactions
methods
how they can foreshadow later discussions of the most approach
relevant margins of informality on which policy makers Currency demand
approach
should focus.
Kaufmann-
By definition, most economic activities that are classi- Physical input
Model Kaliberda method
fied as informal are not captured by national accounts and (electricity
approach
consumption)
official statistics. One exception is informal employment, Lacko's method
which can typically be measured or proxied using questions
Source: Garc�a-Verd� 2007.
from household survey data on affiliation to social security,
the mandated benefits workers receive, or the size of the
firms they work for (in terms of the number of employees), difference between the income declared in tax returns and
or using a combination of those variables. the income actually found after an audit. A potential prob-
There are several methods that can be used to obtain lem in extrapolating to the national economy is that audits
estimates of the magnitude of the informal sector. These are usually nonrandom and, hence, may not be representa-
methods have been described in detail, and their strengths tive. In both cases, the applications of these methods have
and weaknesses have been discussed extensively.7 These can been limited to a few developed countries because of the
be separated into three classes: (1) direct methods, (2) indi- paucity of the available data.
rect methods or "indicator" approaches, and (3) the model For Latin America, we have three principal sources of
approach (figure 1.2). data. One is the newly collected investment climate assess-
ment that asks firms about the level of underreporting of
Direct approaches to measurement income and workers. The World Bank Doing Business
The direct methods are microeconomic in nature and use indicators use an analogous definition in their compila-
either voluntary survey data or the results from tax audits tions. Figure 1.3 presents the unweighted average of these
to construct estimates of total economic activity and its responses across firms in Latin America and the Caribbean
official and unofficial (or measured and unmeasured) com- and suggests a wide range of noncompliance, from less than
ponents. Voluntary surveys typically ask respondents to 5 percent in Chile (similar to Organisation for Economic
declare or reveal their incomes, labor status, or impressions Co-operation and Development [OECD] levels) to over
of levels of tax compliance in their industry. This method 40 percent in Panama.
has been criticized for its sensitivity to how the questions Household and labor surveys provide the second and far
are posed, and its confidence in the respondents' willing- more extensive source of direct data. The issue is finding
ness to truthfully reveal their income. Tax audit-based mea- the right definition of informality. As noted in box 1.1, the
sures define the magnitude of the informal economy as the ILO has traditionally employed what might be called a
28
FIGURE 1.3
Selected measures of informality
a. Percent of sales not reported1 b. Percent informal labor force (legalistic definition)2
Panama Paraguay
Nicaragua Bolivia
Brazil
Peru
Honduras
Mexico Nicaragua
Costa Rica Ecuador
El Salvador Guatemala
Colombia Mexico
Guatemala
Colombia
Latin America and the Caribbean
Ecuador Latin America and the Caribbean
Paraguay El Salvador
Bolivia Argentina
Uruguay Venezuela, R. B. de
Argentina
Brazil
Jamaica
Peru Uruguay
Chile Chile
0 10 20 30 40 50 10 20 30 40 50 60 70 80
c. Percent informal labor force: Productive definition (% employed)3 d. Self-employment (% of labor force)4
Bolivia Dominican Republic
Paraguay Bolivia
Colombia Venezuela, R. B. de
Peru Honduras
Guatemala Paraguay
Ecuador Peru
Nicaragua Colombia
Honduras Guatemala
Latin America and the Caribbean Jamaica
Jamaica
Ecuador
El Salvador
Latin America and the Caribbean
Brazil
Mexico El Salvador
Venezuela, R. B. de Panama
Dominican Republic Brazil
Panama Chile
Argentina Mexico
Uruguay Costa Rica
Costa Rica Uruguay
Chile Argentina
0 20 40 60 80 100 10 15 20 25 30 35 40 45 50
e. Lack of pensions (% of labor force)5 f. Shadow economy (% of GDP)6
Bolivia Bolivia
Paraguay Panama
Ecuador Peru
Nicaragua Guatemala
Guatemala Uruguay
Honduras Honduras
El Salvador Nicaragua
Mexico Latin America and the Caribbean
Dominican Republic
Brazil
Venezuela, R. B. de
Colombia
Latin America and the Caribbean
Argentina Jamaica
Brazil Ecuador
Colombia Venezuela, R. B. de
Jamaica Dominican Republic
Uruguay Mexico
Panama Costa Rica
Chile Argentina
Costa Rica Chile
20 30 40 50 60 70 80 90 100 0 10 20 30 40 50 60 70 80
Sources: Gasparini and Tornarolli 2006; investment climate surveys 2006; Loayza and Rigolini 2006; Schneider 2005; World Bank 2006b.
Note: 1. Informality is measured by the percentage of sales that businesses do not report for tax purposes (Investment Climate Surveys 2006).
2. "A salaried worker is informal if s(he) does not have the right to a pension linked to employment when retired"
(Gasparini and Tornarolli 2006, 10).
3. "An individual is considered an informal worker if (s)he belongs to any of the following categories: (i) unskilled self-employed, (ii) salaried
worker in a small private firm, (iii) zero-income worker" (Gasparini and Tornarolli 2006, 8).
4. "Self-employment is measured as the percentage of self-employed workers with respect to the total active population"
(Loayza and Rigolini 2006, 15).
5. Share of the labor force not covered by a pension scheme (World Bank 2006b).
6. "The shadow economy includes all market-based legal production of goods and services that are deliberately concealed from public authorities
for the following reasons: (1) to avoid payment of income, value added or other taxes, (2) to avoid payment of social security contributions, (3) to
avoid having to meet certain legal labor market standards, such as minimum wages, maximum working hours, safety standards, etc., and (4) to
avoid complying with certain administrative procedures, such as completing statistical questionnaires or other administrative forms"
(Schneider 2005, 600).
In all cases, regional figures are unweighted averages.
29
I N F O R M A L I T Y
"productive" definition, focused more on informal firms. security but are not. The data suggest that evasion in larger
Since these data are available on a global basis, they are firms is a relatively minor issue in Uruguay, for instance--
commonly used in empirical work.8 The weighted average around 10 percent--and quite large in Ecuador, Nicaragua,
of 28 percent of the Latin American and Caribbean labor and Peru--more than 30 percent. Column (i)/(i) (ii) cap-
force is below those of Africa and South Asia, but above tures a related measure--the percentage of workers classi-
those of the OECD and Eastern Europe. Along these lines, fied as formal in the productive definition and as formal in
the report tabulates a measure calculated by Gasparini and the legalistic definition. The fit ranges from poor in Bolivia,
Tornarolli (2006) that is broadly consistent with the ILO Nicaragua, Paraguay, or Peru (at rates of 30�40 percent) to
measure for Latin America (see the annex) but adds in paid reasonably good in Brazil, Chile, Uruguay, and Colombia.
workers in those microfirms. For the purposes of this The third column of the next panel suggests that workers
report, we will refer to the ILO definition as "self- classified as informal in small firms are, in fact, generally
employment" and to the Gasparini-Tornarolli definition as informal in the legalistic definition as well, with rates of
the "productive" definition. overlap often greater than 90 percent.
A second definition, called by Saavedra and Chong Several points merit mention here. First, the substantial
(1999) the "legalistic" or "social protection" definition, mismatch of classification of formal workers in the first
focuses more on coverage of workers by mandated labor panel, as captured in column (ii), reflects the different ques-
protections. It thus is more concerned with workers' tions underlying the measures; the ILO focus on small
welfare per se (or perhaps with job quality) than with the firms in the productivity definition, by design, cannot cap-
nature of their employment; and when not including self- ture evasion or coverage in large firms, while the legalistic
employed or owners, who are often not required to register definition is more informative in this respect. While, in the
with social security administrations, it captures compliance aggregate, the two measures are highly correlated, for par-
with labor laws. This is more consistent with the ILO's ticular questions the definition matters. For example, in 7
(2002) more recent emphasis in its "Decent Work" report out of 12 countries in figure 1.4, the relative representation
on noncompliance by either enterprises or workers with of women versus men in the informal sector depends on the
all or some of the rules and regulations in the body of particular measure used.
national or local legislation, commercial, and/or labor leg- Second, informality measured along the labor dimen-
islation. This new focus implies expanding the definition to sions in many countries is largely a small-firm phenome-
include informal contractual arrangements among other- non. In most countries, the share of uncovered workers in
wise formal entities (see box 1.1). Hence, this definition firms with more than 10 workers is a minority; and, as
puts a greater emphasis on the division between informal figure 1.5 shows for Argentina, Brazil, and Mexico, in firms
salaried workers in any size firm and the informal self- of more than 10 workers, the share of workers plausibly not
employed; and, in fact, the report will show that there are covered is small. Though there has been increasing infor-
substantial differences in the behavior of these two classes malization of the large-firm labor force in Argentina and
of workers that make the bifurcation of informal workers metropolitan Brazil (and the reverse in Mexico), the rele-
critical for analysis. Global data do not exist for this vant margins for understanding the raz�n de ser of the infor-
measure, but, again, Gasparini and Tornarolli (2006) have mal laborer seem more along the margin of small firms
calculated consistent series for Latin America, and other growing into formality, and the intrasectoral margin of
authors providing background papers for this report use worker flows among the formal and informal sectors.
some close variant. Hence, along this dimension of formality--that is, compli-
Overall, both the productive and the legalistic measures ance with labor laws--the intrafirm margin with large
give broadly similar measures of the level of informality in firms in mind, while still employing an important share of
Latin America and the Caribbean. However, the individuals informal workers in some countries, does not seem to be
under each measure may differ substantially.9 Column (ii) of where the majority of the action is, overall. Understanding
table 1.1 tabulates the share of the labor force that, when the decisions that employers and workers in small firms
classified as formal under the productive definition, is infor- make on whether to register with the authorities becomes a
mal under the legalistic definition. In practice, it is a mea- central question to be taken up in later chapters.
sure of what fraction of workers in firms with more than five A final direct measure capturing social protection is an
employees probably legally should be covered by social index of pension coverage of the population that considers
30
T H E I N F O R M A L S E C T O R : W H AT I S I T, W H Y D O W E C A R E , A N D H O W D O W E M E A S U R E I T ?
TABLE 1.1
Correspondence of the "productive" and "legalistic" definitions of informality
Formal productive Informal productive
Formal L Informal L Formal P & L Formal L Informal L Informal P & L Total
Sample (i) (ii) (i)/(i)+(ii) (iii) (iv) (iv)/(iii)+(iv) (i)+(ii)+(iii)+(iv) (i)+(iv)
Argentina 2004 Only salaried workers 50.6 15.6 76.5 6.1 27.8 82.1 100.0 78.4
Bolivia 2002 Only salaried workers 24.6 35.5 40.9 1.1 38.9 97.3 100.0 63.5
All workers 7.6 15.5 33.0 0.8 76.1 98.9 100.0 83.7
Brazil 2003 Only salaried workers 53.3 10.6 83.4 11.8 24.2 67.2 100.0 77.6
All workers 36.2 8.8 80.4 10.2 44.8 81.5 100.0 81.0
Chile 2003 Only salaried workers 67.0 11.6 85.3 10.7 10.8 50.1 100.0 77.7
All workers 51.8 11.4 82.0 11.2 25.6 69.5 100.0 77.4
Colombia 1999 Only salaried workers 86.0 14.0 86.0 100.0 86.0
All workers 13.6 10.6 56.1 2.8 73.0 96.3 100.0 86.6
Ecuador 1998 Only salaried workers 36.9 32.4 53.2 2.6 28.1 91.6 100.0 65.0
El Salvador 2003 Only salaried workers 49.9 20.8 70.6 1.9 27.4 93.6 100.0 77.3
All workers 28.8 16.2 64.0 1.5 53.4 97.2 100.0 82.2
Guatemala 2002 Only salaried workers 37.8 24.1 61.0 2.3 35.7 93.9 100.0 73.5
All workers 15.4 15.1 50.5 1.0 68.5 98.5 100.0 83.9
Mexico 2002 Only salaried workers 37.6 25.7 59.4 3.4 33.2 90.7 100.0 70.9
Nicaragua 2001 Only salaried workers 29.5 30.7 49.0 2.3 37.5 94.1 100.0 67.0
All workers 14.9 20.4 42.2 1.5 63.3 97.7 100.0 78.1
Paraguay 2003 Only salaried workers 23.6 27.4 46.2 2.1 47.0 95.8 100.0 70.6
All workers 10.5 17.1 38.1 1.4 71.0 98.1 100.0 81.5
Peru 2002 Only salaried workers 26.6 36.1 42.4 1.4 35.9 96.2 100.0 62.5
All workers 11.4 21.6 34.6 1.4 65.5 97.9 100.0 77.0
Uruguay 2004 Only salaried workers 64.1 9.9 86.7 8.3 17.7 68.0 100.0 81.8
All workers 49.3 8.4 85.5 10.0 32.3 76.3 100.0 81.6
Venezuela, 2003 Only salaried workers 53.4 19.2 73.6 5.0 22.4 81.8 100.0 75.9
R. B. de
Source: Gasparini and Tornarolli 2006.
Note: Table shows what fraction of workers categorized as informal under the �pro ductive" definition are also informal under the
"legalistic" definition, and analogously for the formal. Formal L = formal using legalistic definition, informal L = informal using
legalistic definition, and formal P&L = formal under both definitions.
both labor-related and universal pension schemes. This
FIGURE 1.4 measure raises an important issue. If our concern is that
Informality and gender: women versus men (ages 25�64)
families are covered by certain protections, it need not be
% informal women % informal men the case that these protections are linked to the particular
1.5 labor contract. Throughout the region, there has been an
1.3 expansion of social protection programs that aim to provide
a minimum safety net for families, regardless of labor mar-
1.1
ket status. These are not captured in the pension measure,
0.9 and cross-country comparisons are not yet available.
Finally, all these stock measures of informality obscure
0.7
the fundamentally dynamic nature of the labor market.
0.5 Chapters 2 and 4 document high flows between jobs with
and without formal pension programs. Not only does this
Peru . de
BoliviaBrazilChile
Mexico aguay
Salvador UruguayR.B
Argentina suggest a need to understand workers' choices among sec-
El Guatemala Nicaragua
Par
tors and the constraints they face in making them, but also
Venezuela,
that the individuals in the informal population change sub-
Productive Legalistic stantially from one month to the next. Such high flows
have implications for what coverage really means. As chap-
Source: Gasparini and Tornarolli 2006.
ter 7 will show, in Mexico and Uruguay, poor workers flow
31
I N F O R M A L I T Y
Mexico, there is little evidence that either informal salaried
FIGURE 1.5
or self-employed workers are less well-off than comparable
Informal salaried workers (legal definition) across
firm size and time workers in protected jobs, why should policy makers care
about the particular bundle of money and benefits in which
Argentina (greater Buenos Aires)
those workers are paid? The answer is complex but under-
% of informal and self-employed workers
scores the importance of understanding decisions across the
50 1980
45 margin of worker flows between the two sectors for the
40
35 interpretation of informality measures.
30 2003
25
20
The multidimensional continuum of informality
15
10 As suggested above, formality is multidimensional and
5
0 continuous. At the microfirm level, there is a substantial
1 2�5 6�25 26�100 101�500 501 gray area (see Tokman 1992) where firms comply with cer-
Firm size (number of workers)
tain norms and not necessarily to the same degree. Gray
Brazil (metropolitan areas) areas prevail and, in the extreme, one can argue that a
% of informal and self-employed workers realistic--but one that is less easy to operationalize--
50 description is that of a continuum from complete lack of
45
40 1990 integration with formal institutions to full compliance
35
30 with all.
25 Compliance along any one particular dimension of for-
20 2002
15 mality is not discrete. For example, Robles et al. (2001)
10
5 find that 16 percent of microfirms in Peru do not pay any
0
tax, 83 percent pay some taxes, and 2 percent pay all taxes
1 2�5 6�10 11
Firm size (number of workers) that they are required to pay. Figure 1.6 suggests that, in
Mexico, firms of, say, seven workers may well have one
Mexico (urban areas)
worker registered but not all. Further, the registered�not
% of informal and self-employed workers
registered dichotomy does not capture the gradations of
50
45 protection that exist across labor contracts. Though not for-
2004
40
35 mally covered, workers nonetheless appear to benefit from
30 some social norms of fairness. Souza and Baltar (1979)
25
1994
20 introduced the concept of the efeito farol, whereby the min-
15
10 imum wage ends up being an indexation mechanism valid
5 also for the informal sector. In fact, Maloney and Nu�ez
0
1 2�5 6�10 11�15 16�50 51�100 101�250 250 (2001) and Cunningham (2007) show that, in many coun-
Firm size (number of workers) tries of Latin America, the minimum wage is most binding
Sources: Encuesta Nacional de Empleo Urbano 1994, 2004; Encuesta among the informal salaried, suggesting that salary norms
Permanente de Hogares 1980, 2003; Pesquisa Nacional por Amostra are respected outside the realm of the official work contract.
de Domicilios 1990, 2002.
Chavez and Chacaltana (1994) show, in a study of microen-
terprises in Peru, that a large percentage of workers with-
so frequently in and out of covered jobs that, in practice, out a formal contract and without social protection benefits
they will never accumulate enough years to gain a pension. do enjoy vacations and the customary December bonus
They pay, but are de facto not covered. Further, such salary, much as dictated by labor legislation. Among larger
flows also raise the question (discussed at length in chap- firms, such norms may carry over to workers hired illegally
ters 2 and 3) of what a worker's choice to be uncovered (bajo la mesa) or subcontracted out, but on the same
implies about the social protection and, to a lesser extent, premises. In Argentina, however, there is an almost one-to-
pension definitions as measures of worker welfare. That is, one correspondence between pension coverage and other
if, as appears to be the case in the Dominican Republic and labor benefits, suggesting substantial variance by country.
32
T H E I N F O R M A L S E C T O R : W H AT I S I T, W H Y D O W E C A R E , A N D H O W D O W E M E A S U R E I T ?
FIGURE 1.6 FIGURE 1.7
Distribution of manufacturing sector firms according to worker Distribution of manufacturing sector firms according to tax
registration in Mexico compliance in Mexico
% of firms % of firms
100 100
90
80
70 90
60 80
70
50
60
40
50
30
40
20 30
10 20
0 10
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 0
Firm size (number of workers) 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Firm size (number of workers)
No workers registered Some workers registered
All workers registered Tax compliant Not tax compliant
Source: Encuesta Nacional de Micronegocios 1992�2002. Source: Encuesta Nacional de Micronegocios 1992�2002.
The point remains, however, that many of those workers across the de Soto margin is likely to be somewhat different
who are unprotected in large firms (identified in table 1.1) from that of larger firms partially evading obligations.
may, in fact, enjoy other elements of the standard labor
contract.10 Indirect and modeling approaches to estimating
But it is also the case that the firms may be formal along aggregate informality
one dimension, but not along another. Levenson and Maloney Indirect methods are macroeconomic in nature, and com-
(1998), taking a broad view of formality as integration with bine various aggregate economic variables and a set of
not only government but also civil society more generally, assumptions to produce estimates of total economic activ-
find for Mexico that firms may pay taxes, but only pay labor ity (that is, measured and unmeasured, official and unoffi-
taxes as they get larger, and engage with business associa- cial). Box 1.2 outlines several popular methods--in
tions only when they grow larger still. Figure 1.6, combined particular, those based on unexplained components of
with figure 1.7, suggests that while most firms with a labor money demand or electricity consumption--and some
force of five workers are registered with tax authorities, com- of their drawbacks. By far the most common method is that
pliance with labor law is far less complete. This is consistent of the Multiple Indicator�Multiple Cause (MIMIC) Model
with the findings of Robles et al. (2000) from Peru that the that imputes a level of underlying informality from a set of
majority of firms pay the value-added tax, just over half pay presumed causes of informality on one hand, and measur-
municipal taxes, 45 percent pay income taxes, and 13 per- able consequences of it on the other. This exercise was first
cent pay labor taxes. For larger firms, as later chapters will undertaken by Loayza (1996) for Latin America with a
show, there tends to be partial formality that is relatively relatively tight, theoretically motivated set of input and
well synchronized across the tax and labor dimension. The outcome variables. However, recently, a more expansive
logic here is clearer: larger, more frequently monitored firms estimate of the "shadow" economy as a share of gross
will raise suspicions if they report half of their true product, domestic product (GDP) by Schneider and Enste (2000,
but all of their workers producing it. Hence, the logic dri- 2002) has been tabulated globally and is presented in
ving less easily monitored microfirms operating fuzzily panel (f) of figure 1.3. As box 1.2 suggests, these have been
33
BOX 1.2
Indirect methods of estimating informality
One indirect method of estimating informality is to economy are assumed to occur only in cash. Third, it also
attribute the discrepancy between aggregate income and assumes a base year in which the magnitude of the infor-
expenditure from the National Income and Product mal economy is zero or negligible--again, an unrealistic
Accounts, which capture economic activity, to the infor- assumption for most countries.
mal sector. For this method to work, it is necessary to Thus, both the physical input and the currency demand
have measures of gross domestic product (GDP) obtained methods--two of the most widely used approaches--are
independently through the expenditure and the income somewhat arbitrary in the following sense. Depending on
approaches. Given that only one independent measure of the assumption made about the base year in which the
GDP is typically available for most countries, in practice magnitude of the shadow economy is zero or negligible,
the application of this approach has been limited to a few one can obtain widely different estimates of the magnitude
developed countries. of the shadow economy.1
Another indirect method commonly employed is the The third group of methods is the model approach.
physical input (electricity consumption) approach. This The most popular among these is the Multiple Indicator�
method assumes that electricity consumption is the Multiple Cause (MIMIC) or structural equation model.2
"single best physical indicator of overall [official and The MIMIC approach postulates that magnitude of the
unofficial] economic activity" (p. 27). The method then unofficial economy can be modeled as a latent or index
defines the growth rate of the shadow economy as "the variable. While this variable is unobservable, its causes
difference between the growth of official or measured (for example, an increase in the tax burden) and effects
GDP and the growth rate of electricity consumption" (such as an increase in the demand for currency) can be
(p. 28). This method has been criticized on several observed directly.
grounds, all related to the assumption of a constant coeffi- A system of equations forms the basis of this model:
cient of use per unit of GDP. First, it does not consider one set models the effects (or indicators) as a function of
technological progress, which reduces the amount of elec- the latent variable; the other group models the magni-
tricity consumption per unit of output. Second, it needs tude of unofficial economy as a function of the causal
to assume a base year in which the magnitude of the variables. The parameters in this system of equations are
informal economy is zero or negligible--an unrealistic estimated simultaneously, typically using maximum
assumption for most countries. Third, it does not consider likelihood. The fitted values of the latent or index vari-
the incorporation over time of new households to the elec- able obtained from the reduced form equation are then
tric grid, a fact that explains a large fraction of the increase used to produce an estimate of the unofficial economy.
in electricity consumption in developing countries. The model approach has been criticized (see Breusch
A third indirect method that has also been commonly 2005) since it has been shown that its results are sensitive
employed is the currency demand approach. This method to transformations of the data, to the units of measurement,
begins by estimating a form of money demand equation and to the sample used. Another criticism is that no theory
in which the dependent variable is the ratio of cash hold- is used in order to determine which variables to include as
ings to current and deposit accounts (M0/M2). The equa- indicators or as causes. Moreover, the shadow estimates,
tion controls for most known determinants of money while relying on the MIMIC Model to generate trends over
demand; it also includes as covariates variables that are time, appear to rely on traditional currency demand or the
thought to be determinants of the shadow economy (for physical input methods for the initial levels, which makes
example, the tax burden). It then defines the growth rate it vulnerable to the criticisms of these two methods.
of the shadow economy as the difference between the fit-
Notes
ted values obtained using the estimated model and the
1. See Thomas (1993, 1999) for a more detailed description
observed values from actual data. Just like in the case of
and criticism of these two methods.
the physical input approach, this method has been criti- 2. For a detailed description and critique of these models, see
cized on several grounds. First, it assumes a common Breusch (2005).
velocity of circulation of money between the official and
unofficial economies. Second, transactions in the shadow Source: Garc�a-Verd� 2007.
34
T H E I N F O R M A L S E C T O R : W H AT I S I T, W H Y D O W E C A R E , A N D H O W D O W E M E A S U R E I T ?
BOX 1.3
Schneider and Enste in the New World: Checking MIMIC estimates against Mexican data
Mexico is one of the few countries that calculate official Official and unofficial estimates of the informal economy,
statistics on the contribution of the informal sector to Mexico 1993�2003
total value added. The National Statistical Institute
13.5 31.0
(INEGI) employs the International Labour Organisa-
tion's official definition of the informal sector, and 30.0
imputes its value added using a variety of sources. Over 13.0
29.0
the period 1993�2003, the INEGI calculates that the
informal sector averaged 12.4 percent of gross domestic
12.5 28.0
product (GDP)--a share that remained relatively con-
stant across the period (figure at right). This conflicts 27.0
with the estimates from Schneider (2005) and Schneider 12.0
and Enste (2000, 2002), which suggest that over the 26.0
periods 1990�91 and 1999�2000, the shadow economy
11.5 25.0
in Mexico increased from 24.1 to 30.1 percent of GDP. 3 4 5 7 8 9 0 2 3
199 199 199 1996 199 199 199 200 2001 200 200
INEGI1 (left) Schneider2 (right) Loayza3 (right)
Sources: 1. Cuenta Sat�lite del Subsector Informal de los Hogares.
Sistema de Cuentas Nacionales de M�xico. Instituto Nacional de
Estad�stica, Geograf�a e inform�tica (INEGI).
2. Schneider (2005), using DYMIMIC and currency-demand methods.
3. Loayza (1996), using MIMIC Method.
subject to substantial criticism for, among other reasons, explanations, some of which will be touched on in this vol-
their relatively atheoretical combination of different causal ume. Again, since most independent workers in Latin
factors and indicators, and the difficulty in assuming that America are not covered by pensions, and many informal
informality is the only thing linking the two. Both suggest salaried workers are found working in these very small
that the shadow economy runs the risk of being a measure firms, we may expect lack of pension coverage to follow
of an agglomeration of known size but unclear content. An GDP closely as well. Globally, the shadow economy measure
exercise comparing MIMIC estimates with official esti- is moderately correlated with self-employment and pension
mates is presented for Mexico in box 1.3. coverage.11 The limited correlation of the tax compliance
measure with both GDP and the other measures is sugges-
Correlations among measures and trends tive that, if it is reliable, it may be measuring a different
over time phenomenon. As chapter 8 will show, tax evasion or elusion
As table 1.2 indicates, globally, the pensions, self- may be a relevant phenomenon across the firm-size spec-
employment, and shadow measures show a modest degree of trum and be related to levels of social norms or collective
correlation generally of the expected sign. All are impor- responsibility, and less to income levels. Labor informality
tantly negatively correlated with GDP. This makes certain measured as lack of compliance with legislation, however,
sense since, as figure 1.8 shows, self-employment decreases may fundamentally be a small, low-productivity firm issue
sharply with development, from high levels in Latin rather than a compliance issue per se.
America and the Caribbean region (60 percent in Peru) to In Latin America, the productive measure, including
near single-digit levels in the OECD. The close connection self-employed and all employees, and the legalistic/social
between self-employment and GDP per capita has already protection measure are highly correlated (.8�.9) with
been documented by, among others, Blau (1987), Loayza each other and, not surprisingly, with the pension measure.
and Rigolini (2006), and Maloney (2001) with a variety of It is perhaps not unexpected that all are somewhat less
35
I N F O R M A L I T Y
TABLE 1.2
Correlations across measures of informality
All countries Shadow economy Self-employment Sales nonreported Lack of pensions GDP pc PPP 05
Shadow economy 1
Self-employment 0.58 1
Sales nonreported 0.13 0.17 1
Lack of pensions 0.60 0.81 0.43 1
GDP per capita (PPP 05) 0.69 0.76 0.30 0.85 1
Shadow Self- Lack of Informality Informality
Latin America economy employment Sales nonreported pensions (productive) (legalistic) GDP pc PPP 05
Shadow economy 1
Self-employment 0.35 1
Sales nonreported 0.29 0.06 1
Lack of pensions 0.43 0.62 0.04 1
Informality (productive) 0.60 0.70 0.11 0.80 1
Informality (legalistic) 0.58 0.68 0.32 0.89 0.90 1
GDP per capita (PPP 05) 0.58 0.75 0.24 0.66 0.83 0.75 1
Sources: Gasparini and Tornarolli 2006; investment climate surveys 2006; Loayza and Rigolini 2006; Schneider 2005;
World Bank 2006b.
Note: GDP = gross domestic product; pc = per capita; PPP = purchasing power parity; PPP05 = data correspond to year 2005.
correlated with the ILO self-employment measure that in the productive measure. As will be documented in chap-
omits salaried workers. The underreporting of sales mea- ter 4, this arises from the fact that the increase happened
sures is capturing something else and is poorly correlated through increasing informalization of large firms, not the
with other measures. Finally, the shadow economy is not emergence of new informal microfirms. Some anomalies--
well correlated with the self-employment or underreport- such as why Ecuador should have the largest increase in lack
ing of sales measure or pensions measure, but is moderately of coverage in pensions, but apparently little increase in legal
correlated with the productivity and legalistic measures. Its informality--are likely due to the time spans covered. Also
poor performance on the self-employment measure may be important to keep in mind are the subnational differences in
due to some odd values of the measure. For instance, trends. Though the legal definition for Brazil as a whole
Uruguay has relatively low levels of self-employment, but shows little increase, there has been a dramatic increase in
is among the highest in the size of its simulated shadow metropolitan informality across the same period, and it will be
economy. explored in chapter 4. The shadow measure somewhat
strangely shows global increases in informality for all coun-
Trends across time tries of the world from 1990 to 2000--increases from 30 to
The underreporting of sales is available for only a handful of 36 percent of GDP, an increase of 24 percent--and substan-
countries; however, we report the productive, legal/social tial increases in Latin America.12 Perhaps the estimates are a
protection, shadow economy, lack of pensions, and ILO self- bit too substantial, showing an average increase over the
employment for Latin America and the Caribbean where period 1990�2000 of 7.4 percentage points or approxi-
available (figure 1.9). With the exception of the self- mately 21 percent. This is far above every other measure and
employed definition, all measures suggest increases across is reasonable only if we assume that productivity in the
the available sample period, although there are suggestive informal sector rose substantially more than that in the for-
differences among them and even within individual country mal sector across the period.13 Because of these odd results,
experiences. For instance, Argentina shows important and the theoretical concerns discussed above, the report does
increases in the legal and pension coverage variable, but not not rely significantly on this measure in its analysis.
36
T H E I N F O R M A L S E C T O R : W H AT I S I T, W H Y D O W E C A R E , A N D H O W D O W E M E A S U R E I T ?
FIGURE 1.8
Global correlation of measures of informality with GDP
Underreporting of taxes (% of sales)1 Self-employment (% of labor force)2
100 100
90 90
80 80
70 70
60 60
50 50
40 40
30 30
20 20
10 10
0 0
0 10,000 20,000 30,000 40,000 0 10,000 20,000 30,000 40,000
2005 GDP per capita, PPP adjusted 2005 GDP per capita, PPP adjusted
Lack of pensions (% of labor force)3 Shadow economy (% of GDP)4
100 100
90 90
80 80
70 70
60 60
50 50
40 40
30 30
20 20
10 10
0 0
0 10,000 20,000 30,000 40,000 0 10,000 20,000 30,000 40,000
2005 GDP per capita, PPP adjusted 2005 GDP per capita, PPP adjusted
Latin America Advanced countries Rest of the world
Sources: Investment climate surveys 2006; Loayza and Rigolini 2006; Schneider 2005; World Bank 2006b.
Note: 1. Informality is measured by the percentage of sales that businesses do not report for tax purposes (Investment Climate Surveys 2006).
2. "Self-employment is measured as the percentage of self-employed workers with respect to the total active population"
(Loayza and Rigolini 2006, 15).
3. Share of the labor force not covered by a pension scheme (World Bank 2006b).
4. "The shadow economy includes all market-based legal production of goods and services that are deliberately concealed from public authorities
for the following reasons: (1) to avoid payment of income, value added or other taxes, (2) to avoid payment of social security contributions,
(3) to avoid having to meet certain legal labor market standards, such as minimum wages, maximum working hours, safety standards, etc., and
(4) to avoid complying with certain administrative procedures, such as completing statistical questionnaires or other administrative forms"
(Schneider 2005, 600).
Nonetheless, the overall perception from the various mea- number of phenomena it encompasses and the limitations of
sures and other sources, as well as the general "feeling" of the its measures are manifold, raising some serious doubt about
region, is that informality has risen. What will be dealt with how useful the term really is. Yet two stylized facts remain:
in the next chapters are some of the forces driving the move- First, however measured, Latin America ranks high in its
ments over the last decades and across which margins. degree of informality. Not especially high for its level of devel-
opment, but informality remains an important phenomenon.
Conclusions Second, several countries have experienced striking increases
This chapter has sought to unpack our understanding of the in informality across the last decades. Whatever adverse regu-
term informality, why we may care about it, and, broadly latory, poverty, growth, or social morale implications infor-
speaking, what dynamics may be driving its elements. The mality may have, they have become more relevant with time.
37
FIGURE 1.9
Trends in informality by various definitions
Informal labor force: Productive definition (% of employed workers)1 Informal labor force: Legalistic definition (% of salaried workers)2
Venezuela, R. B. de 1989�2003 18.5 Argentina 1992�2005 11.9
Uruguay 1992�2004 7.0
Honduras 1992�2002 6.8 Venezuela, R. B. de 1995�2003 7.7
Panama 1995�2003 5.4 Brazil (metropolitan) 1992�2002* 6.2
Colombia 1996�2004 4.8
Peru 1997�2003 4.6 Nicaragua 1993�2001 5.9
Jamaica 1996�2002 3.4 Peru (metropolitan Luna) 1990�2000 4.5
Dominican Republic 1996�2004 3.1
**
Paraguay 1997�2003 2.6 Mexico 1990�2004a 4.0
Mexico 1996�2002 2.4 Chile 1990�2003 1.1
El Salvador 1991�2003 2.2
Argentina 1995�2005 1.9 Ecuador 1994�98 0.7
Bolivia 1997�2002 1.5 Brazil 1990�2003 0.8
Ecuador 1994�2003 1.1
Costa Rica 1992�2003 0.4 Paraguay 1997�2003 0.9
Nicaragua 1993�2001 0.9 Colombia 1996�99 2.4
Brazil 1992�2003 3.3
Chile 1990�2003 5.2 El Salvador 1991�2003 12.0
10 5 0 5 10 15 20 15 10 5 0 5 10 15
Percent Percent
Lack of pensions (% of labor force)3 Self-employed: ILO (% of employed workers)4
Ecuador 1990�2004 12.75 Colombia 1992�2005 17.3
Argentina 1992�2004 10.26 Bolivia 1990�2000 6.9
Dominican Republic 1991�2005 4.7
Nicaragua 1993�2001 8.08
Chile 1996�2005 0.1
Costa Rica 1990�2004 3.83 Costa Rica 1990�2005 1.4
Venezuela, R. B. de 1995�2004 3.82 Jamaica 1997�2005 2.3
Chile 1990�2003 2.75 Panama 1991�2005 2.4
El Salvador 1995�2004 2.7
Uruguay 1995�2004 2.19
Honduras 1996�2005 3.4
Colombia 1996�99 0.64 Argentina 1996�2005 3.7
Brazil 1992�2002 0.54 Peru 1996�2005 6.9
El Salvador 1995�2003 8.6
4.33 Mexico 1991�2005
10 5 0 5 10 15 20
15 10 5 0 5 10 15
Percent
Percent
Shadow economy 1990�2000 (% of GDP)5
Peru 12.8
Panama 12.7
Bolivia 11.7
Guatemala 10.1
Uruguay 9.8
Honduras 8.9
Average 7.3
Brazil 7.3
Chile 6.2
Venezuela, R. B. de 6.2
Mexico 6.0
Colombia 5.7
Ecuador 5.5
Nicaragua 5.1
Jamaica 5.0
Costa Rica 4.2
Dominican Republic 3.8
Argentina 3.3
0 2 4 6 8 10 12 14
Percent of GDP
Sources: Gasparini and Tornarolli 2006; ILO 2006; Loayza and Rigolini 2006; Schneider 2005; World Bank 2006b.
Note: 1. "An individual is considered an informal worker if (s)he belongs to any of the following categories: (i) unskilled self-employed,
(ii) salaried worker in a small private firm, (iii) zero-income worker" (Gasparini and Tornarolli 2006, 8). 2. "A salaried worker is informal if s(he)
does not have the right to a pension linked to employment when retired" (Gasparini and Tornarolli 2006, 10). 3. Share of the labor force not
covered by a pension scheme (World Development Indicators 2006). 4. "Self-employment is measured as the percentage of self-employed workers
(employers, own account workers) and contributing family workers with respect to the employed workers" (ILO 2006, 15). 5. "The shadow
economy includes all market-based legal production of goods and services that are deliberately concealed from public authorities for the
following reasons: (1) to avoid payment of income, value added or other taxes, (2) to avoid payment of social security contributions, (3) to avoid
having to meet certain legal labor market standards, such as minimum wages, maximum working hours, safety standards, etc., and (4) to avoid
complying with certain administrative procedures, such as completing statistical questionnaires or other administrative forms"
(Schneider 2005, 600).
*% of workers without carteira (work card). **Based on the balanced panel sample (common municipalities) for the period 1990�2004.
a. Author's calculations based on ENEU.
38
T H E I N F O R M A L S E C T O R : W H AT I S I T, W H Y D O W E C A R E , A N D H O W D O W E M E A S U R E I T ?
TABLE 1A.1
Comparisons of ILO and Gasparini-Tornarolli measures of self-employment
ILO Table: Proxied with Gasparini Data vs. ILO Data
Informal sector
Independent workers Domestic workers Microfirms Total
Country Year Gasparini ILO Gasparini ILO Gasparini ILO Gasparini ILO Difference
Argentina 2004 20.7 17.9 -- 7.4 24.6 19.0 45.3 44.3 1.0
Bolivia 2002 47.4 44.6 -- 4.3 18.2 17.8 65.6 66.7 1.1
Brazil 2003 25.4 21.0 -- 9.3 22.2 14.3 47.6 44.6 3.0
Chile 2003 21.3 21.5 -- 6.2 15.7 11.1 37.0 38.8 1.8
Colombia 2004 39.6 37.6 -- 5.8 27.9 16.6 67.5 59.9 7.6
Costa Rica 2003 22.0 18.1 -- 5.3 19.5 20.2 41.5 43.6 2.1
Ecuador 2003 35.1 31.9 -- 5.2 20.6 19.4 55.7 56.5 0.8
El Salvador 2003 36.7 32.1 -- 5.7 20.3 16.4 57.0 54.2 2.8
Honduras 2003 45.4 40.8 -- 4.8 18.3 13.8 63.7 59.4 4.3
Mexico 2002 24.8 19.5 -- 4.4 23.0 17.9 47.8 41.8 6.0
Panama 2003 34.8 24.7 -- 7.1 15.4 10.7 50.2 42.5 7.7
Paraguay 2003 33.9 30.0 -- 11.8 26.6 19.9 60.5 61.7 1.2
Peru 2003 40.3 34.5 -- 5.7 19.0 15.8 59.3 56.0 3.3
Rep. Dominicana 2004 39.1 32.5 -- 5.7 12.2 11.3 51.3 49.5 1.8
Uruguay 2004 24.1 17.2 -- 9.1 18.3 11.5 42.4 37.8 4.6
Venezuela, R. B. de 2003 39.4 33.0 -- 3.0 14.7 17.6 54.1 53.6 0.5
Sources: Gasparini and Tornarolli 2006; ILO 2006.
Note: -- = not available.
Annex 4. We also know that, within the formal sector, individuals
choose among degrees of formal sector protection (for example, how
Formostofthereport,werequiremoredetailthanprovidedby
much insurance and what kind to buy).
the ILO tables. Hence, Gasparini and Tornarolli (2006) have
5. See Livingstone (1991), who argues that many of these goods
replicated the ILO data with identical data and definitions.
and services are "appropriate" for lower-income consumers. In fact,
Although in this chapter we use measures that include infor- these consumers are willing--given their preferences, information,
mal salaried workers in our definition, we check here to be rates of discount, and income--to eat in a cheaper, less hygienic restau-
sure thatthesubcomponentofourmeasurethatcorrespondsto rant in any Latin American capital or ride a less safe taxi or mototaxi.
6. Sethuraman (1981), in another ILO report, mentioned that
self-employment is similar to that of the ILO. The right-hand
there was no evidence that informal workers were en route to or
column of table 1A.1 suggests that, with some exceptions--
queuing for a formal sector job, but that their activities were a per-
Colombia, Mexico, Panama--the two series are quite close.
manent source of income. This may testify more to extreme barriers
to entry than to voluntariness in the sector.
Notes 7. For two comprehensive surveys of these methods, see Thomas
1. This section draws heavily on Maloney (2006). (1993) and Schneider and Enste (2000, 2002).
2. Without abandoning the central principle, a certain amount 8. The version of the original ILO definition presented here con-
of state-sanctioned evasion may be optimal. Undertaking a cost�benefit siders an individual as an informal worker if she or he belongs to any
analysis of monitoring and enforcement, the state may decide to leave of the following categories: (1) unskilled self-employed, (2) salaried
its coverage incomplete. As an example, many countries collect no worker in a small private firm, or (3) zero-income worker. It is impor-
taxes below a certain level of income or have streamlined labor regu- tant to note that labor market�related definitions include within the
lations for microfirms. In this case, the "informal" becomes simply informal sector at least two types of workers, self-employed people
the population that it wasn't socially optimal to force to be formal. and informal wage earners for whom the micro determinants and
3. The tax morale literature departs from the finding that, under motivations to participate in formal or informal economic arrange-
normal estimates of individual risk aversion, the existing penalties ment vary, as will be discussed in chapter 2.
for cheating and the probability of being caught are simply too low 9. For a discussion of Brazil, see Henley, Arabsheibani, and
to explain the high rates of compliance in the advanced countries. Carneiro (2006).
See, for example, Graetz and Wilde (1985); Alm, McClelland, and 10. The gray area of informality may also exist in the public sector
Schulze (1992); and Frey and Feld (2002). where rigid hiring and firing laws generate the need to hire public
39
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Department of Economics, University of Virginia, Charlottesville. owy Measurement?" Photocopy. World Bank, Washington, DC.
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Are Job Losses Less Painful near the Mediterranean?" Discussion America and the Caribbean: Patterns and Trends from Household
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Bond, P., and R. Townsend. 1996. "Formal and Informal Financing Press.
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Breusch, T. 2005. "Estimating the Underground Economy using Bureau of Economic Research, Cambridge, MA.
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Gregory, P. 1986. The Myth of Market Failure: Employment and the Labor Maloney, W. F., and J. N. Nu�ez. 2001. "Measuring the Impact
Market in Mexico. Baltimore: Johns Hopkins University Press. of Minimum Wages: Evidence from Latin America." Policy
Greif, A. 1993. "Contract Enforceability and Economic Institutions Research Working Paper 2597, World Bank, Washington, DC.
in Early Trade: The Maghribi Traders' Coalition." American Mazumdar, D. 1976. "The Urban Informal Sector." World Development
Economic Review 83: 525�48. 4: 655�79.
------. 1998. "The Historical and Comparative Institutional Analy- North, D., J. Wallis, and B. Weingast. 2005. "The Natural State: The
sis." American Economic Review Papers and Proceedings 83: 80�84. Political-Economy of Non-Development." Burke Center for Inter-
Hart, K. 1973. "Informal Income Opportunities and Urban Employ- national Relations, University of California, Los Angeles.
ment in Ghana." Journal of Modern African Studies 11: 61�89. O'Donnell, G. 1996. "Illusions about Consolidation." Journal of
Henley, A., G. R. Arabsheibani, and F. G. Carneiro. 2006. "On Democracy 7 (2): 34�51.
Defining and Measuring the Informal Sector." Policy Research Perry, G., O. Arias, H. L�pez, W. Maloney, and L. Serv�n. 2006.
Working Paper 3866, World Bank, Washington, DC. Poverty Reduction and Growth: Virtuous and Vicious Circles.
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Bureau of Statistics, International Labour Organization, Geneva. Rauch, J. E. 1991. "Modelling the Informal Sector Formally." Journal
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the Informal Economy." Report VI for the 90th International Robles, M., M. Torero, J. Saavedra, N. Valdivia, and J. Chacaltana. 2000.
Labour Conference, Geneva. "EstrategiasyRacionalidaddelaPeque�aEmpresas." ILO, Lima.
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http://laborsta.ilo.orgl. America: Concepts and Measurements of Coverage." Social
INEGI (Instituto Nacional de Estad�stica, Geograf�a e Inform�tica). Protection Discussion Paper 0616, World Bank, Washington, DC.
2004. Cuenta Sat�lite del Subsector Informal de los Hogares Saavedra, J., and A. Chong. 1999. "Structural Reforms, Institutions
1998�2003. Cuentas por Sectores Institucionales, Sistema de and Earnings: Evidence from the Formal and Informal Sectors in
Cuentas Nacionales de M�xico. Urban Peru." Journal of Development Studies 35 (4): 95�116.
Jovanovic, B. 1982. "Selection and Evolution of Industry." Economet- Schneider, F. 2005. "Shadow Economies around the World: What Do
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Working Paper, 1988, World Bank, Washington, DC. Causes, and Consequences." Journal of Economic Literature 38 (1):
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Washington, DC. Serageldin. Washington, DC: World Bank.
Lucas, R. E., Jr. 1978. "On the Size Distribution of Business Firms." Tendler, J. 2002. "Small Firms, the Informal Sector, and the Devil's
Bell Journal of Economics 9 (2): 508�23. Deal." Institute of Development Studies Bulletin 33 (3): 98�104.
Maloney, W. F., 1999. "Does Informality Imply Segmentation in Thomas, J. J. 1993. Informal Economic Activity. Ann Arbor: University
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Mexico." World Bank Economic Review 13: 275�302. ------. 1999. "Quantifying the Black Economy: `Measurement
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Forum, ed. S. Devarajan, F. H. Rogers, and L. Squire. Washington, Underground to Legality." In Beyond Regulation: The Informal Econ-
DC: World Bank. omy in Latin America, ed. V. Tokman. Boulder, CO: Lynne Rienner.
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Bank, Washington, DC. www.worldbank.org.
41
CHAPTER 2
The Raz�n de Ser
of the Informal Worker
SUMMARY: This chapter brings to bear a variety of conceptual and empirical approaches to flesh out the rationale (raz�n
de ser) for the existence of the informal worker. The chapter argues that the traditional segmentation/exclusion view as
the sole explanation of informality is seriously incomplete and offers evidence of a large voluntary entrance into informal
work. Two types of informal employment emerge: one component corresponds to workers excluded from more desirable for-
mal jobs, and the other to those driven by voluntary motives. The majority of independent or self-employed workers are
voluntary, attaching significant value to the nonpecuniary benefits of autonomous work and choosing to "exit" formal
social protection systems. In contrast, the majority of informal salaried workers appear to be excluded from more desirable
jobs both as formal salaried and independent workers, although voluntary motives are significant for many workers (for
example, youth) and predominant in some country contexts (such as the Dominican Republic and Mexico). In both cases
there is substantial heterogeneity of motives and demographic characteristics with gradients and gray areas that cloud
universal conclusions about what determines the relative size and welfare implications of each group.
C HAPTER 1 SUGGESTED THAT INFORMALITY with a range of motivations and constraints that spans the
in the labor market spans all three possible traditional view of workers excluded from the formal sector,
margins: firms of all sizes contracting some as well as those stressing the voluntary "exit" of many
part of their workforce without mandated workers from state-sponsored labor and social protection
labor benefits; owners of small firms contem- systems.
plating registering their workers with the labor ministries;
and informal and formal workers weighing the advantages Informal work: Adding exit to exclusion
and disadvantages of jobs in the two sectors. What deter- As noted in chapter 1, much of the debate over the nature
mines whether workers are formal or informal at each of and implications of a large informal sector can be traced
these margins has been the focus of intense debate over the broadly to two views of whether workers are driven to or
last four decades and the policy implications critically pushed toward informal work. In the "exclusion" view,
depend on the diagnosis. This and the next three chapters informal workers, either self-employed or salaried, are the
bring to bear a variety of analytical tools--motivational and disadvantaged class of a segmented labor market arising
self-rated welfare responses, labor market transitions, earn- from economic dualism and institutional rigidities.
ings comparisons, and labor force dynamics across the busi- Workers would prefer the presumed higher wages and ben-
ness cycle--to shed light on the significant drivers of efits of formal work, but are rationed out. In contrast, the
decisions at these margins. Although a crisp, stylized image integrated view emphasizes the voluntary character of infor-
of the sector would be desirable, the picture that emerges is mal employment. Workers may choose informal jobs, given
a complex one of a heterogeneous sector containing workers their preferences, skills, other means of social protection,
43
I N F O R M A L I T Y
and their valuation of costs and the characteristics of infor-
FIGURE 2.1
mal and formal employment. The main rationale behind
Relative sector sizes and wages under a nominal wage rigidity
each view is discussed below. Since the traditional exclusion
view is better known, there is a more detailed discussion of Wage I Wage F
the integrated view.
Wage rigidity in the
formal sector
WM
The exclusion view: Segmentation and beyond
An extensive body of literature with its roots in Harris and WI WF
Todaro (1970) has equated the informal sector with under-
employment or disguised unemployment--the disadvan- DF DI
taged or excluded sector of a labor market segmented by
rigidities in the formal or covered sector of the economy.1
This view has mainly focused on the second margin, or
LI LF
labor flows between informality and the formal salaried sec-
tor: above-market-clearing wages force workers to queue LF
for preferred formal jobs while subsisting in the informal Source: Authors' illustration.
microfirm sector, which is characterized by little capacity
for capital accumulation (thus low productivity), an
absence of labor benefits, irregular work conditions, high Business Group at the World Bank, microfirms would like
turnover, and lower rates of remuneration. The large pro- to formally register their businesses and workers, but bur-
portion of women in the sector with lower earnings raises densome or costly registration precludes their doing so, and
additional suspicions of discrimination in the allocation of mandated non-wage benefits make hiring/firing too costly.
"good" jobs. The steady rise in informal salaried work in Thus, a size dualism is created in which small firms are forced
larger firms in several countries, such as Argentina (see to operate informally. More generally, if the state makes
chapter 1), has also led to focus on the within-firm margin. compliance with taxes and regulations too costly, even larger
Related to both is the Portes, Castells, and Benton (1989) firms will be forced to operate as partially informal. In gen-
structural articulation view that informal work is a means eral, regulations that affect the profitability of firms in com-
by which large firms resort to informal labor (directly or petitive markets can induce size and labor market dualism
through subcontracting) to sidestep labor regulations and (Fortin, Marceau, and Savard 1997; Rauch 1991).
unions in order to adjust to increased global competition. However, labor market dualism can result from factors
Figure 2.1 depicts one mechanism of how labor market other than rigidities in labor institutions or badly designed
segmentation may happen. A nominal wage floor, arising regulations. The high levels of quitting may induce formal
from a minimum wage (Wm) or union power, will expand firms to pay higher-than-market-clearing "efficiency wages"
informal employment and drive an earnings wedge to secure the more productive employees (see Shapiro and
between the two sectors, with informal workers occupying Stiglitz 1984; Stiglitz 2000).2 Since informal, small firms
inferior (lower-pay) jobs. Thus, segmentation yields two are able to monitor workers' efforts almost without cost,
key predictions: identical workers receive higher earnings they do not need to pay the efficiency wage (Esfahani and
in formal jobs; and, given the opportunity to move, infor- Salehi-Isfahani 1989). In his interviews with hundreds of
mal workers would happily take a formal job. This and the business executives, labor leaders, and human resource per-
next two chapters document numerous findings gauging sonnel, Bewley (1999) found that there was an aversion to
these predictions, although, as argued below and in chap- cutting wages of either current employees or new hires,
ter 3, informal-formal earnings gaps cannot offer unam- even during economic downturns, under the concern that
biguous tests of segmentation. this would hurt workers' morale and their support for
Poorly designed regulations may also impede firms to internalizing the firm's needs to enhance its competitive-
engage in as much formality as they may wish and, as a ness. Because of information asymmetries, young workers
result, generate higher informal employment (Loayza 1996). without a track record may find formal employers reluctant
Along the de Soto margin, since elaborated by the Doing to hire them and hence may queue in the informal sector
44
T H E R A Z � N D E S E R O F T H E I N F O R M A L W O R K E R
while they gain experience. Finally, in many countries, posited the idea of a two-tier sector--one of which is vol-
social security contributions are collected with income untary and prosperous--and, in fact, recent studies for
taxes. Even when these are collected separately, the pay- numerous Latin American countries conclude that the
ment of social security contributions provides public infor- majority of informal self-employed workers have chosen
mation so that firms tacitly colluding to underreport their occupation after undertaking a cost�benefit analysis
output and tax liabilities will also resort to informal hiring. of whether to be self-employed or salaried and then
That is, part of labor informality may be a result of pure whether to be formal or informal.4 The literature on infor-
evasion of income and sales taxes. mal salaried workers is scant to date, but the same pair of
The persistence of exclusionary factors is often associated considerations may enter both sectors' calculations: com-
with weak institutions and state capture by both elites and parative advantage, and, as will be argued in chapter 7, the
organized segments of middle classes, or, in Hirschman's perceived inadequacy of the benefits of formality or their
(1970) terms, "the lack of voice of those excluded." The high opportunity cost and alternative self-insurance mech-
implications of this view can be disturbing. First, over half anisms or free social protection programs. As chapters 5
of Latin America's workers, far more in some cases, are and 6 will elaborate, firms also appear, more generally, to
without desired social protections. Second, the increase in choose the degree of participation in formal institutions
informality is driven by either increasingly onerous labor, according to their business needs. Finally, as will be posited
tax, or business regulations or increased global competition in chapter 8, an important leitmotif underlying both
that is causing a race to the bottom in workers' rights and worker and firm decisions is a concern with the overall
protections. Both informal workers and firms lack "voice" competency and legitimacy of the state.
in the political system to change the exclusionary rules and As will be discussed in more detail in chapter 3, work-
processes that pushed them to informality. The next sec- ers' comparative advantage is central to their occupational
tions and chapters of the report show evidence that "exclu- choice. This arises from the matching of individual abilities
sion" factors are indeed important, document their or tastes to the different demands and characteristics of
negative impacts on productivity and welfare, and discuss jobs. Lucas (1978) argued that individuals choose between
some of the reforms necessary to mitigate them. salaried work and self-employment, depending on whether
they are relatively more talented as an entrepreneur or as a
The integrated market view: Opting out salaried employee. Rosen (1981), Heckman and Sedlacek
of or "exiting from" formality (1985), and, recently, Carneiro, Heckman, and Vytlacil
However, there is a second and equally important lens (2005) argue that a worker's comparative advantage--
through which to view informality that is more akin to emerging from a variety of work-related skills and
Hirschman's voluntary "exit": workers and firms make characteristics--drives him or her to choose among distinct
implicit cost�benefit analyses about whether to cross the jobs the one that best matches his or her talents and tastes.
margin into formality, and they frequently decide against Informal and formal jobs differ by more than labor protec-
it.3 In this lens, much of the informal sector, in fact, offers tions, and formal benefits are just one ingredient in
jobs that are equally valued by workers to those they could workers' calculations. In figure 2.1, workers equilibrate
get in the formal sector. Contrary to the predictions of the utilities--not just earnings--in choosing between jobs in
exclusion view, this implies that many informal workers are the two sectors.
equally well-off (in broad welfare terms) as in other formal In addition to Lucas's (1978) discussion of comparative
jobs fit to their skills; and, being "voluntarily" informal, advantage based on relative entrepreneurial skill, informal
they can move to the formal sector but choose not to. It is jobs may offer an entry point to the labor market for youth
imperative to highlight that this does not imply that these and unskilled middle-age workers that partially remedies
workers are prosperous or happy--only that they would deficient or obsolete skills through on-the-job training
not be better-off in the formal sector jobs that workers with unavailable to them in formal salaried jobs. For married
similar characteristics occupy. women, informal jobs offer flexibility to better balance
Again, when Keith Hart coined the term informality, he work and child rearing. For some talented workers, infor-
surely never assumed the sector was necessarily bad, and mality may offer better prospects for upward mobility than
neither did several subsequent authors. Some authors have the formal sector.5
45
I N F O R M A L I T Y
In addition, as Maloney (1999, 2004) notes, it is often consider saving for their retirement unaffordable or to
critically overlooked that social protections are not free. resort to other informal arrangements, such as investing in
Workers pay for them, either explicitly (through contribu- a microenterprise that may be sold upon retirement. Youth,
tions) or implicitly in terms of lower wages, as has been in particular, tend to have a high discount rate (or myopia)
documented, for example, in Ecuador, Peru, and Colombia and be less concerned about having jobs with pension con-
(Kugler and Kugler 2003; MacIsaac and Rama 1997, tributions. Further, poor workers who face temporary
2001). Drawing on the industrialized countries' experience financial hardship will curtail savings to preserve current
of predominantly formal salaried labor, "decent" jobs are consumption so that incentives for opting out of benefits
generally considered to be those covered by labor legisla- programs would be higher during crises. The work on
tion. However, the low quality of many formal services and Chile by Barr and Packard (2000) and Packard (2002) cor-
high administrative overhead costs may cause many workers roborates the significance of some of these considerations.
to see mandatory contributions to benefits programs as a They find that participation in the government's voluntary
disadvantage of formal salaried work. As the sociologist pension scheme, a private individual account in which
Bryan Roberts (1991) notes, based on his interviews with workers receive what they contribute, is barely around
informal workers in Guadalajara, Mexico: "The absence of 4 percent. Thus, independent workers are choosing to be
welfare coverage is a drawback, but, on the other hand, "unprotected" even by the scheme that arguably best aligns
many informants cited the deductions made for welfare as a costs and benefits in the region.6
disadvantage of formal employment, particularly since the Moreover, informal support networks may be able to
services they received were poor" (p. 50). partially substitute for unemployment and health insur-
This misalignment of costs and benefits can lead work- ance or retirement funds at lower transaction costs and with
ers to regard their contribution as a tax and to opt out of greater ease of monitoring those who intend to abuse the
the system. In fact, a microentrepreneur, faced with bor- system. Morduch (1999) reviews numerous studies that
rowing constraints to expand a business, may be reluctant find that informal insurance has a significant ability to off-
to hand over current resources for an uncertain promise of set income or other shocks, although it is far from perfect.
an old-age payment in the distant future. At worst, it Bentolila and Ichino (2000) argue that, in Italy and Spain,
means throwing money away if pension funds are raided or household consumption fell only 20 percent as much in
inflated away to finance the fiscal deficit. But even with sta- response to unemployment of the household head as it did
ble macroeconomic times, Levy (2006) finds that the sub- in Germany, where formal credit and social protections sys-
stantial rates of transition of many Mexican workers tems are more advanced. They attribute this to the greater
between jobs with formal pension contributions and those influence of (informal) interhousehold transfers.7 Some
with none would, in all likelihood, leave them with insuffi- workers may find settling for informal mechanisms justi-
cient months of benefits to qualify for a pension. As chap- fied by the other benefits of informality--for instance, flex-
ter 7 will discuss, this situation is relevant even in ibility. This is akin to strains of the social capital literature
countries with low levels of informal employment, such as that see individuals optimizing their investment in infor-
Uruguay. mal networks with a view toward long-run returns broadly
Even in the case where benefits are well aligned with conceived.
costs, workers may still opt out if they prefer higher cash In fact, not being formally enrolled with the social secu-
compensation or if an alternative exists at lower cost or is rity system does not preclude being de facto covered by other
better suited for their needs. The clearest example is that labor protections. Recent work (Cunningham 2007; Maloney
often an entire family is covered by medical benefits when and Nu�ez 2002) finds that minimum wages in several Latin
any one member is formally employed, so the second for- American countries are actually most binding among salaried
mal sector worker sees zero return to paying labor taxes, workers in informal firms. This "lighthouse" effect, as it is
explicitly or implicitly. Using cross-country employment called in Brazil, suggests that there are norms on level of pay
surveys for the region, Galiani and Weinschelbaum (2006) that informal employers follow even if they do not register
find that secondary workers are indeed more likely to be their workers with social security administrations.
informal if the household's primary worker has a formal Similar considerations apply to firms approaching the
job. Liquidity constraints may lead very poor workers to de Soto margin contemplating registering their business or
46
T H E R A Z � N D E S E R O F T H E I N F O R M A L W O R K E R
workers with the authorities. Saavedra and Chong (1999) later in chapter 8)--also enters here. In any case, the opti-
argue that, in deciding to register, firms consider whether mal choice for firms, workers, and the state itself would not
the increased expansion of scale and access to other institu- obviously be the full formal sector package for all.
tional supports that facilitate growth makes the registra- In sum, workers, in making their multidimensional
tion expenses worthwhile. Levenson and Maloney (1996) evaluation of sectoral choice along the third margin--as
show that formality along a broad set of dimensions (regis- well as microfirms contemplating a jump into formality
tering with tax and labor authorities, or joining business along the de Soto margin--will weigh the costs and bene-
associations) can be considered "normal goods" in the pro- fits of being formal, and we cannot assume, immediately,
duction function. Entrepreneurs with the underlying that all who are without protections would desire to be oth-
ability to expand, eventually, need and seek these inputs. erwise. As Maloney (1999) argues, and chapter 3 will inves-
This is consistent with numerous studies showing that tigate further, this insight also compounds the difficulties
formality increases with firm size and time in business (see of establishing segmentation, and hence the degree of
chapters 5 and 6). involuntary informality, by the traditional method of com-
In essence, low productivity may be the main reason why paring earnings adjusted for human capital. In a market
many small firms, and their employees, remain informal. with no rigidities, informal earnings should be higher to
The fact that most small firms operate in the informal sector compensate workers for the lost value of benefits and what-
(that is, size dualism) may just be a natural result of their ever risk they may be facing. On the other hand, they may
lower managerial ability (Amaral and Quintin 2006; de be lower to compensate for taxes evaded, greater indepen-
Paula and Scheinkman 2006; Straub 2005; and Levenson dence and flexibility, or, perhaps for young workers, on-the-
and Maloney 1996). The observation that size and labor job training.
market dualism go hand in hand (that is, unskilled workers
tend to be employed in informal small firms) can simply Avoiding the extremes in the debate
reflect the efficient allocation of more productive labor and The exaggerated size of the informal sector in the region
entrepreneurship (Galiani and Weinschelbaum 2006). Sort- raises the stakes of the debate dramatically: if over 50 per-
ing also leads to matching of employees and employers with cent of Latin American labor markets are thought of as dis-
higher (lower) propensities to evade. Thus, part of informal guised unemployment, then the implied labor market and
salaried employment could be a result of microfirms' sole regulatory distortions are indeed large. But if informality is
decisions to opt out of formal institutions for reasons unre- largely opting out, as discussed above, then the concern with
lated to the presence of labor or other regulatory distortions, segmentation born of minimum wages, excessive union
and some may reflect explicit opting-out collusions between power, or excessive business regulations may be overstated.
owners and employees. In fact, however, there is no need to be so Manichean in
Given the very uneven enforcement of legislation in the approaching the issue: the two views, exclusion and exit, are
region, workers and firms are able to choose the degree of complementary rather than competing analytical frame-
participation in benefits programs or formal institutions. works. First, individual countries differ greatly in history,
Of course, those operating informally need to weigh the institutions, and legal framework; hence, exclusionary mech-
benefits of being informal against the expected value of any anisms may be more important in some, and exit mecha-
sanctions if they are caught evading (D�vila Capalleja nisms in others. Second, the informal sector is tremendously
1994; Hibbs and Piculescu 2006). But, in fact, a share of heterogeneous, and arguably, therefore, there is a continuum
informality could be effectively mutually tolerated; the in the relative importance of exit and exclusion within
state may not find it cost-effective or equitable to levy countries. Third, in some cases the two can be virtually
penalties or force compliance on small enterprises, particu- indistinguishable. A microentrepreneur concluding, through
larly if this could lead to bankruptcy (employment without a cost�benefit analysis, that formality is not worth the exag-
social security contributions is deemed better than unem- gerated registration costs may be explicitly excluded or self-
ployment). The strength of the sense of reciprocity or, alter- excluded, but the effect is much the same. A poor worker,
natively, the level of tax morale--that one should pay excluded from health services by virtue of living in a
because others pay, or conversely that evasion is rampant remote, poor rural area or urban neighborhood, may see little
and considered an acceptable business practice (discussed point in being formal and paying labor taxes for services
47
I N F O R M A L I T Y
to which he or she has no access. Finally, informality is a
FIGURE 2.2
multidimensional concept in which agents interact with the
Relative sector sizes and wages in the presence of a labor tax
state along some dimensions and not others, creating a large
gray area between the extremes of full compliance and non- Wage I Wage F
Increase in taxes on
compliance. Exit and exclusion can play different roles formal wages
across different dimensions: a microfirm owner unregistered
due to the high costs of registration may feel de facto
excluded from desired formal credit, while opting out from WI WF
contributing to poorly designed state pension funds on WI WF
behalf of his or her workers. The evidence presented below DF DI
and across the next chapters suggests that each viewpoint
DF
has validity in some sectors, in some countries, at some
points in time; both lenses can help understand and address
LI LF
the causes and consequences of informality in the region.
Furthermore, it is important to stress that saying that LI LF
workers voluntarily choose to be unprotected does not imply Source: Authors' illustration.
that this is the best outcome for society as a whole. Ideally, Note: L and W, respectively, are the labor allocated to and the
wages paid in the informal (I) and the formal (F) sectors.
we would like all families to be covered by at least the basic
protections against income and health shocks, even if they, The next sections will bring to bear a variety of tools--
myopically, may not value, for instance, pensions, in the short motivational responses, sociological studies, and analyses of
run. That such protections should be linked to a characteris- worker flows--to characterize the informal sector and
tic of a job is not obvious, however, as will be discussed in sketch out the underlying motivations for being in it.
chapter 7. Even further, saying that a worker is "voluntarily"
informal means only that the worker would not be better-off The sectors of informal labor: Characteristics
in the jobs that comparable workers have in the formal sector, and dynamics
not that he or she is prosperous and happy, or would not Informal labor can broadly be broken into two subsectors:
prefer the kinds of formal jobs found in more advanced coun- informal salaried and independent work. Table 2.1 shows
tries. However, it does have important ramifications for what the relative importance of the two sectors in the region using
we mean by "decent" work: if a worker is indifferent between the social protection/legal definition where data permit.
a job with protections and one without, the jobs must, there- Formal salaried urban employment by this definition ranges
fore, be equally decent in that worker's judgment. Thus, the from nearly 20 percent in Bolivia, Paraguay, and Peru, to
issue of increasing job quality concerns both formal and roughly 60 percent in Chile--reaching roughly 40 percent
informal jobs, not just the latter. for the region overall. Salaried informal work, including
Finally, a finding of equal levels of welfare across sectors or unpaid and domestic workers--mostly women--comprises
voluntary informality does not preclude the presence of large roughly 33 percent of urban employment in the region,
labor or business climate distortions. More straightforwardly, ranging from 17 percent in Chile to over 45 percent in
regulation-stunted growth prevents the generation of firms Ecuador, Nicaragua Paraguay, and Peru. Informal indepen-
with potential for generating higher-paying jobs over the dent (self-employed) workers, comprising single-person
long run that would draw workers from the informal firms or owners employing other workers, represent roughly
microfirm sector. Second, figure 2.2 shows how labor 24 percent of the regional urban workforce, ranging from
distortions--restrictions on firing, labor taxes--can shift in 18 percent in Chile to over 35 percent in Bolivia, Colombia,
the demand curve for formal labor, leading to a larger share of theDominicanRepublic,Peru, andthe Rep�blica Bolivariana
informal workers without creating segmentation. Both argu- de Venezuela. Clearly, the relative proportions depend on
ments allow us to reconcile the findings that many informal conventions for allocating workers--for instance, the Inter-
workers are as well-off as their formal counterparts with those national Labour Organization (ILO) categorizes domestic
stressing how distortions affect the size of the informal sector workers as independent--or whether unpaid workers are
(Botero et al. 2004; Djankov et al. 2002; Loayza 1996). counted as "salaried." However, the overall picture is one in
48
TABLE 2.1
Distribution of formal salaried, informal salaried (social protection/legal definition), and self-employed in urban areas of Latin America (percent)
Formal Salaried Informal Salaried Independent workers
Public Domestic Unpaid Formal) Informal
Country Year Subtotal Large firms Small firms workers Subtotal Large firms Small firms workers workers Subtotal (professional) (unskilled)
Argentina (GBA) 2005 45.33 27.96 4.03 13.34 30.36 10.83 10.87 7.65 1.01 24.32 9.31 15.01
Bolivia 2005 18.50 8.32 0.38 9.81 40.94 16.41 12.19 3.82 8.52 40.56 4.36 36.20
Brazil 2003 48.16 30.25 5.52 12.39 28.52 6.69 9.43 6.56 5.84 23.32 4.05 19.27
Chile 2003 60.81 43.94 4.60 12.27 17.20 7.64 4.26 4.03 1.27 21.99 4.45 17.54
Colombia 2006 30.64 21.25 1.80 7.59 28.01 7.99 12.06 4.65 3.31 41.35 2.85 38.50
Dominican Republic 2006 33.24 18.84 0.60 13.80 27.26 13.24 7.06 5.10 1.86 39.50 2.10 37.40
49
Ecuadora 1998 23.93 12.82 1.68 9.43 49.06 18.00 13.70 5.09 12.26 27.01 1.68 25.33
El Salvador 2003 38.78 26.54 1.13 11.10 33.78 11.25 11.43 4.31 6.79 27.45 0.72 26.73
Guatemala 2002 31.10 23.16 1.50 6.44 40.68 12.63 12.96 3.64 11.44 28.22 0.31 27.92
Mexico 2002 35.33 22.23 2.93 10.16 43.79 14.87 17.61 4.30 7.01 20.88 0.14 20.74
Nicaragua 2001 24.19 14.92 1.68 7.59 47.12 16.15 14.74 5.98 10.26 28.70 0.22 28.47
Paraguay 2003 17.93 6.15 1.05 10.74 48.06 15.74 15.79 11.79 4.74 34.01 0.59 33.42
Peru 2002 18.15 9.72 0.89 7.54 45.66 16.57 14.86 5.44 8.80 36.19 1.40 34.79
Uruguay 2004 51.85 29.26 3.98 18.61 21.81 7.08 6.69 6.65 1.40 26.34 5.75 20.59
Venezuela, R. B. dea 2003 38.77 21.80 2.37 14.60 22.55 8.24 9.47 2.06 2.77 38.68 3.46 35.22
Latin America 40.18 25.32 3.75 11.11 33.24 10.10 11.86 5.52 5.76 26.58 2.94 23.64
Sources: Gasparini and Tornarolli 2006; authors� estimates.
Note: GBA denotes Greater Buenos Aires. Formality among independent workers proxied by having a university degree.
a
I N F O R M A L I T Y
which the informal salaried account for almost 60 percent of focus largely on salaried workers. Among these, formal
the informal, and independent workers slightly less. employees are generally found in larger firms. The informal
As chapter 1 noted, firm size has been an important crite- salaried appear to be found more or less equally in small and
rion in the past for categorizing the informal, and table 2.1 large firms, although table 2.2 suggests that, as discussed in
further breaks out each category by small firms of less than chapter 1, most are concentrated in relatively small enter-
the traditional ILO definition of five workers and the rest as prises, if not necessarily in those employing fewer than five
"large." The characteristics of independent workers, partic- workers. In Mexico, 73 percent of paid informal salaried
ularly as entrepreneurs or firm owners, will be discussed at workers and 97 percent of unpaid workers are found in firms
length in chapters 5 and 6 on firm dynamics, so here we of fewer than 15, with the majority of those firms having
TABLE 2.2
Distribution of informal salaried, self-employed, and unpaid workers, by firm size (percent)
Argentina, 2003
Informal salaried Self-employed Unpaid workers
Firm size Share of firm workers Distribution Share of firm workers Distribution Share of firm workers Distribution
1 0.00 0.00 99.56 72.95 0.44 8.36
2 to 5 32.54 53.12 25.13 27.05 1.79 50.53
6 to 25 47.27 29.57 0.00 0.00 1.26 22.99
26 to 100 20.15 9.98 0.00 0.00 0.29 4.17
101 to 500 16.87 4.95 0.00 0.00 1.03 8.82
501+ 13.35 2.38 0.00 0.00 0.99 5.13
Source: Encuesta Permanente de Hogares.
Note: Sample constrained to Gran Buenos Aires.
Brazil, 2002
Informal salaried Self-employed Unpaid workers
Firm size Share of firm workers Distribution Share of firm workers Distribution Share of firm workers Distribution
1 0.00 0.00 100.00 59.39 -- --
2 to 5 47.82 41.79 24.40 28.29 -- --
6 to 10 35.03 17.01 10.00 6.44 -- --
11+ 17.25 41.20 1.85 5.87 -- --
Source: Pesquisa Nacional Amostra Domicilios.
Note: -- = not available. Sample constrained to the metropolitan areas.
Mexico, 2004
Informal salaried Self-employed Unpaid workers
Firm size Share of firm workers Distribution Share of firm workers Distribution Share of firm workers Distribution
1 0.00 0.00 100.00 64.64 0.00 0.00
2 to 5 53.49 56.78 25.02 30.65 13.65 93.03
6 to 10 50.53 11.55 10.02 2.64 2.63 3.87
11 to 15 40.88 4.58 6.29 0.81 0.79 0.57
16 to 50 28.76 10.90 2.48 1.08 0.43 1.05
51 to 100 16.29 3.11 0.54 0.12 0.07 0.09
101 to 250 8.59 1.01 0.32 0.04 0.22 0.17
251+ 10.47 12.06 0.01 0.01 0.17 1.23
Source: Encuesta Nacional de Empleo Urbano.
Note: Second quarter 2004.
50
T H E R A Z � N D E S E R O F T H E I N F O R M A L W O R K E R
TABLE 2.3
Characteristics of informal salaried employees in Mexican microfirms
Workers Paid workers Unpaid workers
Variable Relatives Nonrelatives Relatives Nonrelatives Relatives Nonrelatives
Observations (n) 1,317,330 994,045 372,032 964,275 945,298 29,770
% of Workers 56.99 43.01 27.84 72.16 96.95 3.05
Spouse 23.62 3.45 31.47
Children 50.66 35.77 55.63
Other relatives 25.72 60.78 12.89
% Male 51.62 65.8 72.4 66.65 43.44 38.18
Average hours 33.17 44.09 42.47 44.58 29.51 27.97
Average age 28.15 30.17 28.64 30.38 27.96 23.03
% IMSS 4.31 51.7 13.02 53.28 0.90 0.30
% written contract 0.91 27.46 3.23 28.31 0.00 0.00
Source: Encuesta Nacional de Micronegocios, 1994.
Note: IMSS = Mexican Social Security Institute.
fewer than five workers. In Argentina, this is somewhat less women and is sometimes thought to be particularly
the case, although 83 percent are found in firms of under 25 exploitative, may also emerge from this dynamic (box 2.1).
workers, which also encompass 80 percent of unpaid work- Third, among family members, the verbal open contract
ers. Hence, understanding the nature of informal salaried is the rule (96 percent), while written contracts are reserved
work is, to an important degree, about understanding for the 28 percent of Mexican workers who are paid nonrel-
worker and firm decisions to become formal (the de Soto atives. This surprisingly small number suggests that most
margin) and the determinants of worker flows between large employment relations are ruled by informal mechanisms
formal firms and small informal firms. The evasion margin without recourse to any sort of formal employment con-
among large firms is more important in Argentina, where tracts. As other dimensions of informality, this is very
roughly 15 percent of salaried workers in firms of over 100 much a question of size of the firm, as noted in chapter 1
are informal, compared to roughly 10 percent in Mexico. and will be further discussed in chapters 5 and 6 on formal-
Therefore, we are dealing with modestly differing mixes of ity decisions of firms. Relatively few firms with fewer
phenomena across countries. than 3 workers have registered with the social security
The Mexican microenterprise survey offers additional administration, while most firms of 10 or more have at
insight into the salaried and unpaid workers in small firms least 1 worker registered. Plausibly, more formal contract-
(under 16 workers). Several striking findings emerge from ing relationships will become more important as workers
table 2.3. First, the microenterprise appears to be very with fewer personal ties are hired.
much a family affair. In Mexico, over half of all workers and
almost 30 percent of paid workers are directly related to the Life-cycle patterns and dynamics
owner of the firm. This clearly complicates earnings com- The informal self-employed and salaried labor show very dif-
parisons, as family workers are likely to receive payment in ferent patterns of behavior both across the life cycle and in
kind--either food or shelter. Second, essentially all unpaid their flows through the labor market. To begin, figure 2.3
workers (97 percent) are family workers, and so probably illustrates employment trajectories across the life cycle, plot-
should be seen as earning pay within the context of the ting the share of the working-age urban employed popula-
family unit rather than truly "unpaid." Whether their mar- tion in the three categories. Young workers are most strongly
ginal product to the household is as high as it would be in represented in informal salaried employment in each of the
the formal sector, or whether many of these workers are, in three countries, peaking at around 20 percent for those in the
fact, underemployed, the data cannot tell us. Finally, even a workforce at around the age urban of 20. Thereafter, it falls
large part of home-based work, which largely involves steadily, although middle-aged and older workers still make
51
BOX 2.1
Home-based work: Exploitation or flexible work arrangement?
A particular modality of the informal microfirm that As can be seen in figure 2B.1, home-based workers do
has received increasing attention is home-based work. earn less than other workers. Controlling for lower skill
Numerous authors (Arriagada 1998; ILO 1995; Prugl and levels in the sector, home-based workers earn 22.8, 28.9,
Tinker 1997; Tomei 2000; WIEGO 2000) tend to see the and 39.6 percent less than do workers outside the home in
subcontracting out of these workers as a way for large firms Mexico, Brazil, and Ecuador, respectively (Cunningham
to maintain flexibility, quality, and global profitability by and Ramos 2001). But we cannot rule out that these lower
both avoiding benefits and transferring the risks of demand wages are reflecting unobserved characteristics or the price
volatility to workers. The absence of an internationally of the flexibility that allows juggling other household
accepted definition of home-based work, among other responsibilities, not having to travel to the worksite, or
problems, means that the reported shares of the workforce, other benefits that accrue to home care providers. This is
ranging from 1.5 to 20.0 percent (see table 2B.1), are prob- partially borne out by the fact that home-based workers
ably not comparable (Chen, Sebstad, and O'Connell 1999). spend an average of 30 hours in productive activities each
Although some very famous firms, such as Italy's week, compared to more than 40 hours weekly among
Beneton, started as a cluster of home-based workers, it is nonhome-based workers (Cunningham and Ramos 2001;
questionable how important international links really are. Tomei 2000). This result is driven by women, especially
As with informal microenterprises more generally, the those with young children and/ or spouses. In Brazil,
fraction that reports working as contract workers, perhaps Ecuador, and Mexico, home-based female workers spend
for large companies, rather than selling their work one-third fewer hours on the job than do women who work
directly in the local market, is generally small (0.7 per- outside the home. Home-based work may thus be a pre-
cent in Brazil, 1.2 percent in Ecuador, and 1.6 percent in ferred work arrangement for those who have both home
Mexico). Yet the sector is often over 75 percent women and and market duties. Women with young children and/or
those whose personal characteristics make outside work who are married are more likely to engage in home-based
inaccessible (Carr, Chen, and Tate 2000; Cunningham work than are those without such household constraints,
and Ramos 2001; ILO 1995; Tomei 2000). The concern and less than half are household heads (Cunningham and
is that employers may take advantage of the situation of Ramos 2001). Interviews with female home-based workers
those whose work options are limited to the home by sub- with children reveal that these women hope to work out-
jecting home-based workers to lower remuneration and side the home once their children have left home (Jelin,
labor standards than workers who can compete in the Mercado, and Wyczykier 2001).
labor market (Krawczyk 1993; WIEGO 2000). Despite
suggestive anecdotal evidence, statistical studies have yet
to document it as a widespread phenomenon. FIGURE 2B.1
Hourly wage premium of outside home work to home-based work
Percent
TABLE 2B.1
40
Home-based workers' participation (percent)
35
Estimated Proportion Year of 30
Country proportion female estimate
25
Algeria 3.3 97.0 1989
Australia 2.9 -- 1989
20
Brazil 5.5 74.8 1999
Ecuador 17.3 73.6 1999 15
India 2.5 -- 1981
Japan 1.6 93.5 1988 10
Mexico 4.4 64.4 1999
Philippines 23.0 -- 1980s 5
Peru 10.5 -- 1987
0
United Kingdom 2.3 70.0 1981
Brazil Ecuador Mexico
United States 7.53 -- 1985
Men Women
Sources: Cunningham and Ramos 2001; ILO 1995.
Note: -- = not available. Source: Cunningham and Ramos 2001.
52
T H E R A Z � N D E S E R O F T H E I N F O R M A L W O R K E R
up around 40 percent (almost half in Argentina) of all infor-
FIGURE 2.3
mal employees. By contrast, self-employment is almost the
Rate of urban employment across sectors, by age
mirror image, with virtually no representation among the
Argentina (2001) very young, but then climbing steadily until late middle
Percent
50 age. The formal sector is largest among prime-age workers.
45 Older workers are as likely to be found in the formal sector or
40 self-employment.
35 The commonalities across all three countries highlight a
30 suggestive, distinct role for the two informal sectors. First,
25 informalsalariedworkisapointofentrytothelabormarketfor
20
manyoftheyoung.Thisisconsistentwiththeaccumulationof
15
skills enabling young workers to eventually find a job in the
10
formal sector or realize any desire to be self-employed. Second,
5
informal salaried work remains a source of jobs for older work-
0
15 19 23 27 31 35 39 43 47 51 55 59 63 67 ers, around 10�15 percent of prime-age workers. They may
lack the skills or capital to become self-employed or get a for-
Brazil (2002)
Percent mal salaried job, or they may opt out of formality since they
50 cannot accrue sufficient years to secure a meaningful pension.
45
Finally, there is no inexorable evolution from informality to
40
formality with age; informal self-employment and formal
35
salaried work are equally common at the end of work life.
30
Further insight can be gained into the differences between
25
the sectors and, more fundamentally, their respective roles in
20
the labor market by looking at patterns of mobility of work-
15
ers through types of work. As Maloney (1999) argues in the
10
first analysis of this kind for Latin America, the segmentation
5
0 or exclusion view would predict a predominantly unidirec-
15 19 23 27 31 35 39 43 47 51 55 59 63 67 tional move toward formality: on average, workers leave
school, enter informality to queue until they find a formal
Mexico (2004)
Percent
job, and eventually retire. In an integrated market, however,
50
workers search among formal and informal jobs, treating
45
them as different in type but not necessarily in quality, so
40
that flows among sectors are more symmetrical.
35
Reliable panel data that permit constructing transition
30
25 probabilities from actual movements of the same workers
20 across sectors are available for three countries in the region:
15 Argentina, Brazil, and Mexico (see box 2.2). Bosch and
10 Maloney (2005) follow them through the three sectors of
5 paid work--informal self-employed, informal salaried, and
0 formal salaried--as well as unemployment and being out of
15 19 23 27 31 35 39 43 47 51 55 59 63 67
the labor force (OLF). Such transitions represent "reduced
Self-employed Formal Informal forms," capturing disposition as well as ease of entering a
sector. Without further relating them to the dynamics of
Source: Cunningham et al. 2007.
earnings and the business cycle, they need to be seen as more
Note: Considers all self-employed and informal salaried uncovered
by social protections in Argentina and Mexico, and the availability suggestive than conclusive. Such structured analysis of the
of a carteria de trabajo (work card) in Brazil.
determinants of entry into sectors, as well as the analysis of
cyclical labor force dynamics, is taken up in chapter 4.
53
I N F O R M A L I T Y
FIGURE 2.4a
Probabilities of transition among sectors of employment
Males
Raw intensities Adjusted propensities
Argentina, 1993�2001 Argentina, 1993�2001
0.5 2.0
0.4
1.5
0.3
1.0
0.2
0.5
0.1
0 0
Formal, Formal, Informal, Formal, Formal, Informal,
self-employment informal self-employment self-employment informal self-employment
Brazil, 1982�2001 Brazil, 1982�2001
0.5 2.0
0.4
1.5
0.3
1.0
0.2
0.5
0.1
0 0
Formal, Formal, Informal, Formal, Formal, Informal,
self-employment informal self-employment self-employment informal self-employment
Mexico, 1987�2004 Mexico, 1987�2004
0.5 2.0
0.4
1.5
0.3
1.0
0.2
0.5
0.1
0 0
Formal, Formal, Informal, Formal, Formal, Informal,
self-employment informal self-employment self-employment informal self-employment
From/to To/from
Sources: Bosch and Maloney 2005, 2007.
Note: Probabilities in the second column are standardized by final sector job turnover and destination sector size.
The first column in each panel of figures 2.4a and b pre- in both Mexico and Brazil, the probability that a worker
sents the probability of moving from one sector of work to found in informal salaried work moves to formal work
another,8 and two points emerge as noteworthy. First, the across a one-year period is 40�50 percent. The relatively
three labor markets show a high degree of commonality smaller reverse probabilities would seem consistent with
in most transitions. The relative mobility between any the conventional one-way flows out of informality. How-
given pairing of sectors is broadly similar across the three ever, as Maloney (1999) argues, such observations need to
countries, although with some notable exceptions. Sec- take into account both the likelihood of a worker separating
ond, the level of mobility is relatively high. For example, from the previous job, regardless of destination sector, and
54
T H E R A Z � N D E S E R O F T H E I N F O R M A L W O R K E R
FIGURE 2.4b
Probabilities of transition among sectors of employment
Females
Raw intensities Adjusted propensities
Argentina, 1993�2001 Argentina, 1993�2001
0.5 2.0
0.4
1.5
0.3
1.0
0.2
0.5
0.1
0 0
Formal, Formal, Informal, Formal, Formal, Informal,
self-employment informal self-employment self-employment informal self-employment
Brazil, 1982�2001 Brazil, 1982�2001
0.5 2.0
0.4
1.5
0.3
1.0
0.2
0.5
0.1
0 0
Formal, Formal, Informal, Formal, Formal, Informal,
self-employment informal self-employment self-employment informal self-employment
Mexico, 1987�2004 Mexico, 1987�2004
0.5 2.0
0.4
1.5
0.3
1.0
0.2
0.5
0.1
0 0
Formal, Formal, Informal, Formal, Formal, Informal,
self-employment informal self-employment self-employment informal self-employment
From/to To/from
Sources: Bosch and Maloney 2005, 2007.
Note: Probabilities in the second column are standardized by final sector job turnover and destination sector size.
the availability of positions to move into the destination Given the low rates of turnover in formal salaried and self-
sector. The first differs greatly across sectors. Figure 2.5 employment, it is not surprising that flows between these
shows the inverse of the probability of leaving--the average sectors should be the lowest in figure 2.5. This turnover,
amount of time spent or duration in a sector. Again, the combined with the size of the destination sector, is
similarities across countries are far more striking than also related to the number of positions into which a worker
the differences: durations are shortest in unemployment, can move.
followed by informal salaried, self-employment, or out of The second column in each panel of figures 2.4a and b
the labor force; and longest in formal salaried employment. standardizes, by both turnover and destination, available
55
I N F O R M A L I T Y
BOX 2.2
Data from rotating panels in Argentina, Brazil, and Mexico
In order to construct continuous time transition matrices covering approximately two years through the period
to study worker flows across sectors, Bosch and Maloney 1982�2001. The total number of transitions is 2,520,000
(2005) employ three different surveys that compile infor- (1,190,000 for men, 1,330,000 for women).
mation about the labor status of workers and other rele-
Mexico
vant information. They employ one year as the time unit
The Encuesta Nacional de Empleo Urbano (ENEU, National
to analyze labor mobility dynamics, mainly as a common
Urban Employment Survey) conducts extensive quarterly
sampling interval for the three countries.
household interviews in the 16 major metropolitan areas.
The questionnaire is extensive in its coverage of partici-
Argentina
pation in the labor market, wages, hours worked, and so
For Argentina, in the Encuesta Permanente de Hogares (Per-
on that are traditionally found in such employment sur-
manent Household Survey) a panel covers the area of the
veys. The ENEU is structured so as to track a fifth of each
Federal District and surroundings (Gran Buenos
sample across a five-quarter period. The authors concate-
Aires), which accounts for approximately 60 percent of
nated panels from the first quarter of 1987 to the fourth
Argentina's urban employment. Until 2003, the survey
quarter of 1999. Each individual contributed two transi-
was conducted every six months (April/May and Octo-
tion pairs (from the first quarter to the fourth, and from
ber) with a 25 percent rotation of the panel. As a conse-
the second to the fifth), giving rise to approximately
quence, each household is followed for two years at
1,785,000 transitions (810,000 for men, 975,000 for
sampling intervals of six months. The authors employ
women).
panels from May 1993 to October 2001. The sample is
"Informal" refers here to self-employed (including
notably smaller than the Mexican and Brazilian surveys,
small firm owners) and informal salaried workers in firms
and only 29,000 transitions (13,900 for men, 15,100 for
with fewer than 16 employees who lack social security or
women) can be studied.
medical benefits. Formal salaried workers are defined as
Brazil those enjoying labor protections. To focus on the tradi-
The Pesquisa Mensual de Emprego (Monthly Employment tional first margin of informality, Bosch and Maloney
Survey) follows monthly employment indicators. House- (2005) do not consider unprotected workers in large
holds are interviewed four months in a row, and then firms. The remainder of the sample is divided into two
reinterviewed eight months later, so that 25 percent of groups: those out of the labor force and the unemployed.
the sample is renewed every month. Given this panel Unfortunately, the Brazilian survey lacks information on
structure, we can construct four yearly employment sta- firm size, and informal status is given by whether the
tus transitions for each individual. The authors put worker holds a signed work card guaranteeing access to
together nine consecutive panels starting in February benefits in Brazil. Mexican and Argentine surveys con-
1982. Each panel consists of 12 consecutive cohorts tain very similar questions about benefits and firm sizes.
positions in the final sector. This gives a measure of whether What is striking is that there is a reasonably high degree
a separating worker from one particular sector is more or less of symmetry in these adjusted probabilities, with some
likely to move into an available job in another sector than are exceptions: flows from formal salaried to informal salaried are
all workers entering that sector from all other sectors (see not so different from the reverse--or, put differently, if an
Duryea et al. 2006). Bosch and Maloney (2007) also show informal salaried worker has a comparative advantage in for-
that this standardization can be interpreted as a measure of mal salaried work, the reverse is also likely to be true. Fur-
revealed comparative advantage of a worker: in the absence of ther, the symmetry of the flows also suggests that, overall,
barriers to entry, what sectors do the individual characteris- there is not a one-way flow from informality into formality,
tics and personal constraints predispose workers to enter? with some exceptions. For instance, Brazilian formal salaried
56
T H E R A Z � N D E S E R O F T H E I N F O R M A L W O R K E R
FIGURE 2.5
Absolute mean duration of labor force status
Males Females
Years
7
6
5
4
3
2
1
0
Out of Unemployed Self- Informal Formal Out of Unemployed Self- Informal Formal
labor force employed labor force employed
Argentina Brazil Mexico
Source: Bosch and Maloney 2005.
men move relatively more into informal salaried work than tually leave behind--there may be many instances of subse-
the reverse. The same is true for Mexican females. In the case quent return to informal salaried work in later transitions.
of Brazil, this may suggest the reduction in the availability of However, what is clear is that, first, we are dealing more
formal salaried jobs across this period, described in detail in with "quantum" informality where there is a large amount
chapter 4. It is also notable that, for all cases except Mexico, of movement among sectors, rather than patient queuing by
formal workers do not seem to have a comparative advantage most of the informal salaried to enter a formal salaried job
to enter self-employed work and vice versa, although these permanently. Second, the high frequency of job changes,
flows are generally symmetrical, except for Argentine females. even for formal workers, is consistent with the Levy (2006)
As chapter 4 will show, in fact, these averages hide sub- observation that the rotation in and out of formal pension
stantial changes in relative fluidity across the business schemes implies that many "quantum formal" workers will
cycle. Further, as discussed below, this rough symmetry never accrue enough years in the system to earn a pension,
hides important demographic differences, consistent with thus creating incentives for opting out. Exploring the
the previous patterns of participation across the life cycle. dynamic demographic signature of the two informal sectors
However, it seems safe to say that, on average, workers do over the next sections will further help in understanding
not graduate unidirectionally from informal work to avail- their role.
able jobs in the formal sector.
More generally, the exercise suggests that static summary Patterns of mobility of the self-employed
statistics of the allocation of workers obscure important The patterns of transition into informal self-employment by
aspects of the dynamism of worker flows among sectors. On age and education suggest that this sector behaves broadly
average, informal salaried workers do not remain so for long similarly to its counterpart in advanced economies and rather
periods of time; their durations are very short. As is argued less like a queue for formal sector jobs (figure 2.6). Evans and
later, this does not necessarily mean that informal salaried Jovanovic (1989) argue that the observed increasing proba-
labor is a transitory state that the majority of workers even- bility of entry with age, despite a presumably lower level of
57
I N F O R M A L I T Y
risk aversion among the young, is consistent with the exis- Mexican workers leaving the informal (formal) salaried sector
tence of credit constraints that dictate that potential entre- become independent, compared with the 57 percent (44 per-
preneurs must accumulate the necessary physical and cent) of their older counterparts. Similar results are found in
working capital. These credit constraints may be exacerbated Argentina and Brazil, where roughly 20 percent (10 percent)
in developing countries, where not only do credit markets of exiting young informal (formal) salaried workers find a
function poorly, but weak educational systems make the self-employment opportunity, compared to 40 percent
accumulation of human capital difficult as well. (20 percent) among older workers.9 These low rates of entry
Strikingly consistent with this view, and with our earlier among the young confirm the pattern found in figure 2.4 that
examination of life-cycle employment trajectories, self- self-employment is the least viable source of employment for
employment is not a port of entry into work. In all three coun- the young in all three countries.
tries, the probability of entry for young workers from OLF or Again, the evidence is consistent with a life-cycle model
unemployment is a mere fraction of that for older workers. For in which many workers enter formal employment to accu-
less than 10 percent of young workers (aged 16�24) leaving mulate both human and financial capital, and then become
the OLF sector and unemployment, self-employment appears self-employed or open a small business--a pattern identi-
as the entry point to the labor market, approximately three fied in the OECD literature (see Blanchflower and Oswald
times less than for middle-aged workers. The propensity to 1998; and Evans and Jovanovic 1989). The sociologists
enterthesectorfrominformalorformalsalariedworkisalso,in Bal�n, Browning, and Jelin (1973) argue precisely for such
all cases, often over double for older workers than for younger a life-cycle model in Mexico, where workers with entrepre-
workers. For instance, 35 percent (20 percent) of younger neurial motives enter into salaried work; accumulate
FIGURE 2.6
Propensity to move to self-employment from different sectors
Out of labor force to self-employment Unemployment to self-employment
Probability, conditional on separation Probability, conditional on separation
0.6 0.6
Age Education Age Education
0.4 0.4
0.2 0.2
0 0
16�24 24�40 40�65 Low High 16�24 24�40 40�65 Low High
Informal to self-employment Formal to self-employment
Probability, conditional on separation Probability, conditional on separation
0.6 0.6
0.4 0.4
0.2 0.2
Age Education Age Education
0 0
16�24 24�40 40�65 Low High 16�24 24�40 40�65 Low High
Argentina Brazil Mexico
Source: Bosch and Maloney 2005.
58
T H E R A Z � N D E S E R O F T H E I N F O R M A L W O R K E R
knowledge, capital, and contacts; and then quit to open States by Evans and Leighton (1989), so the considerations
their own informal businesses (cited in Maloney 1999).10 of these potential entrepreneurs are similar to those found
A further disaggregation of figure 2.6 (not shown) sug- everywhere.12 Nonetheless, since small firms have high
gests that older and better-educated workers spend longer mortality rates, both their owners and their workers in the
in self-employment (Bosch and Maloney 2005). This is region are more likely to find themselves without employ-
consistent with the mainstream firm dynamics literature ment and searching for a new job, without the broad cover-
that suggests that young firms, which, ceteris paribus, are age of safety nets common in most developed countries.
more likely to be opened by younger workers, have very Further insights are gained by examining transitions by
high failure rates (Evans and Leighton 1989; Jovanovic gender. Figure 2.7 suggests a more dynamic corridor of
1982). The higher tenure for better-educated workers is mobility between being out of the labor force and informal
similar to that found in the formal sector and the opposite self-employment for women as compared to men. While at
of the pattern for the informal salaried. This topic will be first this may suggest discrimination against women in
analyzed further in chapter 5. formal sector jobs, further examination reveals that this is
It may be argued that both the pattern of late entry and largely driven by married women. Figure 2.8 shows
longer duration with age are also consistent with exclusion: that while it is true that single mothers have high levels of
a middle-aged worker who loses his or her formal sector participation in informal self-employment and wives are
job is unable to find a new one, and therefore is forced into overrepresented in the unpaid sector, single women with-
self-employment as a safety net. This dynamic may have out children have the highest rate of participation in formal
been of particular relevance during the economic restruc- jobs of any group, male or female. Moreover, replicating
turings of the 1990s, when older displaced workers may this analysis for a cohort of single women in Argentina and
have found their skills obsolete and of little demand in the Mexico (the two surveys with a marital status variable),
emerging sectors. The features of the observed transitions Bosch and Maloney (2005) show that the transitions of sin-
mitigate against this view as being the entire or even a gle women are very similar to those of men, and this simi-
large part of the story. The rate of transition into the sector larity holds up when disaggregated by duration and
in all three countries seems broadly linear in age until mid- propensity. The high mobility is partly due to the fact that
dle age. That is, there is not a sudden spike in propensities women have far lower tenure in self-employment, suggest-
among older workers, but rather a gradual increase with an ing that these jobs are not intended to be careers, but rather
inflection point at prime age when the propensity to enter transitory supplements to family income.
often decreases. Overall, this pattern seems more consistent In a view with lineage to Becker's (1991) work stress-
with the life-cycle pattern found in more advanced ing structural determinants of employment patterns,
economies, although coexisting with some older workers Cunningham (2001a) argues that Mexican women's patterns
with little access to the formal sector market once fired.11 of participation--and particularly their gravitation toward
Even if the life cycle well describes the patterns of entry self-employment--are driven by their need to balance their
into self-employment, it is still the case that this is a risky other responsibilities in the household; child-raising
business. Not only are most independent workers out of the requires greater job flexibility than the salaried sector
formal circuit of employment protection, but also operat- offers. Women with young children are often more prone to
ing a small business is intrinsically riskier everywhere, with be self-employed rather than formal sector employees
many firms not lasting through their first year (box 2.3). (Cunningham 2000; Cunningham and Ramos 2001; see
Again, the sociological literature provides striking confir- also chapter 3), and interview data from Geldstein (2000)
mation of this insight when Bal�n, Browning, and Jelin for Argentina and Chant (1991) from Mexico suggest that
(1973) argue that "although self-employment is a goal for women may more easily balance their productive (market)
many Mexican workers . . . [b]ecoming self-employed and reproductive (home care) roles if they work for them-
involves a large risk, especially for those men who had sta- selves than if they are employees.13
ble and secure jobs" (p. 216). In fact, chapter 5 will show
that comparisons of patterns of entry and exit derived from Patterns of mobility of the informal salaried
the Mexican and Nicaraguan microenterprise surveys The patterns of transitions for informal salaried workers in
appear to be broadly similar to those derived for the United small firms offer a more nuanced picture. As noted earlier, the
59
I N F O R M A L I T Y
BOX 2.3
Informal self-employment: Risky and informal, or risky because informal?
Many of the "precarious" characteristics associated with as participation in the numerous formal institutions: fed-
informality are natural by-products of the fact that the eral and local treasuries, governmental programs such as
informal self-employed resemble the fundamental charac- social security, the legal system, the banking system,
teristics of the owners of a small firm. The industrial coun- health inspection, firm censuses, trade organizations, and
try literature on firm behavior offers two important civic organizations. These, of course, have costs in terms
findings about such firms. First, there is a wide range of of compliance with legal norms, which very small firms
sizes among long-standing firms determined by factors can easily avoid in developing countries. Small firms are
such as how efficient or hardworking an entrepreneur is, anchored in social networks of family and immediate
how well placed is his or her firm, and the logic of the pro- neighborhood that allow them to enforce implicit con-
duction process. This means that the existence of many tracts and insure against risks. However, as firms grow,
small firms does not necessarily imply failure of either labor they increasingly need to secure property rights or permit
or credit markets. The reason that 80 percent of microfirms formal contracting mechanisms, pool risk, and gain access
have only one or two employees and tend to be family based to credit. De Soto (1989) offers a striking example in
may reflect a logic rooted in the tradition of the family which informal street vendors in Peru tried to pay their
farm, or possibly reflects the sustainable reach of informal taxes since this would guarantee them some property
contracting relations. rights over their pitch and hence offer some security to
A second finding about small firms everywhere is their investments they wanted to make. Chapters 5 and 6 will
extraordinarily high rate of failure. Seeking to explain the show that firms do become more formal with age and size.
U.S. case, Jovanovic (1982) argues that this is due to the Combining the two characteristics of microfirms and
fact that entrepreneurs cannot know how good their loca- this notion of formality implies that small firms will have
tion is or how competent they will be as entrepreneurs higher costs, are likely to be informal, and will have very
until they actually start the business. Very soon after high failure rates. Although this corresponds exactly to
starting, many enterprises find that they are not viable the standard picture of the stagnant, precarious, unpro-
and fail. Rough calculations from the Mexican microen- tected informal worker familiar in the literature, it
terprise survey suggest that these firms show high failure emerges naturally from potential entrepreneurs trying
rates, but not particularly higher than those in the their luck (risk taking), often failing, and not engaging
United States. in the formal institutions until they grow. Thus, the exis-
Thus, most of the characteristics of the sector may be tence of the microfirm informal sector may be largely
intrinsic and not imply any inferiority or undesired pre- unrelated to questions of labor market dualism or even
cariousness. Levenson and Maloney (1996) treat "formality" credit market distortions.
age trajectories of informal salaried workers sketched in fig- except in Argentina. Thus, the sector may represent both an
ure 2.4 are almost the mirror opposite of the self-employed; it important element of disguised unemployment and a port of
is the sector with the highest share of very young workers entry into the workforce, particularly for youth, older
and shows a constant decline across all subsequent ages. In unskilled workers, and some women.
Mexico, for instance, this translates into the average age of As noted before, workers appear to spend relatively little
the informal salaried being 29, five years below that of formal time in this sector--durations are just over a year. The
salaried workers, and 14 years below that of the self- brevity of tenure is similar to that found for young workers
employed. Still, 40 percent to almost half of the sector is in Brazil by Sedlacek et al. (1995), and is similar to the
composed of older workers in the three countries. Further- United States, where the median tenure for young workers
more, figure 2.9 shows that in contrast to self-employment, 16�24 years of age is only 1.4 years, and for workers aged
entry into the sector from either unemployment or OLF 25�34, the median tenure is 3.4 years (BLS 1991). More
decreases with age, except in Brazil, as well as education, detailed studies of transitions also show a high degree of
60
T H E R A Z � N D E S E R O F T H E I N F O R M A L W O R K E R
FIGURE 2.7
Transition between self-employment and out of labor force, by gender
Males Females
0.003 0.008
0.007
0.003
0.006
0.002
0.005
0.002 0.004
0.003
0.001
0.002
0.001
0.001
0.000 0.000
Argentina Brazil Mexico Argentina Brazil Mexico
Self-employment to out of labor force Out of labor force to self-employment
Source: Bosch and Maloney 2005.
FIGURE 2.8
Employment sector allocation by gender, marital status, and parental status in Mexico
Females Males
Percent Percent
70 70
60 60
50 50
40 40
30 30
20 20
10 10
0 0
/ /
aid er
ormal salary wage salary wage
Unpaid owner own
Inf al Contract Unp
mployed Informal Contract
Firm Firm
Unemployed orm piecework
Formal Une mployedormal piecework
Formal
Inf Inf
self-employed self-e
All Wives Single mothers All Husbands Single
Single, no children
Source: Cunningham 2001a.
mobility between school, unpaid work, and, to a lesser of this are numerous, including the relative size of the pool of
extent, unemployment that suggests a pool of generally incoming young people, the difficulty of signaling the
poorer workers not yet tracked into regular employment appropriateness of an applicant for a particular job, the diffi-
(see World Bank 2007).14 culty of dismissing a new worker if the match appears poor,
In this sense, informal salaried work has an important or exclusionary factors related to deficient schooling or dis-
component that corresponds to the very high levels of crimination of unskilled and minority youth. These factors
unemployment found among youth in the OECD that are translate to the Latin American context; thus, even in the
often double or triple those of prime-aged males 25�54 years absence of nominal rigidities that might segment the
of age (Jimeno and Rodriguez Palenzuela 2003). The causes market, both very restrictive labor legislation and poor
61
I N F O R M A L I T Y
For the sizable fraction of the informal salaried who are
FIGURE 2.9
prime age or older, both exclusionary and exit rationales
Propensity to move to informal salaried status from different
sectors apply. While the arguments of greater flexibility and higher
earnings are less applicable, as noted before, the informal
Out of labor force to informal salaried
salaried in several countries do earn the minimum wage and
Probability, conditional on separation
often receive other benefits (such as vacation and extra
1.0
Age Education salaries), and may prefer not to contribute to social security,
0.8
especially if they are past the age at which they cannot accrue
0.6 enough years in the system to earn a pension. However, the
0.4 case for exclusion is also strong, particularly for the unskilled
and those fired former formal sector workers whose skills
0.2
have been rendered obsolete. As chapter 4 will show, much
0
of the trend in informality in Argentina, the metropolitan
16�24 24�40 40�65 Low High
area of Brazil, and over the last five years in Mexico, is due to
Unemployed to informal salaried
the increase in informal salaried work affecting, in particu-
Probability, conditional on separation lar, groups that previously were covered by formal work con-
1.0
Age Education tracts, including prime-aged and older workers.
0.8 Finally, the low tenures observed among informal
0.6 salaried workers do not mean that this is a transitory state
that the majority of workers eventually overcome. The
0.4
actual spells of informal salaried work experienced by many
0.2
workers (especially low-skilled youth and older workers)
0 may be much longer, since many spells end with unemploy-
16�24 24�40 40�65 Low High
ment or dropping out of the labor force, and may revert to
Argentina Brazil Mexico informal salaried employment.16 The actual time these
workers can take to find a formal salaried job, if desired, may
Source: Bosch and Maloney 2005.
be quite long. In fact, the lifetime occupational history data
in table 2.4 show that around half and 84 percent of prime-
mechanisms for resolving information asymmetries can aged and older informal salaried workers in Argentina and
impede young workers' entry into the formal sector. As chap- the Dominican Republic, respectively, have never held for-
ter 4 will show, in Argentina and Brazil, the rise in informal mal salaried employment. In fact, one-third of 46�55-year-
salaried workers had a disproportionate impact on young old informal salaried workers report being informal salaried
entrants to the workforce. their entire work-life in Argentina, and nearly 60 percent in
One scenario is that while in school--and just after leaving the Dominican Republic. Whether this is voluntary or
school--many students work at a family business, with or involuntary, the data alone cannot tell; in fact, both the
without pay, before moving on to formal salaried jobs.15 As motivational and job satisfaction responses analyzed below
noted further below, in the case of Mexico, fully half of those and in chapter 3 show consistency with both hypotheses.17
working for microenterprises are children of the owner. Even
for those who are not family members, informal small enter- Motivations for participation in informal work
prises may train more apprentices and workers than the As noted above, informal employment may reflect workers
formal education system and the mostly government job- opting out of benefits programs voluntarily or exclusion to
training schemes together (Hemmer and Mannel 1989). The employment of last resort given the lack of better alterna-
informal salaried experience may constitute continued school- tives. This section introduces another tool for distinguish-
ing with an attendant lower wage. Still, the education� ing between the two: asking workers directly what drives
occupational profiles indicate that graduation to formal their occupational choices. Employment surveys in a hand-
salaried work is unlikely for youth who drop out of school ful of countries of the region have done this in the 1990s,
before completing at least a full course of secondary education. although until recently only Mexico and Brazil did so with
62
T H E R A Z � N D E S E R O F T H E I N F O R M A L W O R K E R
TABLE 2.4
Informal employment and work-life occupational history, Dominican Republic and Argentina (percent of workers)
Dominican Republic (2006) Argentina (2005)
Status in current job is . . .
Have ever held a job as . . . Formal salaried Informal salaried Independent Formal salaried Informal salaried Independent
Workers aged 15�25
Formal salaried only 76.5 5.1 7.8 66.3 7.5 11.3
Informal salaried only 15.9 88.7 16.9 25.1 84.4 23.3
Independent only 5.9 5.1 72.8 2.2 7.2 62.4
More than one category 1.7 1.0 2.5 6.4 0.9 3.0
Total 100.0 100.0 100.0 100.0 100.0 100.0
Workers aged 26�45
Formal salaried only 65.9 12.8 12.2 56.0 27.9 29.5
Informal salaried only 17.9 69.4 23.2 25.7 50.5 19.2
Independent only 11.3 14.1 57.4 9.3 9.8 31.0
More than one category 4.9 3.7 7.2 9.1 11.8 20.4
Total 100.0 100.0 100.0 100.0 100.0 100.0
Workers aged 46�65
Formal salaried only 64.9 12.5 13.3 58.2 37.5 50.7
Informal salaried only 14.6 59.1 21.1 15.4 33.2 8.8
Independent only 16.0 24.1 61.8 16.4 7.8 23.9
More than one category 4.5 4.3 3.8 10.1 21.6 16.7
Total 100.0 100.0 100.0 100.0 100.0 100.0
Sources: Arias and Bustelo (2007), Arias, Landa, and Yanez (2007), based on household survey, 2005, 2006 data.
Note: Each cell gives the percentage of workers currently in each occupational group who have held employment in the other
occupational groups some time during their work-lives.
broad coverage. Below we report the findings from studies results;thesedataofferfreshprimafacieevidenceonthesignifi-
using these surveys. canceofthevoluntaryorinvoluntarynatureofinformalemploy-
Inpreparationofthisreport,newspecialsurveysoninformal mentinavarietyofcountrycontexts.
employment were collected in the main urban areas of Bolivia,
Colombia, and the Dominican Republic, building on a 2005 Self-employment
survey conducted in Greater Buenos Aires (see box 2.4, World Both the sociological and economics literatures offer
Bank 2007b).Thesurveysincluded,amongotherthings,ques- reasons why many workers might actually prefer self-
tions on the motivations or reasons for workers to be salaried or employment over salaried work. In addition to the already
self-employed and to participate or not in labor benefits discussed greater flexibility, autonomy, and entrepreneurship
programs (box 2.4). Workers were asked questions such as, "If motives, the literature also talks about risk taking, family
you were able to choose, would you rather be a salaried or inde- tradition, and mobility opportunities. Blau (1987) and
pendentworker?";"Whatis(are)themainreason(s)whyyouare Maloney (1999) argue that in poor countries, lack of
asalariedemployeeratherthanindependent?"(andtheconverse human capital specific to an occupation or firm and the low
question); and "What is the main reason why you do not have a formal sector productivity mean that the opportunity cost
job with contributions to pension and health insurance bene- of self-employment is low. Contrary to these "exit" factors
fits?" The responses were structured around key proposed dri- are, of course, the view of the sector as employment of last
vers of informality in the literature. Despite some variations in resort for workers unemployable in the formal sector.
questionnaire design, the responses are largely comparable The evidence below suggests that the majority of the sec-
across the four countries. Therefore, below we discuss the evi- tor corresponds more to exit motives and the entrepreneurial
dencearisingfromtheBrazilianandMexicansurveys,followed view in the advanced country literature, although a signifi-
bytheotherfourcountries.Tables2.5and2.6 presentthemain cant component corresponds to involuntary workers.18
63
I N F O R M A L I T Y
BOX 2.4
Special informal employment surveys: What can we learn from them?
The World Bank, in partnership with line ministries and to the informality of the productive units and the moti-
the national institutes of statistics in Argentina, Bolivia, vations to participate or not participate in formal institu-
Colombia, and the Dominican Republic, supported the tions; (3) questions on informal-formal occupational
implementation of special modules on informality transitions through all other categories except the current
attached to regular household surveys in these countries. one ("When was the last time you've been . . . indepen-
These modules were collected in the fall of 2005 in dent worker/registered worker/unregistered worker?");1
Argentina and Bolivia, and in the fall of 2006 in Colombia and (4) questions on access to social protection mecha-
and the Dominican Republic. The analysis presented in nisms through private means or publicly provided bene-
this volume is just a launching point for new work that fits programs other than social security.
can be carried out with the rich data in these surveys.
Depending on the country, the surveys covered four
Note
main sets of issues: (1) questions on motivations for
1. The third set of questions will allow analyzing long-term
employment category choice and participation in social labor market dynamics, which has been impossible with available
security and health insurance plans; (2) questions related short-term panel data.
Table 2.5 shows the data from the most recent surveys in of the sociological literature. For instance, more than two-
Greater Buenos Aires, and urban areas of Bolivia, Colombia, thirds of the Brazilian informal self-employed in the early
and the Dominican Republic. Except for Colombia, over 1990s reported that they would not take a formal salaried
70 percent of independent workers are voluntary, in the sense job, and less than 20 percent in Mexico reported involuntary
that they would rather be independent if they were able to reasons (see below).19 Moreover, over half of salaried workers
choose their job. In Colombia, by a different measure, only in Bolivia and the Dominican Republic and close to one-
41 percent of urban independent workers can be considered third in Argentina and Colombia have intrinsic preferences
voluntary; they reportedly would not take a formal salaried for independent work, consistent with Blanchflower and
job with earnings equal to the earnings in their current job. Oswald's (1998) findings for the United Kingdom, the
When asked if they would take the same formal job but with United States, and Germany. The informal salaried show
lower earnings (a stricter standard), 71 percent of the Colom- somewhat stronger preferences for independent work than
bian informal self-employed said they would not. These find- the formal salaried, especially in Bolivia.
ings are also remarkably in line with those for Mexico and A comparison of the reported desires of self-employment
Brazil based on very different surveys, as well as the findings with comparable international data shown in figure 2.10
TABLE 2.5
Preference for independent employment (percent of workers)
Country All salaried Formal salaried Informal salaried All independent Formal independent Informal independent
Argentina 37 38 43 70 86 60
Bolivia 55 41 62 73 65 74
Colombia 36 34 40 41 46 41
Dominican Republic 53 51 57 75 85 75
Sources: Arias and Bustelo (2007), Arias, Landa, and Yanez (2007), based on household survey, 2005, 2006 data.
Note: Independent workers include self-employed and the small fraction of microfirm owners in each country. Except for Colombia,
percentages are based on responses to the question, "If you were able to choose, would you rather be a salaried or independent
worker?" For Colombia, the figures are based on (1) independent workers reporting they would not take a salaried job with bene-
fits and the same earnings they get as independent; and (2) salaried workers reporting the main reason for being in their current
job was their inability to become independent.
64
T H E R A Z � N D E S E R O F T H E I N F O R M A L W O R K E R
gives further credence to these findings.20 First, the rates few individual socioeconomic and demographic character-
of desired self-employment are not out of line with the istics to be good predictors of self-employment desires.
average in this sample of countries. Second, the four Latin This suggests that entrepreneurship motives have a large
American and Caribbean countries considered (the only ones idiosyncratic component, such as the reasons enumerated
with such data) are among those with the lowest divergence above, and that most workers found in this sector are likely
between desired and actual self-employment rates. That is, to show strong preferences for its characteristics.
self-employment rates in these four Latin American and Nevertheless, table 2.5 shows that a significant fraction
Caribbean countries are largely in line with workers' inclina- of the self-employed is involuntary and conforms to the tra-
tions to independent work. In a sense, many more workers ditional view of the sector. In particular, the fraction of
become self-employed than what one would expect, given the informal independent that would rather be employees is
credit and human capital constraints of these countries. This roughly 40 percent in Argentina and 25 percent in Bolivia
may be a result of a host of factors, including the low oppor- and the Dominican Republic, while a sizable 59 percent of
tunity cost of salaried work (formal or informal) and rigidities the Colombian informal self-employed would rather take
that create rationing of salaried jobs. In countries such as a salaried job with benefits over their current job. Again,
Colombia and Bolivia, this may lead many workers who lack by similar measures, in Brazil roughly one-third of the
the qualities to succeed as entrepreneurs to end up in self- informal self-employed (45 percent among women) are
employment; as noted earlier, the importance of tradition and involuntary.21
the family business enters as an important consideration here. The results are further corroborated by the reported
A noteworthy pattern of the data is the lack of a clear motivations for actually engaging in independent employ-
correlation between desires of self-employment and their ment. Table 2.6 first presents the aggregate responses of for-
materialization with level of development. While the mal and informal independent workers in the most recent
United States has one of the highest rates of want-to-be- surveys. Where workers were asked to report more than one
but-immaterialized entrepreneurship, Japan appears in the reason, the table also shows the second-most important reason
other extreme. In fact, using these data, Blanchflower or the relative frequency of total responses. The fraction of
(2004) and Blanchflower, Oswald, and Stutzer (2001) find informal independent workers who report loss or difficulties
FIGURE 2.10
International comparison of desired and actual self-employment rates
Percent
90 60
People preferring self- Gap between desired and
80 employment (left scale) actual (right scale)
50
70
60 40
50
30
40
30 20
20
10
10
0 0
na
Colombia BoliviaJapan Spain Italy gary rland many States
Norway IsraelSweden gdom France Hun
Argenti Denmark Kin CanadaZealandBulgariaPortugalSloveniaPoland
Germany Ger ted
Netherlands n FederationRepublicRepublic Switze
Czech New East Uni
West
United
RussiaDominican
Sources: Based on data from Blanchflower 2004; Blanchflower, Oswald, and Stutzer 2001; and author's estimates for Latin American and
Caribbean countries, using labor survey data, 2005 and 2006.
65
I N F O R M A L I T Y
in obtaining a salaried job as their primary motivation is differences in motivations by gender and age. Most workers
25 percent in Bolivia, and 44 percent in the Dominican in the two countries report reasons that imply the sector is a
Republic, although it emerged as the second-most impor- source of valued jobs, including higher earnings, greater flex-
tant reason for only 8 percent of cases in the latter. Lack of ibility, or family and personal motivations. In Mexico, 44 per-
salaried employment was cited among the main reasons by cent of males said they entered the sector for higher earnings,
59 percent of the informal self-employed in Argentina and and just under 17 percent said they entered because they
by 55 percent in Colombia, and accounted for 43 and either lost a previous job or could not find a salaried formal
35 percent of their responses, respectively. All the remain- job. Only 7 percent of women appear to be rationed out of
ing responses correspond to voluntary reasons in nature, salaried jobs. In Brazil, almost two-thirds of men and 44 per-
such as higher earnings or mobility opportunities, greater cent of women reported that they were happily in the sector.
autonomy, flexible hours, family tradition, or having the These findings are consistent with smaller sociological
opportunity to become independent, and a variety of other surveys that track workers across time. For instance, in
reasons (for example, marriage, studying, the job being Monterrey, Mexico, Bal�n, Browning, and Jelin (1973) find
one's trade), and age (in Colombia). The rates of involuntary that being one's own boss was well regarded and that move-
motivations among the formal self-employed compared to ments into self-employment from salaried positions often
the informal are much lower in Argentina, somewhat lower represented an improvement in job status. Figure 2.11
in the Dominican Republic, and similar in Bolivia lendscredencetotheseresponses.TrackingMexicanworkers
and Colombia. from formal salaried jobs into informal self-employed jobs,
The results are further corroborated by the earlier sur- on average voluntary movers gained around 15 percent
veys in Mexico and Brazil. Tables 2.7 and 2.8 show the while those who entered because of losing a formal job did
responses in these countries further disaggregated to gauge not experience a statistically significant change in income.
TABLE 2.6
Distribution of the motivations/reasons for being in the current job as an independent worker (percent)
Argentina Bolivia Colombia Dominican Republic
Cited as Percent of all Main Cited as Percent of all Main Secondary
Motivation/reason relevant responsesa reason relevant responsesa reason reason
Formal independent
Could not find job as salaried 19.6 9.6 30.8 41.4 35.0 32.5 9.0
Autonomy/no boss 29.5 6.6 13.5 20.3 10.9 16.1 31.5
Flexible hours/less responsibility 34.3 7.0 8.3 23.9 17.6 10.7 24.5
Family tradition 21.5 11.3 6.8 2.3 2.5 3.7 4.1
Earns more n.a. n.a. n.a. 20.3 5.2 26.4 5.3
Better mobility/benefits/prospects 59.4 31.3 n.a. 14.9 4.3 8.4 20.4
Able to become independent 66.8 25.8 24.9 n.a. n.a. n.a. n.a.
Age n.a. n.a. n.a. 21.1 16.5 n.a. n.a.
Other 10.2 8.5 15.8 7.7 8.0 2.3 5.3
Informal independent
Could not find job as salaried 58.8 43.0 25.3 55.3 34.5 44.3 8.1
Autonomy/no boss 16.5 3.2 9.5 22.2 16.4 16.2 33.5
Flexible hours/less responsibility 30.1 6.1 13.3 21.7 11.5 10.2 22.0
Family tradition 11.7 4.2 17.4 4.4 2.8 3.8 9.2
Earns more n.a. n.a. n.a. 11.5 9.7 14.0 7.8
Better mobility/benefits/prospects 29.6 15.0 n.a. 7.4 5.7 7.8 12.4
Able to become independent 43.0 15.9 26.0 n.a. n.a. n.a. n.a.
Age n.a. n.a. n.a. 23.2 13.5 n.a. n.a.
Other 15.5 12.6 8.5 10.8 5.8 3.7 6.9
Sources: Arias and Bustelo (2007), Arias, Landa, and Yanez (2007), based on household survey, 2005, 2006 data.
Note: n.a. = not applicable. In Argentina, individuals could mark all relevant response options; in Colombia, they were asked for the
two most important reasons, but without distinguishing first and second, unlike the case of the Dominican Republic.
a. Computed as the ratio of the frequency with which each reason is reported to the total number of valid responses in the sample.
66
T H E R A Z � N D E S E R O F T H E I N F O R M A L W O R K E R
TABLE 2.7
Reported reasons to be informal self-employed in Mexico (percent of workers)
Male Female
Reason Alla 15�18 years 19�24 years 25�54 years 55�70 years Alla 15�18 years 19�24 years 25�54 years 55�70 years
Family tradition 8.9 6.0 17.4 8.3 10.0 3.6 9.8 8.4 2.8 4.5
Complement family income 18.0 40.2 13.9 17.1 20.9 65.1 21.3 59.4 64.5 74.7
Higher income than salaried 43.7 15.2 41.8 47.0 31.5 12.2 7.5 9.9 13.1 6.9
No salaried job 12.4 17.9 8.3 11.2 18.3 6.1 22.4 5.0 5.7 8.0
Flexible hours 3.8 9.4 9.1 3.4 3.3 4.2 11.5 9.0 4.6 1.2
Fired or lost job 4.0 0.3 0.8 4.2 5.5 0.6 0.0 0.3 0.8 0.2
Other 9.1 11.1 8.7 8.8 10.6 8.1 27.5 8.0 8.6 4.5
Percent of sample 68.1 0.7 4.6 49.4 11.3 31.9 0.2 2 23.6 5.1
Percent of gender 100.0 1.0 6.7 72.6 16.5 100.0 0.7 6.2 73.8 16.0
Source: Author's estimates, based on Encuesta Nacional de Micronegocios 1994.
a. Considers all self-employed (including people under 15 years of age and above 70) who respond to this question.
TABLE 2.8
Reported reasons to be informal self-employed in Brazil (percent of workers)
Would you like to leave [your current] job for a job with a signed work contract? (Self-employed)
Male Female
Response Alla 15�18 years 19�24 years 25�54 years 55�70 years Alla 15�18 years 19�24 years 25�54 years 55�70 years
No 67.9 29.9 52.6 68.3 80.6 55.5 24.6 41.8 55.2 71.2
Motivations to prefer an unprotected job (Self-employed)
Male Female
Reason Alla 15�18 years 19�24 years 25�54 years 55�70 years Alla 15�18 years 19�24 years 25�54 years 55�70 years
Earn more in current job 18.0 13.4 17.6 21.0 9.6 10.6 5.1 13.3 12.1 3.9
Needed to care for home 0.2 0.0 0.0 0.1 0.4 26.9 15.3 22.8 27.5 28.8
Need time for other 2.9 7.5 3.2 2.5 3.2 6.7 6.8 7.9 6.6 6.8
activities
Happy in current job 64.9 69.5 68.3 64.0 67.6 44.1 59.3 47.7 44.8 39.0
Did not want the 10.1 8.0 9.8 10.0 10.6 7.5 8.5 7.6 6.9 9.8
commitment
No answer 4.0 1.6 1.1 2.2 8.6 4.1 5.1 0.8 2.2 11.6
Percent of sample 73.5 0.8 5.0 51.3 13.7 26.5 0.3 1.7 20.0 3.9
Percent of gender 100.0 1.1 6.8 69.8 18.6 100.0 1.0 6.3 75.4 14.8
Source: Author's estimates, based on Pesquisa Nacional por Amostra de Domic�lios 1990.
a. Considers all self-employed (including people under 15 years of age and above 70) who respond to this question.
The results also confirm the advantages of self-employ- 19, above 60 percent compared to roughly 15�20 percent for
ment for many women. In Mexico, almost two-thirds of men. In Brazil, one-third of women alluded to the need for
women in self-employment reported the need to supplement flexibility to attend to family and personal activities.
family income, and only 7 percent appear to be rationed out Roughly 25 percent of Brazilian women over the age of 19
of salaried jobs. Unlike men, Mexican women show a sharp say they entered self-employment to care for the home, com-
increase in responding that they have entered self- pared to virtually none of the men. This correlation of rising
employment to complement family income after the age of self-employment with moving into marriage age is also
67
I N F O R M A L I T Y
could not find a formal job. But this steadily rises with age
FIGURE 2.11
to 15 percent for males aged 25�54 and finally to 24 percent
Earnings gain from voluntary movement to informality in Mexico
for male workers aged 55�70. Involuntary entrants con-
% hourly wage gain for males entering informal self-employment tinue to represent a minority of entrants, but there is some
from salaried
40 evidence of the sector serving increasingly as a sector of last
35 resort for older workers. In Brazil the trend is exactly the
30 reverse, however; the oldest age group (55�70) reports
25 being least interested in finding a formal salaried job at 81 per-
20
cent. This is consistent with many of these workers not
15
interested in having a covered job if they can no longer
10
assure sufficient years of formal experience for a pension.
5
0 The age and gender breakdowns of the survey responses for
5 the other four countries (not shown) studied are broadly
10 consistent with the results for Mexico and Brazil, with dif-
More Higher pay Involuntary
ferent gradients across countries.
independence
Share of respondents Median earnings differential Informal salaried work
Although many of the considerations for why workers
Sources: Encuesta Nacional de Micronegocios, linked to Encuesta
Nacional de Empleo Urbano, 1992; Maloney 1999. might prefer to be informal apply to the informal salaried
as well, overall this sector shows a much larger component
of involuntary entry consistent with the exclusion view.
consistent with the effect of having coverage through their Until now, the information on the informal salaried was
spouses, as suggested by the results of Galiani and much scarcer; the informality modules conducted in the
Weinschelbaum (2006). Again, a large part of home-based four countries above included special components designed
work may also emerge from this dynamic. In no way does the precisely for them.
evidence here intend to validate the division of labor in the Table 2.9 suggests that, in contrast to the self-employed,
household, but simply to suggest that women's patterns of the majority of informal salaried workers appear to be invol-
employment are consistent with their pressing need to bal- untarily in their jobs, although not necessarily queuing for
ance family and work-life--whether or not this is largely a formal salaried employment. The inability to find a better
socially ascribed gender role. job constitutes a much higher fraction of the reported rea-
Furthermore, tables 2.7 and 2.8 offer supporting evi- sons for being in informal salaried jobs than for the formal
dence to the life-cycle nature of self-employment. Of the salaried: 48.4 versus 22.4 percent in Argentina; 64 versus
very few (1 percent) of male self-employed in the age range 32 percent in Bolivia; 43 versus 16 percent in Colombia;
of 15�18 in Mexico, most are entering to complement fam- and 40 versus 22 percent in the Dominican Republic. These
ily income and almost 30 percent cite lack of salaried jobs. are consistent with responses from the Brazilian informal
For Brazil, of the similarly small fraction of self-employed salaried in 1990 (table 2.10) that roughly 70 percent would
in the same age group, about 70 percent would prefer a for- rather have had a formal salaried job, although some care is
mal salaried job, unlike the older age groups that increas- in order since, as chapter 4 will show, this was a time of
ingly prefer self-employment.22 In sum, self-employment extreme segmentation in the Brazilian labor market.
is not a viable or good alternative for most youth to the Although the traditional queuing view enjoys substantial
extent they still lack the experience and capital to have a support, some clarifications are in order. While higher than
chance to succeed as entrepreneurs. among the formal salaried, the inability to find a better for-
Finally, the motivations of Brazilian and Mexican self- mal salaried job is not the overwhelming majority response
employed offer mixed evidence on the rationing out of mid- among informal salaried workers. For instance, in the case of
dle-aged and older workers from formal salaried jobs. In the Dominican Republic, only 17 percent cite this when
Mexico, only 9 percent of prime-age males 19�24 years asked about the second main reason. This explains why,
old report entering the sector because they either lost or as will be shown in chapter 3, the 18-percentage-point
68
T H E R A Z � N D E S E R O F T H E I N F O R M A L W O R K E R
TABLE 2.9
Distribution of the motivations/reasons for being in the current salaried job (percent)
Argentina Bolivia Colombia Dominican Republic
Cited as Percent of all Main Main Main Secondary
Motivation/reason relevant responsesa reason reason reason reason
Formal salaried
Could not find another job 50.7 22.4 31.7 16.2 21.5 9.4
Independent work is unstable 42.7 18.9 11.3 13.3 24.4 15.7
Less responsibility n.a. n.a. n.a. 0.7 1.0 5.0
Earns more than as independent 29.3 12.9 15.1 24.8 16.8 26.9
Better mobility/benefits/prospects 69.3 30.6 n.a. 8.5 16.7 22.8
Unable to become independent 25.5 11.2 15.0 33.7 17.4 17.3
Other 8.9 3.9 26.9 2.9 2.3 3.0
Informal salaried
Could not find another job 87.3 48.4 64.2 43.0 39.8 16.8
Independent work is unstable 23.5 13.0 4.5 6.4 20.0 13.1
Less responsibility n.a. n.a. n.a. 0.8 1.6 8.6
Earns more than as independent 17.9 9.9 4.8 3.9 5.9 13.7
Better mobility/benefits/prospects 17.4 9.6 n.a. 2.3 7.5 13.9
Unable to become independent 26.1 14.5 15.7 40.0 22.3 29.1
Other 8.1 4.5 10.8 3.7 3.0 4.9
Sources: Arias and Bustelo (2007), Arias, Landa, and Yanez (2007), based on household survey, 2005, 2006 data.
Note: n. a. = not applicable.
a. Computed as the ratio of the frequency with which each reason is reported to the total number of valid responses in the sample.
TABLE 2.10
Reported reasons to be informal salaried in Brazil (percent of workers)
Would you like to leave [your current] job for a job with a signed work contract? (Informal salaried)
Male Female
Response Alla 15�18 years 19�24 years 25�54 years 55�70 years Alla 15�18 years 19�24 years 25�54 years 55�70 years
No 30.3 22.8 25.0 31.8 55.3 37.4 25.5 28.5 43.5 70.1
Motivations to prefer an unprotected job (Informal salaried)
Male Female
Reason Alla 15�18 years 19�24 years 25�54 years 55�70 years Alla 15�18 years 19�24 years 25�54 years 55�70 years
Earn more in current job 6.2 3.1 7.6 10.6 2.4 2.2 1.7 3.0 2.6 0.8
Needed to care for home 0.2 0.2 0.0 0.1 0.0 18.2 4.7 9.5 25.7 24.3
Need time for other 7.1 8.5 5.1 3.5 4.4 6.7 8.7 5.3 5.4 3.7
activities
Happy in current job 67.1 74.1 74.7 68.7 57.1 60.3 73.6 71.6 55.6 47.6
Did not want the 9.8 6.6 8.3 10.8 16.6 7.8 6.7 7.7 7.1 13.7
commitment
No answer 9.7 7.6 4.3 6.2 19.5 4.8 4.6 2.9 3.6 9.8
Percent of sample 56.0 9.7 9.6 20.3 5.9 44.0 6.1 6.8 22.3 4.2
Percent of gender 100.0 17.3 17.2 36.2 10.5 100.0 13.8 15.4 50.8 9.4
Source: Author's estimates, based on Pesquisa Nacional por Amostra de Domic�lios 1990.
a. Considers all informal workers (including people under 15 years of age and above 70) who respond to this question.
69
I N F O R M A L I T Y
difference does not prevent these workers from reporting that may be better paid to enter (or return to) domestic
similar levels of welfare and job satisfaction than formal service, citing flexibility, in terms of work hours and pay
employees. Further, while similar responses are not available schedules, and security in terms of a source of emergency
for Mexico, rates of on-the-job search, a measure of dissatis- income, networks to other sources of employment, and a
faction, are only somewhat higher than for the largely general feeling of connection with the employer (Geldstein
voluntary self-employed.23 2000). However, it is also reported that this is a vulnerable
More important, there are numerous indications that job, in which employer abuse, isolation, few chances for
while a majority of informal salaried workers in Argentina organization, and limited opportunities for career advance-
may be in fact queuing for formal salaried employment, in ment are a reality.
the other countries many lean more toward independent The dissatisfaction of younger informal salaried workers
employment, most of which is informal. As shown in does reveal that few see the sector as a career job. Only 2 per-
table 2.9, the inability to become independent accounts for cent of informal salaried workers in Colombia, 5 percent in
15 percent of their reported reasons for being in their cur- Bolivia, roughly 10 percent in the Dominican Republic, and
rent job in Argentina and Bolivia, similar to the formal 17 percent in Argentina consider their job as preparation for
salaried. In contrast, in Colombia and the Dominican formal salaried employment or as offering better opportuni-
Republic, these represent about 40 percent of all responses, ties for social mobility. These are broadly corroborated by the
about seven points higher than for the formal salaried. responses from the Dominican Republic of unpaid workers
Moreover, table 2.5 shows that the informal salaried have where roughly 22 percent see their unpaid work, for 73 per-
higher rates of overall preference for self-employment than cent their first job, as preparation for the future. This is only
the formal salaried: in Bolivia (62 versus 41 percent); the partially consistent with Hemmer and Mamel's (1989)
Dominican Republic (57 versus 51 percent); and in asserted role of training in the sector. In any case, consistent
Argentina (62 versus 57 percent). Finally, the majority of with previous results for Mexican enterprises, table 2.11
"other reasons" reported by the informal salaried for being shows that most unpaid workers are related to the owner and
in their current job are related to the exercise of their trade, paid in kind, and that helping out the family is the over-
apprenticeships, and flexibility. whelming motivation for working without pay.
Finally, there are clear differences across demographic In sum, while the informal salaried have a majority com-
characteristics in the view of being in the sector. Table 2.10 ponent of discontented workers corresponding to the more
breaks down motivations by age and gender for the Brazilian classic queuing view of the sector, it is also a heterogeneous
informal salaried. Younger workers show the higher discon- sector, and the magnitude of each subcomponent would
tent with being informal salaried at about 80 percent. Mean- vary across countries and time. All the observations made
while, half of male workers and 70 percent of females close earlier are relevant here. The sector comprises young workers
to retirement (55 and above) show no inclination to move to
a formal salaried job. This may arise because of quality of life
issues--formal jobs being excessively demanding for older TABLE 2.11
individuals (Gonzalez de la Rocha 1994; Lorenzen, Selby, Principal reason for working without monetary compensation in the
Dominican Republic (percent of workers)
and Murphy 1990), the realization of the limited use in
further contributing to pensions, or perhaps now being able
to take advantage of the family benefits enjoyed by their Reason Distribution
prime-age children in the formal sector.
Learning a profession 8.5
Even among prime-age workers, 44 percent of females Helping family 62.4
age 25�54 are inclined to stay as informal salaried and Getting experience to get a better job 13.4
Paying a debt to the owner of the firm 1.3
among these, again flexibility to attend family life gains Compensated with food, housing, or apparel 5.1
importance in marriage age (25 percent). Another logic Compensated with partial or full payment 2.8
for studies
applies to domestic workers, a main component of this
Other 6.5
group, although with nagging tradeoffs. Interviews with
poor working-class Argentine women reveal that it is not
Source: Authors' estimates, based on employment survey
uncommon for unskilled women to leave formal sector jobs data, 2006.
70
T H E R A Z � N D E S E R O F T H E I N F O R M A L W O R K E R
possibly rationed out by labor and regulatory distortions, 42 percent of the informal salaried cited their unawareness
and those entering the labor force, shopping around for jobs about how private pensions work as the prime reason for
and being frustrated by the lack of a track record and infor- being out of the social security system; one-quarter said
mation asymmetries in the labor market, and some women their employers did not offer the benefit, and another quar-
who find more flexibility in microfirm salaried jobs. Again, ter said their income was too low. In Colombia, 30 percent
labor or regulatory distortions that curtail formal salaried reported that their employers did not offer the benefit or
employment are not the only factors that may be behind the that most available jobs are like this; 56 percent said their
largely involuntary nature of the sector. The final section of income was too low, and only 10 percent reported reasons
this chapter examines more closely the reasons that cause that reflect an explicit opting out. In the Dominican
workers in both informal sectors to be without old-age and Republic, 42 percent reported similar employer or labor
health protections in their jobs. market constraints (including 5 percent unaware of their
pension rights); 23 percent alleged insufficient incomes, but
Workers' motivations to lack old-age one-third actually cited voluntary reasons. In all four coun-
and health protection tries, only a small fraction (5�7 percent) said that the main
When asked explicitly about the reasons for not having pen- reason for not being affiliated was low expected benefits or
sion and health insurance benefits, a large fraction of infor- lack of trust in the social security system.
mal salaried workers report relatively external constraints. Likewise, most of the informal self-employed alluded to low
As shown in table 2.12, when the informal salaried in incomes or lack of knowledge as the main reason for not con-
Argentina were asked whether they lack social security ben- tributing to the pension system. Insufficient income to afford a
efits because their employers did not offer them or because pension plan is reported by three-fourths of independent
they reached a consensual agreement to obtain higher earn- workers in Argentina and Colombia, half in the Dominican
ings, 95 percent said it was the former reason. In Bolivia, Republic and one-quarter in Bolivia. Meanwhile, 55 and 20
faced with a larger number of response options, about percent of the informal self-employed in Bolivia and the
TABLE 2.12
Main reasons why the informal do not contribute to social security (percent of workers)
Argentina Bolivia Colombia Dominican Republic
Salaried Salaried Salaried Salaried
Reason worker Independent worker Independent worker Independent worker Independent
Too young, too n.a. n.a. n.a. n.a. 3.8 2.4 5.0 3.4
far in the future
Prefers higher earnings 4.5 1.7 n.a. n.a. 1.7 1.3 11.8 1.8
Income too low n.a. 76.0 25.4 26.0 55.8 74.8 22.9 51.2
Not worth it n.a. 3.0 n.a. n.a. n.a. n.a. 2.9 1.9
Employer only 95.5 n.a. 23.7 n.a. 11.8 0.6 21.0 n.a.
offered this job
Lack of trust n.a. 4.3 6.9 15.4 2.0 6.2 2.4 5.6
Jobs are like that n.a. n.a. n.a. n.a. 4.6 1.8 15.7 n.a.
Unaware of right/ n.a. n.a. n.a. n.a. n.a. n.a. 5.2 19.4
could contribute
Employer does not n.a. n.a. n.a. n.a. 13.4 1.3 n.a. n.a.
require it
Children, spouse n.a. n.a. n.a. n.a. 0.3 2.1 0.6 10.1
will look after
Prefers own savings n.a. n.a. n.a. n.a. 0.8 2.5 4.3 2.3
Don't know how n.a. n.a. 42.1 55.3 n.a. n.a. n.a. n.a.
system works
Other n.a. 15.0 1.9 3.3 5.8 6.9 8.3 4.5
Sources: Arias and Bustelo (2007), Arias, Landa, and Yanez (2007), based on household survey, 2005, 2006 data.
Note: n.a. = not applicable.
71
I N F O R M A L I T Y
Dominican Republic, respectively, alleged lack of knowledge of the benefits and services mandated in formal labor con-
about the functioning of private pensions as the prime reason tracts. As will be discussed in chapter 8, other survey evi-
for not contributing to social security. Among the 20�30 per- dence reveals that trust and satisfaction with public
cent of the informal self-employed who reported explicit vol- institutions are very low, and in some cases are declining, in
untary reasons, only 6�8 percent in Colombia and the these and other countries in the region, and that this issue
Dominican Republic and 15 percent in Bolivia alluded to low may cultivate a social norm of noncompliance with taxes
expected benefits or lack of trust in the social security system and regulations. While the survey responses indicate that a
as the main reason not to be affiliated. Most voluntary reasons perceived inadequacy of benefits is not a first-order driver of
reported in Colombia and the Dominican Republic were workers' informal status, they cannot tell us whether this
relying on their spouses or children to cover their living factor could be a secondary but significant driver of infor-
expenses in old age, being too young to be concerned about mality (for example, if income and informational con-
this, and a preference to earn more now or save on their own. straints were not binding).
However, a small fraction (10�30 percent) of those in jobs Table 2.13 shows that the reported reasons why the infor-
not contributing to pensions in all four countries reported mal salaried lack health insurance coverage in Colombia and
that they were using other means (e.g., savings, investment the Dominican Republic (the only two countries that col-
in assets) to prepare for old age. lected such data) reflect a much larger degree of voluntary
Some caution is in order in approaching these responses. choice. About 82 percent of salaried workers without pen-
First, it is hard to distinguish true credit constraints from sion benefits in Colombia and three-fourths in the Domini-
classic myopia or inertia in the mainstream pension litera- can Republic do not have health insurance coverage on their
ture. Turner and Verma (2007) show that of those who were own, in contrast to the almost full coverage of the formal
eligible to participate in 401K plans in the United States but salaried. In the two countries a small fraction of informal
did not, 40 percent responded that they could not afford to. salaried workers (20 percent in Colombia, 11 percent in the
Yet these are workers earning several orders of magnitude the Dominican Republic) reported the employer not offering
income of Latin American workers. Further, automatic the benefit as the main reason, and again, a significant
enrollment substantially increased their participation; many fraction (23 and 46 percent, respectively) cited very low
allegedly income-constrained workers did not opt out, thus incomes as the main reason.
suggesting that for many the contributions were, in fact, Among those reporting clear opting-out reasons, 44 per-
quite manageable. The explanation for this is some mixture cent in Colombia said they have the benefit through
of inertia and myopia. Whether, in fact, informal workers in another family member or the public subsidized regime,
the countries surveyed here or elsewhere in the region would and 30 percent in the Dominican Republic reported a host
do the same, or whether they would still opt out into infor- of reasons ranging from preferring to cover health costs on
mality, we cannot know. However, in several countries of the their own (10 percent), having the benefit through another
region, including Chile, Uruguay, and to a lesser extent family member (6 percent), and relying on the public
today Argentina, many low-income formal salaried workers health system (7 percent). In both countries, less than
are able to contribute to pension plans. In fact, as will be 5 percent reported low coverage or quality of health ser-
shown in chapter 3, the Dominican self-employed have aver- vices as the main reason not to be affiliated.
age earnings similar to those of formal salaried workers, sug- Low incomes and the preference for other alternatives
gesting that, in principle, contributions to the system should also emerged as the main reported reasons of independent
be as affordable. Thus, the response of "lacking income" in workers in Colombia and the Dominican Republic to
these surveys cannot be taken at face value and should be lack health insurance coverage. Between 12 and 14 per-
plausibly viewed as voluntarily opting out of old-age sav- cent of independent workers without pension plans in
ings, combining a mixture of unaffordability due to eco- Colombia and the Dominican Republic had other types
nomic hardship, inertia, and myopia. of health insurance coverage, compared to three-fourths
Second, although low expected returns and trust in the and two-thirds of the formal self-employed, respectively.
pension system do not appear prominently as main reasons, Around half of the informal self-employed in the
this does not negate that many workers in these countries Dominican Republic and one-third in Colombia said
might in fact have concerns with the quality and reliability they do not have health insurance because they could not
72
T H E R A Z � N D E S E R O F T H E I N F O R M A L W O R K E R
TABLE 2.13
Main reasons why workers do not contribute to health insurance (percent of workers)
Colombia Dominican Republic
Informal Formal Informal Informal Formal Informal
Reason salaried independent independent salaried independent independent
Health service inefficient/ 0.4 1.1 1.0 1.1 1.0 1.0
low coverage
Health service low quality 0.4 4.3 0.6 1.6 0.0 1.1
Beneficiary through relative 44.0 57.9 53.7 6.0 19.0 5.6
Prefers higher earnings 1.3 0.5 0.5 2.6 0.0 1.1
Employer does not offer it 9.9 0.4 0.6 6.7 1.1 0.4
Employer does not require it 10.0 0.5 1.2 4.7 0.0 0.8
Don't know how to enroll 0.6 0.1 1.0 4.0 11.5 7.7
Too low incomes 23.4 11.7 33.2 45.5 41.5 49.1
Temporary situation 2.3 0.4 0.9 4.6 1.8 2.8
Prefers self-coverage 1.1 7.6 1.9 10.2 12.4 14.2
Has private insurance 0.3 4.8 0.7 n.a. n.a. n.a.
Attend public hospitals n.a. n.a. n.a. 6.7 7.1 11.5
Insurance companies rejection n.a. n.a. n.a. 0.5 0.0 0.5
Other 6.2 10.9 4.6 5.8 4.6 4.2
Sources: Arias and Bustelo (2007), Arias, Landa, and Yanez (2007), based on household survey, 2005, 2006 data.
Note: n.a. = not applicable.
afford it, compared to 42 and 12 percent of formal self- age does not prevent informal workers in the Dominican
employed, respectively. Republic from reporting levels of job satisfaction equal to
About 54 percent of the Colombian informal self- those of formal salaried employees.
employed and 58 percent among formal cited having the The policy implications of the reported significance of
benefit through another family member or the public sub- low incomes for low pension and health insurance coverage
sidized regime. The Dominican informal self-employed depend on the alternative interpretations. If workers are
reported a host of reasons, including preferring to cover unable to save for their retirement because they are forced to
health costs on their own (14 percent), reliance on the pub- spend their incomes entirely on necessities, forcing them to
lic health system (12 percent), lack of information on how save (through mandatory savings programs such as social
to enroll (8 percent), and being a beneficiary of another security) may reduce their welfare during working years,
family member (6 percent). These are very similar for the and, therefore, well-targeted social insurance pillars would
formal self-employed, except for their heavier reliance on be more advisable. However, to the extent that this behavior
coverage through relatives. In both countries barely 2 per- partially reflects myopia or inertia in the savings behavior of
cent said they were not affiliated due to low coverage or some workers for retirement, there is an important role for
quality of health services. programs that mandate or provide incentives for voluntary
Again, considerations similar to the above apply to the savings. In any case, whether workers end up with insuffi-
interpretation of the "low income" responses and the low cient savings for old age because they consume "excessively"
fraction of workers citing overriding concerns with the during their earnings years or because they have low long-
quality of health services. In this case, risk aversion behav- term income potential, there is some justification for some
ior becomes relevant. The fact that many workers resort to government intervention to influence individuals' savings
self-coverage or are happy with the protection offered by and retirement decisions or to provide minimum protection
universal health services suggests that these are judged from poverty at old age by pooling efforts through the tax
to be adequate as compared to privately provided health system. These issues will be discussed in detail in chapter 7.
insurance plans considering the cost of the latter. In fact, as Furthermore, the significance of information failures and
chapter 3 will show, the lack of pension and health cover- the availability of alternatives to substitute for mandated
73
I N F O R M A L I T Y
benefits, either publicly provided or through private means, salaried in the other countries leans more toward indepen-
require policy attention. It is imperative to ensure a good dent employment, most of which is informal, as a desired
design of social protection and social assistance systems to destination.
minimize distorting individuals' employment behavior, as The next chapter revisits this question and the more gen-
will also be discussed in chapter 7. eral question of the role of the different sectors by studying
Finally, to the extent that the decisions of firms to oper- whether workers' stated voluntary or involuntary motiva-
ate informally are important drivers of the informality of tions to be in informal employment conform to their earn-
salaried workers, as will be discussed in chapters 4 through ings performance and, ultimately, their welfare. Chapter 4
6, improved design and enforcement of labor, tax and busi- on labor dynamics will introduce additional evidence
ness regulations, and incentives for firms to find benefits in exploiting transitions and patterns across the business cycle
participating in formal institutions have an important role to more fully flesh out the nature of the informal sector.
to play in addressing informal employment.
Notes
Conclusions
1. The Harris-Todaro (1970) model is perhaps the traditional
This chapter first laid out several conceptual and empirical statement of this view. Also see Fields 1990; Peattie 1987; Portes and
approaches to understanding the raz�n de ser of the informal Schauffler 1993; Tokman 1992; and Turnham and Er�cal 1990.
worker. It then brought to bear two sets of empirical tools 2. See also Krebs and Maloney (1999) for an efficiency wage
to begin to distinguish among these approaches. The first model applied to Mexico.
3. Schneider and Enste (2000) linked Hirschman's "exit" and
approach moved beyond simple tabulations of stocks of
"voice" to the causes of the informal economy, but their emphasis was
workers in different sectors to studying the dynamics of
on opting out driven by the desire to avoid dealing with excessive
their movements through the labor market, and what these state burdens, rather than on the perceived inadequacy of the benefits
sectoral transitions can tell us about why workers are where that formality entails.
they are. The second analysis relied on the reasons workers 4. Fields (1990) argued for two tiers, with a minority upper tier
report for being in their current job with or without social that is voluntary and prosperous. Yamada (1996), Maloney (1999),
Saavedra and Chong (1999), and Mondino and Montoya (2002) have
protections.
argued with evidence from Peru, Mexico, Brazil, and Argentina that
In the cases of both the informal salaried and self-
the majority of the informal self-employed are voluntary.
employed, there is evidence of substantial heterogeneity of 5. The interviews by sociologists Bal�n, Browning, and Jelin
motives and demographic characteristics. However, the (1973) in Mexico suggest that the paucity of openings for promotion
characters of the two sectors emerge as very distinct, lend- on the rigid escalaf�n (seniority-driven job ladder) can make informal
ing credence to both the exclusion and voluntary nature of self-employment the remaining outlet for further advancement.
6. In fact, even in the United States, some workers leave large
informal employment.
firms to open their own, taking on the responsibility for health care
Evidence from workers' patterns of mobility and reported
and pensions through private or independent means.
motivations to be in their current occupations lends support 7. The fraction of households receiving financial help from rela-
to the view that the majority of independent workers are tives in other households is 38 percent in Spain and 11 percent in
largely voluntary and attach significant value to the nonpe- Italy versus 1 percent in the United Kingdom and 6 percent in the
cuniary benefits of autonomous work (although an important United States.
8. Maloney (1999) standardized probabilities both on initial
fraction conforms to the traditional view of the sector as
turnover and on final sector size. Bosch and Maloney (2005) standard-
employment of last resort). Self-employment is concentrated
ized on initial separations.
among older workers and is not an entry point of work. 9. As one example, broadly replicated in the other surveys, the
Meanwhile, the majority of informal salaried workers National Urban Employment Survey (ENEU) from Mexico shows
appear to be involuntary, although there is also significant that transitions into self-employment from the other paid sectors
heterogeneity of characteristics (most are young) and occur four to six years later than transitions into formal or informal
salaried work, leaving the mean age eight years higher than the next
motives. This may not necessarily imply that they are
closest sector (see Maloney 1999; Maloney and Aroca 1999).
queuing for preferred, better-quality formal salaried
10. See Lopez-Casta�o (1990) in Colombia, and Fields (1990)
employment; although this seems to be the case for a and Peattie (1982), who find a tendency for employees of large firms
majority in Argentina, a significant fraction of the informal to leave and open their own businesses. Aroca and Maloney (1997)
74
T H E R A Z � N D E S E R O F T H E I N F O R M A L W O R K E R
find confirmation in a logit analysis for Mexico with rotating 18. These results are very close to Gottschalk and Maloney's
panel data. (1985) finding that roughly 70 percent of U.S. job changes are vol-
11. This mixed story is put forward by Guadalajaran sociologist untary. Put differently, the implied rates of involuntary entry into
Gonzalez de la Rocha (1994), who argues that, for many older workers, self-employment would be normal by the standards of a flexible
self-employment provides a safety net by offering insecure occupa- industrial country market.
tions (such as the services) in which their age is not a limitation after 19. Survey data for other countries are also broadly consistent. For
they have been kicked out of the formal manufacturing or formal instance, Itzigsohn (2000) reports that most informal entrepreneurs in
services, while also suggesting some degree of voluntary movement Costa Rica and the Dominican Republic preferred their jobs to being a
in that older men may also find the pace of industrial (formal) work formal employee in a special export zone. In Paraguay, only 28 percent
too arduous and leave such jobs. The voluntary take is stressed by of those in the informal sector stated a desire to change occupations
anthropologists Selby, Murphy, and Lorenzen (1990) who note the (DGE 1998). In Guatemala, only 31 percent of informal independent
"surprising desirability of informal sector employment as the basis workers were willing to become formal employees (CIEN 2006).
for a household earning strategy, particularly for poorer, older house- 20. These data come from surveys with the same or very similar
holds with lower educational qualifications" (p. 144). questions on preferences for self-employment over salaried work to
12. Fajnzylber, Maloney, and Rojas (2006) find that Mexican firms the adult (employed) population of the countries.
have mortality rates of the same order of magnitude as those found in 21. Interestingly, the fraction of formal independent workers who
the United States by Evans and Leighton (1989); the 18 percent exit are involuntary is only 15 percent in Argentina and the Dominican
to wage work (measured as the fraction of self-employed workers Republic, but 35 percent in Bolivia and 54 percent in Colombia.
moving to wage work) compares to 14 percent across a year. This is 22. This disproportionately high level of youth reporting comple-
consistent with much higher entry rates as a fraction of wage work- menting income makes sense, given that around 2.5 percent of
ers, averaging 8 percent in Mexico compared to the 4 percent found 15�18-year-old males are heads of their households, while 30 percent
by Evans and Leighton (1989) for the United States. Among young are in the next category.
workers 20�28 years old, failure rates are roughly equivalent at 23. Likewise among Paraguayan informal salaried workers, the
around 50 percent, while for prime-age workers, 31�35, failure rates percent looking for a better job was only slightly higher than the self-
are roughly equivalent at 20 percent. See also Levenson and Maloney employed, at 32 percent (DGE 1998).
(1996).
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78
CHAPTER 3
Informality, Earnings, and Welfare
SUMMARY: Based on an examination of differences in earnings and self-rated welfare, this chapter lends credence to both
the "exclusion" and the "voluntary" nature of informal employment suggested in chapter 2 by workers' reported motiva-
tions to be informal. Earnings and welfare assessments support the view that the majority of independent workers are
largely voluntary and attach significant value to the nonpecuniary benefits of autonomous work, while the majority of
informal salaried workers tend to be excluded from more desirable jobs both in the formal salaried and independent
sectors. However, the data caution against simple generalizations. Both groups exhibit important heterogeneity, and data
for the Dominican Republic show that both the informal self-employed and informal salaried are as well-off as formal
salaried workers, while in Colombia both informal groups exhibit much lower levels of satisfaction with current jobs.
While there are seemingly two tiers of informal employment, gradients and gray areas cloud universal conclusions about
who they are, what determines their relative size, and the welfare implications of each tier.
C HAPTER 1 ILLUSTRATED THE (for example, flexibility, autonomy) characteristics of infor-
considerable heterogeneity of informal mal jobs partially compensate workers for any lower earn-
workers in the region and how, on average, ings? This chapter examines these questions, relying heavily
they tend to face a significant earnings dis- on analyses of household surveys containing the relevant
advantage. Chapter 2 discussed the various data from Argentina, Bolivia, Colombia, and the Domini-
hypotheses that aim to explain the raz�n de ser of the infor- can Republic to illustrate the issues in a variety of country
mal worker and their implications regarding the relative contexts.
quality of formal and informal jobs. This chapter delves The chapter first describes the characteristics of workers,
into a more in-depth investigation of the characteristics their jobs, and the firms that affect the propensity to infor-
associated with the propensity of workers to be informal, mal employment (proxied by lack of pension coverage). It
and the variation in the earnings and welfare differentials then examines whether informal workers receive equal pay
associated with informal work, making a clear distinction for equal work along the entire remuneration scale, and
between informal salaried and independent workers. what fraction of informal-formal earnings gaps result from
Who are the informal (salaried and independent) workers? differences in worker characteristics and in how these are
Does informal employment in itself imply lower earnings-- rewarded in the labor market, including differences in the
that is, do informal workers receive lower pay for equal returns to human capital (schooling or work experience).
work? Are all informal jobs "bad jobs" in terms of carrying Finally, the chapter examines workers' self-rated welfare
lower earnings for a worker's skills, or do some individuals (propensity to consider themselves poor) and job satisfac-
find niches in informal employment that are more suitable for tion responses as more complete indicators to assess welfare
their skills, preferences, and situations? Does informal work differences between workers in formal and informal jobs, as
lead to lower individual welfare, or do the nonpecuniary well as the significance of nonpecuniary job characteristics
79
I N F O R M A L I T Y
(that is, flexibility, autonomy, stability/mobility) in the wages that makes workers indifferent toward the various
sectoral participation of various workers (for example, types of jobs. The differences in these implicit wages are
women/men, the skilled/unskilled). called compensating differentials. Given heterogeneity in
worker preferences and skills, both supply and demand for
Compensating differentials, comparative particular jobs determine the size of the compensating dif-
advantage, and informal work ferential between jobs with different working conditions.
As discussed in chapter 2, the nature of informal employ- Thus, the labor market comprises a set of interrelated mar-
ment has been examined mainly through two lenses: the kets for different labor types whose wages are set by supply
"exclusion" and "voluntary" views. In the exclusion view, and demand.
workers would prefer the benefits of formal jobs but are The consideration of major labor-demand constraints in
rationed out due to segmentation of the labor market. The the framework can bring to bear the concerns of the exclu-
latter is traditionally linked to institutional rigidities, sion view of informality. In particular, with high unem-
but--again--can arise from economic dualism, barriers to ployment, an oversupply of some types of labor, or in a
labor mobility (geographical or informational), efficiency situation when workers are in "noncompeting groups," the
wages, or coordinated evasion of corporate, sales, and payroll market pressure to pay compensating differentials can van-
taxes. In contrast, the voluntary view suggests that infor- ish. In this case, more workers would be willing to take the
mal jobs largely reflect workers' implicit choices given their less desirable jobs at wages below those in the more desir-
preferences, skills, the costs and benefits of formality, and able-but-scarce jobs. Therefore, when the demand of some
the availability of other means of social protection, the last labor types is very constrained for whatever reason, includ-
in turn being a function of the quality of existing country ing market segmentation, the room for workers' choice is
policies and institutions. As noted before, both views have greatly diminished and their wages are set primarily by the
potential explanatory power to understand the nature of employing firms.
informality in the Latin American and Caribbean region. This framework has three key implications for the
The labor literature on compensating differentials and nature of informal employment. First, in choosing
occupational choice based on workers' comparative advan- between informal and formal employment, workers weigh
tage provides a framework that encompasses these two seem- the advantages and disadvantages of each potential job,
ingly irreconcilable views. The basic idea, first advanced by subject to the availability of jobs with their desired attrib-
Adam Smith (1876, p. 111), is that the wages paid to vari- utes; therefore, comparative advantage could make the
ous types of labor must, in general, equalize total advantages informal sector a better match for many of them. As noted
and disadvantages, pecuniary and nonpecuniary, and that in chapter 2, informal and formal jobs tend to require
workers select occupations that yield the highest net varying degrees of skills, and the various amenities of
advantage for their tastes and skills. This is the cornerstone informal and formal jobs may be valued differently by
of the modern literature on comparative advantage in the some groups. Some workers might find advantageous
labor market as a determinant of occupational choice, human niches to their observed and unobserved skills in occupa-
capital investments, and earnings performance (Carneiro, tions with a higher propensity to be informal (such as
Heckman, and Vytlacil 2001; Heckman and Sedlacek 1985; those in construction).
Rosen 1981). Others may be willing to forgo some of the benefits of for-
According to this, individuals choose the jobs that mality in exchange for the nonpecuniary benefits of informal
better fit their preferences and specific ranges of talents, jobs. As an example, for low-skilled youth and older work-
including cognitive, social, and mechanical skills. Jobs that ers, informal salaried jobs may offer an entry point to the
are more desirable (due to amenities such as fringe benefits, labor market that partially allows them to remedy deficient
stability, safety, autonomy, and flexibility) or that require schooling or the obsolescence of skills through on-the-job
relatively abundant skills should have lower-than-average training unavailable to them in formal salaried jobs. For
wages while jobs that are less desirable or demand scarce women, the demands for flexibility to balance work and
skills should pay higher wages. A competitive labor market family responsibilities that arise with child rearing may
determines an implicit (hedonic) wage for each type of labor render the greater flexibility and autonomy of informal
and equilibrates when labor mobility leads to a set of relative jobs a better match. Furthermore, employers could attract
80
I N F O R M A L I T Y, E A R N I N G S , A N D W E L F A R E
enough workers without offering a compensating wage dif- The profile of participation in informal employment
ferential if a large subset of workers does not regard a given As discussed in chapters 1 and 2, informal employment
job attribute (such as not having social security) as a disad- encompasses a diverse range of people. Using contributions to
vantage. In some cases, amenities and disadvantages may social security as a criterion to define informal employment,
cancel each other out without giving rise to compensating we can distinguish four employment categories: informal and
differentials. formal independent, informal and formal salaried. The infor-
Second, there is no clear a priori presumption that infor- mal independent generally comprise relatively better-paid
mal employment should carry lower, equal, or higher earn- small firm owners, self-employed professionals (for example,
ings than formal jobs. On the one hand, informal jobs doctors, lawyers, teachers), semiskilled workers with some
should command higher earnings to compensate workers for technical competencies (for example, artisans, handymen,
the value of lost fringe benefits such as social protection construction laborers, taxi drivers), and unskilled workers in
for health risks and old age (net of payroll contributions), precarious employment or under a semi-dependent work rela-
and their greater risk of unemployment and income shocks. tionship (street vendors, small artisans under subcontract).
On the other hand, earnings may be lower to adjust for the The informal salaried largely comprise domestic employees, a
value of nonpecuniary amenities such as flexible hours, variety of young apprentices, and older unskilled workers in
autonomous work, training, and tax savings, particularly for small enterprises (for example, sales clerks, beauticians,
independent workers but much less so for the informal salaried artisans), but also the workers in larger firms who are
salaried workers. Thus, differences in earnings cannot be under informal labor arrangements.
used to test segmentation in the labor market (Magnac Regression analysis can be used to isolate the character-
1991; Maloney 1999). istics that best predict the propensity that a given worker
Moreover, since workers may sort into formal and infor- engages in the four employment categories. The analysis is
mal jobs acting on the returns to their skills and competen- carried out for Argentina, Bolivia, and the Dominican
cies in each sector, direct average earnings comparisons are Republic, considering a host of characteristics of workers,
flawed. Frequently, high-paying skilled jobs also offer bet- their jobs, and the firms for which they work. Figures 3.1
ter fringe benefits. It is necessary to control for differences to 3.3 present the odds ratios or relative propensities that a
in observed and unobserved skill level (leading to produc- worker with a given characteristic belongs to each of the
tivity differences reflected in wages) in order to measure two informal groups rather than to the formal salaried,
correctly informal-formal compensating differentials. Fur- holding other characteristics constant. An odds ratio of 1
thermore, average earnings gaps do not fully characterize represents no effect of a variable; a ratio greater than 1 indi-
the earnings gains or losses from formal employment for cates that the characteristic increases the odds of that
any given worker. Some workers could emerge as top earn- employment category compared to the formal salaried
ings performers for their skills in informal jobs, but if they group, and a ratio less than 1 indicates that it diminishes
were to move to a formal job they may actually lose out in the odds. For instance, an odds ratio of 0.75 signifies that
the earnings rankings. Section 3 of the chapter presents the chance that a worker with the given characteristic gets
empirical results in this vein. a given job type is 75 percent of the chance of being formal
Finally, more generally, the relative qualities of informal salaried. An odds ratio of 1.5 implies a 1.5 times greater
and formal jobs and the ensuing differences in workers' wel- chance of being in the given category than formal salaried.
fare have to be assessed more broadly to take into account The larger the odds ratio, the stronger the relationship, so
nonpecuniary job attributes. The conditional informal- these provide an implicit ordering of workers with differ-
formal earnings comparisons could be seen as providing ent education levels, age groups, sectors, firm sizes, and so
orders of magnitude of the potential net value of the ameni- on across the four occupational groups.
ties and disadvantages of informal jobs. Establishing whether Adjusting for workers' personal characteristics, firm
amenities fully compensate for any lower informal earnings so size has the strongest negative association with informal
that workers are equally well-off in terms of welfare faces the work, and sector of employment also has an important
challenge of limited data. The last section of the chapter pre- independent effect. The odds of being informal salaried
sents new analyses of subjective welfare and job satisfaction in microenterprises relative to large firms are over 40 to
data that attempt to provide some evidence on this key issue. 1 in Bolivia and the Dominican Republic, and over 11 to
81
I N F O R M A L I T Y
1 in Argentina.1 In these countries, the odds fall signifi-
FIGURE 3.1
Propensity to informal employment by firm size and economic cantly for employees of medium-sized companies, although
sector, 2005�06 remaining at 12 to 1 in the Dominican Republic.
Propensity to informal salaried work and firm size Employment industry also significantly affects informal-
Odds ratio compared to formal salaried, firm size: large firm ity propensities, with no universal patterns across coun-
Ratio
tries. Adjusting for firm size and other characteristics,
45
40 informal independent workers are more likely to be
35 found in construction and transport as well as in agricul-
30 tural activities and commerce in the Dominican Repub-
25 lic, and in construction and commerce in Argentina.
20
Informal salaried employment is more likely in the same
15
sectors in the Dominican Republic, while it is more
10
5 prevalent in transport, social, and personal services in
0 Argentina. Informal employment propensities are quite
Dominican Republic Argentina Bolivia
similar across sectors in Bolivia, except for greater odds
(urban) (Greater Buenos Aires) (urban)
of independent work in agriculture and informal salaried
Micro firm Small and medium size
employment in transport. These differences across and
within countries in sectoral propensities to informality
Propensity to informal self-employment and economic sector
Odds ratio compared to formal salaried, manufacturing may reflect differences in the incentives entailed by exist-
Ratio ing regulations and in their enforcement across sectors
60 and countries, as well as an intrinsic inclination toward
14 informality of workers with occupational traits fit to sec-
12 tors such as construction and commerce.
10 Among personal characteristics, education and tenure
8 are the strongest predictors of informal employment (figure
6 3.2). The informal employment propensities decline pro-
4 gressively with education, especially with full completion
2 of secondary schooling. Compared to a college graduate, the
0 odds that a worker with incomplete primary or no educa-
Dominican Republic Argentina Bolivia
(urban) (Greater Buenos Aires) (urban) tion is informal salaried or informal independent are 15 and
8 times greater in Bolivia, respectively, about 2 to 1 in the
Propensity to informal salaried work and economic sector
Dominican Republic, while in Argentina the odds are 6 to
Odds ratio compared to formal salaried, manufacturing
Ratio 1 and above 2 to 1, respectively. Holding constant other
10 characteristics, those with a high school diploma face equal
8 chances of informal employment as the college-educated in
6 Argentina, 4-to-1 odds in Bolivia, and still close to a 2-to-1
4 chance in the Dominican Republic. The significant fall in
the informality propensity with the completion of high
2
school suggests that this diploma may serve as a signal to
0
Dominican Republic Argentina Bolivia employers that a worker has the minimum skills required
(urban) (Greater Buenos Aires) (urban)
to justify the cost of a formal labor contract. This may be
Construction Transport and communication more important in the presence of job rationing due to
Primary sector Commerce labor market rigidities or other sources of job segmenta-
Public administration, education, health, and
social services tion. This is consistent with the differences observed
between Argentina and Bolivia, on one hand, and the less
Source: Based on Arias and Bustelo (2007), Arias, Landa, and Yanez
(2007), and author's estimates using household survey 2005, 2006 rigid Dominican labor market on the other. Interestingly,
data. results (not shown here for brevity) indicate that in all three
82
I N F O R M A L I T Y, E A R N I N G S , A N D W E L F A R E
FIGURE 3.2
Propensity to informal employment by education and tenure, 2005�06
Propensity to informal self-employment and education Propensity to informal salaried work and education
Odds ratio compared to formal salaried, college graduate Odds ratio compared to formal salaried, college graduate
Ratio Ratio
16 16
14 14
12 12
10 10
8 8
6 6
4 4
2 2
0 0
Dominican Republic Argentina Bolivia Dominican Republic Argentina Bolivia
(urban) (Greater Buenos Aires) (urban) (urban) (Greater Buenos Aires) (urban)
Primary incomplete Primary complete Secondary incomplete Secondary complete College incomplete
Propensity to informal self-employment and job tenure Propensity to informal salaried work and job tenure
Odds ratio compared to formal salaried, 5 years or more tenure Odds ratio compared to formal salaried, 5 years or more tenure
Ratio Ratio
10 10
9 9
8 8
7 7
6 6
5 5
4 4
3 3
2 2
1 1
0 0
Dominican Republic Argentina Bolivia Dominican Republic Argentina Bolivia
(urban) (Greater Buenos Aires) (urban) (urban) (Greater Buenos Aires) (urban)
Less than 1 year Between 1 and 5 years
Source: Based on Arias and Bustelo (2007), Arias, Landa, and Yanez (2007), and author's estimates using household survey 2005, 2006 data.
countries the college-educated are generally equally or more propensities (figure 3.3). Although far from universal,
likely to be formal independent than formal salaried, some common patterns emerge by age and women's mari-
adjusting for other characteristics. tal status. As shown in chapter 2, younger workers experi-
Finally, workers with less than one year in their current ence much higher rates of informal salaried work. The
occupation have a much larger risk of being informal salaried regression analysis shows that this is largely a result of
than those with longer tenures. For instance, compared to youth's much shorter tenures and higher rates of employ-
those with five or more years in their occupation, the odds are ment in small firms. In fact, holding these and other fac-
9 to 1 in Argentina, 7 to 1 in Bolivia, and 3 to 1 in the tors constant, the odds ratio of informal to formal salaried
Dominican Republic. Short tenures also correlate with greater work is constant across all age groups in Argentina and
chances of being informal independent relative to formal the Dominican Republic, although they still fall system-
salaried in Argentina and Bolivia (4 to 1 and 2 to 1, respec- atically with age in Bolivia, where youth are 50 percent
tively), while the odds are similar in the Dominican Republic. more inclined to informal over formal salaried work
Individual and family demographics show an indepen- than middle-aged workers. The age profile of informal
dent but second-order correlation with informality independent work is consistent with life-cycle theories of
83
I N F O R M A L I T Y
FIGURE 3.3
Propensity to informal employment by age, gender roles, and work preferences, 2005�06
Propensity to informal self-employment and age Propensity to informal salaried work and age
Odds ratio compared to formal salaried, 36�45 years old Odds ratio compared to formal salaried, 36�45 years old
Ratio Ratio
3.0 3.0
2.5 2.5
2.0 2.0
1.5 1.5
1.0 1.0
0.5 0.5
0 0
Dominican Republic Argentina Bolivia Dominican Republic Argentina Bolivia
(urban) (Greater Buenos Aires) (urban) (urban) (Greater Buenos Aires) (urban)
15�25 years 26�35 years 46�55 years 56�65 years
Propensity to informal self-employment and gender Propensity to informal salaried work and gender
Odds ratio compared to formal salaried, man Odds ratio compared to formal salaried, man
Ratio Ratio
5.0 5.0
4.5 4.5
4.0 4.0
3.5 3.5
3.0 3.0
2.5 2.5
2.0 2.0
1.5 1.5
1.0 1.0
0.5 0.5
0 0
Dominican Republic Argentina Bolivia Dominican Republic Argentina Bolivia
(urban) (Greater Buenos Aires) (urban) (urban) (Greater Buenos Aires) (urban)
Married Single With small children
Propensity to informal self-employment and desire to work Propensity to informal salaried work and desire to work
independently. Odds ratio compared to formal salaried, independently. Odds ratio compared to formal salaried,
prefers salaried work prefers salaried work
Ratio Ratio
1.0 1.0
0.8 0.8
0.6 0.6
0.4 0.4
0.2 0.2
0 0
Dominican Republic Argentina Bolivia Dominican Republic Argentina Bolivia
(urban) (Greater Buenos Aires) (urban) (urban) (Greater Buenos Aires) (urban)
Wants to work independently
Source: Based on Arias and Bustelo (2007), Arias, Landa, and Yanez (2007), and author's estimates using household survey 2005, 2006 data.
84
I N F O R M A L I T Y, E A R N I N G S , A N D W E L F A R E
self-employment, although it also varies across countries. preference for the job amenities they enjoy--or, conversely,
The odds of independent (formal or informal) employment it could be an expression of their higher satisfaction with
to formal salaried work increase with age in Argentina and salaried work. Other results (not shown) indicate that, con-
the Dominican Republic, but are unrelated to age in trolling for all characteristics, urban migrants (coming
Bolivia. The latter finding suggests that the accumulation from rural or other urban areas) in all three countries and
of savings and occupation-specific skills may be less foreign migrants in Argentina and the Dominican Repub-
important for the ability to engage in the type of indepen- lic have similar employment propensities as nonmigrants.
dent employment predominant in very low-income The same is true for indigenous workers in Bolivia. Thus,
countries. the observed higher incidence of informal employment in
The gender patterns of participation in informal work these groups is largely a result of their having personal
are broadly consistent with the findings reported in characteristics or jobs in sectors or firms with a higher
chapter 2 for Mexico and other middle-income countries, propensity to informality, rather than to their migrant or
although with some country variation. For instance, ethnicity status, per se.
Argentine married women are more inclined than men to In summary, the results show that firm size, education
be independent (4 to 1 informal, 2 to 1 formal) and infor- levels, tenure, and sector of employment--variables related
mal salaried (2 to 1) than formal salaried, regardless of to the productivity of workers and firms and the ease of
family structure. The same is true for Dominican married government enforcement--are the most important predic-
women with small children. Conversely, single Argentine tors of informal employment in Argentina, Bolivia, and the
and Dominican women have greater odds than men of Dominican Republic. There is a similar pattern of impacts
engaging in formal salaried employment. These results are of these characteristics on the propensity to be informal
consistent with Galiani and Weinschelbaum's (2006) find- salaried or informal self-employed in all three countries.
ings; using data for a large sample of Latin American However, the orders of magnitudes differ markedly, which
countries, they found that, ceteris paribus, a spouse is suggests that the underlying mechanisms determining
more likely to work informally if the head of household informal employment vary with level of economic develop-
has a formal job. Meanwhile, Bolivia shows no gender ment, economic structure, and the nature of public poli-
differences in informal participation, regardless of the cies and institutions.
presence of small children (or elderly) in the family. The next section examines empirically whether the
Overall, there is no systematic evidence of discrimination informal-formal characteristics of jobs have an impact on
forcing women into informal employment; the pattern of workers' earnings in Argentina, Bolivia, and the Domini-
female employment that allows them to balance work and can Republic. The analysis considers the ample spectrum of
family life varies with economic and social conditions, remunerations and worker prototypes in the labor market
including the availability of protection through other and demonstrates that workers' sectoral participation is
family members or publicly provided benefits programs, affected by the expected returns to their skills and the per-
in their countries. ceived qualities of informal and formal jobs.
With regard to other personal characteristics, there is
strong evidence that workers act on their tastes for inde- The question of equal pay for equal work
pendent or salaried work, and little evidence of an indepen- in the informal and formal sectors
dent correlation of informal employment with migration or The heterogeneity in the prototype of informal workers is
ethnicity. The bottom panel of figure 3.3 shows that the reflected in a wide earnings variation. Figure 3.4 illustrates
chance that workers who report a preference for salaried this with a comparison of the distributions of hourly earn-
over independent work are actually employed as indepen- ings for formal, informal salaried, and independent workers
dent is only 30 to 40 percent of their chance of being for- in urban areas of Argentina and Bolivia.2 No distinction is
mal salaried. Interestingly, the chances that these workers made between the informal and formal self-employed, as
are informal salaried are 50 percent (Bolivia) to 70 percent the latter are a small fraction of employment and their
(Argentina and the Dominican Republic). This could separation would complicate the econometric analysis. The
reflect the fact that formal salaried workers have a stronger left panels contain the frequency distributions (that is,
85
I N F O R M A L I T Y
FIGURE 3.4
Distribution of hourly earnings for workers in urban areas of Argentina and Bolivia, 2005�06
Argentina Argentina
Density Percent of workers
0.8 100
80
0.6
60
0.4
40
0.2
20
0 0
6 4 2 0 2 4 6 8 0 1 2 3 4 5 10 15 20 25
Log of hourly labor income Hourly labor income
(2005 Argentine pesos)
Bolivia Bolivia
Density Percent of workers
0.8 100
80
0.6
60
0.4
40
0.2
20
0 0
4 2 0 2 4 6 8 0 5 10 15 20 30 40 50 60 70 80
Log of hourly labor income Hourly labor income
(2005 Bolivian pesos)
Self-employed Informal salaried Formal salaried
Source: Based on Arias and Khamis (2007), Arias, Landa, and Yanez (2007), and author's estimates using household survey 2005, 2006 data.
Note: Incomes measured in 2005 local currency.
smoothed histograms) showing the earnings where most the bottom). Second, the informal salaried have a slight
workers are concentrated in each group (that is, near the earnings advantage over independent workers in the bottom
peaks). The right panels present the cumulative distribu- 40 percent of the distribution (their distribution lies below
tions of hourly earnings which show the fraction of workers and closer to the formal salaried), but this is reversed in the
at or below any given level of hourly earnings (that is, the top of the distribution (the high-earnings jobs). Third, the
percentiles). The horizontal distance between the distribu- earnings distribution for independent workers is more dis-
tions yields measures of the gap in informal-formal earn- persed, consistent with the international evidence of higher
ings at different earnings percentiles. For instance, in earnings variations in independent activities.3 Moreover,
Argentina the difference in hourly earnings between the there are two clear tiers of low- and high-earnings indepen-
formal and the two informal groups at the 40th percentile dent workers (illustrated in circles for Argentina), consistent
is $2.5 ( $5 2.5), while in Bolivia the difference at the with the heterogeneous composition of the group.
80th percentile is $15 ( $20 15). Table 3.1 quantifies the raw (unconditional) gaps in
There are three main points worth noting. First, hourly earnings for jobs of low, median, and high remuner-
although the formal salaried have an earnings advantage at ation within each occupational category for the three coun-
any point of the pay scale (their distribution is further to the tries considered.4 Clearly, there are significant differences in
right), informal-formal earnings gaps are larger for workers the pattern of earnings gaps across and within the countries.
in low-earnings jobs (the distributions are further apart at On average, informal salaried workers earn between 40 to
86
I N F O R M A L I T Y, E A R N I N G S , A N D W E L F A R E
TABLE 3.1
Unconditional hourly earnings gaps (percent difference in earnings) for formal employees, informal employees, and independent workers in
urban areas in Argentina, Bolivia, and the Dominican Republic, 2005
Worker status by country Low-earnings jobs Median-earnings jobs High-earnings jobs Average-earnings jobs
Argentina
Informal/formal salaried 53.3 47.8 45.1 43.1
Independent/formal salaried 58.0 37.3 19.3 22.3
Informal salaried/independent 11.1 16.7 32.0 26.8
Bolivia
Informal/formal salaried 60.0 64.0 68.0 67.0
Independent/formal salaried 69.6 61.0 51.0 60.0
Informal salaried/independent 32.3 7.3 31.8 18.0
Dominican Republic
Informal/formal salaried 44.0 46.5 46.0 45.9
Independent/formal salaried 9.4 11.0 5.8 5.7
Informal salaried/independent 38.2 51.8 49.0 48.8
Source: Based on Arias and Khamis (2007), Arias, Landa, and Yanez (2007), and author's estimates using household survey 2005, 2006 data.
Note: The high, medium, and low pay correspond, respectively, to the 80th, 50th, and 20th percentiles of earnings for each group;
that is, they represent the top 20 percent of workers with the highest earnings, the bottom 20 percent with the lowest earnings,
and workers with median earnings. Average pay = mean earnings.
66 percent less than formal salaried employees in all coun- having an unregistered job. More generally, as noted earlier
tries, while independent workers earn as little as 60 percent in the chapter, differences in earnings can result from labor
less in Bolivia and 28 percent less in Argentina but have a market segmentation or barriers that prevent workers from
slight advantage in the Dominican Republic. accessing the best possible job for their skills, or can simply
The differences in average hourly earnings understate the reflect the compensated earnings differentials from differ-
disadvantage of informal salaried workers in low-earnings ences in the amenities of informal and formal jobs.
jobs in Argentina, but not as much in Bolivia and the To determine whether informal workers receive equal
Dominican Republic. Independent workers face a larger pay for equal skills, one must compare earnings of workers
earnings disadvantage in the low-earnings jobs, which falls with similar observed and unobserved characteristics who
progressively for workers at the top of their pay scale and differ only in having a formal or an informal job. This is best
actually turns into an earnings advantage in the Dominican accomplished through regression analysis to purge earnings
Republic. The low-earnings informal salaried are in fact gaps of spurious correlations induced by observed and unob-
slightly better off than low-earnings independent workers served worker characteristics that affect earnings and cause
in Argentina and Bolivia, but earn less in the top-paying selection (either by choice or rationing) into formal, infor-
jobs. In these countries low-earnings workers face a more mal salaried, or independent work. For instance, the most
precarious employment situation whether they are salaried talented individuals may be more likely to obtain formal
or independent. The distinct patterns across countries salaried employment because of better prospects for mobil-
suggest that the relative earnings of formal and informal ity in a career as wage earner. On the contrary, individuals
workers probably vary with economic structure, overall pro- with more entrepreneurial ability are more likely to suc-
ductivity, and other conditions specific to their countries. ceed as independent workers. Those with low work attach-
However, these earnings gaps do not prove that formal ment and little adherence to authority or rigid work
sector jobs are superior, per se. As we saw before, informal schedules may be excluded from formal salaried employ-
workers tend to be younger and less educated, working in ment or voluntarily seek the flexibility of self-employment
smaller firms and sectors such as commerce and construc- even at the cost of lower earnings. Many women may forgo
tion, all of which are cause for lower earnings. Their lower the higher earnings of being employees in exchange for
earnings may be due to their disadvantage in productive flexibility in informal employment. The end result is selec-
attributes (both observed and unobserved) rather than to tion into occupations based on returns and tastes.
87
I N F O R M A L I T Y
Even among workers with the same credentials, experi- tional Heckman-selectivity corrections. The extent to which
ence, and line of work, some earn more than others due this procedure corrects fully or partially for self-selection
to, for example, their innate abilities, or because they biases depends on the strength of variables that affect sector
landed jobs in more productive firms. That is, there are participation but not earnings (see the studies by Arias
low-paying and high-paying jobs among doctors, teachers, [2007, 2005] and the coauthors for details).
carpenters, and salespeople, as well as in construction, man- We decompose the estimated earnings gaps into the
ufacturing, and large and small firms. Gaps in average earn- portion due to between-group differences in characteristics
ings between informal and formal workers with the same (endowments) and the part due to differences in how these
observed characteristics may misrepresent the situation of characteristics are remunerated (returns) across job cate-
those with earnings below or above the average pay for gories. The latter differences in returns are more adequate
their skills; some workers may be paid differently or find measures of the compensated earnings differentials between
advantageous niches across job categories. Informal jobs informal and formal jobs.7 Figure 3.5 shows the results of
may carry a lower reward in manufacturing where small- this decomposition for the three countries considered. The
scale production tends to be less productive, while pay may predicted earnings gaps (in logs) at low-, median-, and
be similar across all categories in service jobs where high-paying jobs are given by the height of the bars. The
economies of scale are less important. shaded areas reflect the portion attributed to informal
More important, the returns to observed skills (such as workers' less favorable characteristics; the rest represents
education or work experience) may be different. Schooling our measures of the compensating earnings differentials
returns may be higher for the formal salaried, since education among formal and informal jobs, which also encapsulate
is generally more productive in activities employing more any differences in earnings arising from possible labor mar-
skills and physical capital. However, informal occupations ket segmentation due to macroinstitutional rigidities.
prevalent in small-scale activities require fewer cognitive The results provide a different picture across countries.
skills and may offer low-educated workers compensatory In Argentina the bulk of the informal earnings gap reflects
practical skills that enhance the productivity of their school- unequal pay for similar skills, especially at the bottom of
ing. Returns to education might be higher for independent the earnings scale. Approximately two-thirds of the earn-
workers, since they can optimize the use of their credentials in ings difference between formal and informal Argentine
their economic activity with the flexibility of small size and employees in low-paying jobs is due to the overall lower
lesser division of labor. The returns to work experience can remuneration to the skills of the latter in the labor market.
also differ for similar reasons.5 Although many of these differ- This fraction falls to 54 and 42 percent in the median- and
ences are hard to ascribe to segmentation or to voluntary sort- high-paying jobs.8 The contribution of unequal pay is sim-
ing of workers, they have implications on life-cycle incomes. ilar for independent workers in the low-paying jobs, falling
In light of all this, earnings regressions are estimated to 38 percent in median-pay jobs, and turning insignificant
separately for each of the three employment categories at at the top. That is, all of the earnings advantage of the best-
different percentiles of the group-specific earnings distrib- paid formal salaried workers over the best-paid indepen-
utions. This allows measurement of earnings gaps between dent workers in Argentina is due to differences in their
formal and informal workers who have the same observed characteristics rather than unequal pay. In fact, the absolute
characteristics (for example, education, work experience, level of both informal earnings gaps falls as we move up to
gender) and other unmeasured characteristics and in the compared workers in the best-paid jobs of each of the three
same positions of the pay scale fit to their skills and job cat- sectors. The results are consistent with high-earnings inde-
egories. For instance, we measure the earnings gap between pendent workers having primarily voluntary motivations
the best-paid formal salaried and the best-paid self- to be independent in Argentina, to the extent that they
employed with the same skills set using quantile earnings cannot get better pay for their skills in formal salaried jobs.
analysis.6 To deal with selection biases with cross-section The gaps at the bottom of the earnings distribution are
household survey data, we proxy unobserved factors by esti- consistent with compensating earnings differentials in
mates of the relative probabilities that individuals work as favor of those in formal salaried jobs (for example, to com-
formal, informal salaried, or independent and include these pensate for lower flexibility/autonomy), and/or labor mar-
in the earnings regressions. This is a modification of conven- ket segmentation against the self-employed.
88
I N F O R M A L I T Y, E A R N I N G S , A N D W E L F A R E
FIGURE 3.5
Earnings cost of informality in urban areas of Argentina, Bolivia, and the Dominican Republic
Argentina Argentina
Formal-informal salaried Formal salaried-independent
Log earnings gap Log earnings gap
1.5 1.5
1.0
1.0
0.5 0.52
0.19
0.55
0.5 0.37 0.26 0.29 0.32 0.35
0
0.08
0.28 0.31 0.35
0 0.5
Low pay Median pay High pay Low pay Median pay High pay
Bolivia Bolivia
Formal-informal salaried Formal salaried-independent
Log earnings gap Log earnings gap
1.5 1.5
1.0 1.0 0.88
0.38 0.46
0.62
1.25 1.25
0.5 0.5
0.68 0.45 0.57 0.66
0 0
0.45 0.35
0.5 0.5
Low pay Median pay High pay Low pay Median pay High pay
Dominican Republic Dominican Republic
Formal-informal salaried Formal salaried-independent
Log earnings gap Log earnings gap
1.5 1.5
1.0
1.0
0.51
0.31 0.5 0.84
0.5
0.77 0.25 0.24
0.51 0.65 0
0.44 0.54
0 0.81
0.05 0.5
0.5 1.0
Low pay Median pay High pay Low pay Median pay High pay
Due to characteristics Due to returns
Source: Based on Arias and Khamis (2007), Arias, Landa, and Yanez (2007), and author's estimates using household survey 2005, 2006 data.
Note: See table 3.1 for definitions.
The results for Bolivia show the existence of unequal pay the gaps). The differences in returns actually favor the infor-
for informal jobs, but with an opposite pattern for the infor- mal salaried in high-pay jobs. That is, workers in the high-
mal salaried and independent workers. Differences in charac- pay jobs of the informal salaried sector receive better
teristics account for the bulk of earnings gaps between the remunerations for their skills than workers in the high-pay
formal and informal salaried, especially in the low- and high- formal jobs. The pattern is similar for the self-employed
pay jobs, while differences in returns are more important in and is close to the results for Argentina. The returns to their
the average-pay jobs (accounting for close to 60 percent of skills become increasingly similar to the formal salaried as
89
I N F O R M A L I T Y
we move up the earnings scale, and in fact they are remuner- of a relatively flexible labor market. Labor rigidities, how-
ated slightly better than the formal salaried at the best- ever, are known to be relatively high in Argentina and
paying jobs for their skills set. As in Argentina, all of the Bolivia, although other factors may also be at play--for
earnings advantage of the best-paid formal salaried workers example, excessive costs of registration in Bolivia, lax
over the best-paid independent workers arises from their enforcement, and coordinated general tax and payroll evasion
more favorable characteristics rather than unequal pay, and in Argentina.
yet the absolute level of the earnings gaps is less monotonic Again, these "unexplained" earnings gaps cannot be
along the pay scale. interpreted as evidence of segmentation in the labor mar-
Finally, the Dominican Republic shows a mixed pattern ket. They provide an order of magnitude of the pecuniary
for the informal-formal salaried earnings gaps and a very value that informal job amenities may have for informal
different situation for independent workers. Close to 60 per- salaried and independent workers net of the implicit value
cent of the earnings gaps between formal and informal of the foregone benefits of formal salaried jobs. Yet, they
employees in jobs of median pay or above are due to differ- provide inconclusive evidence to discriminate against the
ences in their characteristics, but the latter explain little of segmentation and comparative advantage hypotheses.
the gap in the low-pay jobs. That is, the lower earnings of Moreover, the results may still suffer from biases arising
informal salaried workers in the bottom of the earnings from the failure to fully account for unobserved productiv-
distribution are entirely due to lower remunerations to ity differences between workers. In fact, even if it accounts
their characteristics. However, contrary to Argentina and for self-selection into the sectors, the analysis still assumes
Bolivia, they are not as worse off in an absolute sense, since that workers' positions in the earnings distribution remain
the level of the informal-formal salaried earnings gaps is intact were they to switch sectors. For example, it presumes
actually much lower at the bottom than at the top of the that an informal worker positioned at the top of the infor-
distribution. Meanwhile, consistent with the simple earn- mal earnings distribution would remain at the top of the
ings differentials shown above, the results actually show formal salaried distribution were he or she to take a formal
that independent workers are in a favorable situation salaried job. However, when comparative advantage is pres-
regardless of their position in the earnings scale. In ent, some workers could emerge as top earnings performers
fact, their advantage in earnings arises from better remu- for their skills in the informal sector, but if they were to
nerations to their characteristics, which fully compensate move to a formal job they may actually lose out in the earn-
for their less favorable personal and job characteristics, ings rankings if their unobserved skills are less rewarded in
especially in the low-earnings jobs. If they had a similar set that sector. The decision to participate in the formal sector
of average characteristics as formal salaried workers, they could depend on the expected return for the individual to
would actually earn even more than their formal salaried both observed and unobserved characteristics. In this case,
counterparts. the above comparisons of high-earnings workers in the
In sum, all three countries show a clear earnings dis- informal and formal sectors would not give a true measure
advantage of informal salaried workers that cannot be of the potential change in earnings that either would derive
accounted for by lower observed productivity, and is indeed by moving across sectors. This complicates the estimation
much larger in the low-paying jobs for any skills set. The through conventional regression methods.
situation is similar for independent workers in Argentina Arias and Khamis (2007) apply recently developed
and Bolivia, and markedly different in the Dominican econometric methodologies to Argentinean data (Heckman,
Republic. There is substantial heterogeneity in earnings Urzua, and Vytlacil 2006; Heckman and Vytlacil 2001,
performance, particularly among independent workers. The 2005) to deal with these issues and properly analyze the rel-
similarities and differences in performance across countries evance of labor market comparative advantage in the partic-
may be related to differences in country policies and institu- ipation and earnings performance of workers in the formal
tions as well as the dynamism of the informal economy. and informal sectors. To correct for selection biases, they use
For instance, the good performance of the self-employed in variations in the enforcement of labor legislation across
the Dominican Republic has been associated with the Argentine provinces and workers' reported preferences for
growing and well-performing tourism sector and construc- salaried or independent work as factors that affect employ-
tion booms that the country has experienced, in the context ment sector participation, but not the earnings returns to
90
I N F O R M A L I T Y, E A R N I N G S , A N D W E L F A R E
TABLE 3.2
Impact of informality on earnings in Argentina, estimated log-earnings differences and treatment parameters
Formal salaried versus informal Formal salaried versus Informal salaried versus
Treatment type salaried [SE] self-employed [SE] self-employed [SE]
Treatment on the treated 2.088* 0.187 0.449
[0.187] [0.443] [0.426]
Treatment on the untreated 1.892* 0.122 0.989**
[0.204] [0.245] [0.510]
Average treatment effect 2.002* 0.105 0.600*
[0.105] [0.291] [0.244]
Source: Arias and Khamis 2007.
Note: SE = standard error.
*p < .005.
**p < .001.
formality or informality. The methods yield a whole range of negative effect for those workers who have more self-
earnings differentials as a function of workers' propensity to employed-like characteristics. That is, workers with inde-
formal or informal employment, by comparing workers who pendent-like characteristics (observed and unobserved)
are at the margin of indifference between jobs fit to their would receive lower earnings were they to move to formal
skills and preferences in the three sectors. A summary of the salaried jobs, although the effect is not statistically signifi-
results is presented in table 3.2. This presents a distinct set cant. The results are again consistent with workers' primar-
of summary parameters to answer different policy questions: ily voluntary motivations to be independent in Argentina.
the average treatment effect (ATE), that is, the mean earn- These results are in contrast to the findings from quantile
ings gain from formality for a randomly selected worker; the earnings estimation and suggest that the sorting of workers
treatment on the treated (TT), that is, the mean earnings based on differences in tastes for various types of work is of
gain from formality derived by those with characteristics major importance for those entering self-employment. This
similar to workers currently in formal jobs; and the treat- again underscores the importance of considering differences
ment on the untreated (TU), that is, the mean earnings gain in the nonpecuniary qualities of independent work as
(or loss) for those in informal (salaried or independent) jobs revealed by the motivational analysis of chapter 2. The
were they to switch to formal salaried jobs.9 These are alter- absence of compensating differentials suggests that the per-
native measures of the mean earnings gain from having a ceived amenities (for instance, independence and flexibility)
formal occupation for workers with the same set of observed and disadvantages (for example, lack of benefits and risk) of
and unobserved characteristics, who are indifferent between self-employment tend to cancel each other out.
a formal and an informal job and are found participating in On the contrary, for informal salaried workers all the
different sectors. parameter estimates are positive and large, so that informal
The results corroborate the mixed view of the Argentine salaried work implies very high earnings penalties when
labor market and support the importance of comparative compared to formal salaried work. Although the full results
advantage in workers' selection into formal salaried and self- suggest some heterogeneity in the full comparison of earn-
employment but also a role for segmentation. On the one ings of formal and informal salaried workers, the summary
hand, the results reveal little difference in the earnings of treatment parameters are very similar, so that workers with
formal salaried and independent workers once one fully informal-like characteristics (observed and unobserved)
accounts for the sorting of workers based on preferences and would experience roughly similar earnings gains were they
the returns to their observed and unobserved skills. All three to move to formal salaried jobs. To the extent that these
treatment parameters are statistically insignificant. The are derived from comparing identical workers at the margin
ATE is positive; however, this reflects a combination of a of indifference between the two sectors, they provide mea-
positive earnings effect for workers whose characteristics sures of differences in earnings arising from nonpecuniary
make them more prone to formal salaried work (TT) and a characteristics of jobs across sectors or from labor market
91
I N F O R M A L I T Y
disequilibria or segmentation. The magnitude of earnings TABLE 3.3
gaps seems very large to arise from compensating earnings Correlation between income and self-rated poverty
differentials and suggests the presence of segmentation
between informal and formal salaried employment. This is Income
consistent with the evidence cited above on the involuntary Country Nonpoor Poor Total Coincidence
nature of individual reasons for being informal salaried in Argentina
Argentina. The next section presents an analysis of subjec- Self-rated Nonpoor 45.1 13.8 58.8
tive response data that attempts to establish more definitely Poor 21.5 19.7 41.2 64.8
Total 66.5 33.5 100.0
whether the value of nonpecuniary job characteristics fully
Dominican Republic
compensates for the lower earnings of informal workers in
Self-rated Nonpoor 46.4 19.0 65.4
Argentina as well as other countries. Poor 18.9 15.7 34.6 62.2
Total 65.3 34.7 100.0
Informality and self-rated welfare
One way to assess whether the informal-formal earnings Source: Based on Arias and Lucchetti (2007).
disparities reflect actual differences in welfare is by consid-
ering individuals' perceptions of their own welfare. Some
household surveys in a number of countries have collected of coincidence in the classifications: in both countries,
data on subjective well-being by asking individuals ques- approximately 65 percent of individuals self-rate their sta-
tions such as the following: "Do you consider yourself or a tus similarly to what conventional income poverty mea-
member of your family to be: very poor, poor, nonpoor, or sures dictate.
rich?" We use available surveys for Argentina, Bolivia, and Figure 3.6 also shows that self-rated poverty measures
the Dominican Republic to examine the link between follow fairly closely the pattern of income poverty classifica-
informal-formal occupational status and expanded notions tions by education level and labor market status of respon-
of welfare beyond incomes. In Argentina and the Dominican dents. In the case of Bolivia, income poverty rates are
Republic, the surveys include data that allow alternative calculated with the 1999 national living-conditions survey.
measures of informal employment including pension cover- There is a strikingly similar correlation in the case of edu-
age, firm size, and the temporary or permanent nature of cation; both poverties are lower among the well-educated.
the labor contract.10 Regrettably, the Bolivian survey does There is also considerable coincidence in the case of occu-
not allow a clear distinction between informal and formal pational status, although some noteworthy divergences
salaried workers, other than through proxies of whether the are already apparent. For example, the gap between the
worker is temporary and employed in a blue-collar occupa- self-rated and income poverty rates of the self-employed
tion. Workers are classified according to two groups: those is much smaller than among the informal and formal
answering "rich" or "nonpoor" and those answering "poor" salaried. Moreover, small-business owners tend to self-rate
or "very poor." Except for Bolivia, the surveys contain suffi- less poor than their income would suggest.
cient income data that allow classification of workers also in Figure 3.7 and table 3.4 present the main results of
terms of their income poverty. Regressions are estimated the multivariate regression analyses for Argentina and
relating the subjective responses to a large number of indi- the Dominican Republic. The coefficients in the figure rep-
vidual and family characteristics including the job category resent the impact of alternative measures of informal
variables, and comparing these with the results from simi- employment on the propensity of individuals to consider
lar regressions of income�poverty status of the individual themselves poor (figures in bold indicate that the effect is
according to conventional poverty-line analysis. zero at conventional statistical significance), and have a
Before discussing the results, it is useful to establish similar interpretation to the odds ratios discussed earlier in
some facts on the data. Table 3.3 first presents a compari- the chapter. The main conclusions are summarized below.
son of the self-rated and income poverty classifications in The coefficients in the table are standardized for proper
Argentina and the Dominican Republic. Despite the comparisons of the effect of the variables on self-rated
markedly different processes involved in classifying work- (binary indicator) and income poverty (a continuous
ers as income-poor and self-rated poor, there is a high level variable).
92
FIGURE 3.6
Fraction of workers who are income-poor and self-rated poor, by education and occupational group
Percent Argentina Argentina
70
Formal salaried
Informal salaried
60
Permanent contract
50 Temporary contract
Large firm
40 Medium size enterprise
Small firm
30 Microfirm
Self-employed
20 Small firm employer
Employed
10
Out of labor force
Unemployed
0
Primary Secondary Tertiary 0 10 20 30 40 50 60 70
Percent
Percent Bolivia Bolivia
70
Self-employed
60 Employee
Underemployed
50
Private
40 Public
White collar
30 Blue collar
Employer
20
Employed
10 Out of labor force
Unemployed
0
Primary Secondary Tertiary 0 10 20 30 40 50 60 70
Percent
Percent Dominican Republic Dominican Republic
70
Formal salaried
Informal salaried
60
Permanent contract
50 Temporary contract
Large firm
40 Medium size enterprise
Small firm
30 Microfirm
Self-employed
20 Small firm employer
Employed
10
Out of labor force
Unemployed
0
Primary Secondary Tertiary 0 10 20 30 40 50 60 70
Percent
Self-rated poor Income poor Overall self-rated poor Overall income poor
Source: Based on Arias and Lucchetti (2007).
Note: Self-rated poverty is based on individual responses. Income poverty is based on national poverty lines and per capita family incomes.
93
I N F O R M A L I T Y
wealth, living conditions, and so on). However, the
FIGURE 3.7
Dominican informal salaried consider themselves as poor as
Impact of informality on self-rated poverty
formal salaried workers, despite being more likely to be
Argentina income-poor. Thus, incomes are not a good proxy for the
Propensity to self-rated poverty actual welfare situation of the Dominican informal salaried
Independent workers. As can be seen in figure 3.7 and table 3.4, these
large firm
results are strikingly robust to different definitions of infor-
Independent
formal salaried mal salaried employment. In the case of Bolivia, the regres-
Independent sion results of Arias and Sosa-Escudero (2005) find that
permanent contract employees, temporary salaried workers, and blue-collar
Microfirm worker workers, most of whom are likely to be informal, also have
large firm
lower self-rated welfare than the formal salaried.
Informal salaried
formal salaried Contrary to the results for the informal salaried, inde-
Temporal salaried pendent workers in both countries consider themselves as
permanent contract
poor as formal salaried workers. This is at odds with their
0 0.5 1.0 1.5 2.0 being more likely to be income-poor in Argentina, all other
Odds ratio factors constant, but is consistent with their lower income
Dominican Republic poverty in the Dominican Republic. Thus, in these two
Propensity to self-rated poverty countries, independent workers report having similar levels
of welfare as the formal salaried workers. This was also
Independent
large firm found to be the case in Bolivia, where the self-employed are
Independent as likely to be self-rated poor as formal salaried workers,
formal salaried
holding other factors constant (Arias and Sosa-Escudero
Independent
permanent contract 2005).
Microfirm worker An important finding also shown in figure 3.7 and
large firm table 3.4 is that access to social protection correlates with
Informal salaried higher self-rated welfare. In both Argentina and the Domini-
formal salaried
can Republic, individuals who live in families where some
Temporal salaried
permanent contract member has social security benefits are about 17 percent
less likely to self-rate as poor (see figure 3.8). This result
0 0.5 1.0 1.5 2.0
Odds ratio also holds if access to benefits is proxied by employment in
large firms or by having a permanent labor contract. Thus,
Source: Based on Arias and Lucchetti (2007).
Note: Self-rated poverty is based on individual responses. workers seem to attach an important welfare value to hav-
ing access to social protection.
The results that Dominican informal workers report the
The impact of being an informal salaried employee on same level of welfare as formal salaried employees are
self-rated poverty is identical to its impact on income corroborated by the recently collected data on job satisfac-
poverty in Argentina, but is quite opposite that in the tion as part of the special informal survey in this country.
Dominican Republic. The informal salaried Argentines Table 3.5 presents the responses to the question "How satis-
consider themselves poorer than formal salaried workers, fied are you with the following aspects of your current job?"
holding other factors constant, even when we control for for the four occupational groups. These questions refer to
their own labor income and the incomes of other family workers' general satisfaction with their jobs and a variety of
members. Moreover, the informal salaried in Argentina specific working conditions including incomes, working
tend to self-rate as poor as their family income indicates, all hours, benefits, flexibility, and mobility opportunities. As
other factors held constant. Thus, they have a lower level of can be seen, there is strikingly little difference in the levels
self-rated welfare that cannot be explained on the basis of of satisfaction reported by informal salaried and informal
their individual and family characteristics (proxies for independent workers relative to formal salaried workers
94
I N F O R M A L I T Y, E A R N I N G S , A N D W E L F A R E
TABLE 3.4
Impact on the propensity to self-rate poor and be income poor (normalized logit regression coefficients)
Argentina Dominican Republic
Informality proxy Self-rated Income Self-rated Income
Informality proxied by firm size
Independent worker 0.06 0.27 0.07 0.12
Microfirm worker 0.17 0.23 0.13 0.06
Family member in large firm 0.11 0.34 0.02 0.39
Informality proxied by pension
Independent worker 0.06 0.24 0.01 0.06
Informal salaried worker 0.26 0.27 0.04 0.10
Family member formal salaried 0.16 0.41 0.11 0.45
Informality proxied by type of contract
Independent worker 0.04 0.23 0.04 0.06
Temporal salaried worker 0.27 0.29 0.00 0.09
Family member with permanent contract 0.15 0.41 0.16 0.35
Source: Based on Arias and Lucchetti (2007).
Note: Coefficients are normalized so that they measure the relative weight of each explanatory variable on the total variation
explained. Coefficients in bold are not statistically significant at the 5 percent confidence level. Regressions control for other
individual and family characteristics.
the informal is remarkable given that the differences in
FIGURE 3.8
characteristics between the groups are not controlled. The
Direct impact of having access to social protection through a
family member on self-rated poverty only exception is with regard to the benefits offered by
the job which, as can be expected, are regarded as inferior by
Propensity to self-rated poverty
the informal, as well as mobility opportunities (which may
Odds ratio
1.4 reflect between-group differences in skills). The lower satis-
faction with respect to incomes among the informal salaried
1.2
is exclusively due to family workers being included in this
1.0
group, when the latter are excluded, the rates become
0.8 similar to those for the formal salaried. Moreover, in
0.6 terms of flexible work schedules, the informal self-employed
Dominicans report higher levels of job satisfaction.
0.4
Regrettably, the recent Argentine informal survey did
0.2
not include questions on job satisfaction; however, a
0 comparison with the responses to a similar question in
Argentina Dominican Republic
Colombia offers a useful polar case to benchmark. These are
Family member with permanent contract presented in table 3.6. In sharp contrast to the Dominican
Family member with formal salaried job Republic, the informal salaried and informal self-employed
Family member in large firm workers in Colombia are clearly more dissatisfied with their
jobs in all of the surveyed dimensions. In several cases, the
Source: Based on Arias and Lucchetti (2007).
Note: Self-rated poverty is based on individual responses. Income differences are fairly large, although still only a quarter of
poverty is based on national poverty lines and per capita family
incomes. informal workers report being unsatisfied with their jobs.
The similarities in responses between the informal salaried
(informality proxied by pension contributions). Interest- and the informal self-employed in Colombia are quite
ingly, the formal self-employed report the higher levels of remarkable. The results are consistent with the overall
job satisfaction. The fact that the overall job satisfaction rate lower degree of voluntariness directly revealed and implicit
is only 5�7 percent higher for the formal salaried than for in the reasons to be in the current occupation for both
95
I N F O R M A L I T Y
TABLE 3.5
Job satisfaction and informal employment in the Dominican Republic
What is your overall level of satisfaction Formal Informal Formal Informal
with your economic activity or main job? salaried salaried independent independent
Very satisfied 9.3 5.7 25.2 8.8
Satisfied 69.3 67.6 55.0 62.4
Unsatisfied 20.0 25.0 14.7 25.0
Very unsatisfied 1.4 1.7 5.1 3.9
Total 100.0 100.0 100.0 100.0
What is your overall level of satisfaction Formal Informal Formal Informal
with the following aspects of your main job? salaried salaried independent independent
The number of hours you work
Very satisfied 5.3 4.5 12.7 5.9
Satisfied 73.2 70.7 75.4 71.6
Unsatisfied 19.1 22.4 10.4 20.0
Very unsatisfied 2.5 2.4 1.5 2.5
Total 100.0 100.0 100.0 100.0
The level of income received (earnings and monetary pay)
Very satisfied 3.9 2.4 7.2 3.7
Satisfied 48.5 40.8 61.9 49.2
Unsatisfied 40.1 39.9 22.3 36.8
Very unsatisfied 7.5 8.5 8.6 10.4
Not applicable/don't have 0.0 8.4 0.0 0.0
Total 100.0 100.0 100.0 100.0
Additional benefits received (health insurance, pension, paid vacations, and so on)
Very satisfied 5.0 1.0 1.9 0.1
Satisfied 70.7 26.1 1.3 1.0
Unsatisfied 18.9 33.8 0.5 0.3
Very unsatisfied 5.5 18.9 0.0 0.1
Not applicable/don't have 0.0 20.2 96.3 98.5
Total 100.0 100.0 100.0 100.0
Flexible work schedules
Very satisfied 6.1 5.4 15.1 8.8
Satisfied 70.2 72.7 80.1 78.8
Unsatisfied 21.7 19.5 4.1 10.9
Very unsatisfied 2.0 2.3 0.7 1.5
Total 100.0 100.0 100.0 100.0
Opportunities for economic mobility or to be promoted
Very satisfied 6.1 3.6 9.5 5.2
Satisfied 58.0 46.7 61.7 46.4
Unsatisfied 32.2 39.4 15.3 35.3
Very unsatisfied 3.8 10.3 13.5 13.1
Total 100.0 100.0 100.0 100.0
Source: Author's estimates, based on household survey data, 2006.
Note: Numbers are rounded.
groups presented in chapter 2. These results for Colombia formal work, figure 3.9 presents some calculations derived
and the Dominican Republic caution against simple- from the self-rated poverty regressions for Argentina. These
minded generalizations across countries and highlight that reflect the difference between the actual average labor
voluntariness or levels of job satisfaction can vary among incomes of various groups of workers and the income level
both the informal self-employed and the informal salaried required to make them borderline of self-rating poor. That
sectors across and within countries. is, these are measures of the "excess income" above the
Finally, in order to have a quantitative notion of the amount individuals in each group need to reach a level of
potential value attached to the amenities of informal and welfare that puts them with a 50:50 chance of self-rating
96
TABLE 3.6
Job satisfaction and informal employment in Colombia
What is your overall level of satisfaction Formal Informal Formal Informal
with our economic activity or main job? salaried salaried independent independent
Very satisfied 13.2 3.0 14.9 4.2
Satisfied 79.3 69.9 71.1 70.2
Unsatisfied 7.4 27.1 14.0 25.6
What is your overall level of satisfaction Formal Informal Formal Informal
with the following aspects of your main job? salaried salaried independent independent
The number of hours you work
Very satisfied 8.0 2.0 10.0 2.3
Satisfied 78.8 67.4 69.6 67.4
Unsatisfied 13.2 30.6 20.4 30.3
The level of income received (earnings and monetary pay)
Very satisfied 6.8 1.3 8.9 1.8
Satisfied 62.5 45.3 55.4 45.3
Unsatisfied 30.7 53.3 35.7 53.0
Additional benefits received (such as health insurance, pension, and paid vacations)
Very satisfied 8.3 0.9 5.1 1.0
Satisfied 73.7 28.7 43.5 29.4
Unsatisfied 18.0 70.4 51.4 69.6
Flexible work schedules
Very satisfied 5.9 1.2 8.5 1.7
Satisfied 81.1 68.1 71.7 68.3
Unsatisfied 13.0 30.7 19.8 30.0
The application of your knowledge at work
Very satisfied 17.6 6.4 22.3 8.7
Satisfied 75.7 76.1 66.8 75.3
Unsatisfied 6.7 17.5 10.9 16.0
Source: Author's estimates, based on household survey data, 2006.
Note: Numbers are rounded.
FIGURE 3.9
Differences between actual labor incomes and the level of income needed to avoid self-rating poverty in Argentina
Income (1997 Argentine pesos)
400 By sex By marital status By level of education
300
200
100
0
100
200
300
400
500 479
600
Men Women Married Unmarried Primary Secondary Tertiary
Informal Self-employed Formal
Source: Based on Arias and Lucchetti (2007).
Note: Estimates based on the logit regression of self-rated poverty. Positive (negative) values indicate that average labor incomes exceed
(fall short of) the self-rated poverty threshold of individuals.
97
I N F O R M A L I T Y
poor. The negative values for the informal salaried indicate to address the barriers to more desirable formal salaried
that they actually have an income deficit--that is, they earn jobs are of first-order importance, and may include removal
less than what is needed to be equally likely to self-rate of labor market frictions, tighter enforcement and improve-
poor or nonpoor. The fact that independent workers have ment of labor and tax laws, and improvement of the role of
lower values than the formal salaried means that they derive unions in achieving better overall employment, wages, and
a similar level of self-rated welfare with less income. productivity growth.
Since the regressions hold other observed individual As noted in chapter 2, there is a two-tier divide among
and family characteristics constant, these differences may independent workers: a majority of workers who choose
partially reflect the significance of the above-mentioned this sector voluntarily and conform closer to entrepreneur-
nonpecuniary aspects of employment for the two informal ship motives, and an important but lower fraction who use
groups. Although the data do not provide sufficient grounds it as a safety net. The lower tier faces significantly higher
to estimate the imputed value of formal benefits in relation earnings disadvantage in the low-paying jobs, but the best-
to the cost of contributions and of the nonpecuniary amenities paid independent workers enjoy remunerations similar to
of informal work, the figures are suggestive of the relative the best-paid formal salaried workers with similar charac-
significance of these factors for different groups of workers. teristics. The evidence for Argentina is consistent with
The implications for antipoverty and social protection workers sorting into formal salaried and self-employment
policies will be discussed in detail in chapter 7. occupations according to labor market comparative advan-
tage. That is, some workers find advantageous niches for
Conclusions and policy implications their observed and unobserved skills and tasks in sectors or
This chapter lends credence to both the "exclusion" and occupations where jobs have a different propensity to be
"voluntary" nature of informal employment suggested by exercised as formal salaried or independent. Moreover, the
workers' reported motivations to be in their current occu- results on self-rated welfare differentials suggest that non-
pation presented in chapter 2. Evidence from workers' pecuniary factors may be to a large extent compensating
reported motivations to be in their current occupation, the independent workers for any lower earnings. This is consis-
sources of earnings differentials, and self-rated welfare tent with chapter 2's survey-reported motivations for being
assessments lends support to the view that the majority of independent and not contributing to social security.
independent workers are largely voluntary and attach sig- However, the Dominican Republic (as well as Mexico, as
nificant value to the nonpecuniary benefits of autonomous will be argued in chapter 4) and Colombia provide excep-
work. Meanwhile, informal salaried workers tend to be tions that caution that this distinction between the infor-
excluded from more desirable jobs in either formal salaried mal salaried and the informal self-employed need not be
or self-employment. true in every country. Overall, the nature and determinants
The existence of a sizable earnings differential between of informal employment would depend on country-specific
informal and formal salaried workers, unrelated to compen- contexts, particularly on cross-country and over time varia-
sating differentials, like those found in Argentina and tion in formal sector productivity, the demographic and
Bolivia, has implications for the functioning of labor mar- skills composition of the labor force, and the incentives to
kets. This can reflect "queues" for formal salaried sector comply with tax and labor regulations (including partici-
jobs, given that they are comparatively better paid across pation in the social security system).
the spectrum of low- and high-paid jobs in the labor mar- The fact that a fraction of independent workers enjoys
ket and have social benefits. It may, for instance, be a prod- higher--although presumably more variable--incomes
uct of the labor market not being flexible enough to but are not contributing to social security poses the ques-
equalize earnings through arbitrage. However, as discussed tion: How much will they be willing to pay for the social
in chapter 2, it may be related to other sources of labor seg- protection benefits that formal wage earners enjoy (which,
mentation. For instance, it may reflect a serious problem of as indicated above, are positively valued by workers)?
general evasion of income and value-added taxes that must The issue of employment protection and old-age security
be addressed (at least in part) with tighter enforcement and merits an analysis that considers the incentives to par-
improvements in the structure of these taxes. Thus, policies ticipate in the social security system of workers with
98
I N F O R M A L I T Y, E A R N I N G S , A N D W E L F A R E
different preferences regarding job flexibility, with differ- methods used here are different, the results might reflect the differ-
ent concerns as to their futures, with different intertempo- ence in time periods. The informal-formal salaried earnings gap has
widened considerably in the last 10 years.
ral discount rates, and with respect to who derives different
9. As shown by Heckman and Vytlacil (2001, 2005), these para-
levels of welfare from a particular benefit package. Workers
meters can be derived from an estimate of the marginal treatment
may have a differing willingness to pay or accept lower effect using local instrumental variables (LIVs) and other approaches.
take-home earnings in exchange for such benefits depend- The results shown here are based on semiparametric estimation but
ing on their individual preferences, the cost and quality of also robust to different empirical specifications and alternative esti-
the services (real and perceived) provided by the public and mation approaches. (See Arias and Khamis [2007]).
10. The surveys used are the 1997 Encuesta de Desarrollo Social
private sectors, and the characteristics of alternative sources
in Argentina, the 1999 Encuesta Nacional de Aspiraciones y Priori-
of services and benefits not related to the labor contract (for
dades de Desarrollo Humano in Bolivia, and the Encuesta de Condi-
example, informal insurance, social networks, and such). ciones de Vida in the Dominican Republic.
There also may be a role for flexible benefits plans. Chapter
7 analyzes these issues in more detail, while the next chap- References
ter summarizes the main lessons for labor market policies
Arias, O., and M. Khamis. 2007. "Comparative Advantage and Infor-
emerging from the existing literature for Latin America mal Employment." Photocopy. World Bank, Washington, DC.
and this report. Arias, O., and W. Sosa-Escudero. 2005. "Subjective and Objective
Poverty in Bolivia." Background paper for the 2005 World Bank
Notes Bolivia Poverty Assessment. World Bank, Washington, DC.
1. This effect cannot be identified for independent workers, Arias, Omar, Fernando Landa, and Patricia Y��ez. 2007. "Movilidad
because the majority of them are in microfirms and one-person Laboral e Ingresos en el Sector Formal e Informal de Bolivia."
enterprises. Documento de Trabajo, UDAPE, La Paz, Bolivia.
2. Earnings of formal salaried are net of labor tax contributions, Arias, Omar, and Monserrat Bustelo. 2007. "Perfiles y Din�micas del
while independent earnings are computed netting out the costs and Empleo Informal en Am�rica Latina." Photocopy. World Bank,
returns to capital as much as labor surveys allow. Washington, DC.
3. Maloney and Mendez (2003) find evidence that the influence Arias, Omar, and Leonardo Lucchetti. 2007. "Informal Employment
of minimum wage norms is far stronger on the more concentrated and Self-Rated Welfare: Measuring Compensating Differentials."
informal earnings distribution in Argentina. Photocopy. World Bank, Washington, DC.
4. A low-earnings formal job gets the earnings ceiling of the bot- Carneiro, P., J. Heckman, and E. Vytlacil. 2001. "Estimating the
tom 20 percent formal workers (the 20th percentile of the Rate of Return to Education When It Varies among Individuals."
formal salaried distribution), while a high-earnings formal job gets the Paper presented at the Royal Economic Society annual meeting.
earningsfloorofthetop20percentformalworkers(the80thpercentile). Durham, UK, April.
5. The economics literature offers various rationales for lower Galiani, S., and F. Weinschelbaum. 2006. "Modelling Informality
returns to experience in independent work. While pay raises based on Formally: Households and Firms." Photocopy. World Bank,
seniority are used in salaried work to induce the best workers to Washington, DC.
remain in the firm, the self-employed have less incentives to shirk in Heckman, J., and G. Sedlacek. 1985. "Heterogeneity, Aggregation,
the job (or quit). Also, since independent workers often have a and Market Wage Functions: An Empirical Model of Self-
sunken investment at the start-up of their businesses, they may not selection in the Labor Market." Journal of Political Economy 93
be able to move out quickly from a poor-performing activity. (6): 1077�125.
6. The chapter loosely uses the term "low- and high-paying jobs" Heckman, J., and E. Vytlacil. 2001. "Policy-relevant Treatment
to refer to the conditional percentiles of the earnings distribution. Effects." American Economic Review 91 (2): 107�11.
7. For more on the empirical testing of labor market segmenta- ------. 2005. "Econometric Evaluations of Social Programs." In
tion and compensating differentials theories, see Magnac (1991). The Handbook of Econometrics, Vol. 5, ed. J. Heckman and E. Leamer.
earnings gap decomposition technique was first presented by Oaxaca Amsterdam: North-Holland.
(1973). For more on earnings decompositions, see Oaxaca and Heckman, J., S. Urzua, and E. Vytlacil. 2006. "Understanding
Ramson (1994). Instrumental Variables in Models with Essential Heterogeneity."
8. The results here differ from the findings of Pratap and Review of Economics and Statistics 88(33): 389�432.
Quintin (2006), who found no evidence of systematic differences in Magnac, T. 1991. "Segmented or Competitive Labor Markets?"
earnings between formal and informal salaried workers. They use Econometrica 59 (1): 165�87.
1993�95 Encuesta Permanente de Hogares (EPH) data and propensity Maloney, W. F. 1999. "Does Informality Imply Segmentation in
scores methods to deal with the problem of bias due to self-selection Urban Labor Markets? Evidence from Sectoral Transitions in
of low productivity workers into the informal sector. While the Mexico." World Bank Economic Review 13: 275�302.
99
I N F O R M A L I T Y
Maloney, W., and J. N. Mendez. 2003. "Measuring the Impact of Pratap, S., and E. Quintin. 2006. "Are Labor Markets Segmented in
Minimum Wages: Evidence from Latin America." Working Paper Argentina? A Semiparametric Approach." European Economic Review
9800, National Bureau of Economic Research, Cambridge, MA. 50 (7): 1817�41.
Oaxaca, R. 1973. "Male-Female Wage Differentials in Urban Labor Rosen, S. 1981. "The Economics of Superstars." American Economic
Markets." International Economic Review 14: 693�709. Review 71: 845�58.
Oaxaca, R., and M. Ramson. 1994. "Discrimination and Wage Smith, A. 1876. The Wealth of Nations. Chicago: University of
Decomposition." Journal of Econometrics 61 (1): 5�21. Chicago Press.
100
CHAPTER 4
The Informal Labor Market
in Motion: Dynamics, Cycles,
and Trends
SUMMARY: This chapter takes an aggregate view of the informal sector, asking what determines the size of the sector,
both across the business cycle and across longer periods of time. In the process, we shed more light on the raz�n de ser of
the informal sector, the overall functioning of labor markets in least-developed countries (LDCs), and what legal and
regulatory factors affect the allocation of workers across sectors. The chapter begins with a discussion of gross labor
flows--the movements of workers across types of work--to establish the dynamic relationships among sectors. The chapter
then takes a step back and locates the labor market in the context of a standard small-country macroeconomy model to
explain pro-cyclical movements in informality. Finally, it examines determinants of the longer-term trends observed in
LDC labor markets.
C HAPTER 3 DISCUSSED THE DECISION- updated view of how the labor market adjusts across the
making process of workers choosing business cycle. Overall, the gross labor flow analysis offers
between the formal and informal sectors. further evidence that, as a first approximation, informal
This chapter takes a more aggregate view, jobs--particularly those in the informal self-employed
asking what determines the size of the sec- sector--are not obviously worse than formal sector jobs for
tor, both across the business cycle and across longer periods many workers. This does not imply that there are no invol-
of time. In the process, we shed more light on the raz�n de untary components, or that there are no distortions in the
ser of the informal sector, the overall functioning of LDC business climate, but it does offer an importantly different
labor markets, and what legal and regulatory factors affect lens through which to view these issues.
the allocation of workers across sectors between the formal The chapter then takes a step back and locates the
and informal sectors. labor market in the context of a standard small-country
We begin the chapter with a discussion of gross labor macroeconomy model. This approach allows for a richer
flows--the movements of workers across sectors of work exploration of the interaction of macroeconomic shocks and
and unemployment--to establish the dynamic relation- the labor market. More specifically, it offers an explanation
ships among sectors. This approach has two advantages. for the pro-cyclical movements we sometimes see. In addi-
First, it offers a complement to the traditional comparisons tion, it shows how looking at the relative size and relative
of wages adjusted for human capital that, because of their earnings of the informal sector can offer a diagnostic of the
inability to account for unobserved job characteristics and state of the labor market.
nonpecuniary welfare effects, turn out to be faux amis in the Finally, in the last section we explore the long-run
quest to establish segmentation in the market or relative determinants of the size of the informal sector and, in the
inferiority or job quality of sectors. Second, it allows us to process, examine some explanations for the expansion of
draw on the recent advanced country literature to offer an informality in some countries over the 1990s.
101
I N F O R M A L I T Y
Informality through the lens of gross labor primarily an employment sector of last resort. More gener-
force dynamics ally, studies of labor market dynamics have moved to the
The recent availability of panel data sets that permit follow- center of the debates about how advanced-country markets
ing workers across employment states allows us to revisit adjust and offer important lessons for Latin America. In
several long-standing issues in the study of developing- the United States, recent work by Davis and Haltiwanger
country labor markets and, in particular, the role of the (1992, 1999), Hall (2005), and Shimer (2005a, 2005b,
informal sector. As noted in the previous chapter, a sub- 2005c) have documented the huge amount of churning of
stantial body of literature with intellectual roots in the workers among sectors. For instance, Davis, Faberman,
Harris-Todaro (1970) model sees informal workers as con- and Haltiwanger (2005) show that 10 percent of U.S.
stituting the disadvantaged component of a labor market workers separate from their employers each quarter, some
segmented by wage rigidities. This general view has impli- moving directly to a new job with a new employer, some
cations for the cyclical adjustment of the labor market dur- becoming unemployed, some exiting the workforce. This
ing recessions: downward rigidities prevent wages from literature has set off a debate about the sources of unem-
adjusting to adverse shocks to the formal sector, leaving the ployment during downturns, whether caused by the
informal sector to absorb workers who would be unem- destruction of jobs (Davis and Haltiwanger 1992, 1999) or
ployed in societies where workers could afford to be so. As by the cessation of hiring (job finding) (Hall 2005; Shimer
will be discussed in the next section, on average, it does 2005a). It has also introduced several new tools and
appear, although with important and frequent exceptions, uncovered striking findings that, as we will show, are
that the informal sector shows a countercyclical behavior directly applicable to the developing-country context and,
consistent with this view and especially during crises. Fig- in particular, explain the cyclical movements of the infor-
ure 4.1 suggests that, especially during the Tequila crisis of mal sector.
1995 in Mexico and the 1999 Brazilian crisis, formality fell Bosch and Maloney (2006) and Bosch, Go�i, and Maloney
along with the increase in unemployment. (2006) draw on two rotating panels constructed from
Worker flows provide the movie to the snapshot pro- employment surveys that permit estimating the probabili-
vided by the simple stock indicators presented in chap- ties of transiting among labor market states and how these
ters 1 and 2 and further support the idea that much of the change across time in Brazil and Mexico. Box 4.1 details
informal sector, and particularly the self-employed, is not the theory and some relevant empirical context.
FIGURE 4.1
Formal share of the labor force and unemployment, Brazil and Mexico
Brazil Mexico
% formal Unemployment rate (%) % formal Unemployment rate (%)
65 8 65 7
7 6
60 60 % formal
6 5
Unemployment
rate 5 4
55 55
4 3
% formal Unemployment
3 rate
50 50 2
1983m1 1988m1 1993m1 1998m1 2003m1 1987q1 1991q1 1995q1 1999q1 2003q1
Sources: Bosch, Go�i, and Maloney 2006; Bosch and Maloney 2006.
102
T H E I N F O R M A L L A B O R M A R K E T I N M O T I O N : D Y N A M I C S , C Y C L E S , A N D T R E N D S
BOX 4.1
Conceptual issues in gross worker flows
Over the last 20 years, the study of the labor market has question. It does, however, highlight potentially impor-
departed from the Marshallian view of instantaneous tant directions for the modeling of labor markets with
adjustments, where prices (wages) are the only allocation informal sectors.
mechanism, toward a view of trade in the labor market as First, empirical evidence has shown that informal work-
an uncoordinated, time-consuming, and costly process ers concentrate their activities in the provision of nontrad-
for both firms and workers (Pissarides 2000). Agents in ables, whereas formal firms operate mainly with tradables.
the labor market have to spend time and resources Hence, it would be plausible to assume an economy where
in order to achieve the desired outcomes. Workers are in there are formal firms posting vacancies and, in parallel,
search of jobs offered by the firms while firms are looking there are informal firms posting vacancies in a different
for workers to fill their vacancies in order to start sector (or, equivalently, self-employment opportunities
production--and even if they agree on the wage, there is arise). Workers may then direct their search toward one
a chance that they may not find each other. of the sectors or search randomly. The first case gives rise to
The process by which firms and workers find each two different market tightness conditions and to an arbi-
other has been the subject of researchers trying to under- tragecondition.Thatis,theexpectedreturnfromthesearch
stand the functioning of the labor market. One of the must be equal in both sectors. This actually implies that if
dominant views is that this process is governed by a wages are higher in the formal sector, the average waiting
"matching function," a sort of production function that time must be shorter in the informal sector. If workers
brings together vacancies and workers, and whose inputs search randomly, then the probability of finding a formal
are the number of vacancies and the number of job job is given by the ratio of formal to informal vacancies.
searchers, m m(u,v). This matching function is nor- Albrecht, Navarro, and Vroman (2006) propose even
mally considered to be increasing in both arguments and another mechanism to generate an informal sector in a
has constant returns to scale. The ratio of vacancies searching and matching framework. Assume that workers
to workers determines what the literature calls market are heterogeneous. The highly educated workers always
tightness, v/u. work in the formal sector, whereas the uneducated
This matching function is the workhorse of an always work in the informal sector. The middle-class
immense amount of research aimed at understanding the workers shift between the formal and the informal sec-
flows between employment and unemployment in an tors, depending on the incentives provided by policy
equilibrium framework. From it, one can obtain what is makers. Similarly, Bosch (2006) also employs worker het-
the probability of an unemployed worker finding a job by erogeneity to generate an informal sector. Firms post
dividing the number of matches by the unemployment vacancies, initially undefined; when the match between
rate m(u,v)/u. the firm and the worker has been established, the firm has
The relevant question is how this process works in a to decide what type of contract it wants to sign (formal or
country with a division between protected or formal and informal). This decision depends on the idiosyncratic
unprotected or informal jobs. This question is actually productivity of the match and on labor cost in the formal
not very different from the distinction between skilled sector. This approach implies that firms decide a thresh-
and unskilled jobs that has been widely studied in a old level of formality. If the match is sufficiently good,
developed-country framework (Acemoglu 2003; Albrecht the firm is willing to bear the higher labor cost of a for-
and Vroman 2002; and Dolado, Jansen, and Jimeno mal job. If not, it will hire the worker informally.
2002). It requires making a number of assumptions Labor markets in developing countries most likely
about how the labor market works. Do firms post both contain some or all elements discussed here. Understand-
types of vacancies? Do workers look for both types of jobs? ing how searching and matching occur in the presence of
The theoretical discussion of how the search process informal labor markets is essential to determine the effect
works in developed economies is by no means a settled of public policies in the labor market.
103
I N F O R M A L I T Y
Cyclical patterns in gross labor flows countries, flows among the formal sector and the two
Transitions between formality and informality informal sectors are remarkably symmetrical and appear
Figure 4.2 offers additional evidence in favor of a more inte- highly correlated across the business cycle, rising in upturns
grated view of the labor market where informal jobs offer and falling in downturns. That is, it is not the case that, as the
distinct, but not necessarily inferior, employment opportu- economy recovers, we see fewer individuals being thrown out
nities, particularly self-employment. The figure plots the of formality into the informal sector and more informal indi-
probabilities of transition among formal and informal sec- viduals being able to find jobs in the formal sector. Such
tors, the raw transitions in Mexico and in Brazil, in the latter asymmetric behavior does characterize flows between
case detrended to account for the longer-term rise in infor- employment and unemployment in the Organisation for
mality across the period that will be discussed later. In both Economic Co-operation and Development (OECD) and, in
FIGURE 4.2a
Probability of transition between formal salaried and self-employment, Brazil and Mexico
Brazil Mexico
Probability F to SE Probability SE to F Probability F to SE Probability SE to F
0.4 1.5 18
7
0.3 Formal to self-employment
1.0 16
0.2
6
0.1 0.5 Formal to 14
0 self-employment
5
0.1 0 12
Self-employment
0.2 4
0.5 to formal 10
0.3 Self-employment
to formal
0.4 1.0 3 08
1987q1 1991q1 1995q1 1999q1 2003q1
1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003
Sources: Bosch, Go�i, and Maloney 2006; Bosch and Maloney 2006.
FIGURE 4.2b
Probability of transition between formal salaried and informal salaried, Brazil and Mexico
Brazil Mexico
Probability F to IS Probability IS to F Probability F to IS Probability IS to F
0.8 5 16
45
0.6 Informal salaried to formal 4
3
0.4
2
14
0.2 1 40
Formal to
0 0 informal salaried
0.2 1
12 35
2
0.4 Informal salaried
3
Formal to informal salaried to formal
0.6 4
30
0.8 5 10
1987q1 1991q1 1995q1 1999q1 2003q1
1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003
Sources: Bosch, Go�i, and Maloney 2006; Bosch and Maloney 2006.
Note: Magnitudes differ between Brazil and Mexico due to technique used to detrend Brazil.
104
T H E I N F O R M A L L A B O R M A R K E T I N M O T I O N : D Y N A M I C S , C Y C L E S , A N D T R E N D S
Brazil and Mexico, between all sectors of employment both informal sectors are substantially higher than the formal,
formal and informal, and unemployment. But, among sectors of but relatively close to each other at a remarkably low 6 per-
employment, what we see are flows in both directions cent. Broadly speaking, then, in Mexico, sentiments about
increased during upturns and decreased during downturns, job quality seem similar among the self-employed and
exactly consistent with the pro-cyclical patterns in job-to- informal salaried, consistent with the high correlation
job flows observed in U.S. literature (Shimer 2005b) that are across the cycle of gross flows across all sectors.
generally attributed to workers searching for and finding However, as chapter 3 notes, this differs strikingly
better jobs in tighter job markets. across countries. In the Dominican Republic, self-reported
The results are most striking for Mexico, but the story is happiness among informal salaried does not suggest that
broadly supported with some caveats in Brazil as well. In either is worse-off than formal salaried. However, in several
both countries, the gross flows among the informal, particu- countries, the informal salaried clearly are. The motiva-
larly the self-employed, and formal sectors do not behave as tional responses of Brazilian informal salaried workers sug-
if the former were a kind of unemployment, but rather as an gest that a large fraction are queuing there as well. This
alternative job. This is consistent with response data pre- may account for the much lower cyclical correlation
sented in chapters 2 and 3 that most of the self-employed observed (0.26 for I-F/F-I transitions versus 0.85 for SE-F/
choose to enter the sector and show equal levels of welfare F-SE transitions).
as those in the formal sector. For Mexico, figure 4.3 shows Perhaps paradoxically, a high degree of voluntary entry
that 75 percent report voluntary entry from both formal and does not rule out some degree of segmentation for certain
informal salaried work, even during the crisis, although, workers, nor distortions more generally. First, at any time,
predictably, the share declines substantially then. there are workers seeking jobs in each sector. Introducing a
An absence of complementary data for workers entering binding minimum wage or other formal sector wage rigid-
informal salaried work leaves us to rely on less direct evi- ity will reduce the probability of finding a job in the formal
dence. If we assume that employed workers searching for sector and make the available informal jobs relatively less
another job ("Have you been looking for a job over the last attractive, thereby introducing a progressive asymmetry to
two months?") are "less voluntarily" employed, then it the flows and a lower degree of voluntary entry, as rigidities
appears from figure 4.4 that in the early 1990s and early become more severe, especially during downturns.
2000s, effectively, job satisfaction was relatively similar Second, a broad class of distortions--excessive labor
across sectors. In the peak of the recession in 1996, both taxes or firing restrictions, for example--may not induce
FIGURE 4.3 FIGURE 4.4
Involuntary transition to self-employment in Mexico Searching while employed, Mexico
Percent Percent
25 80
Searching Searching (informal salaried)
(self-employed)
20
60
15 Searching
(formal)
40
10
20
5
0 0
1992 1994 1996 1998 2002 1987q1 1991q1 1995q1 1999q1 2003q1
Source: Quarterly data from the National Urban Labor Survey
Formal self Informal self All
1987:Q1 to 2002:Q4.
Note: Searching refers to the proportion of employed workers in
Source: Author's estimations, based on Encuesta Nacional de Micro the sector who claim to be looking for a new job and have not
Negocios, several years. changed employment status in the previous quarter.
105
I N F O R M A L I T Y
segmentation, but will nonetheless reduce the vacancies
FIGURE 4.5
opened in the formal sector. Effectively, this will be analo-
Decreased availability of formal sector jobs without segmentation
gous to a shift in the formal sector demand for labor, and
will lead to lower earnings in both sectors; but the vast Wage I Wage F
Increase in taxes on
majority of workers entering informality may still declare formal wages
that they do so voluntarily, given earnings in the formal
sector (see figure 4.5). This point is important: it is entirely
possible for all workers found in the informal sector to be as WI WF
well-off as they would be in the formal sector, in spite of WI WF
very high, nonsegmenting distortions in the formal sector. DF DI
At the limit, we could imagine an oppressive business
DF
climate that prevented growth and the creation of new,
modern sector jobs, but where workers freely chose
LI LF
between the extant menu of vacancies. A discussion of
models of the impacts of regulations on worker flows and LI LF
the size of the informal sector is found in box 4.2. Source: Authors' calculations.
BOX 4.2
Simulated effects of labor market legislation on the size of the informal sector
Several models have been developed to examine the plau- Table 4B.1 shows the simulations of three changes in
sible impact of policies on labor market variables. These labor market policies: a 15 percent rise in minimum wage,
are generally calibrated with a generic economy in mind the introduction of dismissal costs worth three months'
and, hence, should be taken only as suggestive. wages, and an increase of unemployment insurance bene-
Albrecht, Navarro, and Vroman (2006) and Pries and fits equivalent to 20 percent of the wage funded by a
Rogerson (2005) calibrate matching models and simulate 15 percent tax on output. In all cases, we see a reduction in
the effects of labor market regulation on labor force turn- the probability that workers will find a job vacancy and
over and composition. Although Pries and Rogerson work substantial changes in worker turnover (rather than job
only with employment and unemployment, Albrecht, destruction) that drive the results. All policies lead to a
Navarro, and Vroman (2006) explicitly model the informal reduction in the employment rate of between 1 percent-
sector as well. age point (dismissal costs) and 4 percentage points (mini-
The Pries-Rogerson model combines variants of two mum wages) and similar levels of "formal" sector output.
benchmark models from the literature: the Jovanovic The welfare costs are high only for the minimum wage.
(1979) learning model and the Pissarides (1985) match- Under a combination of policies, the interactions roughly
ing model. Job flows are driven by idiosyncratic shocks to double the impact of all single policies.
job productivity, and worker turnover (in excess of job Albrecht, Navarro, and Vroman (2006) extend
turnover) is driven by a process of accumulation of infor- Mortensen and Pissarides (1994) by adding an informal
mation about the quality of the match. Both parties to a sector and allowing for heterogeneity among workers.
match observe a signal about the match's true quality They assume that workers differ in their maximum pro-
prior to deciding whether to form a match, and matches ductivities (low, medium, or high productivity) in formal
form only if they judge that the match quality exceeds a sector jobs. The decision about whether to accept an
threshold value. True quality is revealed over time, but informal sector job thus depends on a worker's type. All
only if a match is formed. Labor market regulations have workers have the option to take up informal sector oppor-
an impact by influencing hiring practices--specifically, tunities as these come along, and all workers are equally
the level of the threshold. productive in that sector, but workers who are most
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T H E I N F O R M A L L A B O R M A R K E T I N M O T I O N : D Y N A M I C S , C Y C L E S , A N D T R E N D S
TABLE 4B.1
Effects of varying minimum wages, dismissal costs, unemployment insurance, and taxes
Differences with respect to benchmark of equilibrium
Policy
Affected variable Minimum wage Dismissal cost Unemployment insurance Taxes
Probability to meet a vacancy 0.13 0.04 0.14 0.13
Unemployment duration 3.02 1.32 1.50 1.06
Annual job destruction (%) 0.20 0.00 0.30 0.30
Annual worker turnover (%) 6.00 4.3 1.80 0.50
Employment rate 0.04 0.01 0.02 0.02
Output 0.04 0.01 0.03 0.02
Welfare loss (%) 1.40 0.18 0.29 0.29
Source: Pries and Rogerson 2005.
TABLE 4B.2
Effects of varying severance taxes and payroll taxes
Differences with respect to benchmark of equilibrium
Policy
Affected variable Severance tax Payroll tax Both taxes
Labor tightness (vacancies/unemployment) 0.360 0.090 0.230
Low productivity (informal)--medium productivity cut-off 0.053 0.063 0.065
Medium productivity--high productivity (formal) cut-off 0.048 0.101 0.085
Unemployment 0.018 0.003 0.005
Productivityformal 0.061 0.036 0.003
WageFormal 0.069 0.070 0.070
Output 0.019 0.004 0.008
Source: Albrecht, Navarro, and Vroman 2006.
productive in the formal sector will reject informal work matches, reducing formal productivity and pushing the
in order to wait for a formal job. Similarly, the least pro- unemployment rate down. In this case, the latter effect
ductive workers are not hired in the formal sector. The dominates and unemployment falls. Overall, as fewer for-
cut-off values that determine how the different types of mal vacancies are open, more workers are forced into
workers are allocated across sectors are endogenous and accepting informal jobs. A rise in payroll taxes from 0 to
are influenced by formal sector labor market policy. A 20 percent has similar effects on the reduction of vacancy
policy change can disqualify some workers from formal creation and the compositional shift toward informal jobs.
sector employment; similarly, some workers accept infor- However, contrary to the severance tax, the introduction
mal sector work, although they would not have done so of payroll taxes makes the firms keep only highly produc-
earlier. tive matches. This increases average formal productivity
Effects of raising severance taxes and payroll taxes but also increases the unemployment rate. The last col-
under this framework are reported in table 4B.2. The first umn of the table reports the effects of applying both
column shows that an increase in severance payments policies simultaneously (each tax is set to be equal to 10
from 0 to 20 percent of the wage makes creating vacancies percent). Both taxes make vacancy creation less attractive,
less attractive for formal sector employers. This should, in employment duration in the formal sector increases (that
principle, increase unemployment. However, a sever- is, the severance tax effect dominates), productivity falls
ance tax also encourages firms to keep low-productivity in the formal sector, and net output decreases.
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I N F O R M A L I T Y
FIGURE 4.6
Probability of transition to unemployment (separation rate), Brazil and Mexico
Brazil Mexico
5 20
4 15
3 10
2
5
1
0
1983m1 1988m1 1993m1 1998m1 2003m1 1987q1 1991q1 1995q1 1999q1 2003q1
Formal Informal salaried Informal self-employed
Sources: Bosch, Go�i, and Maloney 2006; Bosch and Maloney 2006.
The cause of unemployment: Separations driven by the fact that most workers in formal firms are in
from the informal sectors large firms. Smaller and medium-size formal firms are
A second provocative finding emerges from the flows in extremely countercyclical in their separations. This is, per-
and out of unemployment that suggest some rethinking haps, consistent with smaller firms being more likely to fail
about the informal sector serving as sort of disguised in a bad economy (Jovanovic 1982; Hopenhayn 1988) or
unemployment. Figure 4.6 suggests first that, at any time, perhaps it is because a lack of access to credit to smooth over
the probability of separation from the informal salaried difficult times leads to smaller firms being unable to hang on
sector is much higher than from the formal sector. In both to valuable workers while larger firms can.2 However, it is
Mexico and Brazil, informal salaried workers are roughly also the case that informal workers in firms of all sizes in
three times more likely to transit to unemployment, com- Mexico show extraordinarily high separation probabilities.
pared with their formal counterparts. Second, job separa- This would seem to suggest that, again, it is the type of con-
tion probabilities present much higher volatility in the tractual relationship that is determining firing behavior.
informal sector, especially for the informal salaried. Simu- However, an alternative possibility is that, though these
lations for Mexico (Bosch and Maloney 2006) and Brazil workers report that they are working in large firms, in fact
(Bosch, Go�i, and Maloney 2006) suggest that, in fact, the they are contracted by intermediaries that are smaller firms
in-creases in unemployment during recessions are gener- and that hire and fire as such.
ated primarily by workers separating from the informal
sectors. Why the informal sector generally
A number of possible mechanisms may be at play here. expands in downturns
First, workers in the informal sector may be occupying low- That said, why does figure 4.1 suggest that the informal sec-
skill jobs for which training or experience is not excessively tor expands during downturns, much as traditional views
important. During a downturn, these workers are easily dis- would suggest? Indeed, as Gasparini, Haimovich, and
posed of since they are not protected by labor regulations. Olivieri (2006) and Loayza and Rigolini (2006) have shown,
Further, informal workers are employed normally by small this appears, on average, to be the case.
firms, which may suffer disproportionately during reces- The advanced-country literature on understanding un-
sions and, hence, destroy more jobs. Bosch and Maloney employment through the lens of gross worker flows offers
(2006) explore this issue for Mexico and find that job separa- important insights and suggests that we focus on two sets of
tions are, in fact, largely driven by firm size, with the aggre- flows: those into sectors of employment--the job-finding
gate finding of acyclical firings in the formal sector being rate--and those out of those sectors--the separation rate.
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T H E I N F O R M A L L A B O R M A R K E T I N M O T I O N : D Y N A M I C S , C Y C L E S , A N D T R E N D S
FIGURE 4.7
Probability of transition from unemployment (job-finding rate), Brazil and Mexico
Brazil Mexico
Percent Percent
20 8
6
15
4
10
2
5
0
1983m1 1988m1 1993m1 1998m1 2003m1 1987q1 1991q1 1995q1 1999q1 2003q1
Formal Informal salaried Informal self-employed
Sources: Bosch, Go�i, and Maloney 2006; Bosch and Maloney 2006.
Figure 4.7 shows the job-finding rates of the formal United States, the job-finding rate is also strongly pro-
and informal sectors for Brazil and Mexico over the period cyclical, and Shimer (2005a) and Hall (2005) argue that
1983�2003. The main stylized fact emerging from these the magnitude of these fluctuations cannot be well
figures is the strong pro-cyclicality of the job-finding rate explained by state-of-the-art search and matching models.
in the formal sector, compared with the relative stability of Both Shimer and Hall argue that one explanation for the
the job-finding rate in the informal sector. The 1995 crisis excess volatility arises from wage rigidities. In most match-
in Mexico made the formal job-finding probability oscillate ing models (see box 4.2), an adverse shock to the economy
between 30 and 15 percent, while the job-finding rate in will lead to a decline in the productivity of potentially
the two informal sectors fluctuated only around 4 percent- hired workers and to their wages. However, if wages cannot
age points. Evidence from Brazil corroborates this finding. fall, then the likely profitability of hiring a new worker
The 1984 crises decreased formal job-finding rates dramat- falls even more and, as a result, job vacancies will fall much
ically, while the informal counterparts were relatively sta- more than if wages could fall.
ble. Moreover, after the reforms at the end of the 1980s, the The relevance to the LDC case is clear. If formal sector
job-finding rate saw major decreases from 15 to 5 percent. wages cannot fall while informal earnings can, then this
Thus, the job-finding probability in the formal sector might well explain why formal job finding fluctuates so
appears to be an important adjustment variable.3 much more than informal job finding does. In a sense, then,
These differential rates of job finding across the cycle are the focus on gross labor flows could be seen as simply
critical to explaining the frequent expansion of the infor- putting the Harris and Todaro (1970) vintage insight in
mal sector in downturns. As the economy slows, formal sec- new bottles. However, the evidence to date suggests that
tor hiring falls sharply but informal hiring falls much less, the question should be left open. First, Bosch and Maloney
and algebra dictates that the relative size of the informal (2006) for Mexico and Bosch, Go�i, and Maloney (2006)
sector is likely to rise. Though we previously showed that for Brazil find that certainly for self-employment and, to
separations from informal salaried were the most volatile, a lesser degree, for informal salaried work, wages are
net flows into the sector during crises are positive. more flexible than in the formal sector, but not always
This raises the question of why the job-finding rates are compellingly so. For example, in the 1988�92 recovery
so distinct between the two sectors, an issue with striking where formal hiring showed a disproportionately large
resonance in the recent puzzle about the high volatility gain, formal salaried and informal salaried earnings stayed
of job-finding rates in the developed economies. In the effectively equal.
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I N F O R M A L I T Y
More fundamentally, the mainstream literature has not turn, their productivity is affected by their access to the
converged on wage rigidities as being responsible for the benefits of formality. The size of the informal sector is a
common pro-cyclical patterns in job finding that we see function of the productivity differential between formal
in both the Brazilian and Mexican formal sectors and in and informal workers among sectors. This differential is, in
the United States. Mortensen and Nagypal (2005), for turn, determined by the cost of becoming and remaining
instance, even adding wage rigidities and several other formal and the distribution of skills in the workforce.
modifications to the Mortensen-Pissarides (1994) model, Specifically, the productivity differential has a worker-driven
can simulate only 40 percent of the volatility of the job- component, given by the worker's individual skills, and a
finding rate, and they conclude that "in sum, the dilemma sector-related component, given by the relative informal-
[of high employment volatility] persists" (p. 24). This sug- formal regulatory burden, the strength of enforcement, and
gests that the distinctive job creation behavior in the two the access to productivity augmenting public services. The
sectors may involve far more than the traditional focus on size of informal employment is then given by the propor-
formal sector rigidities. Further, as discussed in chapter 2, tion of workers whose skills fall below a threshold level
there is substantial evidence of binding minimum wages in where the worker is indifferent between the two sectors.
the informal sector, although this may be less the case dur- When regulation decreases or enforcement increases, the
ing downturns where "norms" may prove more flexible formal sector becomes relatively more attractive for them
than legal dictates. and more firms join it. Moreover, regulation is a fixed cost
Second, even if wage rigidities turn out to be the critical that all formal firms have to bear. Therefore, when overall
difference, the mechanism driving them may or may not productivity increases, the cost of regulation becomes pro-
include the usual considerations of unions, minimum portionally smaller so that more firms join the formal
wages, or other distortions. Kennan (2005) and Menzio sector, and the reverse is true in downturns.
(2005) both stress asymmetric information in the wage- Empirically, Loayza and Rigolini (2006) find that, on
bargaining process as inducing rigidities in wages with average, gross domestic product (GDP) growth is nega-
respect to productivity shocks. More generally, in the tively correlated with the size of the informal sector--
United States, for instance, Bewley (1999) argues that, for defined as the share of self-employed--indicating that the
reasons of staff morale, firms would prefer to fire workers, informal sector is, on average, countercyclical. Further, the
the collective memory of whom will soon fade, rather than degree of countercyclicality appears smallest for the coun-
reduce all workers' wages, the resentment about which will tries with the very largest informal sectors, Peru and
not drop. In short, wage rigidities, the traditional driver of Bolivia, behaving relatively acyclicality (see figure 4.8).
segmentation, are part of the story but only one candidate Consistent with their model, they find improvements in
for explaining the sharp fall in formal hiring rates.4 Each of law and order strongly reduce the cyclicality of informal
the elements of this debate surrounding "the dilemma" of employment.
excess volatility in the job-finding rate in the United States
applies to understanding the behavior of the formal sector
job-finding rate in Latin America. Explaining pro-cyclical movements in informality
Both of the previous models offer explanations for counter-
cyclical patterns of informality. However, a closer look at
The broader macro-context figure 4.1 suggests that this is not the whole story. In
Working more in the de Soto (1989) tradition of firms Mexico, from 1988 to 2001, unemployment fell at the
deciding to be formal or informal, Loayza and Rigolini same time that informality rose. That is, informality is pro-
(2006) develop a model based on Rauch (1991) that offers cyclical across this period. While gross flows increased in
an alternative perspective on possible drivers of cyclical both directions, net flows were toward self-employment.
behavior of the informal, in this case measured as the self- Fiess, Fugazza, and Maloney (2002, 2006) offer an expla-
employed. Here, the cyclical movements are not driven by nation by introducing distinct shocks to the formal and
the net effects of worker flows among sectors, but rather informal sectors. More specifically, they argue that because
across the de Soto margin. Effectively, individual firms informality is largely concentrated in the nontradables sec-
weigh the benefits of being formal against the costs and, in tor and formal jobs in the more tradables sector, standard
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T H E I N F O R M A L L A B O R M A R K E T I N M O T I O N : D Y N A M I C S , C Y C L E S , A N D T R E N D S
FIGURE 4.8
Informal employment reaction to the business cycle
Change in self-employment growth rate
.01
Peru
Honduras
0
Jamaica Bolivia
Colombia Ecuador
.01 Brazil
Mexico El Salvador
Uruguay Panama
Costa Rica Chile
Argentina
.02
Trinidad
.03
.04
.1 .2 .3 .4
Average self-employment rate
Source: Loayza and Rigolini 2006.
Note: The graph simulates the change in informal employment growth due to a 5 percentage point change in the GDP per capita growth rate.
The simulation is based on a short-run regression like the one shown in table 4, col. 2, but with a sample resulting from applying the constraint
of min. obs. 2. The dashed lines are the 90% confidence bands. Only countries in Latin America and the Caribbean are highlighted. From
left to right: Trinidad and Tobago, Costa Rica, Argentina, Uruguay, Chile, Mexico, Panama, Brazil, El Salvador, Colombia, Ecuador, Jamaica,
Bolivia, Honduras, and Peru.
small-economy models that focus on the response of these movements in the labor market and, in the reverse
two sectors to cyclical shocks (see Obstfeld and Rogoff way, movements in the labor market can inform what is
1996) offer insights into the cyclical behavior of the infor- driving movements in the macroeconomy.
mal sector. A boom in construction, for instance, opens Figure 4.9 plots these three variables for Argentina,
opportunities for informal contractors and others, and could Brazil, Colombia, and Mexico. Again, the early Mexican
lead to a pro-cyclical expansion of the sector. Loosely link- period shows a relative increase in the size of the informal
ing the discussion back to the matching models in the pre- self-employed sector and relative self-employed earnings, at
vious section, although increases in job-finding rates in the the same time that the real exchange rate appreciated
formal sector may generally exceed those in the informal sharply. More generally, we find three types of regimes. First,
sector, a strong enough stimulus to the nontradables/infor- co-integration tests show that, in Brazil during 1994�97
mal sector can outweigh those increases, leading to pro- and in Mexico in the period 1987�91, we find a positive co-
cyclical net job creation in the informal sector. On the movement of the two labor series and an appreciation of the
other hand, a negative shock to the formal sector, perhaps exchange rate. Even in Argentina, from 1991 to 1996, and
due to a major crisis, combined with downward rigidities in Colombia, from roughly 1990 to 1996, visual inspection
in earnings, can lead to countercyclical behavior of infor- suggests a similar pattern. This suggests that the expansion
mality identified previously, on average. The nature of of informality across this period may have been due to either
shocks and the degree of rigidities of earnings, simultane- a productivity or a demand shock to the nontradables sector.
ously determine movements of the exchange rate. The A very probable candidate is that the liberalization of the
correlation of these variables informs what is driving capital account and other reforms taking place around these
111
I N F O R M A L I T Y
FIGURE 4.9
Relative sector shares and earnings, real exchange rate
Argentina Brazil
Relative earnings, real exchange rate Formal Self-employed Relative earnings, real exchange rate Formal Self-employed
1.6 2.2 1.8 5.0
Integrated (I) Integrated (I)
not significant significant 4.5
1.4 2.0 1.6
4.0
1.2 1.8 1.4
3.5
1.0 1.6 1.2 3.0
2.5
0.8 1.4 1.0
2.0
Segmented (II)
0.6 1.2 0.8
significant 1.5
0.4 1.0 0.6 1.0
1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001
Colombia Mexico
Relative earnings, real exchange rate Formal Self-employed Relative earnings, real exchange rate Formal Self-employed
1.6 Integrated (I) 2.4 1.4 2.6
not significant Integrated (I) Segmented (II) Integrated (III)
1.3 significant significant significant 2.4
1.4 2.2
1.2
2.2
2.0 1.1
1.2
1.0 2.0
1.8
1.0 0.9 1.8
1.6
0.8 1.6
0.8
1.4 0.7
1.4
0.6
0.6 1.2
0.5 1.2
0.4 1.0 0.4 1.0
1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 1987 1989 1991 1993 1995 1997 1999 2001 2003
Unconditioned earnings Formal Self-employed Real exchange rate Formal Self-employed
Sources: Fiess, Fugazza, and Maloney 2006; and author's estimates, based on Pesquisa Mensal de Emprego, Instituto de Pesquisa Econ�mica
Aplicada, Encuesta Nacional de Empleo Urbano, and International Financial Statistics.
Note: Formal/self-employed earnings capture relative reported earnings in the formal and informal sectors. Formal/self-employed captures the
relative size of these sectors as a ratio of employed population. "Significant" means a significant cointegrating relationship found. I, II, and III
refer to regime (see text).
periods led to an increased demand for nontradables and an four countries experienced deep recessions across these
expansion of the informal sector. periods.
In a second regime, Brazil (1983�89 and 1998�2002) Finally, in the third regime, Mexico (1997�2003), we
and Mexico (1992�96) correspond to the case of a negative find a negative shock to the formal sector in the absence of
shock to the formal/traded sector in the presence of some downward formal sector rigidities that leads to an expan-
barriers to adjustment of formal sector wages. This is also sion of the relative size and remuneration in the informal
clearly the case in Colombia after 1996 and for much of sector and to a depreciation of the currency.
the period in Argentina, although the small sample sizes
do not permit testing subperiods. The pattern suggests the Drivers of the increase in informality
classic informal/nontradable sector adjusting to take in As chapter 1 (figure 1.10) noted, several measures of infor-
labor no longer absorbed in the formal sector, discussed mality suggest substantial increases in informality across
previously. This is historically plausible, given that all the last decades in Latin America. As noted, using a social
112
T H E I N F O R M A L L A B O R M A R K E T I N M O T I O N : D Y N A M I C S , C Y C L E S , A N D T R E N D S
protection definition, urban salaried informality increased in deterioration, and the lack of flexibility of nominal formal
Argentina from 1992 to 2003 by around 9 percentage points wages and the exchange rate, led to a more classic pattern
and by 17 percentage points in Greater Buenos Aries from of relative contraction of formal sector employment, expan-
1980�2003. Although, nationally, there was effectively no sion of relative earnings, and appreciation that is more
change in informality in Brazil, in a single decade (1990� consistent with traditional queuing models. Hence, a
2000), informality in the metropolitan areas rose by 10 per- pretty straightforward story in the context of macroeco-
centage points. In Colombia, figure 4.9 suggests that, over a nomic adjustment can explain substantial movement in
longer period of time, informality rose by perhaps 6 percent- informality across this period.
age points. And Mexico, despite relatively stable rates of However, dramatic as these movements have been--
informality across the 1990s, saw a sharp 4 percentage point terminating in crises in several of the countries--in
inflection in informal salaried work from 2000 to 2004. Argentina, Brazil, Colombia, and perhaps, in the early
Diagnosing across which margin these changes are 2000s, Mexico, the data suggest longer-term trends that
occurring and why is critical to forming appropriate policy seem to go beyond medium-term macroeconomic adjust-
toward the sector. This, however, is made difficult by the ments and point to longer-term evolutions in underlying
fact that the 1990s were years of far-reaching reforms on determinants of informality.
diverse fronts, as well as the final push on the unfinished Teasing out the impact of these distinct effects is
agenda of macroeconomic stabilization. Teasing out the extremely difficult. To begin, global consensus on the
impact of each policy is perilous and compounded by the impact of many of these reforms on labor markets remains
fact that research on the determinants of informality elusive and the Latin American literature remains in its
remains relatively inchoate. The aims of this section are infancy. To date, the strongest effort to study the impact of
thus relatively modest--to use several country cases to labor legislation has been undertaken by Heckman and
highlight viable hypotheses and to present some evidence Pages (2004), although even here, where the direction of
that informs the emerging discussion. In turn, we discuss impact has been identified, often the magnitudes are still
issues of macroeconomic stabilization, trade liberalization, up for discussion. Relatively little of the work on trade lib-
labor market reforms, supply side effects, and, briefly, eralization has focused on the impact of informality, and
reforms to facilitate formalization of microfirms. perhaps even less on the impact of stabilization. Second,
this report has stressed the potential importance of, partic-
Macroeconomic stabilization and capital ularly, informal independent employment as an exit option
account opening for workers evading social protection coverage that costs
The previous section noted that substantial movements in them far more than the benefits they receive from it.
informality could be generated by distinct shocks to the Changes in the relative attractiveness of formal versus
informal and formal sectors. At the beginning of the 1990s informal work can lead to shifting the supply curve of labor
numerous countries in the region fixed the exchange rate as to the formal sector and, hence, change the allocation of
a means of controlling inflationary expectations while labor. Some of the reforms of the period had potentially far-
liberalizing the capital and current accounts. Virtually all ranging effects in this area, but the efforts to quantify
countries saw sharp appreciations of the exchange rate that, them, presented here, are rudimentary at best. Finally, all
in many cases, were seen as arising from backward indexing the reforms happened at once, thus making isolation of one
of earnings in the context of falling inflation. However, effect from the others especially difficult.
the previous section suggests that these countries experi-
enced the Regime I pattern of a rise in relative size and Demographic and structural factors
earnings of the informal self-employed along with the A natural place to begin is in demographic and structural
exchange rate appreciation. This is consistent with a changes in the economies over the last two decades. Female
demand shock to the nontradable informal sector and views labor market participation has risen sharply and, as chapter 2
stressing borrowing against expectations of future income documents, women at marrying age tend to be dispropor-
that had been sharply revised upward in light of the tionately informal: Galiani and Weinschelbaum (2006)
improving macroeconomic situation and reforms. There- argue that the inflow of secondary workers to the Argentine
after, however, in the lead-up to the crises, macroeconomic workforce, particularly of female workers who choose to be
113
I N F O R M A L I T Y
informal because their husbands are already covered by ben- characteristic affects the probability of being informal. Fig-
efits, has led to a 13 percent increase in informality from ure 4.10 plots how much informality would change if,
1974�76 to 1999. Jimeno and Rodriguez Palenzuela (2003) using the set of estimated country-specific coefficients of
argue that trends in youth participation in the labor market the impact of any particular demographic or sectoral char-
are partly responsible for the rise in unemployment in the acteristic, we assign to the country the set of characteristics
OECD, which, as chapter 2 suggested, also maps to more that tends to lead to both the highest (Nicaragua) and low-
informal salaried work. However, youth participation has est (Chile) levels of informality in the sample. As is clear
broadly stabilized as students spend more time in school and, using both the social protection and productive definitions,
in turn, education appears often as a determinant of infor- characteristics alone can account for a difference of more
mality (see chapter 3)--with some models, such as Krebs than 10 percentage points in level of informality. How
and Maloney (1999) and Loayza and Rigolini (2006), show- a given set of characteristics translates into informality
ing that more educated workers or workforces are less likely appears even more important. Using the parameters that
to be informal. In terms of economic structure, numerous create the highest level of informality (Peru) and those that
studies have shown that different sectors have predispositions yield the lowest (again, Chile) yields large differences:
to informality--services more, manufacturing less (see Peru's structure, using Chile's coefficients, would lead to a
Goldberg and Pavcnik 2003, and Bosch, Go�i, and Maloney 25�50 point reduction in the size of the informal sector.
2006). Clearly, it is critical to understand how the economy trans-
To explore how important such changes may be, lates demographic characteristics into informality.
Gasparini and Tornarolli (2006) undertook two sets of This translation also turns out to have been far more
decompositions, identifying for numerous countries the important to explaining the increase in informality than
relative impact of various demographic and structural fac- changes in structure or demography. Figure 4.11 shows
tors on the level of informality. For each country, they esti- that for Argentina (1995�2003), Brazil, Chile, El
mate the probit coefficients that suggest how much a given Salvador, Paraguay, and Uruguay, structural changes
FIGURE 4.10a
Variation of informality rate (social protection definition)
Using parameters of Chile and Peru Using characteristics of Chile and Nicaragua
Venezuela, R.B. de Venezuela, R.B. de
Uruguay Uruguay
Peru Peru
Panama Panama
Nicaragua Nicaragua
Mexico Mexico
Guatemala Guatemala
El Salvador El Salvador
Chile Chile
Brazil Brazil
Argentina Argentina
50 40 30 20 10 0 10 20 30 40 50 15 10 5 0 5 10 15
Percent Percent
Chile Peru Chile Nicaragua
Source: Gasparini and Tornarolli 2006.
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T H E I N F O R M A L L A B O R M A R K E T I N M O T I O N : D Y N A M I C S , C Y C L E S , A N D T R E N D S
FIGURE 4.10b
Variation of informality rate (productive definition)
Using parameters of Chile and Peru Using characteristics of Jamaica and Nicaragua
Venezuela, R.B. de Venezuela, R.B. de
Uruguay Uruguay
Peru Peru
Paraguay Paraguay
Panama Panama
Nicaragua Nicaragua
Mexico Mexico
Honduras Honduras
Jamaica Jamaica
Guatemala Guatemala
El Salvador El Salvador
Dominican Republic Dominican Republic
Costa Rica Costa Rica
Chile Chile
Brazil Brazil
Argentina Argentina
25 20 15 10 5 0 5 10 15 20 25 30 20 15 10 5 0 5 10 15
Percent Percent
Chile Peru Jamaica Nicaragua
Source: Gasparini and Tornarolli 2006.
independent decomposition by the Argentina Poverty
FIGURE 4.11
Decomposition of changes in informality (social protection Assessment (World Bank 2007a) concludes that changes
definition) for urban salaried workers in such structural factors were not, overall, responsible;
rather, there was a generalized tendency toward noncom-
Percent
15 pliance with labor legislation. Similarly, an independent
exercise for Chile (Contreras, Puentes, and Sanhueza 2006)
10 broadly concurs with Gasparini and Tornarolli (2006),
arguing that changes in worker characteristics over the last
5
40 years would have led to a much larger decrease in infor-
0 mality than they actually observe.
We might argue that the changes in economic structure
5
arising from reforms, away from formality-intensive sectors
into those less so, might be critical. At this point, these do
10
de not seem a first-order explanation. Ramos (2002) found
aguay R.B.
Brazil Chile Uruguay
1�04 that, across the 1990s in Brazil, there was an expansion into
Argentina Argentina SalvadorPar
1993�20031990�2003
1995�20031995�2004 El 1997�2003200
1991�2003 services, but that this would explain a maximum of 25 per-
Venezuela,
5�2003
199 cent of the increase in informality. Goldberg and Pavcnik
(2003) for Brazil and Colombia; Bosch, Go�i, and Maloney
Actual change Characteristics Parameters
(2006) for Brazil; and Bosch and Maloney (2006) for
Source: Gasparini and Tornarolli 2006. Mexico show that most secular changes in informality have
arisen within sectors, not across them.
would lead to a decrease in informality if their impact had This point also applies to the Galiani and
stayed the same. Only for a particular time period for Weinschelbaum (2006) argument about the importance of
Argentina and the Rep�blica Bolivariana de Venezuela the gender composition of the workforce. Looking closely
is there an informality-expanding effect. That said, an at Brazil and Colombia (figure 4.12), we see a complex
115
I N F O R M A L I T Y
FIGURE 4.12a
Labor force participation, rate of formality, and unemployment, Brazil
Males Females
Percent Percent Percent Percent
60 84 30 48
82
50 80 25 46
78
40
76 20 44
74
30 15 42
72
70
20 10 40
68
10 66 5 38
64
0 62 0 36
1 3 1 3 9 1
1983 . 1985 1987 1989 199 199 1995 1997 1999 2001 1983 1985 1987 1989 199 199 1995 1997 199 200
Jan. Jan Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan.
Left scale: Formal Informal Unemployed
Right scale: Labor force participation
Source: Author's estimations, based on Encuesta de Calidad de Vida and Pesquisa Mensal de Emprego.
Note: All aggregates are a share of total population and hence sum to unity.
FIGURE 4.12b
Labor force participation, rate of formality, and unemployment, Colombia
Males Females
Percent Percent Percent Percent
50 78 30 60
45 76
25
40 74 55
35
72 20
30 50
70
25 15
68
20 45
66 10
15
10 64 40
5
5 62
0 60 0 35
1q1 2q3 4q1 5q3 7q1 8q3 0q1 1q3 3q1 1q1 2q3 4q1 5q3 7q1 8q3 0q1 1q3 3q1
1985q1 1986q31988q1 1989q3199 199 199 199 199 199 200 200 200 1985q1 1986q31988q1 1989q3199 199 199 199 199 199 200 200 200
Left scale: Formal Informal Unemployed
Right scale: Labor force participation
Source: Author's estimations, based on Encuesta de Calidad de Vida and Pesquisa Mensal de Emprego.
Note: All aggregates are a share of total population and hence sum to unity.
evolution between and across genders but with a heavy while the male share in informal work rose less strikingly,
emphasis on informalization within genders. with the lost formal workers appearing in the sharply rising
In Colombia, the share of men in formal employment as unemployment of the time. Female participation rose
a share of the population has fallen sharply since 1995 sharply beginning in 1996 and went entirely to informality.
116
T H E I N F O R M A L L A B O R M A R K E T I N M O T I O N : D Y N A M I C S , C Y C L E S , A N D T R E N D S
This represents a break with past trends where the gently decline in formal sector employment. The increase in
rising female participation from 1985 to 1995 left the share salaried informality could be made manifest through a cou-
of females who were informal relatively constant. The appar- ple of channels. The negative shift of the demand curve for
ent correlation of female participation with rising unem- formal labor would lead to lower employment and earnings
ployment would seem consistent with an added worker in the formal sector. Part of the fall in earnings could occur
effect, documented in Mexico and Argentina (Cunningham through lower benefits, an effect that might be exacerbated
2001a, 2001b): women--particularly married women-- if wages were relatively rigid. The same scenario would
enter the workforce if their spouses become unemployed. lead to hiring workers without benefits or subcontracting
Hence, adverse macroeconomic shocks are driving the tasks to lower-paid external workers.
increase in female participation and the rise in informality However, lower tariffs may also foster the import of
both overall and within genders. technology and capital from abroad, thereby increasing the
Brazil saw much less pronounced increases in unemploy- demand for complementary skilled labor that, in the long
ment, female participation, and the share of women who run, tends to greater formality. Generally speaking, indus-
were informal. Rather, what emerges there is a replacement tries that are more exposed to trade tend to pay higher
of male formal positions with informal positions concomi- wages and be more formal (see de Ferranti et al. 2001),
tant with an unexplained fall in male labor market partici- given the human capital of their workers. In addition, the
pation. In both cases, the rising informality within gender availability of higher-quality or lower-cost intermediate
contributes dominantly to the overall evolution of infor- inputs in essence, constitutes a productivity shock increase
mality in the economy. to the formal sector, which, as shown earlier, lends to lower
Finally, the region's overall gain in income would seem informality.
to mitigate against the rise. As noted in chapter 1, numer- Empirical evidence of openness to trade on levels of
ous studies now have shown that informality, measured as informality is mixed, but generally suggests small effects.
the share of the workforce, falls with development; and, Goldberg and Pavcnik (2003) find a very modest impact
overall, in spite of the crises, the region made some small of trade reforms in Colombia and none in Brazil. Bosch,
progress (see Blau 1987; Gollin 2002; Loayza and Rigolini Go�i, and Maloney (2006), revisiting the Brazilian case
2006; and Maloney 2001).5 However, as Loayza and through the lens of job creation and destruction, find a
Rigolini (2006) and others have shown, this broad trend positive, but again small, impact. Figure 4.13 plots the
with development explains perhaps 60�75 percent of the predicted values using the Shimer (2005c) methodology
variance in the size of the self-employed sector. The residual and suggests that, in the absence of trade liberalization,
25�40 percent is broadly consistent with the simulations formal employment may have been 10 percent higher.
above that suggest that similar countries can have very dif- The evidence from Mexico does not suggest a huge impact
ferent levels of informality. We now look at changes in trade either. As noted by Garc�a-Verd� (2007), among others,
regimes and labor legislation as possible explanations. given the dramatic unilateral liberalization beginning in
Trade reforms
The far-reaching trade reforms of the 1990s are a logical FIGURE 4.13
Actual and predicted size of the industrial formal sector, Brazil
suspect, although, theoretically, the effects on informality
are ambiguous. On the one hand, cheaper imports (or the 90
No constitutional reform
appreciation of the currency that accompanied the trade
85
reforms) may introduce pressure on domestic prices, dri- No trade reform
80
ving local firms out of business, reducing their incentives
75
to open new positions, or pushing them toward cheaper Actual
means of production in the informal sector. In the Fiess- 70
Fugazza-Maloney (2006) model, this could be seen as a 65
negative productivity shock to the formal/traded sector, the
19831984198519861987198819891990199119921993199419951996199719981999200020012002
adjustment to which would depend on the degrees of rigid-
Source: Bosch, Go�i, and Maloney 2006.
ity in the formal sector, but in any case would lead to a
117
I N F O R M A L I T Y
1987 and then continuing through the North American Argentina suggests that the impact of trade reform per se
Free Trade Agreement, there is little trend in informality. has a magnitude similar to that in Brazil, although there
Aleman-Castilla (2006), broadly following the Goldberg may be significant additional impacts from the various
and Pavcnik (2003) methodology, finds that those indus- periods of sustained currency overevaluation.
tries more exposed to trade saw higher increases in the Recent trends in Mexico also seem plausibly related to
rate of formality. The reason, he argues, was that international exposure. The sharp increase in both self-
the impact on product prices was minor, while the reduc- employment (shown above) and informal salaried work (see
tion in import prices raised the productivity of the trad- figure 4.15) after 2000 has occurred concomitantly with
ables sector and, hence, expanded the demand for formal the entry of China as a major competitor in some areas of
labor overall. Mexico's comparative advantage. Hanson and Robertson
However, suspicions remain. As Mondino and Montoya (2006) argue that, had China's growth in export capacity
(2002) and World Bank (2007a) have shown, a very large remained unchanged after 1995, Mexico's annual export
increase in the share of informal salaried workers began in growth rate of Chinese-substitutable goods would have
the early 1980s (figure 4.14). Though the last round of been 1.5 percentage points higher in the late 1990s and
trade liberalization began only in 1990, the reforms begun 3.0 percentage points higher than the 1.9 percent it experi-
under Argentina's Minister of the Economy Jos� Alfredo enced going into the new millennium. This does suggest
Mart�nez de Hoz in the late 1970s radically lowered tariffs that international competition is putting a constraint on
and led to an appreciated exchange rate. Galiani and the expansion of some export jobs. On the other hand,
Sanguinetti (2003) and Porto and Galiani (2006) find that Lederman, Olarreaga, and Soloaga (2006), using estima-
the decreased protection had some effect on both the tions of the gravity model of trade, argue that there is little
absolute level of wages and the gap between skilled and evidence that Mexican (and Central American) nonfuel
unskilled labor. To the degree that part of the downward exports overall were affected. It is also noteworthy that the
pressure on unskilled wages came through the reduction sharp increase seems to occur with the relaxation of restric-
of benefits, or subcontracting, it seems possible that trade tions on Chinese textiles and apparel imports in the United
liberalization had an impact. However, preliminary analy- States, which was not one of Hanson and Robertson's
sis replicating the Goldberg-Pavcnik (2003) exercise6 for affected sectors. As an alternative explanation, the overall
FIGURE 4.14 FIGURE 4.15
Informality rate for salaried workers in Greater Buenos Aires Informal salaried versus formal salaried, Mexico,
relative earnings and sector size
1.4 0.45
0.40 Informal vs. Formal
1.2
0.35 Formal informal Relative earnings
1.0
0.30 2.2 1.70
0.8 0.25 Wformal Winformal 1.65
2.1
0.6 0.20
1.60
0.15 2.0
0.4 1.55
0.10
1.9
0.2 1.50
0.05
0 0 1.8 1.45
1.40
1.7
1974 1976 1978 1981 1985 1987 1989 1991 1993 1995 1997 1999 2001 1.35
1.6 Formal informal
Left scale: Right scale: 1.30
1.5
Mean tariff Informality 1.25
Wage premium Import penetration 1.4 1.20
7 8 9 0 1 2 3 4 5 7 8 0 1 2 3 4
Sources: Porto and Galiani (2006) for mean tariff and wage premia; 198 198 198 199 199 199 199 199 199 1996199 199 1999200 200 200 200 200
Gasparini (2002) for informal salaried work; and Olarreaga, Castro,
and Saslavsky (2006) for import penetration. Source: Author's calculations.
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T H E I N F O R M A L L A B O R M A R K E T I N M O T I O N : D Y N A M I C S , C Y C L E S , A N D T R E N D S
reduction in exports due to the U.S. recession may have had increase in informal work. In both Argentina and Brazil,
a straightforward impact through, effectively, a reduction the striking fact is the shift of informality toward larger
in tradables productivity that, in the absence of wage firms, as the rate of informality in those large firms has
rigidities, puts us exactly in Regime III--a depreciation of almost doubled. This casts some doubt on the Beccaria,
the currency concomitant with a rise in relative sector size Carpio, and Orsatti (1999) conjecture that the rise in infor-
and relative earnings (figures 4.9 and 4.15). There may mality in Argentina was driven by increased subcontract-
have been nothing more exotic going on than that, given ing to smaller firms.
the slowdown in the U.S. economy, the opportunities However, the reverse appears to happen in Mexico where
became better in the informal microfirms than in the medium-size and large firms are becoming more formal
maquilas across this period. over time. Table 4.2 suggests that this is not due to
An additional table and graph comparing Argentina, increased subcontracting relationships with the firms of
Brazil, and Mexico are potentially informative here. fewer than 16 employees covered in the microenterprise
Table 4.1 shows the change in the allocation of informal survey. Though the 2002 data are not exactly comparable
sector workers across sector sizes over the relevant period of with earlier data, there does not appear to have been an
important increase in those selling their products or ser-
vices to or buying inputs from large clients. Putting
TABLE 4.1
together the story, we might argue that the shifts in infor-
Evolution of informality across firm size and time: Distribution
mality measured here are due to the increased relative
of informal and self-employed workforce
attractiveness of opening or working for a microfirm over
a. Argentina (GBA)
the last quinquennium, and not to greater subcontracting
Firm size 1980 2003 Variation (%) or within-large-firm informality due to trade opening.
Second, figure 4.16 suggests that, for Mexico, the small
1 45.35 34.60 �10.74
2 to 5 42.11 40.75 �1.36 changes in the distribution of formal employment across
6 to 25 7.82 15.55 7.72 ages over the last 20 years of trade liberalization have been
26 to 100 2.71 5.25 2.54
101 to 500 1.25 2.60 1.35 minimal, with some loss of formality among prime-age
501+ 0.76 1.25 0.49 males and perhaps older workers in the 1987�96 period
that was absorbed both in informal salaried and indepen-
Source: Encuesta Permanente de Hogares. dent work. There have been no substantial changes in the
b. Brazil 1996�2004 period. In Brazil, however, the 1990�2002
period brought a shifting down of formal employment of
Firm size 1990 2002 Variation (%)
roughly 10 percentage points across the whole age spec-
1 35.70 25.52 �10.18 trum, with a fall of 20�30 percentage points for young
2 to 5 42.52 35.99 �6.53
workers. In Argentina, a similar pattern has prevailed,
6 to 10 7.15 12.47 5.32
11+ 14.63 26.02 11.39 although the similarly dramatic losses of formal jobs
Source: Pesquisa Mensal por Amostra de Domicilios. TABLE 4.2
Subcontracting in Mexico, 1992�2002 (percent)
c. Mexico
Firm size 1994 2004 Variation (%) Input/client 1992 1994 1996 1998 2002a
1 25.9 30.0 4.2 Big inputs 37.78 39.8 41.6 46.99 41.79
2 to 5 41.0 44.7 3.7 Big clients 5.31 3.85 3.77 4.14 3.19
6 to 10 7.4 7.4 0.1 Maquila 2.28 1.42 1.31 2.98 0.07
11 to 15 3.2 2.8 �0.4
16 to 50 6.1 6.3 0.2
Source: Encuesta Nacional de Micro Negocios, several years.
51 to 100 3.0 1.7 �1.2
Note: Firms are considered to be subcontracting if there is a big
101 to 250 1.7 0.6 �1.1
provider or a big client, or if the firm does maquila work.
251+ 11.9 6.5 �5.4
a. Includes exports and imports as category in inputs/clients;
no separate question for maquila, included as category of
Source: Encuesta Nacional de Empleo Urbano. input/client.
119
INFORMALITY
FIGURE 4.16
Evolution of informality across age groups
Formal salaried Informal salaried Self-employed
Percent Argentina Percent Argentina Percent Argentina
100 100 100
1980 1995 2003 1980 1995 2003 1980 1995 2003
80 80 80
60 60 60
40 40 40
20 20 20
0 0 0
16 19 22 25 28 31 34 37 40 43 46 49 52 55 58 16 19 22 25 28 31 34 37 40 43 46 49 52 55 58 16 19 22 25 28 31 34 37 40 43 46 49 52 55 58
Age Age Age
Percent Brazil Percent Brazil Percent Brazil
100 100 100
1983 1990 2002 1983 1990 2002 1983 1990 2002
80 80 80
60 60 60
40 40 40
20 20 20
0 0 0
120
15 18 21 24 27 30 33 36 39 42 45 48 51 54 57 60 15 18 21 24 27 30 33 36 39 42 45 48 51 54 57 60 15 18 21 24 27 30 33 36 39 42 45 48 51 54 57 60
Age Age Age
Percent Mexico Percent Mexico Percent Mexico
100 100 100
1987 1996 2004 1987 1996 2004 1987 1996 2004
80 80 80
60 60 60
40 40 40
20 20 20
0 0 0
15 18 21 24 27 30 33 36 39 42 45 48 51 54 57 60 15 18 21 24 27 30 33 36 39 42 45 48 51 54 57 60 15 18 21 24 27 30 33 36 39 42 45 48 51 54 57 60
Age Age Age
Percent Peru Percent Peru Percent Peru
100 100 100
1986 1991 2001 1986 1991 2001 1986 1991 2001
80 80 80
60 60 60
40 40 40
20 20 20
0 0 0
15 18 21 24 27 30 33 36 39 42 45 48 51 54 57 60 15 18 21 24 27 30 33 36 39 42 45 48 51 54 57 60 15 18 21 24 27 30 33 36 39 42 45 48 51 54 57 60
Age Age Age
Source: Author's calculations.
T H E I N F O R M A L L A B O R M A R K E T I N M O T I O N : D Y N A M I C S , C Y C L E S , A N D T R E N D S
among workers in the early part of the life cycle extend to increases in firing costs, labor taxes, and nominal wage
those in their late 20s, unlike in Brazil where the really big rigidities can decrease the size of the formal sector by a few
losses level out at about 20. Further, there is also a marked percentage points. Ulyssea (2006), modeling both barriers
decrease in formalization among workers over 45 years of to entry and labor regulations, found the latter to be of small
age that is roughly double that of the prime-age males. importance, although, as he makes clear, the assumption of
In light of this, there can be no wonder about the con- perfect wage flexibility means that many distortions are
cern in Argentina about the increased informalization of passed on to workers and, hence, have little effect on the
the workforce. The richest country in Latin America once demand for labor. A large body of literature (for example,
had a constant and high formal employment rate of almost Botero et al. 2003; Heckman and Pages 2004; and Nickell
70 percent, where 17-year-old workers had the same access and Layard 2000) concludes that more stringent labor
to formal sector jobs as prime-age males. It now looks market regulations hamper productivity growth. Holmes
closer to Mexico, except the large firms in Mexico are rela- (1998) and Besley and Burgess (2004), exploiting regional
tively more formal. At the very least, this represents differ- variation for the United States and India, respectively, find
ent experiences with trade liberalization. But the summary important impacts of labor regulation on output, and the
picture is striking. Mexico's far-reaching trade liberaliza- latter on employment. Following their general approach,
tions, begun in 1987, had minimal impact on informality Almeida and Carneiro (2005) find that Brazilian states
or its allocation across age groups or firm sizes. Meanwhile, with lower enforcement have higher productivity, wages,
Brazil has experienced an evolution in magnitude of infor- and employment.
mality and its allocation across both dimensions similar to Documenting the impact of legislation on formal sector
that in Argentina. Yet, as figure 4.13 shows, little of this demand in Latin America has been the subject of several
can be attributed to its far-reaching trade liberalization. At major efforts in the region. Of particular importance, the
this point, we begin to look for other explanations. National Bureau of Economic Research volume edited by
Heckman and Pages (2004) collected some of the most
Regulation and distortion serious attempts made to that date to quantify the impacts
A substantial body of literature sees the size of the informal of various regulatory changes, and the literature is well
sector to be determined substantially by regulatory distor- reviewed in the introduction and chapters in that book.
tions or corruption (see Djankov et al. 2002; Friedman For the region and several countries, a credible case can be
et al. 2000). Looking particularly at self-employment in built that labor legislation had a substantial impact on
cross-section, Loayza and Rigolini (2006) find that varia- the size of the formal sector (see Heckman and Pages 2004;
tions in business flexibility account for 16 percent of the and Saavedra and Torero 2004).
variance; variations in government expenditure (a measure The Mexican case has attracted little academic work
of monitoring intensity) account for 7 percent; and enforce- since there were significant changes in neither the size of
ment of contracts, prevalence of the rule of law, and the the informal sector nor, perhaps relatedly, labor legislation.
efficiency of the policy and judicial system account for However, the fall in formal employment in the municipal
26 percent. GDP still accounts for 61 percent.7 Loayza, areas of Brazil has received formidable attention by the
Oviedo, and Serv�n (2006), using the Schneider and Enste analysts8 and the present discussion can only graze the tip
(2000) shadow economy estimates, find similar correlations of the iceberg. However, increased labor market rigidities
with regulatory measures, although, as discussed at length are among the prime candidates to explain the fall in
in chapter 1, it is unclear what this measure is actually cap- formal employment not accounted for by trade liberaliza-
turing. In general, such effects account for about 30 percent tion in figure 4.12. The constitutional reform of 1988
of the variation of informality across countries. included several important changes to the labor legislation
A long tradition sees distortionary regulation, particu- (see Paes de Barros and Corseuil 2004 for a summary).
larly in the labor market, as leading to increased informality First, several measures increased labor costs and reduced
for a variety of reasons and across all three margins. Box 4.2 employer flexibility. Maximum working hours per week
discusses three modeling exercises within the context of were reduced from 48 to 44, the maximum daily work day
matching type models discussed in the first part of this in selected industries was reduced from 8 to 6 hours, over-
chapter. Together, these simulations suggest that modest time remuneration was increased from 1.2 to 1.5 times the
121
I N F O R M A L I T Y
normal wage rate, vacation pay was raised from one to one 1990s. In the context of the Fiess-Fugazza-Maloney model,
and a third of the monthly wage, and maternity leave this corresponds well to a negative formal sector productiv-
increased from 90 to 120 days. Second, union power was ity shock in the presence of a nominal rigidity and, in fact,
expanded: unions were no longer required to be registered the empirical evidence supports that interpretation. In addi-
and approved by the Ministry of Labor; decisions to strike tion to this and consistent with it, other policy changes may
now rested purely on the union's decision, and the required have led to shifting the demand for formal sector workers
advance notification to the employer fell from five to two that interacted with the minimum wage. Kugler (2000)
days; strikes in certain strategic sectors were no longer argues that the 1990 reforms that reduced firing costs
banned. Previous work by Menezes-Filho (1997) docu- induced greater worker flows in and out of unemployment
menting the impact of the reduction in union power across and may have contributed to 10 percent of the reduction in
the 1980s on firm profitability and earnings suggests that unemployment. However, they may also have deepened the
this channel can be important. Finally, firing costs were fall in formal employment by reducing the costs of firing.
raised. The penalty levied on employers for "unjustified" Perhaps more directly, Kugler and Kugler (2003) argue that
dismissal, a category encompassing most legitimate separa- the sharp rise in payroll taxes in Colombia--over 10 percent
tions for economic reasons in the United States, increased from 41 to 51.5 percent--between 1989 and 1996 may also
by four times, from 10 to 40 percent of the accumulated have had important employment effects. As they note, both
separation account (Fundo de Garantia por Tempo de Servi�o). nominal rigidities and the weak link between taxes and ben-
To date, the most comprehensive work relating these efits lead to these higher costs being only 1.4�2.3 percent of
changes to the functioning of the labor market was under- those taxes shifted to workers, the rest leading to a decline in
taken by Paes de Barros and Corseuil (2001) who find that formal employment of 4�5 percent. Cardenas and Bernal
separation rates decreased after the constitutional changes for (2003) similarly find high estimated wage elasticities that
short employment spells and increased for longer spells, but would suggest that such an increase in labor taxes would
find an ambiguous overall effect. However, again, matching have led to a substantial drop in labor demand.9
models discussed in the previous section suggest that several of Peru's large increase in informality of roughly 10 per-
these reforms would lead to a reduction in hiring (job-finding) centage points from 1986 to 2001 in metropolitan Lima
rates as opposed to the separations that Paes de Barros and also seems partly due to the increased regulatory burden.
Corseuil study. By exploiting cross-industry variation in As Saavedra and Chong (1999) note, during the early
proxies related to these reforms, Bosch, Go�i, and Maloney 1990s Peru implemented dramatic trade liberalizations,
(2006) find suggestive evidence that proxies for restrictions fiscal reforms, deregulation of the goods markets, extensive
on hours worked, increases in union power, and increased fir- privatization, and labor market reforms--the respective
ing costs appear to have a strong impact on decreasing formal impacts of which are difficult to disentangle. The results
job creation across the 1990s. Simulations suggest that, had were the substantial downsizing of many firms, and the
there been no change in the constitution, formal hiring rates productivity increase achieved by the reforms was concen-
would have been 40 percentage points higher and overall lev- trated in select sectors that created few additional formal
els of formality would have fallen negligibly. jobs. On the one hand, the labor reform reduced employ-
The impact of minimum wages interacted with other ment rigidities, firing costs were reduced substantially,10
labor reforms plays an important role in explaining the evo- red tape on hiring temporary workers was minimized, and
lution of informality in Colombia. Figure 4.9 shows that, the use of training contracts for younger workers was facil-
around 1996, the labor market began a period of severe itated. Further, enforcement of labor laws fell as budgets for
segmentation captured by the fact that relative earnings in inspections were slashed and labor courts became less pro-
the formal sector rose while the relative size of the sector labor than previously. Finally, union bargaining power also
fell sharply. As Arango and Pach�n (2004), Kristensen and fell dramatically, partly due to changes in labor legislation,
Cunningham (2006), Maloney and Nu�ez Mendez (2003), the decentralization of the collective bargaining process, as
and Santamaria (2000) show, Colombia's minimum wage is well as the increased use of temporary contracts.11
among the highest and most binding in Latin America, and On the other hand, non-wage labor costs increased
it was raised in real terms in the depths of the crisis of the late sharply beginning in the early 1990s (see figure 4.17), due
122
T H E I N F O R M A L L A B O R M A R K E T I N M O T I O N : D Y N A M I C S , C Y C L E S , A N D T R E N D S
sticky and, hence, effectively eliminated downward flexi-
FIGURE 4.17
bility and made operating informally more attractive (see
Labor legislation and related variables, Peru
World Bank 2007a). The authors put together a year-by-
Index 1995 100 year series of tax rates and labor regulations and compare
130
them to the changes that have taken place in rates of
120 informality (for salaried employees). They show that the
110 increase in rates of informal salaried employment during
1980�88 took place during a period of rising taxes on labor
100
and increased regulation. However, the increase in infor-
90
mality in the period 1995�99 was during a period of
80 declining taxes. Arguably, the impact may have been offset
by increased segmentation coming from sliding formal
70
sector productivity and downwardly rigid wages.
60
Changes in labor law in 1991 and 1995, which provided
50 for short-term labor contracts, have received particular atten-
1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 tion as possible triggers for the growth in informality.12 The
reforms introduced fixed-term contracts and provided for
Non-wage labor costs Taxes GDP
Index of tax compliance special short-term contract regimes for small firms and
young workers. Hopenhayn (2004) finds that the 1995
Sources: Saavedra and Maruyama 2000, Peruvian Central Bank
reform substantially increased job turnover rates. Olmedo
(BCRP), and National Tax Office (SUNAT).
Note: Non-wage costs are presented as a percentage of wages in and Murray (2002) credit the changes with promoting an
December of each year. The index of income declaration denotes
the number of contributors (workers and firms) presenting tax acceptance of lower job protections and hence, greater infor-
statements to national authorities. Note that, actually, a
mality. They write, "The new labor laws undermine the idea
proportion of these contributors may not be necessarily paying
any taxes (December of each year). of permanent work with a modicum of economic welfare,
social protection (especially in the fields of medical care, old
age security and educational opportunities), and job secu-
mainly to the elimination of caps on certain types of con- rity" (p. 430). Rates of informality among salaried workers
tributions. In addition, changes in the regulation of the rose when short-term contracts were legalized in 1995 and
unemployment compensation individual account (Compen- then persisted after such contracts were abolished in 1999.
saci�n por Tiempo de Servicios) now forced accumulated This pattern is consistent with the Olmedo and Murray
contributions to be deposited in commercial bank (2002) claim that informality was made more socially
accounts rather than simply counted as a contingent liabil- acceptable by labor law reforms and supported by anecdotal
ity and the resources retained as working capital. Further, evidence that suggests that, in contrast to Peru, enforcement
the 1991 tax reform induced a steady increase in the capa- of the labor law was relaxed. This argument, however, cannot
bilities of tax authorities to reduce evasion. Saavedra and explain the large increases in informality that took place dur-
Torero (2004) show that these movements in labor costs, ing 1980�88, when labor regulation expanded. An alterna-
in fact, have the predicted impact on formal sector labor tive may, again, be that as Perry and Serv�n (2005) note,
demand. The doubling of the non-wage costs led to a rise overvaluation was severe across this 1995�99 period due to
in overall labor costs of 10�11 percent which, at their esti- the devaluations of neighboring currencies; and, much like
mated wage elasticity, could lead to a 3�4 percent decrease the slowdown in the U.S. economy for Mexico, this may have
in formal salaried employment. constituted a negative shock to the tradables sector.
Regulatory explanations for the rise of the informal sec-
tor in Argentina are both many and relatively inconclusive, Increased incentives to exit
and are reviewed in World Bank 2007a. For example, Bour A critical policy conclusion of the analysis in the first section
and Susmel (2000) argue that the low inflation under the above--that there is a high degree of mobility among for-
Argentine convertibility plan made formal sector wages mal and informal sectors--is that we need to be concerned
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I N F O R M A L I T Y
with the incentives generated for working in the two sec- over time, other than during the crisis. Hence, it is an
tors. A nascent literature is emerging precisely around the open question whether the systematically low level of confi-
implications for social policy (see Levy 2006; Maloney 2004) dence is related to the time trend toward higher levels of
and this will be dealt with in greater degree in the next informal work.
chapter. The central point is that any wedge that is driven Gasparini, Haimovich, and Olivieri (2006) attempt to
between the contributions a worker makes explicitly in measure whether the large cash transfers to unemployed
terms of labor taxes or implicitly in terms of lower equilib- household heads implied a disincentive for the program
rium wages, on the one hand, and the perceived benefits, on participants to search for a formal job. They find for
the other hand, makes formality less attractive. Such wedges 2003�04 that the effects were significant and large, reduc-
may arise for several reasons. ing the share of workers moving into formal jobs by 5 per-
In Brazil, the recent establishment of a minimum pen- centage points. However, the effect vanishes later as the
sion for all, regardless of contribution, and the lowering of gap between program benefits and the rising wage shrank
the eligibility age compound the effect discussed by Levy and would seem an unlikely candidate for explaining the
by increasing the net gain from being informal. Further, the effects since the 1980s.
constitutional change toward creating universal health More generally, it is difficult to know how much the
insurance may have also become an incentive to informality, pure tax--that is, income surrendered without correspond-
although research to date is thin on the point (see Bosch, ing benefits--affects the decision to be informal. Regret-
Go�i, and Maloney 2006) and will be dealt with in greater tably, research is in its infancy here, and we can offer only
detail in chapter 5. Carneiro and Henley (2001) suggest two approaches that give a fairly high level of variance. The
that uncovered employment may have risen because first approach is to exploit the now well-established finding
employees and employers collude to avoid costly contribu- that self-employment, which we can use as a proxy for
tions to a social protection system that is perceived to be informality, decreases with level of development. If, in fact,
inappropriate, inefficient, and a poor value for the money.13 as argued above, this reflects the rising opportunity cost of
In principle, then, a universalization of health care de- independent work discussed earlier, then we can see the
linked from the labor market may have changed the imposition of the tax as, effectively, a reduction in this
cost�benefit analysis of being enrolled in, and hence con- opportunity cost. The second approach uses the Krebs-
tributing to, formal sector benefits programs. In the end, Maloney (1999) model of efficiency wages that models the
they conclude that this is unlikely, not only because public firm decision to invest and hire in response to the rate at
health services continued to be thought of as substantially which formal sector workers quit to enter self-employment,
worse than the formal sector product,14 but also because the to calibrate the impact of the tax.
effective supply of these services was available even for non- The estimated semi-elasticity of self-employment with
contributors several years before the reforms took place, and respect to a change in relative formal sector earnings is 0.03
little progress had been made on implementing the mea- (Maloney 1998) to 0.05 (Loayza and Rigolini 2006) in the
sures contemplated in the 1991 social security reform. former case compared with the simulated value of 0.3 in the
However, the fall in participation of Brazilian males across latter. Just as an idea of the broad orders of magnitude
the 1990s suggests some reasonably potent supply side involved, if we assume that 10 percent of formal sector earn-
effects. ings is absorbed in unvalued benefits, and perhaps that
It has sometimes been suggested that Argentina's high another 10 percent of the value of earnings is transferred to
rates of informal employment are a consequence of low informal workers in untied social protection programs, lead-
public confidence in public services and the social security ing to a 20 percent decrease in the relative attractiveness of
system, which has resulted in part from repeated economic formal labor, then, in the first case, the size of the informal
crises. Argentines do have a relatively low level of confi- self-employed sector is increased by 0.6 to 1.2 percent and,
dence in government institutions.15 In 2005, only 18 per- in the second, by 6.0 percent of the share of the workforce.
cent, 26 percent, and 26 percent of Argentines reported As an alternative approach, Fernandes, Gremaud, and
having confidence in political parties, Congress, and the Narita (2006) simulate the impact of replacing the labor tax
judiciary, respectively. However, there is no clear evi- on first minimum wage, thereby effectively providing for-
dence of a deterioration in confidence in public institutions mal sector benefits for free, while maintaining revenue
124
T H E I N F O R M A L L A B O R M A R K E T I N M O T I O N : D Y N A M I C S , C Y C L E S , A N D T R E N D S
neutrality. If the value-added tax on capital goods is point, that changes in labor market regulation and social
deductible, then there is a decline in informality of 1.5 per- security taxes had an important impact in Brazil and
cent. If not, however, the decline in physical accumulation Colombia. Supply side impacts could plausibly have been
decreases the demand for formal workers and leaves infor- important, although the evidence is speculative. Evidence
mality relatively unchanged. The first and third approaches from changes in the difficulty of movement across the
suggest modest although nontrivial impacts, and the second de Soto margin--of small firms becoming informal--
suggests substantial impacts of these "supply side" concerns suggests minimal effects working in the other direction.
on the size of the informal sector.
Policy implications
Reforms along the de Soto margin The previous three chapters offer findings that suggest that
Finally, probably little responsibility can be placed at the labor market policies are potentially important determi-
door of policies that seek to make it easier for microfirms to nants of informality and, hence, there is an agenda for
register their workers. As the chapter on firm formality reform. Since experience shows that specific policy recom-
decisions shows, these had relatively small effects in the mendations have to be sensitive to country context, this
Sistema de Apertura R�pida de Empresas program in section outlines some general principles without attempt-
Mexico, the Sistema Integrado de Pagamento de Impostos e ing to be comprehensive.
Contribucoes as Microempresas e Empresas de Pequeno Porte Labor policies work on informality through three chan-
program in Brazil, and the Monotributo in Argentina. Fur- nels. First, excessive labor costs, whether arising through
ther, in all cases, the results are suggestive that, in fact, the labor legislation--exaggerated minimum wages, severance
small effects were in the direction of lowering informality. costs, labor taxes, or unrealistic union demands--depress
the number of jobs in the formal sector. Other recent reports
Conclusion from the Bank, "Minimum Wages and Social Policies:
The evidence from the analysis of gross worker flows sug- Lessons from Developing Countries" (Cunningham 2007)
gests that, in Mexico and, to a lesser extent, Brazil, the for- and "Job Creation in Latin America and the Caribbean"
mal and informal sectors behave across the business cycle as (World Bank 2007c), as well as the Inter-American Devel-
if they were dynamically integrated. In both countries, the opment Bank publication Good Jobs Wanted; Labor Markets
flows support self-employment as being a desirable sector. in Latin America (IDB 2006), investigate in detail the trade-
The picture for informal salaried workers is mixed. In offs between offering strong protections to some workers
Mexico, pro-cyclical patterns of rematching across sectors at the possible expense of excluding others. This chapter
suggest a sector in line with the previous chapter's findings has offered evidence that, in several countries, exaggerated
about the Dominican Republic: informal salaried jobs are labor costs appear to have created the classic segmented
not particularly inferior to jobs that comparable workers labor market, especially during downturns. Further, the
have in the formal sector. However, the Argentine and experience in the OECD suggests that such regulations
Brazilian evidence suggests a case with a higher proportion have an especially heavy exclusionary impact on young peo-
of salaried workers queuing for formal sector jobs, consistent ple attempting to find jobs and who, in Latin America, are
with the tremendous decline in formality across the 1990s. overrepresented among the involuntary informal salaried.
A unified explanation for the expansion of informality The evidence for a very high degree of integration of the
across the region over the last decades more generally formal and informal sectors found in several countries and
remains elusive, although it appears to result from a combi- subsectors does not necessarily imply satisfactory labor
nation of forces--some medium-term macroeconomic in codes. Severance payments, which, in Latin America,
nature, others related to longer-term structural changes. Heckman and Pages (2004) find to be among the highest in
Some of the increase in the early part of the 1990s was due the world, for example, may substantially reduce the job
to nontradable/informal booms driven by liberalization of creation arising from growth without necessarily segment-
the exchange rate and subsequent inability to adjust formal ing the market.
sector wages downward as difficulties arose surrounding Second, legislation can create incentives to voluntary
the exchange rate pegs. Trade liberalization probably had informality, which the last chapters have shown to compose a
little impact overall. There is substantial evidence, at this substantial fraction of the sector. This implies that the design
125
I N F O R M A L I T Y
of social safety nets and labor legislation needs to take a more allowing workers to collect partial indemnities in some
integrated view of the labor market, taking into account the cases of voluntary resignation; introducing individual sav-
cost�benefit analysis workers and firms make about whether ings accounts to protect against the risk of unemployment,
to interact with formal institutions. This analysis incorpo- and/or, in countries with adequate administrative capaci-
rates the benefits of such interactions, the availability of ties, unemployment insurance schemes; establishing more
informal substitutes, and the weighing of any greater risk flexible rules concerning dismissals for economic reasons
exposure against the benefits of being independent and entre- and seasonal work; ensuring fair, transparent, and timely
preneurial. Hence, high labor taxes that do not correspond out-of-court mechanisms to resolve labor disputes, possibly
to benefits that workers value cause workers to opt out of the including neutral arbitration or mediation councils--all of
formal labor market. The difficulties of managing work and these actions would facilitate job creation and productivity
children also lead women to opt into informal independent growth. Minimum wages in most countries are not
work where there is more flexibility. As chapter 7 will show, extremely binding, but, in some and particularly in Colom-
the provision of substitutes through social security policies bia, they seem to be a brutally segmenting force that begs
untied to the labor contract may offer substitutes to formal for moderation. The problem of lack of flexibility to
protections that further encourage opting out. support child raising poses special challenges since gender-
Third, labor market institutions can have an important specific labor legislation (for example, restrictions of work
impact on productivity growth. Theory and anecdotal evi- hours and indiscriminate maternity benefits) may actually
dence suggest that excessive restrictions on job reallocation create incentives to discriminate against women, rationing
or destruction for just cause, or other related state- or union- them out of the formal market.
induced inflexibilities, may have a disincentive effect on Simply tightening the enforcement of existing laws
the adoption of new technologies and production processes. regarding, particularly, the largely informal microfirm sec-
Productivity gains arising from such innovations account tor may just eliminate jobs, many of which these chapters
for half of the differences in levels of economic develop- have shown to be of good quality measured by overall wel-
ment, the most important determinants of informality, not fare of the worker. At the other extreme, attempting to
to mention long-run worker productivity and welfare more reduce the weight of labor legislation by creating special
generally. Hence, the labor market and its institutions classes of less protective contracts can be problematic. On
must be viewed as a key part of the national innovation sys- the one hand, their strong incentive effects combined with
tem. These issues take on a heightened importance in the the weak enforcement capacities of labor ministries can, in
context of more open economies. While there appear to be essence, create a parallel, unregulated market for jobs that has
few long-run adverse impacts of trade liberalization on resulted in adverse effects, such as destruction/substitution
informality, reaping the benefits of greater integration will away from regulated contracts, higher job turnover, and
require greater attention than interactions between trade diminished incentives for training. Further, it may be the
and labor regulation. case that they contribute to the overall culture of informality
Overall, the present constellation of often well-intended (see chapter 8). On the other hand, the limited use of term
but heavy-handed labor regulations serves workers and contracts tied to special provisions (minimum required
firms poorly, and both could benefit from substantial training investments) to make high-rotation hiring less
reform. In particular, rigorous enforcement of a redesigned attractive can help young people, particularly, enter the
labor code that combined strengthened safety nets, well- market. Further, provisions to accommodate different non-
designed worker protections, and worker representation wage costs for smaller firms, and flexibility to allow for flex-
with the flexibility firms need to adapt in a global economy, ible benefits plans (such as simplified health care/pension
has the potential to expand formal employment and reduce plans) under mutual agreement between employers and
opting out. employees may allow an extension of the overall rubric of
The issues of social protection design are discussed in labor protections without prejudicing the viability of these
more detail in chapter 7, but here it is worth mentioning firms.
only a few pending reforms of labor protections more specif- In addition, however, the substandard education and
ically. Reducing severance payment to bring existing training systems in our region both impede the growth nec-
negative incentives for hiring closer to other regions, while essary to generate jobs in the more modern sector of the
126
T H E I N F O R M A L L A B O R M A R K E T I N M O T I O N : D Y N A M I C S , C Y C L E S , A N D T R E N D S
economy and reduce workers' attachment to it. Informality Finally, institutional strengthening (staffing, training,
sharply decreases with education, partly because the oppor- technical assistance) of the labor ministries and coordina-
tunity cost of being independent rises. Further, the poor sig- tion of relevant public agencies (social security administra-
naling of education quality due to lack of uniform tion, enterprise development agencies, competitiveness
certification or accreditation impedes the entry of young councils) are needed so that they can assume their impor-
workers into formal jobs. Remedying these failures, perhaps tant and increasingly more complex role of facilitating
with an expansion of intermediation services, may reduce labor productivity growth.
the information asymmetries that young workers face.
Further discussion of necessary reforms in this area is offered Notes
in the World Bank regional report "Improving Educational 1. The self-employed�to�formal (SE-F) and formal�to�self-
Quality in Latin America and the Caribbean" (2007). employed (F-SE) transition rates and informal-to-formal (I-F) and
Ongoing upgrading of the workforce through training, formal-to-informal (F-I) transition rates show correlations of 0.85
particularly in rapidly evolving industries, is a central ele- and 0.26, respectively. The same is emphatically not true in any case
between any of the sectors and unemployment that behave as they do
ment of the national innovation system, and critical to
in the United States.
developing skills used in the modern sector of the economy
2. Hall (2005) calls such inefficient separations "Keynesian."
and to productivity growth. Training, however, is not a 3. Finally, it can be argued that the pool of unemployed changes
substitute for good schools. Firms overwhelmingly choose its composition during downturns. This has been called the hetero-
to train skilled (secondary education or above) workers, and geneity hypothesis. Indeed, crises firing rates increase relative to
impacts of training programs on older, unskilled workers quits. If fired workers have a greater propensity to work in the infor-
mal sector, this could generate the patterns found in the job-finding
are very low. Incentives for worker training of youth
rates. This possibility is explored by Bosch and Maloney (2006) and
and older workers without prior experience or sufficient
the data strongly reject it. Workers with different educational levels,
skills--incentives such as tax treatment of investment in ages, or reasons to be unemployed show similar cyclical patterns of
human capital similar to that of capital investments, co- job-finding rates.
investments of workers, and post-training job matching of 4. Another mechanism is also possible. Firms may post vacancies
workers and firms--can ease their entry into the formal and decide whether to formalize the relationship, depending on the
quality of the match. A bad shock reduces the overall posting of
workforce. To capitalize on the efficacy of training, care
vacancies, but it also alters the optimal hiring level of specifically for-
should be taken to ensure homogeneous quality and effec-
mal workers. Lower overall gain from jobs increases the relative cost
tive delivery modalities. Optimal government intervention of signing formal contracts and, therefore, firms shift to a "cheaper"
in training systems may require separation of finance and way of producing. These two combined effects lower the job-finding
provision, with an unregulated private market and a public rate in the formal sector substantially. However, the job-finding rate
subsidy, and a possible new role for public training com- in the informal sector is determined by two opposing effects. On the
one hand, the rate is reduced due to the decrease in the number of
missions/regulators to certify private providers of training;
vacancies created; on the other hand, it is positively affected by
may necessitate the building of so-called lifelong learning/
change in the formality levels within the firm.
competency systems; and may demand subsidizing techni- 5. The mechanism may differ. Blau (1987), documenting this
cal assistance to small and medium-size enterprises for tendency across time in the United States, argued that this and simi-
developing human resource strategies. lar trends in the OECD were due to the increased opportunity cost of
There is also a role for promoting labor mobility and being self-employed. Maloney argues that given that surveys in the
United Kingdom, United States, and Germany (Blanchflower and
equal employment opportunities by making greater use of
Oswald 1998) suggest that roughly half of salaried workers would
labor market intermediation services. Particularly, for women,
prefer to be self-employed and not have a boss, this lower labor pro-
youth, and minorities, employment centers can provide job ductivity in developing countries may simply make this preference
search and employment placement assistance that could affordable. And, in fact, roughly 30 percent of entrants into informal
greatly enhance labor mobility, job matching, and labor self-employment in Mexico suggest that greater independence was
market equity, while better linking regional labor markets. their motivation. Alternatively, Loayza and Rigolini (2006) argue
that income is proxy for lower levels of education, rudimentary infra-
With the use of automated systems, these mechanisms have
structure, and laggard technology, although the precise mechanism is
become easier to implement and administer; and while sev-
not elaborated. Finally, Banerji and Jain (2006) argue that it may be
eral countries in the region are increasingly making use of preferences for higher-quality goods across the development process
them, they remain limited in scope and are underfunded. that reduce the market for informally produced goods.
127
I N F O R M A L I T Y
6. Following Goldberg and Pavcnik (2003), the first stage Aleman-Castilla, B. 2006. "The Effect of Trade Liberalization on
applies a linear probability model to regress the formal dummy indi- Informality, Wages, and Productivity: Evidence from Mexico."
cator on a vector of worker characteristics (gender, age, age2, and edu- Photocopy. Department of Economics, London School of Econom-
cation indicators) and on a set of industry indicators representing the ics and Political Science, UK.
workers' industry affiliations. The coefficients on industry indicators Almeida, R., and P. Carneiro. 2005. "Enforcement of Regulation,
can be considered "industry formality differentials" stripped of Informal Labor and Firm Performance." IZA Discussion Paper
worker characteristics that, in the second stage, are pooled over time 1759, Institute for the Study of Labor, Bonn, Germany.
and regressed on trade-related industry characteristics (tariffs and Arango, C., and A. Pach�n. 2004. "Minimum Wage in Colombia:
imports penetration), either in a fixed-effect or first differences speci- Holding the Middle with a Bite on the Poor." Borradores de
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7. Because of the nature of calculating the contribution of each Banerji, A., and S. Jain. 2006. "Quality Dualism." Photocopy. Depart-
factor from the regressions, the sum may not equal 100. ment of Economics, University of Virginia, Charlottesville.
8. A comprehensive survey of the literature studying the size and Beccaria, L., J. Carpio, and A. Orsatti. 1999. "Argentina: informal-
evolution of the Brazilian informal sector in the labor market can be idad laboral en el nuevo modelo econ�mico." In Informalidad y
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9. On the other hand, Cardenas and Gutierrez (1997) find much Economic Performance? Evidence from India." Quarterly Journal
smaller implicit elasticities of demand, and argue that the larger of Economics 119 (1): 91�134.
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131
CHAPTER 5
Microfirm Dynamics
and Informality
SUMMARY: This chapter describes the patterns of entry, survival, and growth in the self-employment sector of selected
Latin American countries. The chapter shows that those patterns match well the predictions of mainstream models of firm
dynamics. Entrants into self-employment tend to be found more frequently among workers who have accumulated human
and physical capital while working as salaried workers. Higher-productivity firms are more likely to stay in business and
create new jobs while becoming increasingly formal in the process. Few firms, however, tend to evolve along this ideal path,
with most of them remaining informal and owner-only. While to some extent this can be explained by the low opportunity
costs for entry into the sector, policy-induced barriers to formalization may also play a role by impeding microfirm access
to technologies and markets.
A S ARGUED EARLIER IN THIS REPORT, THE microenterprises, including the determinants of entry, exit,
owners and employees of very small, and growth of small firms.
mostly informal firms constitute a major After briefly reviewing some of the industrial country lit-
share of Latin America's labor force. Those erature on firm behavior, this chapter presents evidence on
workers thus play a very important role in the patterns of entry, exit, and growth of microenterprises in
the functioning of the region's labor markets, an issue that Latin America. We then explore the personal and enterprise
has been discussed at length in previous chapters. However, characteristics associated with microfirm formality. Insofar
a full understanding of the dynamics of the informal sector as our results regarding microfirm dynamics are consid-
also requires a complementary perspective that focuses on erably similar to those obtained for industrial countries, we
the firm rather than on the worker as a unit of analysis. argue that they support the idea that the informal microen-
Indeed, to the extent that entry and exit flows in the terprise sector is, to some extent, made up of voluntary
microenterprise sector are at least partially driven by volun- entrants who choose to be there, taking into account their
tary choices regarding forms of participation in the labor business prospects in the sector as well as the attributes of
market, they must also involve calculations related to the the jobs available in other segments of the labor market. We
expected profitability of running one's own business. Thus, interpret this as evidence that the mainstream view may
for example, to the extent that exit, not exclusion, is behind be well suited to understanding the developing country's
the decision of the many formal salaried workers who microenterprise sector. This approach is consistent with the
open new microfirms every year in Latin America, under- early work on Kenya by Hart (1972) and the mounting
standing their behavior may require treating them as evidence of entrepreneurial dynamism and relative job satis-
profit-maximizing entrepreneurs rather than disguised faction of self-employed individuals--see Bhattacharaya
unemployed workers queuing for formal jobs. In that (2002), de Soto (1989), and Maloney (1999, 2004).
respect, the size and evolution of the sector depend, at least Furthermore, we find evidence that formality increases
to some extent, on the factors that affect the dynamics of rapidly with firm size and productivity, and it is higher
133
I N F O R M A L I T Y
among those who voluntarily enter self-employment. Thus, growth in the microenterprise sector, as well as theoretical
some of the same attributes associated with entry and success frameworks to explain them. However, notwithstanding the
in self-employment are also correlated with compliance increasing importance given to the promotion of micro and
with government regulations. This suggests that formality small enterprises in development policy circles, there have
operates as a normal input into the production process, been few systematic attempts to see how their dynamics
with a minimal degree of participation in some institutions approximate those of the mainstream literature.1 This repre-
being a necessary input to growth, and participation sents a loss on two fronts. First, if it seems that behavioral
increasing with the success of the business. In most cases, differences are not so great, then development policy makers
however, the large majority of microfirms remain too small have a wealth of analytical frameworks at their disposal. Sec-
to make the benefits of formality overcome its various costs. ond, a finding of kinship with their advanced country coun-
This could be due to the presence of policy-induced barriers terparts would provide additional evidence on the debate
to formalization--for example, high registration costs, on how we should conceive of the role of the informal
stringent tax and labor market regulations, and other factors microfirm in the developing world.
reviewed in the next chapter--that would in turn limit the In the Organisation for Economic Co-operation and
growth of informal microfirms and contribute to a vicious Development (OECD), opening a business and being one's
continuing circle of low growth and high informality. boss is often celebrated as a desirable alternative to salaried
This chapter, however, makes the case for a complemen- work; however, in the developing world, the very large
tary interpretation of the evidence. In particular, given the unregulated (informal) microenterprise sectors are fre-
similarity between microfirm dynamics in developing and quently seen as the disadvantaged segment of a dual labor
industrial countries, we argue that the high rates of market in which workers queue for good jobs. The two
microfirm failure and the low rates of job creation and views have different implications for entry and firm dynam-
growth, which keep Latin American firms below the thresh- ics. In particular, rather than the patterns of entry/exit and
old over which formality becomes a necessity, could also be growth associated with entrepreneurship dynamics, the tra-
the result of the low levels of human capital and managerial ditional least developed countries (LDC) literature on infor-
ability found among many of the region's microentrepre- mality would predict patterns consistent with the dynamics
neurs. This, in turn, could be due to relatively low opportu- of disguised unemployment.
nity costs of entering self-employment, driven in turn by
low productivity and salaries in the formal sector. The prac- The mainstream view of firm dynamics
tical implication of this interpretation is that policy makers The dominant view of the role of self-employment in
interested in altering the incentives that drive the large industrial countries stresses the risk-taking, entrepreneur-
majority of Latin American microfirms into informality ial nature of the sector, with the celebrated Silicon Valley
should focus not only on the direct costs and benefits of for- high tech start-up at its apex. In the classic framework pro-
mality, but also on the factors that, by keeping formal sector posed by Lucas (1978), individuals are endowed with a
productivity low, indirectly increase the number and reduce given--and known--level of entrepreneurial or managerial
the average "quality"--in terms of their managerial ability ability, which determines the returns from self-employment.
and inherent business prospects--of new entrants into self- Lucas argued that there is a distribution of entrepreneurial
employment. In other words, the agenda for reducing ability in the population: those with a sufficiently high
microfirm informality should also cover the factors that drive level of proficiency become entrepreneurs, while the rest
productivity in the formal sector, encompassing improve- become wage workers. Among those individuals whose
ments in the investment climate and policies aimed at entrepreneurial ability leads them to choose self-employment,
increasing the quantity and quality of human capital. the more proficient have firms that are larger and/or more
successful. This means that the existence of many small
Conceptual framework: Firm dynamics firms does not necessarily imply failure of either labor or
and institutional development credit markets; it may also reflect the inherent distribution
In the industrial countries, the last two decades have seen of managerial ability in the population.
the emergence of a set of stylized facts about the personal This mainstream view of microentrepreneurship is sup-
and firm characteristics associated with entry, survival, and ported by evidence showing that, other things equal, some
134
M I C R O F I R M D Y N A M I C S A N D I N F O R M A L I T Y
individuals may derive a larger utility from entrepreneur- their costs, so it is very unlikely that new information will
ship than from wage work, thus reducing the net opportu- be unfavorable enough to induce them to exit. In addition,
nity cost of entering self-employment. Evidence of this has larger firms are those that found high levels of profits when
been provided by Blanchflower and Oswald (1998b), who they started, and hence grew. Thus, their efficiency level is
stress that 63 percent, 48 percent, and 49 percent of salaried further away from the exit-inducing threshold and they are
workers in the United States, the United Kingdom, and less likely to fail.2
Germany, respectively, report that they would prefer to be Empirical evidence favoring the prediction of a negative
self-employed, a fraction remarkably similar to the over link between time in business and size, on one hand, and
60 percent of Mexican entrants to self-employment who survival and growth on the other, was obtained for the
report doing so voluntarily (see Maloney 1999). Further- United States by Dunne, Roberts, and Samuelson (1988,
more, Blanchflower (2004) reiterates the robust finding 1989) and Evans (1987a, 1987b), for Germany by Wagner
that those who enter self-employment report higher levels (1994), for the United Kingdom by Geroski (1991), for 10
of job satisfaction than employees. Moreover, Hamilton OECD countries by Bartelsman, Scarpetta, and Schivardi
(2000) finds that nonpecuniary benefits--such as being (2003), and for 24 industrial and developing countries
one's own boss--explain the lower conditional earnings by Bartelsman, Haltiwanger, and Scarpetta (2004). In a
generally found in the sector. developing-country context, however, one could argue
Jovanovic (1982) added dynamics to Lucas's view by fur- that market and government failures associated with, for
ther assuming that managerial ability is uncertain, and that instance, credit rationing or inefficient contract enforce-
individuals can gradually learn about their true cost struc- ment mechanisms could limit the growth of small and
ture only by opening and operating a business. Thus, entre- newly created firms, which then would not exhibit the rel-
preneurs cannot know how good their location is, or how atively higher expansion rates of their industrial-country
good their managerial ability is, until they actually start the counterparts. In this scenario, surviving small firms would
business. Entry into self-employment involves a fixed cost, maintain abnormally high profits given their size and effi-
which only those with high expected ability and profits may ciency, a prediction that is consistent with the high rates of
be willing to pay. After entry, entrepreneurs incorporate the return estimated for small enterprises in the developing
information from their actual profits, revise their ability world (see McKenzie and Woodruff 2006, and the refer-
estimates, and adjust the level of profit-maximizing output ences therein). The next section presents direct evidence on
accordingly. Firms with consistently lower-than-expected the subject, aimed at exploring the similarities and differ-
profits tend to contract and eventually go out of business, ences in microfirms' patterns of survival and growth in
while unexpectedly high profits cause upward revisions of industrial and developing-country contexts.
ability estimates and lead to firm expansion.
The framework proposed by Jovanovic (1982) helps Determinants of entry into self-employment
explain why small firms are generally less "productive" or A model of industry dynamics that generates implications
"efficient." Firms that receive favorable cost information that are broadly similar to Jovanovic's, but is especially use-
tend to revise upward their optimal size estimates, and thus ful to analyze issues related to entry into self-employment,
to grow faster. Firms that remain very small are those that is the one proposed by Hopenhayn (1992). This model is
have received negative signals concerning their cost parame- especially notable for its analysis of the effect of the cost of
ters. They are less efficient and have relatively high produc- entry, which can be interpreted as the outside opportunity
tion costs, which lead them to stay small. This framework costs for some resources (for example, managerial ability)
also helps explain why small firms tend to die more often (see used by the firm. Higher costs of entry lead to a lower
Ericson and Pakes 1995; and Lippman and Rumelt 1982). turnover rate, because more ex ante selection occurs. This
Indeed, there is a threshold level of efficiency below could be particularly relevant in developing-country con-
which it is not profitable to stay in business. Small young texts characterized by higher levels of informality and
firms are more likely to cross that threshold when negative lower productivity in the salaried sector, which in Hopen-
shocks suggest that in reality their efficiency is below what hayn's model would lead to a lower entrepreneurial ability
they had expected. On the other hand, firms that have been threshold for entering self-employment and thus to higher
in business for a long time will have an accurate estimate of entry--and exit--rates.
135
I N F O R M A L I T Y
In regard to the personal characteristics likely to be asso- prone to move into self-employment. However, in the pres-
ciated with entry into self-employment, Johnson (1978) ence of credit constraints, workers earning higher wages in
and Jovanovic (1979) postulate that since young people are the salaried sector may also be able to accumulate capital
less risk-averse, they would be overrepresented among faster and hence be more likely to enter self-employment.
entrants. A similar prediction would emanate from the Moreover, there may be a correlation between previous
standard queuing view of LDC labor markets, with young productivity in the salaried sector, remuneration, and
people being more likely to be rationed out. Empirical evi- entrepreneurial ability--or at least competence in the
dence for the United States, however, suggests the reverse chosen field of entrepreneurship. To the degree that this
pattern, with entry increasing with age. As an explanation, would imply a higher probability of success in self-
Evans and Jovanovic (1989) offer a variation of Lucas's employment, we may expect those with conditionally
model where binding liquidity constraints may lead indi- higher earnings in the formal sector to enter self-
viduals to delay or forgo profitable business opportunities, employment while those less skilled may choose not to
reducing entry rates and increasing exit rates among those take the risks.
with low personal assets, including the young. Further- In sum, the impact of personal characteristics of existing
more, they argue that since credit-constrained individuals and would-be entrepreneurs could be potentially different
are more likely to start small businesses with a suboptimal in developing-country contexts, at least in the hypothesis
amount of capital, returns to capital will be higher and that self-employment in LDCs is driven by the presence of
smaller firms (with lower capital stocks) will grow faster dualistic labor markets. Indeed, in this case unemployed
than firms that entered closer to their steady state. individuals, those out of the labor force, young workers, and
Evans and Jovanovic's model of credit constraints to vol- those with lesser schooling and lower wages should all be
untary entry is largely inconsistent with the dualistic view more likely to be self-employed, as they would be in a worse
of self-employment as an easy entry holding pattern in sev- position for finding formal salaried jobs. In contrast, the
eral ways. Indeed, both the dualistic view of informal labor mainstream literature suggests that older, better-educated,
markets and the advanced country sociological literature and well-paid workers with experience in the salaried sector
that sees the numerous self-employed among certain ethnic should have a higher probability of entering, staying, and
minorities as recruited from "misfits"--individuals who growing in the self-employment sector as they should be
lack access to salaried employment due to, for instance, lan- more likely to have accumulated the assets required to start
guage barriers, a history of unemployment, or limited labor a business, and better positioned to find, assess, and take
market experience (see Carrasco 1999; Evans and Leighton advantage of good business opportunities.
1989; and the references therein)--would predict lower Finally, two additional covariates appear in the main-
entry rates into self-employment coming from salaried stream literature but so far yield ambiguous predictions
work than from unemployment or from out of the labor (see box 5.1 for a summary of empirical findings in indus-
market. However, the opposite prediction could be derived trial country contexts). First, we might imagine that workers
from the Evans and Jovanovic's view if individuals acquire with more schooling would find better matches as salaried
more capital and knowledge of business opportunities-- workers in larger firms that could better utilize their
and to some extent their own managerial ability--while specialized skills. On the other hand, Cressy (1996) and
working than while unemployed or out of the labor mar- Rees and Shah (1986) argue that more educated individuals
ket. In particular, if formal schooling is relatively poor and can have lower costs of assessing business opportunities,
most relative human capital is accumulated on the job, and that human capital may be a complement to manager-
then we may find that salaried employment is a logical ial ability. This is suggested by Bates (1990), who shows
stepping stone to self-employment. that in the United States, the probability of survival of
Moreover, the impact of the level of remuneration small businesses is positively related to the level of educa-
earned in these previous jobs also offers some insights that tion of their owners. Second, Carrasco (1999) argues that
may help distinguish between mainstream and dualistic men who are married could be less willing to take risks. On
models. All things equal, we might expect that those the other hand, the Mexican sociologist Gonz�lez de la
earning higher wages in salaried work would be less likely Rocha (1994) suggests that the possibility of combining
to be "misfits," or unsuited to formal work, and hence less the self-employment earnings of the household head or
136
M I C R O F I R M D Y N A M I C S A N D I N F O R M A L I T Y
BOX 5.1
Patterns of entry and exit in industrialized countries
Self-employment and age Unemployment and entry into self-employment
Evans and Leighton (1989) find that, for U.S. men, entry Carrasco (1999) finds that in Spain, for given personal
into self-employment increases only slightly after the late characteristics, the predicted probability of entering self-
20s, exit falls at a decreasing rate with age, and the self- employment is lower for wage workers than for unem-
employment rate reaches a plateau when individuals are ployed individuals. However, the latter become less
in their 40s. For Spain, Carrasco (1999) finds that entry likely to switch either when they receive unemployment
rates are highest for middle-age people, especially for benefits or when aggregate business conditions are unfa-
those aged 35�45. In the United States, Bates (1990) vorable. In the United States, Evans and Leighton (1989)
finds that rates of exit from self-employment are lowest find that U.S. men who changed jobs frequently, and who
for owners of small businesses aged 45�54. Holtz-Eakin, experienced relatively frequent and long spells of unem-
Joulfaian, and Rosen (1994a) find that exit rates reach ployment, have a higher probability of entering self-
their minimum at the age of 47. In addition, for each of employment.
the 18 industrial countries considered by Blanchflower
and Oswald (1998b), a robust positive relationship Self-employment and liquidity constraints
emerges between age and the probability of being Evans and Leighton (1989), Evans and Jovanovic (1989),
self-employed. and Carrasco (1999) find that higher net worth increases
Self-employment and education the probability of entering self-employment. Evans and
Bates (1990) finds that in the United States the proba- Jovanovic (1989) also find that initial assets before enter-
bility of survival of small businesses rises with educa- ing self-employment are positively related to earnings, at
tion. In Spain, entry into the sector also rises with least during the initial years in the sector--as firms grow,
education, as found by Carrasco (1999), particularly for the importance of the initial liquidity constraint dimin-
those who become self-employed with employees. In ishes. Holtz-Eakin, Joulfaian, and Rosen (1994a, 1994b)
other industrial countries, Blanchflower (2000) finds find that liquid assets and inheritances increase the
that self-employment rates are usually highest for indi- likelihood of entry into self-employment, reduce the
viduals with a small number of years of schooling--the probability of exit, and increase the earnings of surviving
United Kingdom being the only exception, with the businesses. Blanchflower and Oswald (1998b) provide
reverse being the case--followed by those with college similar evidence for the United Kingdom; by relaxing
education. liquidity constraints, previous inheritances increase the
probability of being self-employed. As additional evidence
Profitability and exit from self-employment
they report survey data that reveal that most small busi-
Holtz-Eakin, Joulfaian, and Rosen (1994a) use net income
nesses are started not with bank loans but with one's own
as a proxy for entrepreneurial ability and other relevant
or family money, and that shortages of capital are the
factors, such as education, time in business, and gender,
most common reason for not entering self-employment.
not available in their data set. They find that net income
Bates (1990) finds that small businesses that were able to
has a negative effect on the probability of exiting self-
secure loans at the time of getting started are more likely
employment.
to survive.
Previous wages and entry into self-employment Both exit rates and employment growth rates of manu-
Evans and Leighton (1989) find that higher previous facturing firms decrease with size and time in business.
wages lower the likelihood of entering self-employment. Evans (1987a, 1987b) and Dunne, Roberts, and Samuelson
However, the statistical significance of that variable is (1988, 1989) find that size and time in business are both
reduced considerably when individuals' labor market related negatively to the exit and growth rate of U.S. man-
characteristics are controlled for. ufacturing plants.
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I N F O R M A L I T Y
his/her spouse with the salaries of other family members although often overlooked, are numerous and become more
could reduce overall household income risk. important as firms get larger. Consider a select few (and see
de Soto 1989; and chapter 6 of this volume):
Determinants for small firm informality
The high levels of informality found among microenter- � Enforceable/impersonal contracts and credible signaling. All
prises in developing economies can be interpreted as result- entrepreneurs have access to social relationships to
ing from profit-maximizing decisions by private firms subject enforce implicit contracts among their friends and
to environmental constraints that increase the costs or reduce family, who form a small number of their potential
the benefits of formality--for example, high costs of firm or customers and employees. Participation in the legal
property registration, or market and government failures in system is needlessly expensive for transactions with
credit markets, and contract enforcement mechanisms. A these individuals. But this mode of operation is
vicious cycle would be at work, by which barriers to small constrained by the ability of the entrepreneur to
firms' participation in formal market support institutions maintain personal relations with all involved parties,
would limit firm growth, which in turn would help main- a task increasingly unmanageable as firms expand.
tain those institutions out of the reach of most small firms. Legally recognized, enforceable contracts lend credi-
However, a somewhat nuanced alternative view is that bility to arrangements, permit entry into long-term
small firms in developing countries have an inherently lim- commitments, diminish risk, and can reduce moni-
ited demand for those formal services, due to their low pro- toring costs. Larger investments require that prop-
ductivity levels and limited growth prospects. In this erty rights be secured through the legal system.
context, a firm's choices regarding the use of formal or � Access to capital. Informal capital markets (Besley
informal arrangements would depend on the stage of the 1995) may be sufficient to fulfill the firm's external
firm's life cycle. financing needs at low levels of production. However,
This view is related to the burgeoning literature on the small scale and undiversified nature of informal
social capital and informal networks, which has highlighted capital markets make them unsuitable for satisfying
that absence of participation in state-organized or formal the firm's financing needs at larger scales of opera-
market institutions does not imply that agents do not tion; growing firms will turn to formal financial
acquire similar services through less formal means and, to a intermediaries such as banks. This, of course, implies
lesser degree, that informal alternatives are necessarily infe- costs in terms of better record keeping, and transac-
rior to formal ones. In this report, we argue that the calcu- tions costs more generally.
lations involved in participation decisions apply to all � Access to public risk pooling mechanisms. Demand for risk
institutions, both informal and formal. We thus recast the pooling mechanisms can be expected to increase with
question of formality as the firm's decision of how much to firm size. Arnott and Stiglitz (1991) show that where
participate in the numerous institutions of civil society: "peer monitoring" generates more information than
civic organizations, trade organizations, federal and local that available to market insurers, it is an important
treasuries, governmental programs such as social security mechanism in reducing moral hazard and makes non-
(including pensions and health care), the legal system, the market (informal) insurance provided by friends or
banking system, insurance institutions, health inspections, communities an important complement to market
firm censuses, and so on. We argue that a minimal degree insurance. Small firms with relatively little capital
of participation in some institutions is a necessary input to may insure against small losses within the family or
growth for many firms, and that participation increases community rather than pay the premium associated
with the success of the business; it is a normal input into with monitoring pooling across larger groups. As a
the production process (see Levenson and Maloney 1998). firm grows, we may imagine that both the magni-
Firms derive multiple benefits from formality. We can tude of potential losses and the decreasing ability to
view being "formal" as lying at the end of a continuum of peer monitor may lead to increased demand for for-
possibilities of participation beginning at the household mal market insurance.
and extending through communities and networks to the � Access to business information. As a firm grows beyond
formal institutions of the state. The benefits of formality, local customers and suppliers, it may also require
138
M I C R O F I R M D Y N A M I C S A N D I N F O R M A L I T Y
more information and business contacts to continue general public and other firms should increase, leading to
growing. We may, therefore, expect more participa- greater benefits from formality.
tion in business associations, among other changes. A natural corollary is that "inefficient" firms are dispropor-
We can also consider inscription in training pro- tionately informal. However, in contrast to other formulations,
grams and the use of other business development ser- in this case the causality is not necessarily from informality to
vices as formal channels for information gathering. inefficiency: high-cost firms choose less formality because they
benefit less from it than more efficient firms that produce at
Even though formality also has multiple costs--for higher volumes for longer lengths of time. Similarly, young
example, reporting requirements and fiscal obligations--as firms are disproportionately informal. This is partly because young
firms grow, the relative benefits of formality may eventu- firms are more likely to be small. Moreover, conditional on
ally exceed the corresponding costs. De Soto claims that size, the population of young firms contains a disproportionate
Peruvian sidewalk vendors sought, not to avoid, but to pay number that have not received enough signals to figure out
taxes as a way to establish property rights over their precar- whether paying the costs of formality are worthwhile; many
ious business locations. In reality, although the direct eventually will go out of business.
private benefit from paying taxes may be zero (again, Another implication is that the relatively high mortality
assuming no enforcement penalties), there may be ancillary rates found among informal firms are not necessarily evi-
benefits that make compliance worthwhile. dence of the inferiority of informal employment, and could
rather reflect the fact that those firms are predominantly
Implications for microfirm dynamics "young" and small which, even in an undistorted industrial-
and informality country context, would lead to observed high turnover
The combination of the above very stylized concept of par- rates. As more efficient firms grow to their equilibrium
ticipation in formal institutions and the insights from size, however, both mortality and informality rates would
mainstream models of firm dynamics yields a number of naturally decline.
implications. First, it is reasonable to expect considerable In sum, combining the insights from the firm dynamics
heterogeneity in the degree of formality. The benefits and costs of literature with those derived from the literature on institu-
participation undoubtedly vary across societal institutions, tional development provides a new possible interpretation
and vary for firms of a different size and age. While there of the stylized facts on microenterprises and informality.
are potential complementarities between different societal Because they have not assembled enough information on
institutions, a large number of firms will choose to partici- their true efficiency, young firms tend to be small and to
pate in only a subset of institutions at any point in time. have high failure rates. On the other hand, formality is not
For example, the legal system and bank financing are com- an all-or-nothing decision, but rather an option in a con-
plements, but a firm may have to register legally before tinuum of participation possibilities. For young and small
seeking external financing. Thus, informality is not an all- firms, the benefits outweigh the costs of participation in
or-nothing state, and the degree of formality varies by firm. formal societal institutions. But as more efficient firms sur-
A second implication is that small firms are dispropor- vive and grow, their needs for enforceable contracts, formal
tionately informal. Small firms benefit least from partici- credit markets, and access to public risk-pooling mecha-
pation because of the small scope of their dealings with nisms increase, and so does their degree of formality or
the public and hired employees (relative to the total vol- depth of participation in societal institutions.
ume of transactions undertaken by the firm). Indeed, Young and small firms do tend to have higher costs and
firms of different sizes may have different degrees of high failure rates and, at the same time, they are more likely
interaction with the public. Because implicit contracts to be informal. Although this description corresponds
over product quality are cheaper and feasible to enforce exactly to the standard picture of the stagnant, precarious,
with friends and family, the entrepreneur may find it unprotected informal self-employment sector familiar in the
most cost-effective to primarily serve such customers literature, it is, in fact, the opposite. It emerges naturally
when faced with small sales volumes. At larger volumes from workers trying their luck at entrepreneurship (risk
(later in the firm's life cycle), friends and family cannot taking), often failing, and not engaging in the formal insti-
necessarily buy all the firm's output, so sales to the tutions until they grow. In sum, there may be nothing
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I N F O R M A L I T Y
TABLE 5.1
Entry probabilities into Mexico's self-employment sector (percent)
Initial/final status Own account 1�4 workers 5�9 workers 10 or more workers Total entrepreneurs
Salaried 4.2 1.7 0.2 0.2 6.2
Contract 9.0 3.1 0.1 0.1 12.4
Salaried + contract 4.7 1.8 0.2 0.2 6.9
Unemployment 9.3 1.5 0.1 0.1 11.0
Other work 4.6 3.4 0.2 0.1 8.3
Out of labor force 2.6 0.8 0 0 3.5
Source: Author's calculations, using data on males from the Encuesta Nacional de Empleo Urbano 1998�2001.
pathological about the informal microfirm sector, and its they were either "employers" ("patrones") or "own-account
existence may be largely unrelated to questions of labor workers" ("trabajador por su cuenta"). This is similar to the
market dualism or even credit market distortions. standard definition used in the U.S. self-employment liter-
ature. Evans and Leighton (1989), for instance, define as
Microfirm dynamics in Latin America self-employed all sole proprietors, partners, and sole owners
Collecting evidence on the entry, exit, and growth dynam- of incorporated businesses.
ics of Latin American and the Caribbean microfirms is of
interest for at least three reasons. First, we would like to Patterns of entry
know if microfirm dynamics in the Latin America and Taking the United States as a benchmark, the rates of entry
Caribbean (LAC) region are similar to those in the indus- into self-employment in Mexico are of very similar orders
trial countries. Second, the very high mortality rates of magnitude, with a slightly higher fraction of Mexican
among LDC firms contribute to the perception of the sector wage workers becoming entrepreneurs: 6.2 percent com-
as "precarious." If in fact the failure rates are similar to pared to 4 percent per year found by Evans and Leighton
those found elsewhere, it is difficult to make the case that (1989).5 Table 5.1 presents the probabilities of becoming
we are dealing with unusually high rates of risk. Third, the an enterprise owner for Mexican males previously
demographic characteristics associated with entry and exit employed in other segments of the labor market or located
provide useful information about the role the sector is play- outside of the labor force. Rows represent individuals' ini-
ing and the constraints facing it. tial labor market positions, and columns represent labor
Studying the patterns of entry, survival, and growth market statuses a year later. Each cell shows the percentage
in the microenterprise sector requires the use of panel data of individuals who start in a given row-category and end in
that allow following the same individuals and firms over the corresponding column-category.
time. This creates a severe constraint, as most longitudinal New entrants into self-employment are more likely to
industrial surveys exclude small and informal firms. For start their businesses without any employees. Table 5.1
that reason, this section focuses on only a few countries for shows that about two-thirds of the salaried workers
which we were able to obtain appropriate data. Our main who transit into self-employment each year--4.2 out of
focus is on Mexico, using combined data from employment 6.2 percent--do so without hiring any workers, which is
and microenterprise surveys.3 Some of the analysis is repli- consistent with the mainstream firm dynamics literature
cated using a longitudinal household survey for Nicaragua. view of new entrepreneurs "testing the waters" before mak-
Finally, we present evidence on the job creation potential ing significant investment decisions. Table 5.1 also shows
of firms of different sizes using the Colombian industrial that individuals who are outside the labor force have a lower
survey, for a period during which its coverage included probability of entering self-employment--3.5 percent--and
micro- and small firms.4 In what follows, we define the self- that those coming from contract work or unemployment
employed category as including all individuals whose main have higher probabilities of entering the sector--respec-
job consists in working in their own businesses--for exam- tively, 12.4 and 11 percent. In all these cases, however, three
ple, those individuals who report that in their main job out of four new entrants start without hiring any employees.
140
M I C R O F I R M D Y N A M I C S A N D I N F O R M A L I T Y
FIGURE 5.1
Entry and exit into self-employment among men
Mexico United States
Percent Percent
60 60
50 50
40 40
30 30
20 20
10 10
0 0
5 5
�6 �6
18�20 21�25 26�30 31�35 36�40 41�45 46�50 51�55 56�60 61 18�20 21�25 26�30 31�35 36�40 41�45 46�50 51�55 56�60 61
Age Age
Entry rate Exit rate Self-employment rate
Sources: Evans and Leighton 1989; author's calculations, using Encuesta Nacional de Empleo Urbano.
There are also striking similarities in age patterns of self- cases of Mexico and Nicaragua.7 Like men, Mexican
employment between Mexico and Nicaragua, on one hand, women's entry rates rise until the early 40s and begin to
and the United States on the other. The left and right panels decline after the age of 50. Their exit rates are much higher
of figure 5.1 show the fraction of the male labor force in self- and decline at a slower rate until the late 30s, stabilizing at
employment by age group, respectively, for Mexico and the around 50 percent (for yearly transitions). The overall rate
United States. The figure also exhibits the rates of entry into of self-employment is thus much smaller than that of
that sector from salaried work and the rates of exit from self- men, although it also peaks at the age of 50. However,
employment, also by age group. The self-employment rate among working individuals, the share of self-employed
(calculated as a fraction of the labor force) is higher in women increases monotonically with age at an even steeper
Mexico for every age group by at least a factor of two. Note, pace than that of men; it evolves from less than 5 percent
however, that the overall age patterns of self-employment in the early 20s (10 percent in Nicaragua) to more than
rates as well as those of entry and exit are strikingly similar 50 percent after the age of 55 (70 percent in Nicaragua).
in the two countries.6 Econometric examination of the effect of individual
Both in Mexico and the United States, exit rates demographic and labor market characteristics on the proba-
decrease while entry rates slowly increase with age. As a bility of entering self-employment among Mexican males
result, the percentage of individuals who are self-employed confirms the age patterns illustrated in the figures above.8
increases with age at a decreasing rate, peaking at the late Thus, keeping other personal characteristics constant, and
40s. As a foreshadowing of the more detailed analyses comparing with individuals aged 15 to 20 (for which the
below, the common upward and downward sloping rela- rate of entry into self-employment is 2.4 percent), the prob-
tionships of age with the rates of, respectively, entry and ability of entering self-employment is 5.7 percentage points
exit are consistent with the view that older entrepreneurs higher for those aged 21 to 35, and 9 percentage
get a more precise view of their underlying entrepreneurial points higher for those in the 36�50 age bracket. These
capacity and hence are more likely to enter and less likely results are not consistent with the view of the sector as a
to fail than younger individuals. point of entry into the Mexican labor market, but they are
Women exhibit similar patterns of entry and exit into very consistent with the U.S. data. They also provide sup-
self-employment, which is illustrated in figure 5.2 for the port to Evans and Jovanovic's (1989) liquidity constraints
141
I N F O R M A L I T Y
FIGURE 5.2
Entry and exit into self-employment among women
Mexico Nicaragua
Percent Percent
80 80
70 70
60 60
50 50
40 40
30 30
20 20
10 10
0 0
50 55
18�20 21�25 26�30 31�35 36�40 41�45 46� 51� 56�60 61�65 12�20 21�30 31�40 41�50 50�65
Age Age
Entry rate Exit rate SE ALL SE SE SAL
Source: Author's calculations, using Encuesta Nacional de Empleo Urbano and Nicaragua's Living Standards Measurement Study.
hypothesis, and the view that older workers have a more self-employment, and that probability increases by about
precise measure of their underlying entrepreneurial capacity. 25 percent for their married counterparts. Moreover, when
Educational attainment, on the other hand, has a negative the estimation is performed conditioning on individuals
albeit quantitatively small effect on the probability of enter- changing their labor market status, the effect of marriage is
ing self-employment. However, when we focus only on about four times larger.
workers entering self-employment from salaried work and/or The importance of conditioning on changes in labor
when we estimate the effect of education conditioning on market positions becomes clearest in looking at the impact
individuals' changing labor market status, the negative rela- of initial employment and labor force participation status.
tionship between education and entry into self-employment The unconditional results suggest that those out of the
levels off and breaks up at higher levels of schooling, sug- labor force and not studying and those unemployed are
gesting that college graduates (that is, doctors, consultants, more likely to enter self-employment, consistent with tra-
and so on) may find the sector attractive. Moreover, when we ditional dualistic views of the sector as disguised unem-
restrict the definition of self-employment to include only ployment. However, all of the above segments of the labor
those business owners who employ at least one worker, we market are characterized by very high rates of turnover, so
find that both secondary schooling and tertiary schooling are the corresponding workers may well be more likely to
positively linked to entry into self-employment. This result move to all sectors at disproportionately high rates. When
is broadly consistent with Carrasco (1999), Evans and we condition on changing labor market status, we find that
Leighton (1989), and Rees and Shah (1986) who found that those in formal salaried employment are more likely than
entry rises monotonically with education. most other groups to enter informal self-employment.
Also consistent with Rees and Shah (1986) and Carrasco Among the unemployed, however, those workers with
(1999) is the finding that being married is positively asso- longer unemployment spells--especially those who have
ciated with entry, which may reflect either that the sector is been unemployed for between four and six months--have
not riskier than other alternatives available in the labor higher conditional and unconditional probabilities of enter-
market (that is, salaried employment) or that, in fact, being ing self-employment through opening owner-only busi-
married helps diversify risk. Quantitatively, unmarried nesses. This suggests that even if the sector does not
individuals have a 4.5 percent probability of entry into function predominantly as a holding pattern for misfits or
142
M I C R O F I R M D Y N A M I C S A N D I N F O R M A L I T Y
those rationed out of salaried work, it does offer income explanation is that the sector offers more opportunities for
opportunities for the long-term unemployed. very small firms, as it comprises mostly individual con-
As for the links between entry into self-employment and tractors operating without any employees; in the U.S.
the previous job characteristics reported by salaried workers, construction sector, for instance, owner-only businesses
we find that those employed in firms with at most represented 75 percent of all firms, while those with
10 employees have a much higher probability of entry into 20-plus workers were just 2 percent, compared to, respec-
self-employment than those coming from larger firms: tively, 49 and 13 percent in the manufacturing sector. As
12.8 percent compared to about 9 percent for those in firms argued by Tybout (2000) and further discussed in the
with 11 to 250 workers, and 5 percent for those coming next chapter, small firms tend to locate in industries
from firms with more than 250 employees. This may be where they have smaller cost disadvantages with respect
due to the higher nonpecuniary benefits (such as social to larger incumbents, and which are characterized by
security) and job stability offered by larger firms. lower levels of capital and skilled-labor intensity.
For a given firm size, on the other hand, higher prior
wages also increase the probability of entry into self-
employment. While we cannot tell whether this is the Patterns of survival and exit
effect of a relaxation of liquidity constraints or if it reflects As shown in table 5.2, during any given year about 15 per-
entrepreneurial ability, the fact that overperformers in the cent of the Mexican self-employed move to salaried work--
salaried sector are more likely to enter self-employment is and the same number of individuals migrate to other labor
at odds with the predictions of both the dualistic approach market positions, namely, to contract work (6.2 percent)
and the sociological view of that sector as a preferred desti- and out of the labor force (5.7 percent). The probability of
nation for "misfits." leaving self-employment is higher for those who do not
As for the effect of the sectors of economic activity in have employees: 35 percent compared to slightly less than
which individuals have been previously engaged, we find 25 percent for those who own larger firms. Moreover,
that at least in Mexico, entry into self-employment is among those leaving self-employment, the probability of
most likely for those who hold jobs in the construction switching to salaried work is lower for those who own
sector and it is least likely for those employed in smaller firms, when compared with owners of larger firms
manufacturing. Thus, while a salaried worker in manufac- who are less likely to switch to contract work or out of the
turing has a 4.3 percent probability of entering self- labor force.
employment, the corresponding probability for a salaried Econometric estimates of the determinants of firm sur-
construction worker with similar personal characteristics vival using data on Mexican microfirms confirm the age
is 11.8 percent. The higher rate of entry into self-employ- patterns depicted in figures 5.1 and 5.2, with the probabil-
ment coming from salaried work in the construction ity of staying in business increasing with age until the
sector persists even when one controls for the fact that 36�50 age bracket. Thus, while the average self-employed
this sector also has higher turnover rates--workers there individual aged 15�20 has only a 33.3 percent probability
are more likely to change labor market status. One possible of staying in self-employment, individuals with similar
TABLE 5.2
Exit probabilities from Mexico's self-employment sector (percent)
Remain Salaried Other Out of
Initial/final status entrepreneur Salaried Contract contract Unemployed work labor force Total
Own account 65.0 17.0 7.4 24.5 1.5 1.9 7.2 100
1�4 workers 76.6 11.7 5.0 16.7 0.8 2.0 3.9 100
4�9 workers 78.6 13.5 3.2 16.8 0.6 1.3 2.7 100
10 or more workers 78.3 15.2 2.3 17.5 0.3 1.2 2.7 100
Total entrepreneurs 69.9 15.0 6.3 21.3 1.2 1.9 5.7 100
Source: Author's calculations, using data on males from the Encuesta Nacional de Empleo Urbano 1987�2001.
143
I N F O R M A L I T Y
personal characteristics in the 21�35 and 36�50 age brack- a 4.3 percentage point increase in its likelihood of survival,
ets have probabilities of survival in self-employment of, while a tripling of its capital stock is related to a 1.4 per-
respectively, 52 and 60.5 percent. centage point increase in that probability. Despite the
Education has a negative impact on the probability of small magnitude of the effects, these results are consistent
staying in self-employment, suggesting that the "pull" effect both with Jovanovic's "noisy selection" view and with the
of better employment alternatives for more educated indi- bulk of the mainstream empirical evidence that firms get a
viduals tends to dominate over the "push" effect associated more precise estimate of their cost structures with experi-
with lower probabilities of business failure observed in the ence, and past measures of success are informative for the
United States among more educated entrepreneurs. How- future evolution of the firm.
ever, the effect is quantitatively small--a reduction of
about 2 percentage points in the survival probability for Do microfirms grow?
individuals with secondary or tertiary schooling--and it All the available evidence points to the fact that microfirms
becomes positive and significant when the sample is create relatively more jobs, but destroy even more. This is
restricted to firms with at least one worker. In other words, illustrated by figure 5.3, which shows rates of job creation
when the focus is on larger firms, the evidence for Mexico and destruction among Colombian manufacturing plants
confirms that for the United States, with schooling and firm calculated for different employment size categories--the
survival exhibiting a positive correlation. rates are calculated as a percentage of employment in the
Consistent with the various mainstream models of firm respective size category. Firms with fewer than 20 employees
dynamics reviewed above, we find that higher conditional have the highest rates of job creation, but their job destruc-
wages of business owners--which we interpret as reflecting tion rates are proportionally even higher, causing net job
higher profitability due to unobserved characteristics-- creation rates to be the lowest of any size category. As firm
tend to increase the probability of staying in business. size increases, both job creation and destruction tend to
Thus, a doubling of the net earnings from self-employment diminish, but the latter at a larger rate, causing net job cre-
is associated with a 4.2 percentage point increase in the ation to be higher among larger firms. This is consistent
probability of staying in that sector. The effect is quantita- with the findings for the United States, where smaller man-
tively larger when the sample is restricted to businesses ufacturing firms and plants exhibit very high gross job cre-
with at least one employee besides the owner, for which a ation rates, but not higher net job creation rates (Davis,
doubling of self-employment earnings is related to an Haltiwanger, and Schuh 1996).
8.8 percentage point increase in the probability of main-
taining that initial status.
FIGURE 5.3
We also find that survival in self-employment is between Job creation and destruction in Colombia, 1977�82
5 and 8 percentage points higher for married individuals--
% of employment
possibly because they can count on unpaid family workers--
0.3
and about 6 percentage points lower for individuals with a
0.2
second job. Moreover, workers in the construction sector
0.1
have a probability of staying in self-employment that is
between 10 and 15 percentage points lower than for those 0
engaged in agriculture, manufacturing, and services, while 0.1
those engaged in commercial activities have a 5.5 percentage 0.2
point higher survival probability than their peers in the
0.3
above three sectors. The fact that once again the construction
0.4
sector emerges as a more likely source of workers who switch 0 20 50 100 250 Total
sectors could be due to its inherent high rate of firm turnover. Number of employees
As for the effects of firm size and age on survival in self-
Job creation Job destruction Net
employment, we find that they are significant although
quantitatively small. In particular, a doubling of the time Source: Author's calculations, using the Colombian
Manufacturing Survey.
that a microfirm has been in business is associated with
144
M I C R O F I R M D Y N A M I C S A N D I N F O R M A L I T Y
Data on the evolution of Mexican microfirms over a
FIGURE 5.4
12-month period suggest a broadly similar profile (table 5.3).
Job creation and destruction by entering and exiting versus
continuing firms in Colombia, 1977�82 Over 12 percent of owner-only firms expand to one to four
employees across one-year periods. However, 22.1 percent
0.20
of those between one and four employees contract again to
0.15
be owner-only. Thus, in absolute numbers, there are slightly
0.10
less firms that contract from one to four employees than
0.05
firms that expand into that range. Moreover, over a one-
0
year period, only 5.4 percent of the firms with one to four
0.05
employees do actually expand; 49.2 percent stay in the
0.10
same size range and 45.5 percent contract to owner-only or
0.15
go out of business, with the employer moving into wage
0.20
work or unemployment, or leaving the labor force.
0 20 50 100 250 Total
Number of employees Given the low rates of employment growth observed
among microfirms, it is not surprising that the vast major-
Job creation Job destruction Net
ity of them will reach their steady state at a very small size.
Source: Author's calculations, using the Colombian Thus, among Mexican and Nicaraguan microfirms with at
Manufacturing Survey. least three years of time in business and at most 15 workers,
64 percent have no employees, 21 percent have only one,
and between 8 and 9 percent have just two workers (fig-
Gross and net job creation rates by entering Colombian ure 5.6). In other words, in those two cases, 93 percent of
firms are higher than for continuing firms (figure 5.4). As a microfirms do not grow beyond two employees. In fact, the
share of the size category, roughly four times as many jobs large majority of microenterprises are owner-only. In Brazil
are created by entering firms as by those already existing. and Mexico, for example, respectively, 87 and 80 percent of
Job destruction by exiting firms is roughly equal to that by all microenterprises with fewer than five workers have no
continuing firms, so that net job creation by entering and paid employees. Moreover, as illustrated in table 5.4, in
exiting firms is positive, while it is negative among contin- Argentina, Brazil, and Mexico owner-only firms represent
uing firms. Thus, although entering firms more than com- roughly 58�68 percent of all firms. These proportions are
pensate for the jobs destroyed by the plants that fail, the smaller than those found in the United States and the
Colombian data suggest that the low rate of expansion of United Kingdom, where, respectively, 71.6 and 80 percent
smaller continuing firms leads them to provide a negative of all firms have no employees. It is worth noting that the
net contribution to employment growth. lower fraction of firms without employees found for LAC is
Most of the net job creation among microfirms is from not inconsistent with the fact that, as reported in previous
zero to one employee. In the case of Nicaragua, for instance, chapters, those countries exhibit higher rates of self-
looking at firms with at most three employees (plus owner) employment. Indeed, the latter are calculated as a propor-
in 1998, we find that for those that were still in business by tion of the labor force, while the figures reported in
2001, employment grew by an average of about 20 percent. table 5.4 are based on the size distribution of the number of
For those with two and three employees, the losses actually firms--not employment.
exceeded the gains, so all the above growth came from Among firms with at least one employee, however, the
firms with at most one employee (figure 5.5). In fact, most fraction of microenterprises with between one and four
was due to those with no employees at all, which on aver- workers is much larger in the LAC countries for which data
age expanded by 40 percent, despite the fact that 73 per- are available: about 90 percent in Argentina and Mexico
cent did not grow at all. Firms with one employee at the and almost 80 percent in Brazil, compared to, respectively,
beginning of the three-year period also had a positive con- 55 and 65 percent in the United States and the United
tribution to employment growth; although 40 percent of Kingdom (table 5.5). This is consistent with the evidence
those lost their only worker, this was offset by hires by presented by Bartelsman, Haltiwanger, and Scarpetta
other firms in the category. (2004) on the fact that in all countries for which data
145
FIGURE 5.5
Employment growth of microenterprises in Nicaragua
Self-employed One employee
Frequency (%) Average change in employment Frequency (%) Average change in employment
100 1.0 100 1.0
0.9 0.9
80 0.8 80 0.8
0.7 0.7
60 0.6 60 0.6
0.5 0.5
40 0.4 40 0.4
0.3 0.3
20 0.2 20 0.2
0.1 0.1
0 0 0 0
3 2 1 No 1 2 3 4 5 6 7 Net 3 2 1 No 1 2 3 4 5 6 7 Net
change change
Two employees Three employees
Frequency (%) Average change in employment Frequency (%) Average change in employment
100 1.0 100 1.0
80 0.8 80 0.8
60 0.6 60 0.6
40 0.4 40 0.4
20 0.2 20 0.2
0 0 0 0
20 0.2 20 0.2
40 0.4 40 0.4
60 0.6 60 0.6
80 0.8 80 0.8
100 1.0 100 1.0
3 2 1 No 1 2 3 4 5 6 7 Net 3 2 1 No 1 2 3 4 5 6 7 Net
change change
Source: Author's calculations, using Nicaragua's Living Standards Measurement Study.
TABLE 5.3
Growth and contraction probabilities of Mexican microfirms (percent)
Own 10 or more
Initial/final status account 1�4 workers 5�9 workers workers Exit Total
Own account 51.9 12.4 0.5 0.2 35.00 100
1�4 workers 22.1 49.2 3.9 1.5 23.40 100
4�9 workers 7.8 35.1 22.6 13.1 21.40 100
10 or more workers 4.1 15.2 14.4 44.6 21.70 100
Total entrepreneurs 38.4 26.0 2.9 2.6 30.10 100
Source: Author's calculations, using data on males from the Encuesta Nacional de Empleo Urbano 1987�2001.
are available--they consider 19 countries, including 9 much more prevalent in developing than in industrial
industrial ones and, from LAC, Argentina, Brazil, and countries. Not surprisingly, Bartelsman et al. (2004) find
Mexico--small firms with fewer than 20 employees that the average size of firms is much higher in the
account for between 80 and 96 percent of the total firm United States than in the above three LAC countries,
population. However, it appears that within the group of which they show is not related to differences in sector
firms with fewer than 20 workers, microenterprises are composition--for example, some countries specializing
146
M I C R O F I R M D Y N A M I C S A N D I N F O R M A L I T Y
FIGURE 5.6
Size distribution of microenterprises in Mexico and Nicaragua
Mexico Nicaragua
Percentage of firms Percentage of firms
80 80
60 60
40 40
20 20
0 0
1 2 3 4 5 6 7 8 9 10 11 1 2 3 4 5 6 7 8 9 10 11
Number of employees, including owner Number of employees, including owner
Source: Author's calculations, using Encuesta Nacional de Empleo Urbano and Nicaragua's Living Standards Measurement Study.
Note: All firms were at least three years old at the time of measurement. Firms pooled 1992�98.
in industries with a smaller efficient scale--but rather to is something that we investigate next by exploring the per-
within sector differences in average firm size. sonal and firm traits that are associated with firm growth.
As argued above, a high prevalence of small firms does To examine what characteristics seem correlated with
not necessarily imply the presence of high external barriers microfirm employment growth, we use data on the transition
to firm growth. As noted by Lucas (1978, pp. 508�23), the between size-brackets of Mexican microfirms over a one-year
size distribution of firms may be determined by the under- period considering only surviving firms.9 Consistent with
lying distribution of entrepreneurial ability or the implicit mainstream models, entrepreneurs with conditionally higher
costs of operation at different sizes. That is, urban microen- earnings (better performance) seem to show a higher propen-
terprises could be optimally small, given the owners' entre- sity to grow. Similar results are obtained for Nicaragua, for
preneurial abilities, and the costs of conforming to the both male and female entrepreneurs; those with higher profits
requirements of formal contracting arrangements, partici- relative to their peers with similar levels of human and physi-
pation in credit markets, and such. Thus, the prevalence of cal capital are more likely to add workers.
small firms could simply reflect small opportunity costs of Firm size also appears with the negative sign predicted
entry into self-employment. Whether this mainstream view by the mainstream literature: bigger firms are more likely to
of the sector is in fact relevant in the case of Latin America have achieved their optimal size. Time in business also has a
TABLE 5.4
Employment size distribution of firms, selected countries (percent)
Number of employees US (2004) UK (2005) Mexico (2004)a Brazil (2003)b Argentina (2003)a
With no employees 80.0 71.6 64.4 57.7 68.4
1�4 10.9 18.6 33.0 33.3 28.8
5�19 6.6 7.6 2.0 4.9 2.0
20 or more 2.5 2.1 0.7 4.1 0.8
Source: Author's calculations, using data from U.S. Small Business Administration, U.K. Small Business Service Analytical Unit,
Argentina's Encuesta Permanente de Hogares, Brazil's Pesquisa Nacional por Amostra de Domic�lios, and Mexico's Encuesta Nacional
de Empleo Urbano.
a. Third and fourth size ranges: 5�14 workers and 15+ workers, respectively.
b. Third and fourth size ranges: 5�10 workers and 11+ workers, respectively.
147
I N F O R M A L I T Y
TABLE 5.5
Employment size distribution of firms with employees, selected countries (percent)
Number of employees US (2004) UK (2005) Mexico (2004)a Brazil (2003)b Argentina (2003)a
1�4 54.5 65.7 92.4 78.7 91.1
5�19 33.0 26.9 5.6 11.6 6.3
20 or more 12.5 7.4 2.0 9.7 2.5
Source: Author's calculations, using data from U.S. Small Business Administration, U.K. Small Business Service Analytical Unit,
Argentina's Encuesta Permanente de Hogares, Brazil's Pesquisa Nacional por Amostra de Domic�lios, and Mexico's Encuesta Nacional
de Empleo Urbano.
a. Third and fourth size ranges: 5�14 workers and 15 workers, respectively.
b. Third and fourth size ranges: 5�10 workers and 11 workers, respectively.
negative effect, as expected in the context of the literature many microentrepreneurs choose to be there. In practice, one
on developed countries, but its coefficient is not statistically is likely to find some evidence for both views, suggesting
significant. Similarly, consistent with Ericson and Pakes that the self-employment sector is quite heterogeneous,
(1992b, pp. 53�82)--although less so with Evans and with a relatively well-off entrepreneurial group coexisting
Jovanovic (1989, pp. 808�27)--we find that higher capital with those involuntarily informal, respectively, the "upper
stocks are positively correlated with employment growth. tiers" and "lower tiers" of the sector, in Gary Fields's (1990)
As for the relationships between firm growth and the formulation. However, as chapter 2 suggests, at least in the
age and marital status of entrepreneurs, we find that they case of Latin America, the existing evidence suggests that
are broadly similar to those obtained in the survival microentrepreneurs who entered the sector voluntarily are
analysis: business owners who are married and aged most likely the majority.
36�50 are most likely to expand their firms, exhibiting Not surprisingly, formality rates are higher among better-
employment growth rates that are, respectively, 11.1 and performing microentrepreneurs, and for those who entered
9.4 percentage points higher than those of their peers.10 self-employment voluntarily--who arguably constitute the
Interestingly, employment growth for female entrepre- upper tier of the sector. Thus, as seen in the left panel of
neurs increases with their number of children, suggesting table 5.6, among formal Brazilian microfirm owners the
that, as has been noted in the literature, most employees fraction that was unemployed prior to entering the sector is
of microfirms are related to the owner. This is also consis- 21 percent, compared to 32 percent for nonlicensed firm
tent with the finding that a key determinant of female owners. Similarly, licensed businesses are more likely to
children entering the labor force is whether their mother show signs of success, such as having plans to expand--
had a microenterprise (Cunningham and Maloney 2001). 46 percent among licensed firms compared to 37 percent
It may also explain why the rising probability of hiring for nonlicensed businesses--and their owners are less
peaks for both genders around the period when their likely to plan on going back to salaried jobs--6.5 versus
children are old enough to contribute. 13.4 percent, respectively. It must be noted, however, that
the positive correlation between good firm performance
Informality among microfirms and formality could be driven by causal effects in either
In the literature that associates informal microenterprises direction--better-performing firms from the upper tier of
with the disadvantaged sector of labor markets segmented the microenterprise sector being more likely to be formal,
by government- or union-induced rigidities, workers enter or formality causing improvements in performance. We
self-employment involuntarily whereas they queue up for will examine this issue in more detail in the next chapter.
salaried jobs. Informality, in this approach, is not a choice, That informality is higher among microentrepreneurs in
but rather the option of last resort for otherwise- the so-called upper tier of the sector is also illustrated by
unemployed workers. In contrast, the parallel tradition that the fact that, as seen in table 5.7, older business owners--at
views self-employment through the lens of the firm stresses least until age 47 in Mexico and 45 in Brazil--are less
the entrepreneurial dynamism of the sector and the fact that likely to be informal, and so are those with higher levels of
148
M I C R O F I R M D Y N A M I C S A N D I N F O R M A L I T Y
TABLE 5.6
Reasons for starting up, firm prospects, and firm licensing in Brazil
Main reason to Firms with Firms without Firms with Firms without
start a microfirm license (%) license (%) Plans for future license (%) license (%)
Didn't find a job 20.9 32.2 Expand 45.5 36.6
Profitable business 2.2 1.2 Same level 31.2 31.2
Flexible hours 1.6 2.3 Change activity, 9.2 9.5
remain independent
Be independent 27.8 17.1 Find a salaried job 6.5 13.4
Family tradition 11.0 8.1 Don't know 7.6 9.3
To help family income 12.2 20.8 Difficulties to % firms (with % firms (with
regularize when licenses) licenses)
starting up (2003)
Accumulated experience 10.7 8.7 Yes 18 5.1
Make good deal 10.7 7.6 No 57.4 10.4
As a secondary job 2.5 2.1 Didn't try 24.7 84.5
Sources: Pooled Pesquisa Economia Informal Urbana 1997 and 2003 (except for "Difficulties to Regularize" from 2003).
Note: Sample restricted to entrepreneurs aged at least 20.
TABLE 5.7
Informality among Mexican and Brazilian microenterprises by age, education, and previous activity of the owner
Mexico Brazil
(1) (2) (3) (4) (5) (6)
Variable No license No taxes No social security No license No taxes No social security
Owner's age 0.019*** 0.014*** 0.012*** 0.009*** 0.001** 0.0001
(0.000) (0.000) (0.008) (0.000) (0.034) (0.979)
Owner's age squared 0.0002*** 0.0001*** 0.0001 0.0001*** 0.0000** 0.000
(0.000) (0.000) (0.103) (0.000) (0.042) (0.637)
Primary schooling 0.186*** 0.102*** 0.089** 0.048*** 0.008*** 0.0415***
(0.000) (0.000) (0.045) (0.000) (0.001) (0.005)
Secondary schooling 0.365*** 0.218*** 0.205*** 0.107*** 0.022*** 0.170***
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Tertiary schooling 0.523*** 0.357*** 0.390*** 0.247*** 0.039*** 0.3379***
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Female 0.075*** 0.062*** 0.008 0.095*** 0.009*** 0.011
(0.000) (0.000) (0.647) (0.000) (0.000) (0.225)
Previously unemployed 0.035*** 0.034*** 0.068*** 0.039*** 0.014*** 0.074***
(0.001) (0.000) (0.005) (0.000) (0.000) (0.000)
Observations (n) 28,525 28,525 4,599 45,509 45,509 8,841
Pseudo-R2 0.189 0.159 0.215 0.220 0.159 0.220
Source: Author's calculations, using Pesquisa Economia Informal Urbana and Encuesta Nacional de Micronegocios.
Note: Robust p-values appear in parentheses. Firm size, time in business, fixed location, sales to large firms, sector, and state are
also controlled. Samples of business owners aged 21 and older, without complete tertiary education, operating agricultural
activities, and with at most five workers.
**p < .05; ***p < .01.
149
I N F O R M A L I T Y
schooling. Thus, for instance, the probability of a micro-
FIGURE 5.7
enterprise not being registered is 37 percentage points
Informality among Mexican microenterprises by number of paid
lower for Mexican businesses owned by individuals with at workers and time in business
least some secondary schooling, compared to those who
a. Number of paid workers
have no schooling at all. The likelihood of not paying taxes
1.0
or social security contributions also diminishes signifi-
cantly with the education of the business owner, a result 0.8
that is also obtained for Brazil. Moreover, after controlling
for the effect of age and education, female entrepreneurs 0.6
and individuals who opened their businesses because they
0.4
"could not find a job" have a higher probability of being
informal. As shown in table 5.7, this is found both for 0.2
Brazil and Mexico, and for different indicators of informality.
This result is consistent with both types of microentrepre- 0
0 1 2 3 4 5
neurs--females and previously unemployed workers--
viewing their business activity as more temporary than males b. Years in business
and voluntary entrants into the sector, respectively. 1.0
While most microenterprises are informal, formality
0.8
rates increase quite rapidly when firms incorporate paid
employees. In Mexico, 63 percent of all urban microenter- 0.6
prises are not registered with the federal treasury, and
72 percent pay no taxes. Nevertheless, among those 0.4
microfirms with at least one paid employee, only 31 percent
0.2
are unregistered and less than half (46 percent) report pay-
ing no taxes. As illustrated in figure 5.7, by the time firms 0
have hired five paid workers the fraction that remains 0.17 0.67 1 2 3 4
unregistered has fallen to 13 percent and only 28 percent Not registered No tax payment
declare paying no taxes. Moreover, while 86 percent of the No workers registered
firms with only one paid employee do not pay social secu-
Source: Author's calculations, using Encuesta Nacional de
rity contributions for that worker, among those with five Micronegocios.
paid workers, 71 percent report paying social security for at
least some of their employees. Informality also tends to diminish, although less
Similar evidence emerges from data on Brazilian microen- rapidly, with time in business. As suggested by the results
terprises: while 76 percent do not have an operating license in table 5.8, the effect of time in business is stronger for
and 94 percent do not pay taxes, those rates fall to 51 and younger firms, but it remains negative--older firms being
75 percent, respectively, among firms with at least one paid less likely to be informal--until firms have been in busi-
employee. Moreover, among those that employ five paid ness for 18 years (22 in the case of Brazil). This is illus-
workers, 67 percent have operating licenses and 23 percent trated for the case of Mexico in figure 5.7b. Depending
report paying taxes. As shown in table 5.8, the positive effect on which definition is employed--lack of registration, tax
of firm size on formality persists even when one controls, in a payments, and social security contributions for workers--
regression framework, for a number of other firm and business informality rates drop from between 70 and 90 percent
owner characteristics. In Colombia, for instance, the probabil- among firms with under a year of existence, to between 60
ity of a microenterprise with one paid worker not being and 71 percent for those that have been in business for at
registered or not paying taxes falls by, respectively, 20 and least four years. Similarly, while only 12 percent of Brazil-
15 percentage points in comparison with owner-only enter- ian microenterprises with at most three years of existence
prises, and further reductions in informality probabilities are have operating licenses, that fraction is twice as large
found among those with more paid workers.11 among older firms. It is worth noting, however, that the
150
M I C R O F I R M D Y N A M I C S A N D I N F O R M A L I T Y
TABLE 5.8
Informality among Mexican, Brazilian, and Colombian microenterprises by paid employment and time in business
Mexico Brazil Colombia
(1) (2) (3) (4) (5) (6) (7) (8) (9)
No social No social No social
Variable No license No taxes security No license No taxes security No license No taxes security
One paid worker 0.322*** 0.255*** 0.122*** 0.031*** 0.202 0.146 0.937
(0.000) (0.000) (0.000) (0.000) (0.000)*** (0.000)*** (0.000)***
Two paid workers 0.406*** 0.311*** 0.162*** 0.195*** 0.064*** 0.123*** 0.323 0.239 0.969
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)*** (0.000)*** (0.000)***
Three paid workers 0.506*** 0.426*** 0.347*** 0.253*** 0.080*** 0.187*** 0.344 0.280 0.981
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)*** (0.000)*** (0.000)***
Four paid workers 0.528*** 0.434*** 0.469*** 0.273*** 0.108*** 0.260*** 0.349 0.283 0.981
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)*** (0.000)*** (0.000)***
Five paid workers 0.506*** 0.447*** 0.574*** 0.272*** 0.086*** 0.307*** 0.354 0.268 0.979
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)*** (0.000)*** (0.000)***
Time in business 0.011*** 0.013*** 0.009*** 0.009*** 0.001*** 0.008*** 0.297 0.266 0.017
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)*** (0.000)*** (0.000)***
Time in business 0.0003*** 0.0003*** 0.0002*** 0.0002*** 0.0000*** 0.000*** 0.041 0.032 0.002
squared (0.000) (0.000) (0.002) (0.000) (0.000) (0.000) (0.000)*** (0.000)*** (0.000)***
Observations (n) 28,525 28,525 4,599 45,509 45,509 8,841 27,177 27,691 27,690
Pseudo-R2 0.189 0.159 0.215 0.220 0.159 0.220 0.174 0.095 0.665
Sources: Author's calculations using Encuesta Nacional de Micronegocios and Pesquisa Economia Informal Urbana; for Colombia,
calculations performed by Carolina Mejia and Mauricio Cardenas.
Note: Robust p-values appear in parentheses. In the cases of Mexico and Brazil, age, education, and previous unemployment of the
owner, as well as fixed location, sales to large firms, sector, and state, are also controlled. Samples of business owners aged 21 and
older, without complete tertiary education, operating in nonagricultural activities, and with at most five workers. For Colombia,
other controls include having a fixed location and sector. The time-in-business variable is expressed in years for Brazil and Mexico,
and is categorical for Colombia.
***p < .01.
decision to operate formally or informally is often made at services and manufacturing appear in an intermediary
the time of starting up. As seen in the bottom-right row of position. Other firm characteristics that are strongly asso-
table 5.6, almost 85 percent of nonlicensed Brazilian ciated with lower informality rates are the fact of operat-
microfirms did not even try to regularize their businesses ing out of a fixed location, and that of selling mainly to
when they began operating, compared to 75 percent of for- large companies. For given firm sizes, having a fixed loca-
mal businesses that at least attempted to do so. tion is associated with registration probabilities that are
With regard to the sectors of economic activity where up to 25 percentage points higher in the three countries
informality is more prevalent, at least in the case of for which we have data on microenterprise formality
microenterprises, we find that in both Mexico and Brazil (table 5.9). Higher probabilities of paying taxes and social
informal firms are most frequently found in the construc- security are also found in those three countries among
tion sector, possibly due to lower firm survival rates in firms operating out of fixed locations. One interpretation
this sector (see previous section), and they are least com- of this result is that firms that, because their activities do
mon in retail trade (table 5.9). In both countries, other not need a fixed locale for their operations, could also be
151
I N F O R M A L I T Y
TABLE 5.9
Informality among Mexican, Brazilian, and Colombian microenterprises by age, education, and previous activity of the owner
Mexico Brazil Colombia
(1) (2) (3) (4) (5) (6) (7) (8) (9)
No social No social No social
Variable No license No taxes security No license No taxes security No license No taxes security
Fixed location 0.170*** 0.111*** 0.076*** 0.202*** 0.033*** 0.136*** 0.254 0.144 0.024
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)*** (0.000)*** (0.000)***
Large main 0.175*** 0.114*** 0.168*** 0.017* 0.036*** 0.048**
client (0.000) (0.000) (0.000) (0.082) (0.000) (0.019)
Services 0.188*** 0.168*** 0.054*** 0.021*** 0.007*** 0.033*** 0.196 0.158 0.018
(0.000) (0.000) (0.000) (0.000) (0.000) (0.001) (0.000)*** (0.000)*** (0.000)***
Manufacturing 0.226*** 0.176*** 0.040** 0.107*** 0.012*** 0.058*** 0.170 0.140 0.023
(0.000) (0.000) (0.035) (0.000) (0.000) (0.000) (0.000)*** (0.000)*** (0.000)***
Construction 0.368*** 0.271*** 0.178*** 0.137*** 0.013*** 0.055***
(0.000) (0.000) (0.000) (0.000) (0.000) (0.002)
Observations (n) 28,525 28,525 4,599 45,509 45,509 8,841 27,177 27,691 27,690
Pseudo-R2 0.189 0.159 0.215 0.220 0.159 0.220 0.174 0.095 0.665
Sources: Author's calculations using Encuesta Nacional de Micronegocios and Pesquisa Economia Informal Urbana for, respectively,
Mexico and Brazil; for Colombia, calculations performed by Carolina Mejia and Mauricio Cardenas, using data from Colombia
National Administrative Department of Statistics.
Note: Robust p-values appear in parentheses. Firm size, time in business, as well as age, education, and previous unemployment
of the owner, sector, and state, are also controlled. Samples of business owners aged 21 and older, without complete tertiary
education, operating in nonagricultural activities, and with at most five workers. For Colombia, other controls include size and
time in business.
*p < .1.
**p < .05.
***p < .01.
less motivated to formalize themselves because of the formal.12 These results are consistent with the findings of
lower probability of being caught. Moreover, for firms de Paula and Scheinkman (2006), who show that since pur-
that could operate either with or without a fixed locale, chases from informal firms are ineligible for tax credits,
the desire to remain informal--without being caught-- value-added tax systems create incentives for the formali-
could be the deciding factor for choosing the second zation of suppliers located upstream along productive
option. Note, however, that this would not be without chains--then again, informality also tends to be conta-
costs, as informal firms that operate on an ambulant basis gious, as firms that buy from (or sell to) informal firms also
are also, as shown in the next chapter, less likely to accu- have an incentive to operate informally.
mulate assets and increase sales and employment. Even after controlling for the presence of large clients
As for firms selling to large companies, being formally and a fixed location, as well as for the owners' human capi-
registered and paying taxes are likely to be requirements tal and other personal characteristics, firms with higher
imposed by their clients, which would explain the higher levels of productivity are less likely to be informal. This
level of formality among microenterprises that cater to is illustrated in figure 5.8, which reports the effect of a
large companies. The increase in the probability of being doubling of labor productivity--equivalent to about one
formal for firms having large companies as clients is between standard deviation in net revenues per worker--on the
11 and 18 percentage points in Mexico. The increase is probability of Mexican and Brazilian microenterprises being
smaller, while still significant, in Brazil--between 2 and 5 informal. The effects are larger in the case of Mexico, where
additional percentage points in the probability of being a 100 percent increase in labor productivity is associated
152
M I C R O F I R M D Y N A M I C S A N D I N F O R M A L I T Y
Conclusions
FIGURE 5.8
This chapter has shown that the patterns of entry, survival,
Effect of doubling labor productivity on probability of being
informal (%) and growth in the self-employment sector in Latin America
match well the predictions of mainstream models of firm
Add owner,
dynamics developed for industrial-country contexts, sug-
firms traits
Brazil gesting that the behavior of many microfirm owners is dri-
Firm size,
age, sector ven by exit choices and not just by exclusion factors. Thus,
Add owner, entrants into self-employment tend to be found more fre-
firms traits
Colombia quently among workers who have accumulated human and
Firm size,
age, sector physical capital while working as salaried workers. Among
Add owner, the latter, those with relatively higher wages given their
firms traits human capital--the overachievers--are more likely to
Mexico
Firm size, become firm owners, and those with more schooling are
age, sector
more likely to open businesses with at least some paid
20 15 10 5 0
employees. Once in the sector, the owners of more prof-
Mean of lnypw
itable firms are more likely to stay in business and hire
No license more workers. Moreover, as firms grow older and larger,
No registered workers their growth rates tend to diminish and their degree of
No taxes
informality tends to gradually decrease.
Sources: Author's calculations, using Encuesta Nacional Few firms, however, tend to evolve along this ideal
de Micronegocios and Pesquisa Economia Informal Urbana; for
path, with the large majority of microfirms remaining
Colombia, calculations performed by Carolina Mejia and Mauricio
Cardenas, using data from Colombia National Administrative owner-only, and a large fraction of them failing. Thus, at
Department of Statistics.
Note: Coefficients on labor productivity in regressions where least in the short term, the sector is not likely to be an
other regressors and samples are as described in tables 5.7 and 5.9,
important source of net job creation--if any--for Latin
respectively, (see notes to those tables).
American economies. Two complementary explanations
can be proposed to explain the high failure rates and lim-
with a drop of about 15 percentage points in the probability ited growth and job creation of informal firms. On one
of not being registered, and about 10 and 9 fewer percent- hand, informality and the factors that may be behind it--
age points in the probabilities of not paying taxes and social to be discussed in more detail in the next chapter--could
security contributions, respectively. In Brazil, increases in be to blame, with policy-induced barriers to formaliza-
productivity have a small effect on the probability of pay- tion impeding microfirm access to technologies and mar-
ing taxes--between 1 and 2 percentage points higher for a kets, which in turn would keep them small and
doubling of labor productivity--but they reduce the prob- unproductive, and in many cases lead them to exit alto-
ability of not having an operating license and not paying gether, thus perpetuating a vicious circle of low growth
social security contributions by as much as 9 and 10 per- and high informality. On the other hand, the evidence
centage points. As for the evidence on Colombia, we presented in this chapter is also consistent with an alter-
find that a doubling of labor productivity is associated native explanation for the type of microfirm dynamics
with increases of up to 10 percentage points in formality observed in Latin America. In particular, the presence of
probabilities. low opportunity costs for entry into the sector would also
The apparent negative link between productivity and lead to a predominance of low-productivity businesses with
informality can be interpreted, as mentioned above, as evi- low growth prospects and high failure rates. In this con-
dence that firms in the upper tier of the microenterprise text, in order to reduce informality, policy makers should
sector are more likely to become formal. However, as will focus not only on altering the direct costs and benefits of
be discussed in the next chapter, it is also possible that at formality but also on the drivers of formal sector produc-
least to some extent causality also runs in the opposite tivity, including measures to improve the investment
direction, with access to formality leading to further climate and policies aimed at increasing human capital
increases in firm productivity. accumulation.
153
I N F O R M A L I T Y
Notes 9. Firm size is divided into owner-only firms, 2�5 employees,
1. This section draws heavily on Fajnzylber, Maloney, and Rojas 6�10 employees, 11�15 employees, 16�50 employees, 51�100 employ-
(2006b). Only 6 of the 53 papers mentioned by Blanchflower (2004) ees, 101�250 employees, and 250 and more employees. The depen-
in his self-employment literature review concern developing coun- dent variable is the imputed percentage difference between the mean
tries, and they focus mostly on the determinants of earnings. To our value of employment in each firm size bracket. By definition, firms
knowledge, the only previous evidence on the determinants of entry, that remained in the same size interval have a value of zero.
exit, and growth of microenterprises in developing countries are the 10. While the positive sign encountered in the marital status vari-
papers on Africa by Goedhuys and Sleuwaegen (2000), Liedholm able may well reflect the use of nonpaid family workers, the results
(2002), Liedholm and Mead (1999), McPherson (1995, 1996), and are virtually unchanged when the firms with a majority of nonpaid
Mead and Liedholm (1998). Other recent studies on firm dynamics in workers are kept in the sample.
developing countries have focused mostly on larger and/or formal 11. The estimations with Colombian data were generously shared
firms, including Aw, Chung, and Roberts (2003), Bartelsman, Halti- by Mauricio Cardenas and Carolina Mejia.
wanger, and Scarpetta (2004), and Roberts and Tybout (1997). 12. The quantitatively smaller effect obtained for Brazil could
2. Other dynamic models also generate these patterns, although reflect better tax enforcement among smaller firms in Brazil, which
with different analytical structures. Ericson and Pakes (1992a, 1995) would then not be significantly affected by their links to larger ones.
propose a model of active exploration--as opposed to the passive Alternatively, if large companies also exhibit high tax evasion, then they
learning assumption in Jovanovic's model--that incorporates firm- would not necessarily impose strict tax compliance requirements to
specific sources of uncertainty derived from stochastic outcomes of their smaller providers. The second hypothesis is favored by the high
investments made by firms in order to improve their profitability. level of tax evasion revealed by the 2003 Brazil Investment Climate
Favorable outcomes from the firms' own investments--including Assessment survey, in which manufacturing firms reported that one-
those that lead to entry into the industry--tend to move them third of the sales of the average enterprise goes unreported for tax pur-
toward "better" states, while good outcomes of direct competitors poses, compared to 23 percent for Colombia and 30 percent for
move them to less profitable states. As in Jovanovic's model, entry, Mexico--the averages for LAC and the OECD are, respectively, 23 and
exit, and investment decisions are made to maximize the expected 6.5 percent.
discounted value of future net cash flows conditional on the current
information set. References
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margin the process of selection of entrepreneurs is poorer in Mexico, nomic Evidence of Creative Destruction in Industrial and Devel-
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the wage sector in this country. Bartelsman, E., S. Scarpetta, and F. Schivardi. 2003. "Comparative
6. For comparison purposes with Evans and Leighton's figures for Analysis of Firm Demographics and Survival: Micro Level Evidence
the United States, the rates of entry into self-employment reported for the OECD Countries." Economics Department Working Paper
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Moreover, self-employment rates are also calculated as a proportion of Test of Two Rival Models." Journal of International Development
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ure 5.2 cover all self-employed women who move either out of the Blanchflower, D. G. 2000. "Self-employment in OECD Countries."
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Blanchflower, D. G., and A. J. Oswald. 1998a. "Entrepreneurship and Fields, G. S. 1990. "Labor Market Modelling and the Urban Informal
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156
CHAPTER 6
Informality, Productivity,
and the Firm
SUMMARY: This chapter focuses on both the determinants and the consequences of informality from the perspective of pri-
vate firms. The chapter begins by arguing that firm informality encompasses not only the large number of unregistered
microfirms described in chapter 5, but also those medium-size and large firms that fail to comply with at least some gov-
ernment regulations. This is illustrated by recent estimates of a large incidence of tax and social security evasion among
Latin American firms of all sizes. The chapter then reviews the evidence on the factors that may lead private firms to
exhibit different degrees of informality, and analyzes the channels through which regulatory noncompliance can affect
individual and aggregate productivity. Finally, the chapter lays out the possible approaches that policy makers could
adopt to tackle the issue of firm informality.
W HILE INFORMALITY IS OFTEN between small and large firms. Finally, we show that recent
associated with small, unregis- initiatives to reduce red tape and introduce simplified tax
tered microfirms, tax and social and registration systems for microfirms have led to statisti-
security evasion is commonplace cally significant increases in the number of new formally
among larger Latin American registered firms, although further research is required to
firms. This chapter reviews the main firm characteristics establish whether the corresponding effects are permanent
associated with informality among those firms, using data or temporary, and to resolve existing controversies on their
from recently concluded enterprise surveys in a number of magnitude. In particular, some recent estimates suggest
Latin American countries. Not surprisingly, we find that the that the simplification of entry regulation leads more former
incidence of tax and social security evasion varies consider- high-ability wage workers to open formal businesses, but it
ably across and within countries, and it is generally higher has small or no effects on the formalization of unregistered
for small, low-productivity firms that started their opera- businesses.
tions without a formal registration. We argue that there are reasons to expect important
With regard to the factors that may help explain this overall productivity gains if a larger fraction of firms would
variation, we find that informality tends to increase with the formalize and if resources could be shifted away from low-
quantity of labor and product markets regulations, and to productivity informal firms toward the formal sector. This
decrease with the quality of governance--for example, the could be the case in a context where increasing returns to
prevalence of the rule of law and the level of democratic scale are relevant, at least among very small firms, and
accountability. Moreover, firm informality is positively informality is accompanied by a preponderance of small
related to the incidence of corruption, but it can be curtailed firms. Moreover, unfair competition from informal firms
by the improvement of market support institutions--the could slow down the process of creative destruction by
courts, financial markets, and the development of links which inefficient firms are replaced by their more efficient
157
I N F O R M A L I T Y
competitors, and negatively affect the incentives of formal unregulated firms that avoid most taxes and labor regula-
firms to innovate and adopt new technologies. Finally, tions, and do not comply with most government regulations.
growth could increase as previously informal firms gain Informality, in this approach, is seen as affecting mostly the
increased access to markets and services. These positive very low end of the firm-size spectrum.
links between formality and growth are supported by In a more general approach, as argued in chapter 1 of this
firm-level evidence presented in this chapter. Indeed, we volume, it is reasonable to define the informal sector as
find that firms that started operations without formally encompassing all the firms that, at least to some extent,
registering--at least initially--and those located in choose to operate outside of the scope of existing regulations.
regions or sectors where informality is more prevalent Thus, medium-size and large firms can be considered infor-
exhibit, on average, much lower productivity than their mal even if they are appropriately registered, provided that,
peers. Moreover, exogenous increases in formality levels for instance, they underreport their sales for tax purposes; do
caused by changes in the costs of microfirm formalization not register all their workers with the social security admin-
are also found to lead to improved firm performance. istration; or do not comply with some government regula-
In practice, however, policy makers may need to act tions regarding mandatory operating licenses or permits, as
on several fronts at the same time in order to tilt the well as product quality and safety regulations.
cost�benefit analysis of firms toward formality by combining For analytical purposes, however, it is useful to divide the
both positive and negative incentives--respectively, "car- informal sector into two different subsectors. The first is the
rots" and "sticks." Thus, the impact of interventions aimed informal microenterprise sector, which we described in
at reducing the costs of being formal through the removal of the previous chapter and is composed of mostly informal,
regulatory constraints may be larger when accompanied by unregistered microenterprises. The second informal subsec-
measures to enhance evenhanded enforcement of regulations tor, which Djankov et al. (2003) denominate the "unofficial
and increase the potential benefits of joining the formal economy," is made up of firms that are only partially infor-
sector--for example, through improvements in access to mal, in the sense that they are formally registered but keep
credit, contract enforcement mechanisms, and technical a fraction of their workers and sales hidden from govern-
assistance. In particular, recent evidence from randomized ment regulators, and/or fail to comply with at least some
experiments suggests relatively high returns to capital government regulations related, for instance, to mandatory
among very small Mexican microenterprises, which implies permits and licenses. While unofficial firms tend to be
that considerable increases in income could be obtained mostly small, in some countries and regions this subsector
through incentives to the formalization of small businesses can include medium-size and even large companies.1
and expanded access to microcredit. These efforts, however, Data recently collected through surveys of registered
may have larger effects on the subset of higher-productivity firms in seven Latin American and Caribbean countries con-
informal firms (or high-ability wage earners considering firm that many small, medium-size, and even large firms also
entry into the microfirm sector) that may be closer to the exhibit some degrees of informality. This is illustrated in fig-
margin separating the formal from the informal sector--for ure 6.1, which shows that sales and employment underre-
example, because they have more to win from formalizing or porting (for tax purposes) is commonplace among registered
because the opportunity costs of operating informally are medium-size and large firms in selected Latin American and
higher for them. Moreover, for very-low-productivity infor- Caribbean countries of different sizes and levels of income.2
mal firms it is possible that, as argued in the previous chap- The high variation in levels of tax and social security
ter, a larger impact on overall formality levels could be evasion suggested by this figure, across countries with rela-
achieved in the medium-to-long term through actions tively similar levels of income, implies that cross-country
aimed at increasing job opportunities in the formal sector. differences in informality are not driven just by levels of
economic development. In Brazil and Panama, for instance,
Informality among registered firms firms reportedly evade as much as 30 to 40 percent of their
The informal sector is often associated with the large number taxes, compared to less than 20 percent in Uruguay and
of unregistered small businesses found in most urban centers Peru, and less than 5 percent in Chile.3 As discussed in the
of the developing world. Thus, what people often have in next section, possible explanations may be associated with
mind when thinking about the informal sector are small, the size of tax and social security burdens, labor legislation,
158
I N F O R M A L I T Y, P R O D U C T I V I T Y, A N D T H E F I R M
governance issues related to red tape and corruption, levels security evasion is more prevalent among smaller firms. In
of regulatory enforcement, and the value attributed by Bolivia and Mexico, for instance, about 35 percent of sales
firms to market- and government-provided services. go underreported among microenterprises, compared to
A second finding derived from figure 6.1 is that, for most around 10 to 15 percent among firms with 100 workers or
countries, the data suggest, as expected, that tax and social more. However, in Panama, Peru, and Uruguay, the data do
not suggest a clear pattern linking underreporting rates to
FIGURE 6.1 firm size. Thus, large firms appear to evade taxes and social
Unreported sales and workers, by firm size (%) security contributions at rates that are comparable to those
of smaller enterprises--between 10 and 15 percent in Peru
Number of employees
and Uruguay, and above 30 percent in Panama.
5
6�10 The negative relationship between underreporting rates
11�20
Panama
21�50 and employment size in the case of Argentina, Bolivia,
51�99
100 Colombia, and Mexico is maintained when the firms' time
5 in business, location, and sector are controlled for in a
6�10
11�20 regression framework (figure 6.2). Thus, hypothetically
Brazil
21�50
51�99 doubling the size of a firm leads to a reduction in underre-
100 porting rates of more than 5 percentage points in Bolivia
5
6�10 and 4 in Mexico, with roughly one-half of those effects
11�20
Mexico
21�50 obtained for the cases of Colombia and Argentina, respec-
51�99 tively. A small effect is also found for Uruguay, where the
100
5 underreporting of sales for tax purposes diminishes by 1.5
6�10
11�20 percentage points as firms hypothetically double in size. The
Bolivia
21�50 time that a firm has been in business, however, is not found
51�99
100 to be significantly related to informality levels, with the
5
6�10 only exceptions being Colombia (where for each additional
11�20
Argentina decade since starting up firms appear to reduce their sales
21�50
51�99 underreporting by about 1 percentage point, and Mexico
100
5 (where the opposite effect is obtained--increasing underre-
6�10 porting with time in business, at a rate of 1 percentage point
11�20
Colombia
21�50 for each additional decade since starting up).
51�99
100
5
6�10
11�20
Uruguay
21�50 FIGURE 6.2
51�99
Effect of doubling employment size on underreporting rates (%)
100
5
6�10
11�20 Argentina
Peru
21�50
51�99
Bolivia
100
5
6�10 Colombia
11�20
Chile
21�50
51�99 Mexico
100
0 10 20 30 40 50 8 6 4 2 0
Unreported sales Unreported workers Unreported sales Unreported workers
Source: Authors' calculations, using the World Bank's Enterprise Source: Authors' calculations, using the World Bank's Enterprise
Survey Database. Survey Database.
159
I N F O R M A L I T Y
FIGURE 6.3 FIGURE 6.4
Effect of having started informally on underreporting rates (%) Effect of doubling labor productivity on underreporting rates (%)
Average
Argentina
(7 countries)
Bolivia Bolivia
Colombia Colombia
Mexico Mexico
Panama Peru
Peru Uruguay
0 5 10 15 20 25 4 3 2 1 0
Unreported sales Unreported workers Unreported sales Unreported workers
Source: Authors' calculations, using the World Bank's Enterprise Source: Authors' calculations, using the World Bank's Enterprise
Survey Database. Survey Database.
Another relevant finding common to at least five coun- about one standard deviation in that variable--is associated
tries is that firms that start operating in the informal sector with underreporting rates that are, on average, 2 percent-
exhibit higher rates of sales and employment underreport- age points lower.
ing than other firms of the same size, sector, and location, As suggested above, the negative correlation between
even many years after having registered, and after control- productivity and informality is subject to different interpre-
ling for sector and location characteristics.4 Indeed, even tations. On one hand, more productive firms may arguably
after controlling for the time that firms have been in have more to lose from operating irregularly (a topic that we
business--on average, more than 20 years, and about 8 years discuss in the next section while summarizing the main
after having registered--starting without a formal registra- firm-level determinants of informality). On the other hand,
tion is associated with rates of tax and social security evasion however, it is also possible that productivity is affected by
that are between 6 and 25 percentage points higher than for whether firms operate formally or informally, as well as by
firms that registered at the time of starting up (figure 6.3). the general level of informality prevailing in their region
This suggests that efforts to facilitate early registration of and sector (a topic that we cover in the third section of this
new firms have the potential to reduce informality both chapter).
through increasing the number of tax-paying firms and
through reducing tax evasion levels among registered firms. Firm-level determinants of informality
Within given sectors, however, and for given firm size Why do some firms comply with government regulations
and time in business, we find that firms with higher levels while others opt for going underground? It is reasonable to
of labor productivity exhibit, in general, lower rates of tax assume that private firms voluntarily chose to operate in
and social security evasion. This is illustrated in figure 6.4, the formal or the informal sector based on rational profit-
where we report the estimated effects on the rates of sales maximizing calculations, not unlike those underlying
and employment underreporting of a hypothetical dou- investment and production decisions. In particular, the
bling in output per worker (controlling for firm size, time extent to which firms comply with government regulations
in business, location, and sector of activity). The effects are is likely to depend on their weighing of the various costs
not significant for Panama, nor for sales underreporting in and benefits associated with operating formally or infor-
Bolivia and Colombia. However, for all the other cases, we mally. Some of the main factors that firms are likely to take
find that doubling firms' labor productivity--a change of into account are the nature of the regulatory framework,
160
I N F O R M A L I T Y, P R O D U C T I V I T Y, A N D T H E F I R M
the extent to which regulations are enforced, and the vari- longer-term relationship--and that in turn affects their
ous opportunity costs associated with operating in the incentives to invest in training and capital goods.
underground economy. High levels of corruption may also play a role in shaping
firms' incentives for operating informally. Indeed, when
Benefits and costs of informality for private firms caught by government inspectors, irregular firms may have
Among the main advantages that firms may consider when the option of bribing those inspectors to evade fines and
opting for informality are the possibility of reducing or other hassles, which may reduce the risk associated with
eliminating tax payments and social security contributions, operating informally. Second, in countries where formal
and the possibility of avoiding costly and burdensome gov- firms face a high risk of being extorted by corrupt officials,
ernment regulations, including but not restricted to those entrepreneurs may decide to operate informally exactly to
affecting labor markets.5 Some of the main "benefits" from reduce their vulnerability to extortion. In fact, there is evi-
informality are thus directly linked to the value of taxes dence that this is the case in several so-called transition
and social security contributions that irregular firms are economies where one of the main motivations for firms'
able to avoid. going underground is to "dodge the grabbing hand" (see
Other indirect "benefits" are related to cost savings Friedman et al. 2000; Johnson et al. 2000; and Johnson,
derived from avoiding the often complex administrative Kaufmann, and Shleifer 1997).
procedures associated with tax and regulatory compliance, Besides the risk of being caught, informality entails
and to the added flexibility enjoyed by informal firms in other private costs. Thus, operating in the underground
their employment and production decisions. Thus, for economy eliminates--or at least greatly reduces--access to
instance, informal firms arguably enjoy lower hiring and fir- the courts and other formal contract enforcement mecha-
ing costs, and they have more degrees of freedom when set- nisms. This may increase the vulnerability of informal
ting wages and work hours. Moreover, informal firms may firms in their transactions with other private parties as well
be able to reduce their costs--and potentially increase their as with government. As a result, they may be forced to
sales--as a result of not having to comply with government- restrict their transactions to the potentially limited set of
imposed standards for products and production processes. trading partners that are deemed trustworthy. This has
And, last but not least, informal firms may be able to cir- negative implications not only in terms of social welfare, as
cumvent the red tape associated with obtaining government it leads to forgoing potential gains from increased trade,
permits and licenses. As documented by the World Bank's but also in terms of reinforcing the above-mentioned fac-
Doing Business reports, many of those procedures are often tors that tend to limit the expansion of informal firms.
costly and time-consuming, which may lead some firms to Another important cost associated with informality is
opt for operating informally in order to avoid them. given by the narrower set of formal financing mechanisms
Potentially countervailing the above cost savings, infor- available to informal firms. Indeed, bank and other formal
mal firms need to deal with the risk of being caught and financial institutions are generally not willing to grant
closed down. Since better enforcement of regulations credit to companies that lack proper documentation,
increases the expected value of the fines and other losses including that related to government registration and
derived from being detected by regulators, it reduces the licensing, tax compliance certificates, and audited financial
incentives for operating informally. However, since it is statements, all of which are generally lacking in the case of
neither feasible nor efficient for governments to supervise informal firms. Moreover, if to evade taxes companies do
all individual firms, enforcement tends to be concentrated not register all assets as belonging to the company, their
on larger firms. As a result, informality has the effect of ability to use them as collateral for bank loans may also be
limiting firm growth, both because smaller informal firms limited. Similarly, in the case of firms that hide a fraction of
are less likely to be caught by government inspectors and their revenues to elude taxes or other regulations, financial
because the uncertainty associated with informality dis- statements may misrepresent their financial soundness
courages investments in illiquid assets. Moreover, in the and economic prospects, thus reducing their attractiveness
particular case of informality with respect to labor regula- to prospective lenders. The same applies to prospective
tions, irregular firms are likely to have a harder time investors, which reduces informal firms' ability to raise
attracting more educated workers and engaging them in a equity capital.
161
I N F O R M A L I T Y
Informality can also forbid firms from benefiting from separating firms with and without employees (beyond the
government support programs targeted at small and owner). Among the main advantages of formality, the
medium enterprises (SMEs), as those programs are often surveyed firms mention the avoidance of fines and bribes,
restricted to registered tax-paying firms. This can be a seri- followed by the possibility of gaining new clients and
ous obstacle to the growth of informal firms, at least if one expanding operations--to which, interestingly, firms with at
assumes that SME support programs effectively compen- least some employees give more importance than owner-only
sate for market failures that limit the ability of those firms firms. As for the main disadvantages associated with formal-
to access formal credit markets and acquire the technolo- ization, the factors to which the enterprises interviewed
gies and human capital needed for their expansion. How- attribute more importance are the need to renew their
ever, if firms do not place a large value on participating in licenses every year and the tax obligations resulting from
SME-supporting government programs, or if market sup- formality--the second one being more important for firms
port institutions in general are not well developed--for with employees.
example, credit markets do not function well or contract Also cited as important advantages of formality,
enforcement mechanisms are slow and costly--then the although less frequently than the above-mentioned factors,
cost of being excluded from those institutions as a result of are the possibility of improving access to credit and using
operating informally is lower, and a larger share of output is contract enforcement mechanisms--the second one being
likely to be found in the underground economy. more important for larger firms. However, when asked
Evidence on the relative importance of the various costs about the most important advantage of formality, only
and benefits of informality--or, equivalently, the main 14 percent of the surveyed firms say that they are motivated
advantages and disadvantages from formalization--is by the desire to expand or seek new clients, 8 percent men-
presented in figures 6.5 and 6.6, based on information tion access to credit as the top reason for formalizing, and
provided by firms surveyed by the International Finance Cor- just 1.5 percent mention access to the courts. In contrast,
poration in 65 municipalities in Bolivia, Brazil, Honduras, 47 percent of the firms say that the top reason underlying
Nicaragua and Peru.6 The figures report the average degree their decision to register their enterprise is "to comply with
of importance of various factors on a scale from 0 to 4, the law" and 29 percent want to avoid fines or bribes. Thus,
it appears that the risk of being caught prevails over posi-
tive incentives associated with access to markets and
FIGURE 6.5 services, a finding that, in general terms, applies both to
Advantages of formalization reported by IFC-surveyed firms
Avoid
paying fines FIGURE 6.6
Compliance Disadvantages of formalization reported by IFC-surveyed firms
with the law
Avoid Annual
paying bribes license renewal
Gain new clients Payment of taxes
Improved Regular inspection
access to credit
Operation on a Accounting
greater scale
Legal power to demand Compliance
contracts upheld with labor laws
0 1 2 3 4 0 0.5 1.0 1.5 2.0 2.5
Firms without employees Firms without employees
At least one employee At least one employee
Source: Authors' calculations, using the World Bank's Enterprise Source: Authors' calculations, using the World Bank's Enterprise
Survey Database. Survey Database.
162
I N F O R M A L I T Y, P R O D U C T I V I T Y, A N D T H E F I R M
owner-only and to larger firms--the former being slightly
FIGURE 6.7
more afraid of fines, the latter being more concerned about
Impact of changes in costs and benefits of informality
bribes, and both giving limited importance to issues
related to access to credits and the courts. Firms remain informal
The relative importance of the various private costs and
benefits associated with informality is likely to vary with a
number of firm characteristics, including size, time in busi-
ness, and productivity. Thus, for instance, compared to larger
firms, microenterprises may face a smaller risk of being
Benefits Costs Benefits Costs
caught by government inspectors when operating irregu-
larly. However, they are likely to have a harder time Firms become formal
amortizing the fixed costs associated with regulatory
compliance--for example, the costs of firm registration, per-
mits, and licenses--that may be a non-issue for large firms.
Moreover, the red tape and monetary costs associated with
formalization probably have a larger effect on recently cre-
ated firms, which may choose to avoid them until they have Benefits Costs Benefits Costs
accumulated sufficient evidence regarding their actual prof-
Source: Prepared by authors, based on hypothetical cost and
itability and likelihood of staying in business. benefit figures.
Similarly, firms with inherently low productivity and/or
growth prospects are likely to have a lower demand for
credit and business development services, as well as for con- where a reduction in the benefits from informality proves
tract enforcement mechanisms, thus being less affected in insufficient to induce firms to formalize because the costs of
their informality decisions by the level of development of informality--or, equivalently, the advantages of operating
market support institutions--the courts, financial markets, formally--are too low. In those cases, as illustrated in the
and the like. This would explain, for instance, why firms lower panel of figure 6.7, for policy reforms to have binding
belonging to the upper tier of the microenterprise sector effects on firm behavior, efforts may need to be directed
are more likely to operate formally, or why registered firms both at reducing the benefits and at increasing the costs of
with relatively low levels of productivity are more likely to operating informally.7
report higher rates of tax and social security evasion. As for- As an example, establishing the existence of very high
malized by Rauch (1991), to the extent that taxes and reg- registration costs does not, in itself, imply either that this
ulations are enforced mainly among large, formal sector is why firms don't register or that not registering is a fun-
firms, entrepreneurs with higher managerial ability are damental determinant of average small firm performance.
endogenously allocated to big firms where they are able to De Soto's (1989) telling anecdotes--for example, the side-
compensate for the corresponding higher regulatory costs. walk vendor who wishes to pay his/her taxes as a way of
In contrast, smaller and informal businesses are more likely securing quasi-property rights to his/her pitch--do sug-
to be run by less-talented entrepreneurs, which would be gest that the high costs of formalization may impede infor-
compensated by the lower costs of informal operations. mal firms from enforcing their property rights and
It is worth noting that, from a policy point of view, pro- accessing public services, and may limit their access to
grams aimed at reducing informality by means of affecting markets, thus negatively affecting their performance. How-
its private benefits--for instance, by reducing barriers to ever, one must bear in mind that registration costs are only
entry into the formal sector--may prove ineffective if the one of the factors that informal firms are likely to consider
costs of operating informally are too low--for instance, when assessing whether to enter the formal sector. And,
because regulatory enforcement and the odds of getting depending on the importance of other costs and benefits
caught are low or because firms place little value on market- associated with formality, registration costs may not be the
or government-provided services available to formal firms. binding constraint for most small informal firms, perhaps
This point is illustrated in the upper panel of figure 6.7, because enforcement is limited in any case.
163
I N F O R M A L I T Y
This view is supported by recent evidence on Mexico It is worth noting, however, that "pushing" all firms
reported by McKenzie and Woodruff (2006). Using a sur- into the formal sector may not necessarily be feasible or
vey of informal microfirms, they show that the vast major- good social and economic policy. Indeed, if, as argued by
ity of them give as the principal reason for not being Levenson and Maloney (1998), formality operates as a nor-
registered not that registration is too expensive or time- mal input in the production function of firms, it is possible
consuming (respectively, 2 and 8 percent of surveyed that the intrinsic cost structure of many informal microen-
firms), nor that the costs of operating as registered busi- terprises may never, in fact, dictate that they grow large
nesses are too high (4 percent of firms), but that they are enough to need most of the formal institutions of civil soci-
too small to make it worth their while (75 percent). ety. Thus, for instance, given their very restricted markets,
A somewhat different picture emerges, however, from many of those microfirms may find it more efficient to use
household survey data from Argentina, where most unreg- informal contract enforcement mechanisms and to operate
istered microfirm owners report that they have remained on the basis of internal sources of finance. As a result, forc-
informal because registration is too expensive (57 percent) ing them to formalize or trying to bring them into formal
or complicated (4 percent), compared to 39 percent who credit or capital markets would amount to "pushing on a
state that they do not register because it would be useless. string," and it could lead large numbers of self-employed
Data from the Dominican Republic suggest a breakdown workers into open unemployment, while pushing formal
similar to Mexico's: only 8 percent of informal microfirm sector wages downward.
owners report that they remain informal to avoid taxes and Potentially countering these effects, however, one could
social security costs, while 20 percent want to save the time argue that overall productivity could increase in the corre-
and money involved in formalization. In contrast, almost sponding economies, as surviving microenterprises--the
two-thirds indicate that they are too small to make formal- "upper tier" of the sector--become more efficient, thanks to
ity worthwhile, they don't need to be formal, or they don't formality, and as the goods and services previously produced
register because no business like theirs does. Interestingly, by "lower-tier" microfirms are offered by larger and more
92 percent state that their businesses have not suffered as a productive firms. Which effect prevails depends, however,
result of being informal, and 38 percent indicate that they on whether formalization does indeed increase the produc-
have actually benefited from their informal status--mainly tivity of some "upper-tier" microfirms, and on whether
through lower taxes and the avoidance of government reg- informality does generate considerable negative externali-
ulations. Similarly, a survey of Guatemalan informal entre- ties on the rest of the economy (topics that we cover in the
preneurs, performed by the National Economic Research next section of this chapter).
Center, indicates that the majority of them do not perceive
any concrete benefit from complying with government reg- Cross-country evidence on the determinants
ulations (CIEN 2006). of informality
The above evidence leaves open the hypothesis that, Despite convincing cross-country evidence confirming the
depending on each specific country context, registration relevance of several of the above-cited potential costs and
costs may or may not be binding for most small firms and, benefits of informality, the data suggest that, to affect the
in some cases, they could at best be a marginal contributor size of the underground economy, policy makers may need
to informality. If this is indeed the case, further incentives to act on several fronts at the same time. The effects of reg-
may be needed to entice small firms to enter the formal sec- ulations, for instance, appear to depend on the quality of
tor, including both positive and negative incentives--the governance. Moreover, as argued above, small changes in
carrots and sticks mentioned above. While the latter only some of the private costs or benefits of informality may
involves increased government enforcement of regulations not have a binding effect on firms' decisions regarding reg-
and potentially higher penalties for evaders, positive incen- ulatory compliance.
tives range from tax reductions to changes in labor market The presence of a positive relationship between the regu-
regulations and improvements in private and public ser- lation of firm entry and labor markets, on one hand, and the
vices available to formal firms (for example, credit, contract size of the informal sector, on the other, has been illustrated
enforcement, technical assistance, and so forth). by Botero et al. (2003) and Djankov et al. (2002). These
164
I N F O R M A L I T Y, P R O D U C T I V I T Y, A N D T H E F I R M
authors were the first to construct large cross-country data- where tax regulations and enforcement are perceived as
bases covering, respectively, the legal requirements for reg- being fair--thus increasing "tax morale"--low levels of
istering new firms (together with the time and costs tax evasion and informality can be achieved without nec-
involved in the corresponding procedures); and data on essarily reducing tax burdens, thereby allowing for an
employment, collective bargaining, and social security adequate provision of productivity-increasing public
laws.8 Djankov and his coauthors show that, for given levels goods.
of per capita income, the informal sector tends to be larger The above findings imply that both the quantity and the
in countries where registering a new firm involves a larger quality of regulation matter for explaining cross-country
number of procedures or where employment and industrial differences in the size of the informal sector. In particular,
relations laws are more rigid. These results suggest that, at reducing the quantity of regulations may be a good way of
least on average, entry and labor regulations are not driven diminishing informality in countries characterized by bad
mainly by public interests, nor are they means for increasing governance, but it may have a much smaller--or even a
the efficiency with which society operates. null or negative--impact where the quality of institutions
Using a smaller sample but new estimates of the size of is high. This is illustrated by the findings of Loayza,
the informal sector for 14 Latin American and Caribbean Oviedo, and Serv�n (2005) that labor and product
countries, Loayza (1996) shows that informality is posi- markets10 regulations are positively related to the size of
tively associated with levels of taxation and labor market the informal sector only for countries with low governance
regulations, and negatively correlated to the strength and quality, below a threshold that corresponds roughly to the
efficiency of government institutions. Loayza and Rigolini levels of Greece, Japan, and Spain. To measure the quality
(2006) confirm these results in a dynamic framework, of governance, Loayza, Oviedo, and Serv�n use indicators of
showing that, in the long run, informality is negatively and the absence of corruption in the political system, prevalence
robustly related to the flexibility of business regulations, of the rule of law, and level of democratic accountability.
the value of public services associated with law and order, They argue, and their results seem to confirm, that in coun-
and the capacity of governments to monitor and enforce tries with better quality of governance, regulations are
formal taxes and regulations.9 more likely to be driven by valid social goals, as opposed to
One caveat to the above results is that the long-run the interests of particular groups, and their enforcement is
links between regulations and informality may apply dif- probably more transparent and less discretionary. In con-
ferently in countries characterized by strong or weak insti- trast, where corruption is high, and democracy or the rule
tutions, with good or bad governance systems. This is of law is weak, increasing the quantity of regulations is
exemplified by the finding of Friedman et al. (2000), in a likely to stimulate informality. Consistent with the find-
sample of 69 countries, that higher tax rates are not corre- ings of Friedman et al. (2000), Loayza, Oviedo, and Serv�n
lated with a larger unofficial economy, and may, in fact, be (2005) also find that higher levels of fiscal regulations are
linked to a smaller informal sector. They interpret this associated with smaller informal sectors in countries with
result by suggesting that, across the countries in their good governance, but fiscal regulations are unrelated to the
sample, the incentive to evade high tax rates is out- extent of informality in countries where the quality of gov-
weighed by the larger benefits of formality in countries ernance is sufficiently low--the threshold corresponding to
where higher tax revenues help finance productivity- the levels of Colombia and Pakistan.11
enhancing public goods and a strong legal environment.
Indeed, they find that most of the available indicators of Firm-level evidence on the determinants
bad governance--including corruption, overregulation, of informality
and weak legal environments--are positively and robustly Using survey-based, firm-level data for five Eastern European
related to the size of the informal sector. Thus, high tax countries, Johnson et al. (2000) confirm some of the above
rates can coexist with small unofficial economies, provided cross-country results. They find, for instance, that among
that rules and regulations are not enforced in a discre- Russian and Ukrainian manufacturing firms, respectively,
tionary way and that levels of corruption are kept under an average 41 and 29 percent of sales go unreported for tax
control. In other words, as argued elsewhere in this report, purposes, compared to between 5 and 7 percent of sales
165
I N F O R M A L I T Y
in Poland, Romania, and Slovakia. This is not surprising, Panama, Paraguay, and Peru. The relative importance of
Johnson and coauthors argue, given that managers in other labor issues varies across countries, with regulations
Russia and Ukraine face much higher taxes, report much on temporary work being mentioned more frequently in
higher levels of bureaucratic corruption and Mafia extor- Argentina and Bolivia (after severance costs), as well as in
tion, and exhibit a lower trust in their legal and court sys- Colombia and Panama, and retirement benefits being the
tems. However, firm-level regressions on the determinants issue of second-most importance in Uruguay.
of informality using the same data for three of the five In the case of Panama, we also find some evidence of a
countries cited above suggest that only the prevalence of link between informality and the enforcement of tax regu-
corruption--measured through firms' reporting of extrale- lations. Indeed, in this country we find that informality
gal payments for services or government licenses--has a decreases with the percentage of firms in the corresponding
significant relationship with the percentage of sales unre- city and sector that have been visited or inspected by tax
ported for tax purposes, with no effects found for taxation officials during the previous year. For each percentage point
or court efficiency. increase in the probability that a firm is visited by tax
Enterprise survey data for Latin America and the inspectors, the fractions of unreported sales and workers are
Caribbean also suggest that corruption is positively and reduced by between 1 and 2 percentage points. This result
significantly related to informality. As seen in table 6.1, in is consistent with evidence on the higher prevalence of
five of the seven countries for which data are available (the informal salaried workers among Brazilian firms located in
exceptions being Panama and Peru), companies reporting areas where labor regulations are less tightly enforced.
that bribing of government officials to "get things done" is Indeed, Almeida and Carneiro (2005) show that, for each
a common practice in their line of business exhibit rates of 10 percent increase in the number of fines per 1,000 firms
revenue and worker underreporting that are between 4 and issued due to irregularities associated with unregistered
8 percentage points larger than those of other firms. As workers, the fraction of informal employees falls by 1.2 per-
suggested by Johnson et al., (2000), this result could be cent as a proportion of total employment.
due to firms' underreporting some of their activities (sales Interestingly, Almeida and Carneiro also find that the
and workers) in order to hide them from corrupt officials. lower level of informality resulting from a tighter enforce-
Alternatively, if causality runs in the opposite direction, ment of labor regulations is associated with a decrease in
bribes could be a condition for remaining partially infor- labor productivity--a reduction of 3.6 percent for each
mal. Moreover, a complementary explanation is that firms 1 percentage point decrease in the proportion of informal
that view the government as corrupt may also place a lower employment--and lower investments in capital and tech-
value on the public goods that it provides, and thus have nology. This result is consistent with the findings of
lower incentives for contributing to its financing. Scarpetta and Tressel (2004) that higher labor adjustment
To evaluate the effect of labor regulations on informality, costs resulting from stricter employment protection legisla-
we construct a dummy variable for firms stating that those tion may lead, at least in some industries and countries,
regulations significantly affected their hiring and firing to lower levels of total factor productivity. In other words,
decisions during the previous year. Both for the pooled it appears that, in some specific contexts, the added
sample and for three individual countries--Argentina, flexibility resulting from informality--which is one of
Colombia, and Mexico--we find that firms constrained by the above-mentioned private benefits from regulatory
labor regulations evade a higher fraction of taxes and/or noncompliance--can facilitate the introduction of new
social security contributions. In most cases, the cost of sev- technologies and enable firms to operate more efficiently.
erance payments is the aspect of labor market regulations These benefits, however, may not necessarily prevail over
firms most frequently report as the biggest obstacle to hir- the various above-mentioned costs of informality, which, as
ing more workers (figure 6.8). The only exception, among argued below, may lead to a negative relationship between
the eight countries for which data are available, is Mexico, informality and overall productivity.
where severance costs are surpassed (as an obstacle) by the The results in table 6.1 also provide some support to the
costs of health insurance contributions. Health costs are hypothesis that, where market support mechanisms and
second in importance to severance payments in Colombia, links with large firms are better developed, informality
166
TABLE 6.1
Firm-level correlates of sales and employment underreporting
Argentina Bolivia Colombia Mexico
Underreported Underreported Underreported Underreported Underreported Underreported Underreported Underreported
sales employment sales employment sales employment sales employment
Variable (1) (2) (3) (4) (5) (6) (7) (8)
Corruption dummy 6.436 5.655 4.462 6.603 3.119 4.784 7.222 4.850
(0.000)*** (0.000)*** (0.088)* (0.033)** (0.184) (0.043)** (0.001)*** (0.021)**
Labor regulations 1.957 4.793 0.791 4.659 6.771 7.607 8.358 0.731
dummy (0.267) (0.004)*** (0.799) (0.204) (0.005)*** (0.002)*** (0.006)*** (0.803)
167
Tax inspections 0.014 0.054 0.089 0.370 0.209 0.094 0.040 0.056
(average n) (0.898) (0.615) (0.701) (0.176) (0.196) (0.564) (0.644) (0.502)
Contract enforcement 0.086 0.116 0.170 0.100 0.019 0.128 0.288 0.227
(average %) (0.510) (0.352) (0.348) (0.640) (0.890) (0.356) (0.033)** (0.081)*
Large clients dummy 5.775 2.954 1.271 1.378 3.927 3.719 2.360 0.125
(0.001)*** (0.087)* (0.673) (0.698) (0.053)* (0.069)* (0.364) (0.960)
Bank loans (% of 7.292 10.611 34.587 1.148 1.679 5.503 17.277 5.986
firms) (0.461) (0.259) (0.232) (0.973) (0.916) (0.732) (0.156) (0.611)
Observations (n) 744 744 432 432 833 833 1,009 1,009
Correlation of 0.50 (0.00) 0.43 (0.00) 0.64 (0.00) 0.67 (0.00)
residuals (p-value of
independence test)
(Continued)
TABLE 6.1
Firm-level correlates of sales and employment underreporting (Continued)
Panama Peru Uruguay Pooled sample
Underreported Underreported Underreported Underreported Underreported Underreported Underreported Underreported
sales employment sales employment sales employment sales employment
Variable (9) (10) (11) (12) (13) (14) (15) (16)
Corruption dummy 2.246 0.469 2.281 2.948 7.300 3.085 4.832 4.835
(0.680) (0.932) (0.234) (0.171) (0.017)** (0.311) (0.000)*** (0.000)***
Labor regulations 4.139 2.513 2.015 1.141 1.209 2.385 1.937 3.196
dummy (0.438) (0.641) (0.288) (0.593) (0.624) (0.332) (0.062)* (0.002)***
Tax Inspections 1.840 1.270 0.024 0.022 0.439 0.337 0.050 0.022
(average n) (0.007)*** (0.065)* (0.800) (0.834) (0.132) (0.246) (0.237) (0.608)
Contract enforcement 0.861 0.366 0.052 0.073 0.568 0.698 0.119 0.072
168
(average %) (0.191) (0.582) (0.612) (0.528) (0.195) (0.111) (0.009)*** (0.122)
Large clients dummy 2.075 4.501 2.107 4.267 0.191 0.055 2.814 2.709
(0.635) (0.308) (0.280) (0.052)* (0.949) (0.985) (0.004)*** (0.006)***
Bank loans (% of 68.822 15.790 14.453 1.006 11.987 11.923 0.594 4.351
firms) (0.240) (0.789) (0.423) (0.960) (0.572) (0.573) (0.904) (0.383)
Observations (n) 417 417 575 575 268 268 4,278 4,278
Correlation of 0.55 (0.00) 0.52 (0.00) 0.60 (0.00) 0.58 (0.00)
residuals (p-value of
independence test)
Source: Authors� calculations, using the World Bank's Enterprise Survey Database.
Note: Firm size, time in business, labor productivity, formality status at time of starting up, sector, and location are also controlled for. Estimation was performed for each
country, using seemingly unrelated regressions. Probability values are in parentheses.
* p < .1.
** p < .05.
*** p < .01.
I N F O R M A L I T Y, P R O D U C T I V I T Y, A N D T H E F I R M
only significant difference is obtained for manufacturing,
FIGURE 6.8
which shows higher social security evasion than all other
Labor regulations described by firms as biggest obstacle to
hiring workers sectors. At the country level, somewhat different patterns
emerge in some cases: in Argentina, tax evasion is highest
in manufacturing; in Bolivia, employment underreporting
Argentina
is highest in services; and in Mexico, tax evasion is lowest
Bolivia in services. The above cross-sector differences are obtained
after controlling for firm characteristics (for example, firm
Colombia size, productivity, and location, among others), as well as
for such sector-specific factors as the incidence of corrup-
Mexico tion and the strength of regulatory enforcement (see regres-
sors in table 6.1). Thus, there must be other unobserved
Panama characteristics of firms operating in those sectors that make
them more likely to evade government regulations. While
Paraguay we can only speculate about such unobserved factors, they
could include, for instance, a greater ability to avoid gov-
Peru ernment enforcement (as in the case of firms engaged in
local urban transport, short-term construction contracts, or
Uruguay
locally distributed manufacturing goods), and competitive-
ness challenges faced by previously protected industries in
0 0.2 0.4 0.6 0.8
the context of trade liberalization (as in the case of manu-
Retirement benefits Health insurance facturing firms using tax evasion as a way to compete with
Work hours Temporary work
low-cost foreign manufacturers).
Severance cost
The results discussed above also suggest that the factors
Source: Authors' calculations, using the World Bank's Enterprise driving the underreporting of sales and workers are very
Survey Database.
similar. Moreover, the firms' decisions to evade taxes and
social security appear to be quite interrelated, as revealed
tends to be lower. In particular, firms that operate in sectors by the fact that the residuals of the corresponding regres-
and regions where the use of third-party contract enforce- sions are highly correlated (table 6.1). These findings lend
ment mechanisms is more frequent have lower tax and credence to the hypothesis that firms behave strategically
social security evasion rates. On average, for the pool of the when evading taxes (income taxes, value-added taxes, and
seven countries for which we have data, an increase of so forth) and hiring workers off the books, and that they
10 percentage points in the fraction of firms that use third understandably seek to be consistent in the information
parties to solve commercial disputes--a change of about they report to the tax and social security authorities to pro-
one standard deviation in that variable--is associated with tect themselves from possible audits. Moreover, firms prob-
a reduction of about 1 percentage point in the fraction of ably decide simultaneously on their levels of tax and social
unreported sales. Moreover, while we do not find evidence security evasion, taking into account both tax and labor
for any impact of access to financial services on informality, market regulations and enforcement.
the results in table 6.1 suggest that companies that sell A note of caution is in order, however, with regard to
mainly to large firms (that is, companies with more than the regressions reported in table 6.1, as their explanatory
100 employees) exhibit rates of underreporting that are power is relatively small, with R-squared statistics ranging
about 3 percentage points lower. from 5 to 20 percent. Thus, while those results illustrate
As for differences in tax evasion rates across sectors, we the relevance of a number of factors underlying the large
find in the pooled sample that the highest rates of sales size of the informal sector in several countries of the region,
underreporting are in the construction and transport sector, we are unable to explain as much as 80 percent of the tax
followed by manufacturing, and then by commerce and and social security evasion behavior of the corresponding
services.12 In the case of employment underreporting, the firms.
169
I N F O R M A L I T Y
Impact of simplified registration microenterprises that do not have salaried employees, and
and tax systems for whom registration with IMSS is not mandatory. One
While the existing statistical evidence suggests that reduc- possible, albeit somewhat surprising, interpretation of the
ing the time and cost required for firm registration can con- conflicting conclusions reached by Kaplan, Piedra, and
tribute to increases in the number of formally registered Seira and by Bruhn is that SARE could have had a sizable
firms, the magnitude of the corresponding effects is still effect on the creation of new owner-only formal businesses,
subject to some controversy. In particular, both Bruhn but a much smaller impact on the formalization of existing
(2006) and Kaplan, Piedra, and Seira (2006) have analyzed informal microfirms. In any case, it appears that further
the effect of a Mexican program that allows firm registra- research is needed to evaluate the impact on informality of
tion procedures to be completed within three days--the simplified firm registration programs, such as SARE.
so-called Rapid Business Opening System (Sistema de Complementary evidence concerning the impact on
Apertura R�pida de Empresas [SARE]) program imple- informality of red tape reduction programs has been
mented in about 30 Mexican cities. Kaplan, Piedra, and obtained from the analysis of the Brazilian Integrated Sys-
Seira find that SARE has led to statistically significant, tem for Tax and Social Security Payments for Micro and
albeit quantitatively small, effects in the flow of new regis- Small Firms (Sistema Integrado de Pagamento de Impostos
tered firms, which would increase by between 4 and 8 per- e Contribucoes as Microempresas e Empresas de Pequeno
cent as a result of SARE, implying about two to five new Porte [SIMPLES]) program. In a manner different from
firms registered and 12 to 19 new formal jobs created per SARE, however, this program combines simplified firm
municipality per month. They show that the effects of registration with lower taxes and social security contribu-
SARE have been concentrated in the first 10 months after tions for micro- and small enterprises, allowing for an
its implementation, which, they argue, suggests that the 8 percent reduction in the overall tax burden faced by eligible
impact of the program is limited to the formalization of a firms. Both Fajnzylber, Maloney, and Rojas (2006a) and
small fraction of the existing stock of informal firms. Monteiro and Assun��o (2006) find that, at least during the
Bruhn (2006), nevertheless, reaches somewhat different year following the implementation of SIMPLES, the pro-
conclusions on the impact of SARE, possibly as a result of gram led to statistically significant increases in formal reg-
the use of a different data source (employment surveys as istration rates of between 6 and 13 percentage points,
opposed to official administrative records) and a different depending on the sample and methodology. While further
estimation technique (one based on the different timings of research may be needed to establish whether the effects of
implementation of the program across Mexican cities). SIMPLES were permanent or temporary, the above evi-
Bruhn focuses on the effect of SARE on the fraction of dence suggests that there is a potential for increasing
registered businesses, as captured by Mexico's national microfirm formalization by combining red tape reduction
employment survey. She finds that the program had a much with tax relief measures for microfirms.
larger effect than the one reported by Kaplan, Piedra, and Programs to simplify and reduce tax burdens for small
Seira--namely, a 5.6 percent increase in the stock of regis- contributors, including individuals and small firms, have
tered businesses. This implies that SARE can be credited been implemented in recent years in a number of Latin
for about 1,000 new registered firms per county, on aver- American and Caribbean countries. These countries include
age. Moreover, Bruhn shows that past informal business Argentina (the Monotributo program), Bolivia (the simpli-
owners are not more likely to register their businesses after fied tax regime for small firms in selected activities [RTS]),
SARE, but former wage earners with conditionally high Colombia (simplified value-added regime for small contrib-
wages do become more likely to open a formal business. utors), Costa Rica (RTS), Chile (simplified income tax),
The fact that Bruhn's estimates imply effects that are much Ecuador (simplified value-added tax), Mexico (simplified tax
larger than those obtained by Kaplan, Piedra, and Seira can regime for small contributors), Nicaragua (single payment
also be attributed to the different types of businesses that system for value-added and income taxes), Honduras (sim-
are covered in the databases used in each of those reports. plified sales tax), Paraguay (single tax for owner-only firms),
Indeed, while Kaplan, Piedra, and Seira look at firms regis- Peru (simplified unique tax and special income tax regimes),
tered with the Mexican Social Security Institute (IMSS), and Uruguay (small-enterprise tax system).13 Given the evi-
Bruhn's employment data also cover the large majority of dence from the Brazilian case, it appears that most countries
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I N F O R M A L I T Y, P R O D U C T I V I T Y, A N D T H E F I R M
in the region could benefit from a revision of their simpli- of overall productivity drive a large number of firms into
fied tax systems for micro- and small enterprises in order to informality, consumer demand is also likely to be directed
better suit them for the objective of increasing formality-- toward products and services whose production does not
for instance, by combining them with simplified firm regis- exhibit increasing returns to scale, so one should not expect
tration systems, such as Mexico's SARE. large static losses from informality driven by low firm size
alone.
Impact of informality on firm productivity Besides potential static inefficiencies associated with the
and economic growth nonexploitation of economies of scale, a parallel concern is
As argued above, many lower-tier microfirms may choose that unproductive firms are able to compete with their
to operate informally as a result of their limited levels of lower-cost peers by means of avoiding taxes and regula-
productivity and growth potential--levels that translate tions. Thus, informal firms may be able to stay in business
into a small demand for market- and government-provided despite having higher operating costs--driven, for
services that have formality as a precondition. Not surpris- instance, by lower levels of entrepreneurial ability. This
ingly, when deciding to formalize, they are often more could slow down the creative destruction process by which
motivated by sticks--avoiding fines and bribes--than by innovative, high-productivity firms expand to the detri-
carrots like access to credit or formal contract enforcement. ment of less-productive ones. In other words, to the extent
This, however, does not mean that increasing formality that increases in regulatory enforcement drive out of busi-
does not in itself have the potential for increasing overall ness a large number of firms that self-selected into infor-
productivity, through both static and dynamic channels--a mality because of having lower productivity than firms of
possibility that we review next, both conceptually and from the same size operating in the same sectors, one could
an empirical point of view. expect potentially large negative effects on aggregate pro-
ductivity. One caveat to this argument, however, is that, as
Static versus dynamic effects shown by Almeida and Carneiro (2005) for the case of labor
To the extent that informality is associated with a prepon- regulations, informality may allow firms greater flexibility
derance of small firms, there is a concern that it could lead in their employment and production decisions, which, in
to considerable efficiency losses. This prediction, however, turn, could lead them to operate more efficiently. Whether
depends on whether returns to scale are constant or increas- this effect dominates other factors that could lead to a neg-
ing. As reviewed by Tybout (2000), the literature on the ative link between informality and firm productivity--for
subject is divided between simulation studies, which often example, the self-selection of unproductive firms into infor-
assume decreasing average costs, and survey-based esti- mality, the incentives to operate at a small scale to avoid
mates, which generally suggest that the benefits from detection, and the inability to gain access to factor and
increasing plant size are relatively small. Thus, while one- product markets--is a question that only empirical evi-
person establishments are usually found to be less efficient dence can help resolve.
than firms with at least some employees, returns to scale A parallel concern is that high levels of informality could
among the latter firms are very close to unity and, at most, also have negative consequences on the incentives of formal
mildly increasing. firms to innovate and adopt new technologies, which also
This is not to say that increasing returns to scale are not the could reduce overall productivity growth. Several studies have
norm in some specific industries, notably the most capital- emphasized these potentially negative dynamic implications
intensive ones. However, because of their limited access to of informality. Thus, Capp, Elstrodt, and Jones (2005),
capital and skilled labor, and to avoid cost disadvantages, Elstrodt, Lenero, and Urdapilleta (2002), Farrell (2004),
micro- and small firms tend to locate in industries where effi- Kenyon and Kapaz (2005), and Palmade (2005) see informal-
ciency losses associated with low scale production are limited. ity as one of the main causes for the gap in productivity levels
This is facilitated by the fact that demand for such products is between developed and developing countries, inducing dis-
negatively correlated with countries' per capita incomes, as tortions in investment decisions and limiting the growth
Engel effects direct consumer demand toward simpler prod- potential of the corresponding economies. Studies performed
ucts that can be efficiently produced with labor-intensive by the McKinsey Global Institute suggest that informality
technologies. In other words, in countries where lower levels accounts for around 50 percent of the productivity gap
171
I N F O R M A L I T Y
between countries like Turkey, Portugal, and the United effect of impeding the ability of the frontier quality pro-
States; and for 30 percent of the productivity gap between ducer to set a price that would force all other producers--of
Brazil and the United States (Farrell 2004). lower qualities--to leave the market. The impact on
The main argument proposed by these studies is that research and development investments--thereby including
firms that join the informal sector tend to become "trapped the expenditures involved in adapting foreign technologies
in a self-reinforcing dynamic that confines them to subscale, to local conditions--is, however, ambiguous. Indeed, while
inefficient, low-productivity work" (Farrell 2004, p. 30). informality decreases the market power and profit levels of
Moreover, informality also has negative effects on the frontier producers, it also increases the life span of frontier
investment decisions of formal firms, as it reduces their products by augmenting the quality improvements that are
market share and profitability. The relative cost advantages needed to debunk current market leaders. As a result, invest-
enjoyed by informal firms as a result of not paying taxes and ments in research and development--and growth--could
not incurring the costs of regulatory compliance, however, increase or decrease, depending on which effect dominates.
allow them to stay in business despite their low productiv-
ity, which, as mentioned above, could distort competition Aggregate growth effects
and limit the process of creative destruction. Moreover, as Despite the widespread belief that a large informal economy
more productive firms also have fewer incentives to invest in hurts economic growth, cross-country comparisons do not
innovation and technology adoption, the McKinsey studies find a robust association between informality and growth.
(reviewed in Farrell [2004]) suggest that informality leads Figure 6.9 shows the estimated impact of informality on
to an overall reduction in economic growth. growth, using two diverse informality indicators: self-
One caveat to these arguments is that, from a theoretical employment and the Schneider (2005) estimates of the pro-
point of view, technology adoption and innovation could portion of GDP produced by the underground economy in
either decrease or increase as a result of unfair competition the period 1999�2000. In accordance with common wisdom,
by informal firms. In particular, as argued by Cunha under both indicators informality appears to have a negative
(2006), if technological change takes the form of the impact on growth: on average, the regressions suggest that
discovery--or introduction into the country--of improved decreasing informal economic activity by 10 percent of GDP
qualities for intermediary goods, informality may have the is associated with 0.6 percent higher economic growth.
FIGURE 6.9
Estimated impact of informality on growth
Informality - % of GDP Self-employment
Without controls
Controlling for initial education
Controlling for regulation
Controlling for financial depth
Controlling for investment
Controlling for corruption
All controls
0.10 0.05 0 0.05 0.10 0.05 0 0.05
Estimated impact 95% confidence interval
Sources: Authors' calculations from Barro and Lee 2000; Fraser Institute 2005; ILO 2005; Schneider 2005; and World Bank 2005.
Note: The dependent variable is average growth of GDP per capita during the period 1990�2003. All regressions include a constant, regional
dummies, and initial log of GDP per capita. Education represents the average years of education of the population over age 25. Regulation is
an index of regulatory efficiency from the Fraser Institute. Financial depth represents the log of private domestic credit over GDP in 1990.
172
I N F O R M A L I T Y, P R O D U C T I V I T Y, A N D T H E F I R M
Nonetheless, the estimated coefficients tend not to be surprisingly large in developing countries, such as Chile
robust. In none of the presented regressions is the coefficient and Colombia. These results, however, do not necessarily
associated with self-employment significantly different from constitute evidence that the creative destruction process,
zero at the 5 percent level. To be sure, when we use the macro- initially described by Joseph Schumpeter, is alive and well
economic estimates of informality, the basic regression with- in those countries, as the observed high turnover rates could
out added explanatory variables shows a negative and be the result of high macroeconomic instability and of the
statistically significant association between informality and preponderance of small firms--which have inherently
growth. However, the relationship loses its significance when higher rates of failure. Thus, when corrected by volatility,
we control for education, financial depth, or corruption.14 turnover rates are not larger in Latin America and the
Thus, while previous studies have found a negative relation- Caribbean than in industrial countries. Moreover, while
ship between informality and growth, they have relied on a there is evidence that entrants in Chile and Colombia are
very narrow pool of observations (Loayza 1996) or have not slightly more efficient than incumbents, and that new low-
controlledforrelevantcorrelatesofgrowth,suchasregulation, productivity firms tend to go out of business rapidly, the
human capital, and initial GDP per capita (Schneider and impact of this process on overall productivity is found to be
Klinglmair 2004). It is worth noting, however, that the fact relatively small.
that we do not observe large effects of informality on growth
after controlling for other standard growth determinants may Firm-level effects of informality
just reflect our inability to empirically distinguish between As evidenced in figure 6.10, firms that report having
thedirecteffectsofthosevariablesandindirecteffectsthrough started operations without formally registering--at least
informality.Inotherwords,oneofthechannelsthroughwhich initially--exhibit, on average, much lower levels of output
some of those standard drivers of growth operate could be per worker, even after controlling for firm size, time in
increasing informality--for example, low human capital business, sector, and region. In other words, those that start
reducing the opportunity cost of self-employment, or up informally are clearly at the bottom end of the produc-
corruption diminishing the incentives to comply with tivity distribution of the corresponding industries and
regulations--but this would not be apparent in the results regions. The difference in labor productivity between those
reported in figure 6.9. firms and the ones that have always operated formally is
29 percent, on average, for the seven Latin American and
Empirical evidence on creative destruction Caribbean countries analyzed here. The effects are largest
in Latin America and the Caribbean region
The arguments on the negative dynamic effects of infor-
mality offered above should lead us to expect a less vibrant
FIGURE 6.10
process of industrial evolution in developing countries than
Estimated impact of informality on labor productivity (%)
in industrial countries--a process that should be reflected
in higher productivity dispersion and lower firm turnover. Argentina
The evidence, however, suggests that the average distance Bolivia
to "frontier" production technologies is similar in studies of Mexico
developing and OECD countries, with average technical effi-
Panama
ciency levels equivalent to about 60�70 percent of the corre-
Peru
sponding best practices (Tybout 2000). These measures, it
Pooled sample
must be noted, are usually based on data that exclude
microenterprises and low-productivity, owner-only firms, so 50 40 30 20 10 0
Labor productivity
they probably underestimate productivity dispersion.
As for the evidence on the rates of firm and job creation Source: Authors' calculations, using the World Bank's Enterprise
Survey Database.
and destruction, the evidence on whether it is lower or Note: The figure reports coefficients on formality indicators in
regressions of the log of output per worker on a dummy for not
similar in least-developed countries is ambiguous. Roberts
having formally registered at the time of starting up, controlling
and Tybout (1997) show that rates of firm turnover and for employment size, time in business, and sector and region
dummies.
market shares of recent entrants into the formal sector are
173
I N F O R M A L I T Y
in Peru (50 percent), and, while lower in the remaining
FIGURE 6.11
countries, they are statistically significant in four out of
Effects of a 10 percent increase in tax and social security evasion
seven countries, the exceptions being Uruguay, Panama, at the industry region level on individual firm productivity
and Colombia (not shown).15 (pooled sample)
Registered firms that report having started informally
are only 6.6 percent of all formal firms (in the pooled sam-
Labor
ple), and respond for just 4.3 percent of total sales and productivity
3.6 percent of employment. Thus, the increase in aggregate
productivity derived from hypothetically excluding them
Total factor
from their sectors--for example, by a stricter enforcement productivity
of entry regulations--would be relatively small: about
0.8 percent, on average.16 However, to the extent that labor
12 10 8 6 4 2 0
productivity is higher in registered firms that started up
Tax evasion Social security evasion
informally but eventually registered, than in similar firms
that started informally but never registered, the potential
Source: Authors' calculations, using the World Bank's Enterprise
impact on productivity of fully enforcing entry regulations Survey Database.
Note: The figure reports coefficients on formality indicators in
could be much larger. Thus, for instance, in a hypothet- regressions that control for employment size, time in business, fixed
capital stocks (in TFP regressions), and sector and region dummies,
ical scenario where all nonregistered informal Mexican
using a pooled sample of seven countries.
microfirms with no more than five employees (which repre-
sent about 21 percent of total employment in that country)
were to go out of business due to stricter enforcement of our informality measure is aggregated at the industry and
entry regulations, and assuming that employment would region levels so it could hardly be affected by individual
shift to firms with a 35.5 percent productivity advantage firm productivity. The results suggest that there are signifi-
(based on the estimate for Mexico reported in figure 6.10, cant potential productivity gains to be obtained from
which we consider a lower bound for the productivity dif- increased enforcement of tax and social security regulations.
ferentials between formal and informal firms), the resulting Further evidence on the presence of a causal link
impact on aggregate productivity could be as large as between informality and firm performance has been
6 percent.17 Off course, these are very imprecise, back-of- obtained using microenterprise survey data. In the case of
the-envelope calculations that are aimed only at illustrat- Mexico, Fajnzylber, Maloney, and Rojas (2006c) show that
ing a much more general point--namely, the possibility microfirms that report paying taxes exhibit higher levels of
that informality is associated with lower levels of aggregate profit, even after controlling for employment size and capi-
productivity, which should be considered in any analysis of tal stocks. This result is robust to the use of estimation
its social costs and benefits. techniques that control for the impact of unobserved per-
Informality, however, also takes the form of tax and social sonal and firm characteristics--for example, managerial
security evasion among registered firms. In this respect, it ability--that could affect both the decision to formalize
would be useful to know what would be the impact of mar- the firm and its performance. Quantitatively, we find that
ginal reductions in tax evasion on firm and aggregate pro- firms that pay taxes exhibit between 15 and 60 percent
ductivity. With that purpose, we estimate the effect of higher productivity levels, depending on the estimation
average tax and social security evasion in a given sector and method and the performance variable used--either firm
region on the level of productivity of individual firms oper- profits as reported in detailed microfirm surveys or self-
ating in the corresponding areas. The results are presented employment income as reported in the Mexican Employ-
in figure 6.11 for our pooled sample of seven countries. We ment Survey (figure 6.12). In addition, there is evidence that
find that each 10 percent increase in average evasion rates is owners of formal firms are less likely to go out of business.
associated with reductions in labor and total factor produc- One of the channels through which formality could
tivity of 7 and 10 percent, respectively. These effects are not increase firm performance is by facilitating access to factor
subject to the criticism of a possible reverse causality from and product markets. Cull, McKenzie, and Woodruff (2007)
low firm productivity to higher firm informality. Indeed, show that access to credit among small Mexican retail firms
174
I N F O R M A L I T Y, P R O D U C T I V I T Y, A N D T H E F I R M
FIGURE 6.12 FIGURE 6.13
Productivity difference between tax-paying Mexican microfirms Productivity and paid employment effects of exogenous increase in
and informal firms with similar characteristics formality driven by Brazil's SIMPLES program
Control Labor
function productivity
Ordinary Paid
least squares employment
Propensity Total factor
score matching productivity
0 0.2 0.4 0.6 0 0.1 0.2 0.3 0.4 0.5
Firm profits Self-employment income OLS Matching
Source: Fajnzylber, Maloney, and Rojas 2006c. Source: Fajnzylber, Maloney, and Rojas 2006a.
is much higher among formally registered firms. While this estimated to be associated with a 5 percent increase in paid
correlation could reflect the presence of unobserved personal employment, a 15 percent boost in total factor productivity,
and firm traits linked to both formality and access to and a 35 percent increase in labor productivity (figure 6.13).
finance, it is also consistent with informality reducing At least in the Brazilian context, however, only a small frac-
microfirm access to formal loans. Thus, for instance, if tion of the revenue-increasing effects associated with for-
microlenders make formal registration a requisite for grant- mality can be attributed to increased access to credit
ing loans, formalization could allow credit-constrained markets and government-provided technical assistance. In
microfirms to exploit the sizable returns to investment that contrast, the greater willingness of formal firms to operate
have been estimated by Cull and coauthors--between 20 out of a fixed locale is responsible for as much as 50 percent
and 33 percent per month for investments of about $140, of the increase in revenues among formal microfirms and for
using data from a randomized experiment. a third of the corresponding total factor productivity
Evidence consistent with some of the findings for Mexico increase.
has also been obtained for Brazil on the basis of exogenous
increases in formality rates associated with the introduction Conclusions
of a simplified tax and registration system for micro- and The empirical evidence on aggregate negative growth
small firms (the above-mentioned SIMPLES). Indeed, effects of informality is not conclusive, as informality tends
econometric estimates that take advantage of changes in the to lose significance when other standard growth determi-
incentives to formalize, introduced by this program, show nants are controlled for. This, however, could be due to the
that it significantly increased access to credit among eligible fact that many of the standard drivers of growth are also
firms, and altered the amount and composition of invest- likely to affect informality--for example, low levels of
ment toward larger and longer-term projects (Monteiro and human capital or institutional quality leading to both
Assun��o 2006). Moreover, Fajnzylber, Maloney, and Rojas lower growth and higher informality--and it is difficult to
(2006a) show that increases in formality driven by SIMPLES separate their direct growth effects from those that operate
are associated with a higher use of paid labor, higher levels through larger informal sectors.
of capital intensity, and increased labor and total factor pro- The microeconomic empirical evidence, on the other
ductivity. In particular, increases in the rates of microfirm hand, is still quite limited due to the econometric
registration that can be attributed to SIMPLES are difficulties associated with distinguishing the effects of low
175
I N F O R M A L I T Y
productivity on informality (see chapter 5) from the reverse costs associated with operating legitimate businesses.
effects operating from informality to productivity. How- Internet-based technologies and one-stop shops can be
ever, the available evidence suggests that considerable effective tools to implement such programs, although their
efficiency gains could be derived from the transfer of pro- effectiveness can be greatly increased if they are used in
duction from low-productivity informal firms to their more conjunction with comprehensive reviews and revisions of
productive formal peers. Similarly, the evidence indicates existing administrative processes.
that the concerns associated with possible negative exter- We argue, however, that although eliminating unneces-
nalities generated by high levels of tax and social security sary regulations and reducing excessive red tape could con-
evasion could be well justified, as firms operating in indus- tribute to reducing the size of the informal sector, those
tries and regions characterized by high levels of sales and actions should not be the exclusive focus of policy makers
employment underreporting exhibit lower levels of labor engaged in attaining that objective. Indeed, the costs of
and total factor productivity. Moreover, there is evidence regulatory compliance are only one among other factors
indicating that exogenous increases in formality are associ- that may affect formality decisions. In particular, to attract
ated with better firm performance, which should, in princi- more businesses into the formal economy, it is crucial to
ple, translate into higher rates of economic growth. increase the potential benefits of regulatory compliance.
In this context, the interest of policy makers and develop- This implies facilitating the ability of micro- and small
ment practitioners in designing policies and programs to enterprises to tap into formal credit markets and improv-
facilitate the formalization of small businesses and increase ing the provision of business development and training
regulatory compliance by larger firms appears well justi- services available to formal firms. Moreover, it is important
fied. In particular, the fact that efforts to decrease regula- to facilitate access to product markets through public
tory burdens have recently become very popular does not procurement opportunities and supplier development pro-
come as a surprise. Burdensome regulations and costly grams aimed at increasing links with larger private firms.
bureaucratic requirements are indeed an important deter- Other ways of increasing the benefits of formality include
minant of informality that may create barriers for increas- improving the quality of legal services available to small
ing formal entrepreneurial activity. One challenge that businesses and creating mechanisms to provide information
governments face in this respect is that of assessing their to entrepreneurs wishing to formalize their businesses,
existing and new regulations to determine the extent to thereby encompassing advisory services on taxes and regu-
which they are justified by public interests, associated, for lations, as well as information about financial and nonfinan-
instance, with the protection of public safety or the envi- cial services available to them.
ronment. Dealing with this challenge may require compre- Overall, a wider and integrated approach appears to be
hensive regulatory assessments aimed at distinguishing necessary to switch the incentives of a large fraction of
relevant from anachronistic regulations, as well as at identi- informal firms in the direction of formality. Such an
fying those regulations that reflect private rather than pub- approach would likely have to combine both carrots (for
lic interests, and that could represent important barriers to example, lower costs of formalization, better and more effi-
formalization. Examples of such initiatives include national cient government services, and higher access to market-
regulatory reviews, such as those implemented in leading and government-provided services for formal firms) with
transition economies.18 sticks (such as increasing government enforcement of regu-
Similarly, many developing countries are now engaged lations and the expected cost of being caught). Moreover, as
in reducing the time and cost needed by businesses to argued later in this volume, it is crucial that both the
obtain various government-issued permits and licenses.19 enactment and the enforcement of regulations are perceived
Indeed, even well-designed and legitimate regulations may to be fair, as this is vital for maintaining "tax morale" and
create barriers to formalization if they are badly enforced or increasing regulatory compliance.
administered, creating excessive costs and uncertainty for The correct mix of policies, however, is likely to vary
private businesses. Thus, a complementary approach to across countries and over time, depending on the relative
reduce firm informality--to be pursued in parallel to regu- importance of the various determinants of informality.
latory reforms--is the implementation of administrative Moreover, other aspects of public policy should be taken into
simplification programs aimed at reducing the transaction account, including those related to the social consequences
176
I N F O R M A L I T Y, P R O D U C T I V I T Y, A N D T H E F I R M
of drastically reducing the size of the informal sector, which, Risk Guide's index of law and order; and the ratio of government
at least in Latin America, is currently responsible for a large expenditures to GDP.
10. The index of product market regulations is a composite of
fraction of employment and income-generating opportuni-
indexes of regulations in the areas of firm entry, trade barriers, finan-
ties for poor households. In other words, policies aimed at
cial markets, contract enforcement, and bankruptcy.
reducing firm informality should be considered in conjunc- 11. A related point made by Schneider and Enste (2000) is that
tion with the labor market and social protection issues asso- complex tax systems can make legal tax avoidance in the official econ-
ciated with the possibility that large contingents of omy more profitable, and thus create disincentives for informality. As
previously informal workers would have to shift to other a result, fiscal reforms that combine lower tax rates and simpler tax
systems could not necessarily lead to smaller informal sectors; the
segments of the labor market.
Austrian 1989 reform is mentioned as an example.
12. Within manufacturing, the food and beverage industry
Notes
exhibits the highest levels of evasion, even after controlling for firm
1. As in the study by Djankov et al. (2003), we leave outside the and sector characteristics.
scope of this chapter those "underground enterprises" that are 13. See Gonz�lez (2006) for additional details.
devoted to criminal activities. 14. The relationship remains weak when changing the reference
2. Since firms are understandably reluctant to reveal information period from 1990�2003 to 1999�2003 or when using five-year aver-
regarding tax and social security evasion, as well as informal pay- ages for the period 1980�2004. As the macroeconomic estimates of
ments to corrupt officials, the corresponding survey questions are informality are cross-sectional, regressions with five-year averages can
phrased in terms of the practices of "typical firms in this establish- only be performed with self-employment.
ment's line of business." This is a standard approach taken to measure 15. It is worth noting that the estimated effects for most countries
the prevalence of corruption used, for instance, by Johnson et al. are based on a sizable number of initially informal firms: between 5
(2000). Note also that figure 6.1 reports simple averages across firms. and 14 percent of all firms, or 355 in the pooled sample, 72 in
3. The high levels of tax evasion for Brazil are, to some extent, Argentina, 72 in Bolivia, 66 in Mexico, and 104 in Colombia. Our
puzzling as tax revenues in that country have increased considerably estimates are arguably weaker in Panama, Peru, and Uruguay, where
in recent years, reaching 34 percent of gross domestic product (GDP) there are, respectively, 9, 20, and 12 of those firms (between 2 and
in 2002, driven partly by improvements in tax administration effi- 3 percent of all firms).
ciency. However, respectively, 40 and 25 percent of federal tax rev- 16. This is assuming that the employment share of the initially
enues come from indirect cascading taxes and from social security informal firms is taken over by competitors, which, per our estima-
contributions and other payroll taxes that firms, as suggested by the tions, have a 29 percent productivity advantage (figure 6.9).
survey data, appear to be quite successful in evading. 17. This assumption is subject to the criticism that, as argued in
4. The controls are those described in table 6.1. the beginning of this section, informal microfirms tend to locate in
5. De Soto (1989) is the seminal reference on the links between industries where efficiency losses associated with low scale produc-
government regulations and informality. In their survey on the topic, tion are minimized. Moreover, note that we are assuming that all
Schneider and Enste (2000) list taxes, social security contributions, those working in informal microfirms would find employment in for-
and the intensity of regulations (including those of labor markets) mal firms. We base the estimated employment share of informal
among the top causes for growth in the "shadow economy." Loayza microfirms on figures on registration rates from the Encuesta Nacional
(1996) offers a theoretical model illustrating those effects and pro- de Micronegocios--27.5 percent for owner-only firms and 62.7 percent
vides supporting empirical evidence for Latin America. Additional for firms with two to five workers--and on Encuesta Nacional de
cross-country evidence on the links between tax and regulatory Empleo Urbano�based estimates of the employment shares of firms in
burdens and the size of the informal economy is provided by Botero those size ranges--respectively, 15.3 and 27.5 percent.
et al. (2003), Djankov et al. (2002), and Loayza, Oviedo, and Serv�n 18. See Djankov et al. (2003) for a description of the 1995�98
(2005). Hungarian regulatory review.
6. The surveys were done in the context of municipal adminis- 19. See the World Bank's Doing Business reports for global
trative simplification projects supported by the International Finance reviews of country-level reforms and benchmarking exercises.
Corporation.
7. In the theoretical model proposed by Sarte (2000), for
instance, changes in the fixed cost of entering the formal sector do References
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Cull, R., D. McKenzie, and C. Woodruff. 2007. "Experimental Evi- Loayza, N. 1996. "The Economics of the Informal Sector: A Simple
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1�37. McKenzie, D. J., and C. Woodruff. 2006. "Do Entry Costs Provide
Djankov, S., I. Lieberman, J. Mukherjee, and T. Nenova. 2003. an Empirical Basis for Poverty Traps?" Economic Development and
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178
CHAPTER 7
Informality, Social Protection,
and Antipoverty Policies
SUMMARY: While formal sector workers often have access to generous social security packages, informal sector workers
generally have more limited access to risk management instruments. In response to concerns about large gaps in coverage,
several countries have launched or expanded noncontributory assistance programs to help breach the coverage gap,
especially among the poor. A clear rationale for public intervention exists; however, weaknesses in the design and imple-
mentation of many programs actually exacerbate people's lack of access to protection and create further incentives for infor-
mality. Providing effective social protection for the citizens of the region will thus require a reengineering of many
countries' existing programs. In the long run, this should include providing universal "essential cover" in health, de-
linked from the labor contract and financed by general taxation; it should also include "poverty prevention" pensions
aimed at the elderly poor combined, in an incentive compatible way, with individual savings as the mainstay of life-cycle
consumption smoothing. Successful implementation of this agenda will, in most countries, require a number of short-to-
medium-term measures that increasingly improve the efficiency and design of countries' social protection systems.
T HE PREVIOUS CHAPTERS HAVE FOCUSED to ensure that programs are incentive-compatible with pro-
on characterizing the informal sector of ductive employment, as well as with workers' and their
the labor market in Latin America and the families' need for protection against health shocks, poverty
Caribbean, as well as those people who work in old age, and other debilitating risks.
in it. In characterizing informality, one core
definition relates to the absence of worker coverage by tradi- Informality and social protection: Why policy
tional social security programs--most notably health insur- makers should care
ance and pensions, but often also other benefits available to Social protection has been defined in a number of different
workers by virtue of their labor contract. This chapter ways in the literature on social policy and poverty reduction.
focuses on the "flip side" of the informality coin from the Most commonly, however, social protection is defined as a
perspective of the region's workers, that is, access to social range of measures adopted by governments to help people
protection. Specifically, the chapter examines the state of manage risk more effectively--whether in the form of pro-
workers' access to social protection in the region; the role of moting basic income security, protecting people from unan-
public social protection--or social risk management-- ticipated shocks (such as family health shocks or economic
mechanisms; and how deficiencies in the design of social downturns), developing and protecting the human capital of
protection programs contribute to the persistence of infor- society's poorest members to strengthen their ability to
mal employment, as well to as a larger failure to protect the prosper in the labor market, and/or ensuring basic service
most vulnerable members of society. It then discusses how access to those outside the reach of traditional government
the region's social protection systems may be reengineered (or private sector) programs. Social protection programs
179
I N F O R M A L I T Y
typically focus on helping people prevent, mitigate, or cope actors (public and private sectors, employers and employees)
with a range of risks. In doing so, programs that are well have contributed to social security programs and have, in
designed and successfully implemented can contribute not return, been covered by relatively generous, multidimen-
only to household welfare, but also to long-term economic sional benefit packages--often including health insurance,
productivity, growth, and development. Social protection is old-age pensions, disability and workers' insurance, and, in
typically delivered via a range of social insurance and/or some cases, housing, child care, and sports and recreation
social assistance programs (box 7.1). benefits. At the same time, those outside the formal sector,
Nearly all Latin American countries are characterized by both in urban and rural areas, have had much more limited
what have been called "truncated welfare systems." These are access to formal risk management instruments or other gov-
social protection systems in which, historically, formal sector ernment benefits.
BOX 7.1
Social protection--strengthening people's abilities to manage risk and promoting long-term productivity, growth, and development
People in developing countries face a range of risks. Some and families deal with temporary or chronic poverty at
risks, such as economic recessions, harvest losses, natural different stages of their life cycle, and/or strengthen their
disasters, and wars, affect whole societies or large groups. capacities to achieve higher standards of living.
Others, such as the illness of family members, loss of Well-designed public social protection programs can
household breadwinners' jobs, and crime, may affect only compensate for missing insurance markets or other pri-
individual households. Social protection is defined as a range vate risk-mitigation instruments, and thus they create
of public interventions that support society's poorest and opportunities among the poor for more productive
most vulnerable members and help individuals, families, investments and higher incomes. Moreover, certain types
and communities better manage risks by helping them of safety net programs--such as "conditional transfers" in
prevent, mitigate, or cope better with adverse events. which payments are made contingent upon family invest-
Public social protection can comprise a range of mecha- ments in children's health or schooling--both provide
nisms, including regulation, government financing, short-term income support and strengthen longer-term
direct provision of services, or provision of conditional or investments in children's education, health, well-being,
unconditional transfer payments. Intended to augment, and productivity.
not replace, family, community, and market-based risk Other policies and institutions also play important
management mechanisms, such interventions comple- roles in social risk management. Labor market policies
ment national economic policies and support strategies for and institutions play a critical role--by influencing the
poverty reduction and human development. nature and extent of the risks workers face; by providing
Public social protection measures in Latin America the framework in which certain programs, such as pen-
and the Caribbean often are categorized into two main sions, health insurance, or workfare are accessed; and by
groups: social insurance and social assistance. Social insur- providing opportunities for skills development or techni-
ance includes a range of contributory programs, includ- cal training so that people can find more remunerative
ing old-age pensions, health insurance, disability, and employment. Public health systems in developing coun-
professional risk insurance, that are intended to help tries often perform a safety net function, providing subsi-
cushion the impact of shocks affecting income/earnings, dized health services to the poor and others who lack
health, and employment, and thereby prevent families health insurance. And where financial institutions func-
from falling into poverty. These programs generally fall tion well, access to financial services can also contribute in
under the heading of social security. Social assistance important ways to households' ability to manage risk, as a
includes a variety of noncontributory safety net pro- complement to public social protection programs.
grams, such as workfare, assistance to the disabled and
indigent, and cash transfers, all of which help individuals Sources: de Ferranti et al. 2000; World Bank 2001, 2003b.
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I N F O R M A L I T Y, S O C I A L P R O T E C T I O N , A N D A N T I P O V E RT Y P O L I C I E S
While some workers, on having done an implicit or holds and firms), and even at the level of aggregate
explicit cost�benefit analysis, voluntarily opt out of the sys- output (see, for example, Ravallion 2003).
tem of social security, others may not have that choice. For � Failure to cover losses due to health or income shocks
example, by virtue of residing in less favorable geographic can impose external costs on society. Indeed, the exis-
locations (such as poor or remote rural areas), or lacking tence of externalities, along with other market fail-
opportunities to work in the formal sector (their employers ures (for example, information failures), provides a
may not offer benefits), many do not have access to formal powerful rationale for public intervention to improve
risk management instruments. Still others--those who societal outcomes.
through the course of their working lives frequently move
between formal and informal employment--may find they Finally, from the perspective of the social protection system,
are not eligible for some benefits during key stages in their the truncated welfare systems of Latin America and the
life cycles due to program design features or eligibility Caribbean have tended to result in small, inefficient risk
requirements. Historically, there has been a strong correla- pools and forgone savings, due to the absence of scale
tion between income and social security coverage and, con- economies.
comitantly, between poverty status and lack of access to Partly in response to concerns about the truncated wel-
formal risk management instruments. fare state and partly due to political pressures associated
There is ample evidence that individuals and families with democratization, several countries in the region have
employ a number of strategies to manage risk--with vary- launched or expanded noncontributory assistance and/or
ing degrees of success. If so, is lack of access to formal social targeted poverty reduction programs over the last decade to
protection programs really a problem? The evidence, which help breach the coverage gap. These programs have often
will be elaborated upon in this chapter, indicates "yes," on contributed in important ways to the welfare of the poor. At
at least three fronts. First, from the perspective of household the same time, some of these programs have inadvertently
welfare: brought with them their own set of challenges from the per-
spective of the labor market. As this chapter will discuss in
� While even poor, informal sector workers engage in further detail, problems in the design of social protection
private risk management strategies, the evidence programs--and of the social protection system as a whole--
indicates that households are only partially successful can serve to generate adverse incentives in the labor market,
in protecting themselves against the impoverishing stimulating informality and leaving people without ade-
effects of shocks, whether caused by illness, quate protection from key risks. They can also have adverse
disability, unemployment, or loss of income in old effects on economic productivity and growth.1
age. Thus, the design of social protection--both the tradi-
� Poor and near-poor households generally have fewer tional "Bismarckian" social security system linked to the
assets and/or risk management instruments at their labor contract and subsequent noncontributory assistance
disposal, making them particularly vulnerable to programs--appears to have generated a number of critical
shocks. Indeed, inadequate access to risk manage- challenges to ensuring access of country populations to ade-
ment instruments can lead to families engaging in quate risk management instruments, particularly among
harmful "coping" activities--for example, removing the poor. In this context, this chapter
their children from school--that can make it more
difficult for them to escape poverty, and serving to � reviews the state and recent evolution of social pro-
perpetuate poverty across generations. tection in Latin America and the Caribbean;
� examines the role and limitations of households' pri-
Second, from the societal perspective: vate risk management strategies and outlines the
rationale for public social protection in the region;
� A growing body of evidence indicates that, in addi- � analyzes the key challenges policy makers face in
tion to adverse welfare effects, too much uninsured making adequate risk management instruments avail-
risk can have negative productivity and income able to the regions' citizens working in both the
effects at the microeconomic level (that is, house- formal and informal sectors; and
181
I N F O R M A L I T Y
� outlines key policy directions for ensuring that the social risk management concept organizes people's responses
populations of Latin America and the Caribbean are to shocks into three broad categories: prevention (ex ante),
adequately protected from key risks. mitigation, and coping (ex post) (see Holzmann and
Jorgensen [2000] and World Bank [2001]). The comprehen-
In developing directions for policy, the chapter builds sive insurance framework3 offers a tool for determining which
upon the lessons from recent World Bank studies on social mitigation instruments and preventive measures will be
protection policy, based on the concept of social risk man- most effective, given the expected size, frequency, and
agement and on the economics of insurance.2 Individuals extent of externality of a range of possible financial losses;
and societies can respond in a variety of ways to the the framework can also be used to identify when coping is
prospect of economic losses associated with such shocks as an efficient, ineffective, or even damaging course of action
illness, disability, or loss of income due to old age, and the (box 7.2).
BOX 7.2
The comprehensive insurance framework--providing guidance on social protection policy making
In classical theory, individuals facing the likelihood of a range of possible financial losses; the framework can also
financial loss from an adverse event can either insure be used to identify when coping is an efficient, ineffective,
against such a loss or take steps to lower the likelihood or even damaging course of action. From the perspective of
that the loss will occur. The challenge that people face, financial protection, when prospective losses are small and
therefore, is to choose the optimal mix of market insur- infrequent, it is more efficient for individuals to cope with
ance, self-insurance, and self-protection. Both market and the loss after the fact than to insure. In that sense, full
self-insurance transfer income from the "good" states to insurance is not efficient. But as prospective losses become
the "bad" states of the world. Market insurance pools more frequent, it becomes relatively more efficient to
risks across individuals, compensating for differing risks engage in prevention--to lower the probability of the loss
among them. Where market insurance is available, it can occurring--and saving--to cover the costs of the loss.
be purchased at a price--the insurance premium--which When a prospective loss becomes less frequent but
reflects the size of the prospective loss and the probability increases in size, it becomes more efficient to engage in risk
of the bad state coming about. Self-insurance--essentially pooling. For rare but large prospective losses, households
individual or family saving--does not involve risk pool- also have incentives to engage in prevention, again to lower
ing or compensation for risk differentials. Although it has the likelihood that the adverse event will occur. For losses
no explicit price, its cost can be imputed from the expense that are both frequently occurring and catastrophic in size,
people incur to save, for instance, in forgone consumption. there is little that individuals, households, or even markets
Self-protection refers to measures that individuals or can do on their own; specific measures to create a larger
households take, ex ante, to prevent an adverse event from risk pool are required.
occurring. Self-protection reduces the probability that When markets fail or are missing, policy intervention
losses will occur, and may reduce the size of a loss, should can be justified to strengthen people's ability to manage
one occur. For simplicity, the literature often refers to risk. While insurance markets may fail due to the nature
market insurance as risk pooling, to self-insurance as saving, of risk (prospective losses are both frequent and large),
and to self-protection as prevention. When individuals and they also commonly fail due to information problems.
households do not insure through risk pooling or saving, On one hand, individuals may lack critical information
or engage in prevention, they are often forced to cope with on the nature and extent of the risks that they face, lead-
the costs of losses in the wake of a shock. ing to a lack of demand for appropriate risk management
The comprehensive insurance framework provides instruments; on the other hand, problems of "adverse
guidance on which mitigation instruments--risk pooling selection" and "moral hazard," well-known in the insur-
or saving--and preventive measures will be most effective, ance literature, can raise the price of risk mitigation
given the expected size, frequency, and extent of externality of instruments, pricing the poor out of the market, or cause
182
I N F O R M A L I T Y, S O C I A L P R O T E C T I O N , A N D A N T I P O V E RT Y P O L I C I E S
markets not to form at all. Finally, the failure of individ- � Government should help households build and protect
uals or households to manage risks appropriately can their human capital. Investing in human capital--
often impose negative externalities on society. For exam- education, hygiene, and primary and preventive
ple, in countries where a significant number of people health care--can be an effective and powerful means
fail to insure, governments face a dilemma in which of prevention and can strengthen families' abilities
politicians cannot credibly refuse to provide aid when a to cope effectively. However, where credit is con-
large number of people suffer losses, and the burden of strained, individuals may under-invest in human
these losses is transferred onto current and future tax- capital. To ensure appropriate human capital devel-
payers. Similarly, in the case of health, communicable opment, governments can subsidize investments in
diseases that go untreated due to lack of insurance can education and health for the poor. Due to the nature
have important negative spillover effects on large swaths of health shocks and the presence of externalities,
of society. Indeed, the degree of externality posed by government can support work to broaden and
health risks and the public-good nature of many health strengthen risk-pooling instruments.
treatments and interventions present a powerful addi- � It is less costly to help households mitigate losses than to
tional justification for policy intervention. cope with them. The instruments for individuals and
The comprehensive insurance framework provides families to pool risks and save are not always avail-
guidance for public intervention regardless of the able. The resources to take preventive measures are
prospective loss under consideration (for example, due to often scarce. Where individuals and families are
illness, disability, unemployment, or income loss in old constrained, adverse coping can result. Some pre-
age): vention, risk pooling, and saving are always desir-
able. Effective policy should thus place priority on
� Government should provide (or help provide) the instru-
enabling individuals to insure against losses
ments that the market cannot (or will not) provide. Risk
through risk pooling and saving and to lower the
pooling to cover certain losses (for example, lost
probability of losses through prevention, rather
earnings from becoming unemployed, the risk of
than merely coping after a shock.
poverty, disasters, and certain frequently occurring
or preexisting health events with catastrophic costs) While market failures and externalities justify state
does not exist in many contexts due to information intervention, the comprehensive insurance framework
problems. Government can step in to correct market also highlights the risk of "government failure." This can
failures by providing risk-pooling instruments. occur when governments "overreach," that is, where the
� Government should provide (or help markets provide) state tries to do too much by providing coverage that
superior instruments where only inferior instruments are households and markets can--or should--provide them-
available. For risks best covered with individual sav- selves. Examples of this include when governments sub-
ings, private agents may turn to "bad" saving sidize pensions for upper- or middle-class groups or
instruments (for example, property or other nonliq- subsidize insurance for small and frequent health events
uid assets for precautionary saving) because "good" (phenomena that have been common in Latin America
instruments (such as diversified financial assets; safe, and the Caribbean). Overreach can lead to unsustainable
reliable, and competitively priced forms of liquid fiscal burdens, even when coverage rates are low. Govern-
savings; or credit) are not available. Moreover, ment interventions can also be "misaligned," that is,
poorer households simply may not have much mar- focused on the wrong mix of instruments given the
gin to save. Government can intervene to foster the expected size and frequency of loss, or excluding clear
development of more efficient instruments for sav- "insurables" (such as low probability, high expected loss
ing through prudential regulation of capital, credit, events) in mandatory risk-pooling packages.
and insurance markets, as well as provide direct
subsidies for households that are too poor to hold
Source: Adapted from Baeza and Packard 2006; Gill and Ilahi 2000; Gill,
savings or debt. Packard, and Yermo 2004; and Packard 2006.
183
I N F O R M A L I T Y
The state of social protection in Latin America non-wage costs account for over 47 percent of payroll (see
and the Caribbean Mason et al. forthcoming).
The truncated welfare state in Latin America and the Carib- In response to fiscal pressures, as well as concerns about
bean has stemmed largely from what is often called the low coverage and persistently large informal economies, a
"Bismarck" model of social security, which has been devel- number of reform measure changes have been undertaken
oped in most countries in the region since the early part of in Latin American and Caribbean countries since the
the 20th century. The core of the Bismarck model is that 1980s, particularly with respect to pensions. This has
social security coverage is based on the form of the worker's improved the fiscal sustainability in some countries, but
labor contract. In general, workers acquire rights to a pack- increases in coverage have remained elusive. As discussed
age of benefits--health insurance, disability, pensions, and briefly in chapter 1, social security coverage in most Latin
so on--via employment in the formal sector of the econ- American countries remains relatively low, with limited
omy rather than by virtue of working per se (or by virtue of progress recorded over the last decade (figure 7.1). Indeed,
a more inclusive concept, such as "citizenship"). Such ben- in examining changes in pension coverage between the
efits are typically financed through a combination of pay- mid-1990s and the early to mid 2000s, Rofman and
roll taxes on the part of the worker, employer contributions Lucchetti (2006) find that in 9 out of 15 countries (for
on the part of the firm, and, in many cases, subsidies from which comparable household survey data exist) coverage
the government. In some instances, non-wage costs of rates have actually declined over time, and even in the few
employment (payroll taxes plus other benefits) can be very countries where progress has been made (for example,
high, affecting both employers' and workers' informal- Peru), advances have been small.
formal sector decisions. In Colombia, for example, total As discussed in chapter 4, a combination of factors--
non-wage costs have been estimated at 53 percent of pay- macroeconomic, structural, and demographic--appears to
roll, the highest in the region, followed by Mexico whose have contributed to observed patterns since the 1990s. This
FIGURE 7.1
Pension coverage rates in Latin America and the Caribbean
% of economically active population contributing to pension system
80
1990s 2000s
70
60
50
40
30
20
10
0
u or
Per ador . de y
ina Rica
Bolivia R.B Mexico Brazil Chile
Paraguay Nicaragua Colombia Ecu Salvad
Guatemala El Argent Urugua Costa
Venezuela,
Source: Rofman and Lucchetti 2006.
Note: The years for which household survey data are available across countries in the region are not identical. As such, Rofman and Lucchetti
(2006) present figures based on available data in each country that comes closest to the 1995�2004 period. The years used are as follows:
Argentina 1995�2004; Bolivia 1999�2002; Brazil 1995�2002; Chile 1996�2003; Colombia 1996�99; Costa Rica 1995�2004; Ecuador 2000�04;
Guatemala 1998�2000; Mexico 1998�2002; Nicaragua 1998�2001; Paraguay 1999�2004; Peru 1999�2003; El Salvador 1995�2003; Uruguay
1995�2004; Republica Bolivariana de Venezuela 1995�2004.
184
I N F O R M A L I T Y, S O C I A L P R O T E C T I O N , A N D A N T I P O V E RT Y P O L I C I E S
FIGURE 7.2
Social security coverage and GDP per capita
a. Social security coverage in LAC by per capita GDP b. Changes in social security coverage in LAC versus
(latest year) changes in GDP per capita, 1990s�2000s
% of economically active population Average annual change in social security
contributing to social security coverage (%)
70 10
y 0.0043x 4.1392 y 1.2298x 0.0183
8
60 R2 0.5553 R2 0.2124
6
50 4
2
40
0
30
2
20 4
6
10
8
0 10
0 2,000 4,000 6,000 8,000 10,000 12,000 14,000 3 2 1 0 1 2 3 4
GDP per capita (PPP, real 2000) Average annual GDP growth per capita (%)
Sources: Author's calculations. Data on social security coverage from Rofman and Lucchetti (2006); data on GDP per capita purchasing power
parity from World Development Indicators, various years.
includes increases in labor force participation rates (particu- tends to decline (social security coverage tends to rise) as
larly among females) during the 1990s, growth in nontrad- national income rises. Indeed, the same relationship
able sectors driven by currency appreciations in the early between gross domestic product (GDP) per capita and social
1990s, and increased labor market rigidities, at least in security coverage that holds globally is observed when only
Colombia and Brazil.4 In addition, social security reforms Latin American and Caribbean countries are analyzed. This
themselves may have lowered the perceived benefits of the is true whether one looks either at GDP levels or GDP
affiliation relative to its costs. In the case of pensions, for growth (figure 7.2a and b). As can be seen in panel b of the
example, reforms that were designed to increase fiscal sus- figure, however, several countries that experienced positive
tainability often raised contribution rates, minimum con- economic growth did not increase social security coverage
tribution periods, and retirement ages, while lowering between the mid-1990s and the early to mid 2000s; in fact,
replacement rates. These changes in the relative benefits and coverage actually declined in several positive-growth coun-
costs of pension schemes may have more than offset the tries. This suggests that the factors leading to increased
salutary effects associated with closer links between contri- informality--whether macroeconomic, structural, demo-
butions and payments. As will be discussed further in this graphic, or related to social protection design--frequently
chapter, a number of factors related to the design of social offset the positive effects of growth.
security programs and to the incentives created by the Consistent with the evidence presented in the earlier
broader constellation of social protection programs--both chapters, in nearly all countries in the region, coverage rates
social insurance and social assistance--appear to affect cov- are significantly lower among low-income than high-income
erage levels. workers (figure 7.3). In most of the region's countries, the
Data indicate that social security coverage has failed to poorest are practically excluded from the system. The situa-
increase (informality has failed to decline) in the region tion is similar when considering the employed population,
despite net economic growth over the period. As was high- showing that pension systems suffer from major inequities
lighted in chapter 1, global data show that informality in terms of access, even if differential unemployment is
185
I N F O R M A L I T Y
FIGURE 7.3
Coverage rates in Latin America and the Caribbean, mid-1990s to early mid-2000s, by quintile of per capita income
% of economically active population contributing to pension system
80
60
40
20
0
Bolivia Paraguay Peru Nicaragua Guatemala Colombia Ecuador El Salvador
80
60
40
20
0
Venezuela, R.B. de Mexico Argentina Brazil Uruguay Chile Costa Rica
Quintile�I (1990s) Quintile�II (1990s) Quintile�III (1990s) Quintile�IV (1990s) Quintile�V (1990s)
Quintile�I (2000s) Quintile�II (2000s) Quintile�III (2000s) Quintile�IV (2000s) Quintile�V (2000s)
Source: Rofman and Lucchetti 2006.
ignored. Most countries have coverage rates that are above to 59 percent of employed workers), it declined among all
50 percent for the highest quintile, but none has a rate other income groups. Declines in coverage were largest
higher than 50 percent among the poorest workers. Analy- among those in the lowest quintile (from 48 to just under
sis of coverage rates by worker education levels shows simi- 10 percent [Rofman and Lucchetti 2006]).
lar patterns (see Rofman and Lucchetti 2006). Beginning in the 1990s--and partly in response to con-
In addition, inequalities in access to social security have cerns about limited access to formal social security pro-
tended to increase over time (figure 7.3). In Argentina, grams by large swaths of the region's population--a
Uruguay, Chile, and Costa Rica, increases in inequality number of countries in Latin America and the Caribbean
occurred, at least in part, because of noticeable declines in have launched or expanded poverty reduction and/or social
coverage among those in the poorest quintile. Perhaps the assistance programs to help provide support and coverage
most dramatic instance of this occurred in Argentina to the poor or extreme poor (for example, Argentina,
(figure 7.4). While coverage rates in Argentina actually Bolivia, Brazil, Chile, Mexico, and Peru, among others).
increased slightly among those in the top quintile (from 54 These efforts have taken a number of forms--including
186
I N F O R M A L I T Y, S O C I A L P R O T E C T I O N , A N D A N T I P O V E RT Y P O L I C I E S
FIGURE 7.4
Pension coverage rates in Argentina, by quintile of per capita income
% of employed workers
80
60
40
20
0
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Quintile 1 Quintile 2 Quintile 3 Quintile 4 Quintile 5
Source: Rofman and Lucchetti 2006.
subsidized health care and insurance (Acceso Universal para Uruguay and Argentina have small noncontributory
prestaciones integrales y Garant�as Expl�citas [AUGE] in Chile, benefits that cover some impoverished individuals, age
the Regimen Subsidiado in Colombia, and Seguro Popular in 70 or older, who do not qualify for contributory
Mexico), noncontributory pension programs for the poor retirement benefits. In Brazil, there is a large quasi-
(Bono Solidario [BONOSOL] in Bolivia, the Rural Pension noncontributory system that covers rural workers.5 Other
Scheme in Brazil, and Pension Asistencial [PASIS] in Chile), countries, such as Mexico, have some noncontributory
workfare programs (Jefes de Hogar in Argentina), and condi- schemes at the subnational level, including a program
tional cash transfer programs (Bolsa Escola in Brazil, Famil- that covers the elderly in Mexico City. Unfortunately,
ias en Acci�n in Colombia, and Oportunidades in Mexico). data available from household surveys do not generally
Figure 7.5 presents the coverage of the elderly in Latin distinguish between beneficiaries of contributory and
America between the mid-1990s and the 2000s. As with noncontributory programs (so most bars in figure 7.5
participation of the working-age population in formal only show total coverage, not what proportion of the cov-
social security schemes, formal pension coverage among the erage is due to the contributory, quasi-, or noncontribu-
current elderly population is extremely low in many coun- tory programs). There are a few countries--including
tries in the region; rates are at 60 percent or higher only in Bolivia, Ecuador, Chile, and Costa Rica--where data on
Costa Rica, Argentina, Bolivia, Chile, Uruguay, and Brazil. coverage under contributory and noncontributory pro-
While formal pension coverage has increased in several grams are collected. As can be seen, where coverage of
countries since the 1990s--for example, in Colombia, noncontributory programs is measured, they can often
Rep�blica Bolivariana de Venezuela, Costa Rica, and have a substantial impact on coverage of the elderly. Most
Panama--some countries have actually registered declines dramatic is the case of Bolivia's BONOSOL program,
in coverage of the elderly. Coverage in Argentina shows a which extends pension coverage to 58 percent of the
particularly large decline, falling from 77 percent in 1995 elderly who are not otherwise covered by formal pension
to 65 percent in 2004. programs.6
In this context, several countries in the region operate Beyond pensions, several countries have also introduced
noncontributory pension programs, some of which have programs to provide subsidized health insurance (for exam-
had an important impact on coverage of the elderly. ple, AUGE, Chile; Regimen Subsidiado, Colombia; Seguro
187
I N F O R M A L I T Y
FIGURE 7.5
Pension coverage among the elderly in Latin America and the Caribbean, contributory and noncontributory programs
Percent
100
1990s, noncontributory programs 2000s, noncontributory programs
90 1990s, contributory programs 2000s, contributory programs
80
70
60
50
40
30
20
10
0
u de
Per Rica
Mexico R.B. guay
entina Bolivia Chile Brazil
Republic Salvador
Guatemala Paraguay Colombia Ecuador Panama Uru
El Costa Arg
Dominican Venezuela,
Source: Rofman and Lucchetti 2006.
Popular, Mexico) and/or conditional cash transfer programs
FIGURE 7.6
focused on strengthening the human capital of the poor (for
Coverage of two poverty-targeted assistance programs in Mexico:
example, Bolsa Escola, Brazil; Familias en Acci�n, Colombia; Oportunidades and Seguro Popular (by decile, 2004)
Red Solidaria, El Salvador; Programa de Asignacion Familiar,
Percent
Honduras; Programme Advancement Through Health and
100
Education, Jamaica; Oportunidades, Mexico; Red de Protecci�n
90
Social, Nicaragua). In some cases, these programs have had
80
considerable outreach to the poor. In Mexico, for example,
70
the Oportunidades program (formerly known as Progresa) has
60
reached roughly 5 million very poor families, about two-
50
thirds of whom live in rural Mexico.
40
As can be seen in figure 7.6, poverty-targeted programs
30
such as Oportunidades and Seguro Popular in Mexico have
20
done a much better job of reaching the poor than tradi-
10
tional (contributory) social security programs. While
0
analysis of household survey data (as shown in figure 7.3) I II III IV V VI VII VIII IX X
indicates that the distribution of formal social security ben-
Oportunidades Seguro Popular
efits is very regressive, coverage of Oportunidades and Seguro
Popular is highest among the poor. Indeed, around 55 per- Sources: Adapted from Mason et al. forthcoming, based on data
from Mexico's 2004 national income and expenditure survey,
cent of households in the poorest decile were covered by Encuesta Nacional de Ingresos y Gastos de los Hogares.
Oportunidades in 2004, and coverage declines significantly Note: Some Seguro Popular beneficiaries also participate in
Oportunidades. Seventy-two percent of Seguro Popular
as household income rises (figure 7.6). Coverage of Seguro beneficiaries participate in Oportunidades in the first decile,
but the overlap decreases very rapidly with income.
Popular is similarly progressive, albeit at lower levels of
coverage in 2004; nonetheless, coverage of the program has
grown considerably since that time.7
188
I N F O R M A L I T Y, S O C I A L P R O T E C T I O N , A N D A N T I P O V E RT Y P O L I C I E S
FIGURE 7.7
Public social protection spending in Latin America and the Caribbean
% of GDP
20
Mid-1990s Early 2000s
18
16
14
12
10
8
6
4
2
0
r de
Peru Rica
aguay Chile Brazil
Jamaica R.B. Mexico Bolivia
Ecuado Panama Uruguay
Nicaragua Republic HondurasGuatemalaColombia Salvador Par Costa Argentina
El
inican
Venezuela,
Dom
Source: World Bank staff calculations.
Note: No mid-1990s data were available for Brazil, Ecuador, and Guatemala.
A recent study on income redistribution and public American and Caribbean countries. For the countries in
transfers in Latin America and the Caribbean shows that, in which disaggregated data exist, it can be seen that spend-
general, social assistance programs have done better at ing on social insurance (that is, formal social security)
reaching the poor than have traditional social security pro- generally make up the lion's share of spending; with a few
grams, such as health insurance or pensions (Lindert, exceptions (such as Nicaragua and Honduras), spending on
Skoufias, and Shapiro 2006). It is important to note, how- social insurance accounts for more than two-thirds of total
ever, that the quality of targeting varies across types of pro- social protection spending (figure 7.8). At the same time,
grams and across countries, and that not all assistance existing data suggest that the share of spending going to
programs are targeted in a progressive manner. Scholar- social insurance has declined slightly in several countries
ships, for example, as well as many food-based programs in since the 1990s, as the prevalence of poverty-oriented assis-
the region, often lack effective, pro-poor targeting and are tance programs has increased.
therefore more likely to benefit nonpoor families and indi- This growth of social assistance programs over the last
viduals than the (intended) poor. 10 to 15 years has had at least two important effects on
Regional efforts to extend social protection programs social protection in the region. First, an increasing number
more effectively toward the poor can be seen, in part, in the of poor people have access to state benefits that play an
figures on public spending on social protection between important social protection or poverty reduction function--
the 1990s and the 2000s. Average levels of public spending whether to help the poor build their human capital, protect
on social protection in Latin America and the Caribbean them against basic health risks, or provide basic income
increased over the period, from around 4.0 to 4.8 percent of security in old age. These benefits can often have an impor-
GDP (figure 7.7). This is compared to 14.4 percent in the tant positive impact on the recipients, even though the
Organisation for Economic Co-operation and Development unit transfers tend to be considerably smaller on a per-
(OECD), 8.3 percent in the United States, and 16.3 per- person (or per-household) basis than formal social security
cent in continental Europe.8 Clearly, the data show signifi- benefits (Lindert, Skoufias, and Shapiro 2006). Indeed,
cant variations in the levels of spending across Latin there is a growing empirical body of literature on the
189
I N F O R M A L I T Y
without risk management instruments. In some cases,
FIGURE 7.8
workers may have access to health insurance or other formal
Public spending on social insurance and social assistance in
Latin America and the Caribbean, early 2000s risk management instruments by virtue of the employment
status of a spouse, a parent, or other relative.10 Moreover,
% of GDP
individuals and households in Latin America and the
14
Social insurance Caribbean typically engage in a range of private risk man-
12 Social assistance
agement strategies to prevent, mitigate, or cope with a
10
variety of risks and shocks. While, in principle, private risk
8 management strategies could include the purchase of pri-
6 vate insurance (for example, health, disability, and so on),
4 in practice, private insurance markets remain relatively
thin in the region, and access to private insurance instru-
2
ments is generally confined to the wealthier segments of
0
societies. In this context, a number of private risk manage-
de ico
Peru Chile ntina
R.B. Brazil
Mex ment strategies are identified in the literature for Latin
NicaraguaHondurasColombia Paraguay Arge
America, including income diversification, adjustments of
Venezuela, household labor supply, drawing down of household sav-
Source: World Bank staff calculations. ings, sale of assets, and adjustments in household spending
and/or consumption patterns. Such strategies are used both
before the fact to reduce the likelihood of an adverse shock
(or to mitigate the likely impact of a shock, should one
positive impacts of conditional cash transfer programs,
occur), and after the fact to help cope with or deal with the
such as Oportunidades in Mexico or Familias en Acci�n in
effects of an adverse event.
Colombia, on human capital outcomes of the poor (see
Evidence from Mexico, for example, indicates that
Rawlings and Rubio [2005] for a recent summary of
households send additional members into the labor force
impact evaluation findings). Similarly, Brazil's rural
in response to real or expected employment shocks
pension program has contributed to observable declines in
(Cunningham 2001). Evidence from Guatemala, Nicaragua,
old-age poverty in that country (World Bank forthcoming).
El Salvador, and Honduras shows not only that family
At the same time, the growth of social assistance pro-
members increase their hours worked to mitigate the
grams has led to an increasing fragmentation in social pro-
impact of an adverse event, but that they draw down finan-
tection systems in the region, in which the poor (and some
cial savings or other assets, if necessary, to protect their
nonpoor) receive similar--albeit more modest--benefits
income and consumption levels (World Bank 2003a).
for free as formal sector workers receive by virtue of their
Migration and remittances also make up a key element of
payroll contributions. As will be discussed later in more
household risk management in a number of Latin Ameri-
detail, such well-intended efforts to make social benefits
can and Caribbean countries--both ex ante, as preventive
available to those outside the formal sector may--due to lack
measures, and ex post, to soften the impact of a shock (see
of incentive compatibility with contributory programs--be
Arias [2004] and Beneke de Sanfeli� and Shi [2004] for
creating disincentives to the formalization of the work-
evidence from El Salvador). In Argentina, during the 2002
force. To the extent that such disincentives exacerbate dis-
economic crisis, families altered their consumption pat-
tortions in the labor market, they may also have adverse
terns, buying fewer luxury goods and spending less on
productivity effects.9
necessities, educational materials, and children's health vis-
its (World Bank 2003a). When households' abilities to
Private risk management and rationale for public cope with shocks are stretched, as they were during the
social protection 2002 crisis in Argentina or after hurricane Mitch in
While informal employment means that workers are Nicaragua, families often rely on wider social networks,
not directly affiliated with formal social security programs, including memberships in community, religious, or neigh-
this is not to say that informal workers are left completely borhood organizations, that can provide an alternative
190
I N F O R M A L I T Y, S O C I A L P R O T E C T I O N , A N D A N T I P O V E RT Y P O L I C I E S
source of resources--as loans or gifts--in the event of an dynamics in rural El Salvador indicates, for example, that
adverse shock (World Bank 2003a; Klugman, Kruger, and poor households take considerably longer to recover from an
Withers 2003). income shock than nonpoor households (Rodriguez-Meza
It is important to note that while some household risk and Gonzalez-Vega 2004). Evidence from rural China also
management strategies, such as developing diversified indicates that income shocks have deeper impacts on poor
income-earning portfolios, increasing adult labor supply, or households (Jalan and Ravallion 1999). While an income
drawing down financial savings, may be seen as appropriate shock of 10 percent had only a 1 percent impact on the con-
and rational responses to the reality of risk and shocks, sumption of the wealthiest households, it caused a 4 per-
other strategies, such as engaging in distress sales of pro- cent decline in consumption among the poorest households.
ductive assets like land, withdrawing children from school, Indeed, despite the best efforts of workers and their fam-
or deferring utilization of preventive or curative health ser- ilies to protect themselves from risk, households that lack
vices, may generate their own risks to long-term family access to formal risk management instruments remain vul-
productivity and welfare. During the 2002 crisis in nerable to the impoverishing effects of shocks. The evi-
Argentina, spending less on education and on children's dence suggests that families are particularly vulnerable to
medical care raised critical concerns about the long-term the effects of health shocks (Baeza and Packard 2006;
effects on children's human capital and long-term family Skoufias 2004). In addition to treatment costs, households
welfare (World Bank 2003a). Moreover, a recent study of bear the cost of productive time lost from work, as well as
Mexico indicates that children who are removed from the opportunity costs due to days spent taking care of fam-
school in response to a shock are one-third less likely to ily members who are ill. Costs associated with illness can
continue school than those who find ways to continue their drive families into poverty; for the already poor, the costs of
education in the face of a shock (Sadoulet et al. 2004). a health shock can make escape from poverty more difficult.
Thus, in the absence of adequate insurance or other formal Evidence from Argentina, Chile, Ecuador, and Honduras
risk management mechanisms, families can risk long-term indicates that the impoverishing effects of health shocks
losses in their human capital, adversely affecting their eco- can be significant. In Argentina, 5 percent of all nonpoor
nomic productivity and increasing the likelihood of inter- households fell into poverty for at least three months in
generational transmission of poverty. 1997 due to out-of-pocket spending on health (figure 7.9).
A number of recent empirical studies--within and out-
side Latin America--have tried to measure how effectively
households smooth their consumption in the face of
adverse income shocks. Specifically, these studies measure FIGURE 7.9
Nonpoor population who fell below the national poverty line due to
the extent to which a shock to household per capita income
out-of-pocket health expenditures
translates into a shock to household per capita consump-
tion. While the specific findings differ from country to Percent
12
country, these studies find that households are partially--
but not fully--effective at mitigating the impacts of shocks 10
to their incomes. Indeed, recent evidence from several Latin 8
American countries, including Mexico, Nicaragua, and
6
Peru, suggests that households in these countries are able to
protect (or insure) only between 60 and 75 percent of their 4
per capita consumption in the face of an income shock
2
(Glewwe and Hall 1998; Klugman, Kruger, and Withers
0
2003; Skoufias 2004). In other words, a 10 percent shock to
ina as
a household's per capita income translates into a 2.5�4 per- Chile
Ecuador
cent decline in its per capita consumption on average. Argent Hondur
The evidence also indicates that poor households are Sources: Baeza and Packard 2006, citing Maceira (2004) for
often less able to smooth their consumption in the face of Argentina; Bitran, Giedion, and Mu�oz (2004) for Chile;
Montenegro (2004) for Ecuador; and Fiedler (2004) for Honduras.
shocks than nonpoor households. A recent study of income
191
I N F O R M A L I T Y
In Ecuador, 11 percent of nonpoor households fell below many families adequate protection from impoverishing
the national poverty line for at least three months in 2000 risks and shocks. In this context, what is the role for public
due to the direct costs of health care. In Honduras, in 2000, social protection policies and programs? From an economic
4 percent of nonpoor households fell into poverty, at least perspective, if private markets for insurance (or other risk-
temporarily, due to health-related spending. pooling or savings instruments) existed and functioned
Cross-country analysis of public and private spending on well, if actors in the market for risk management instru-
health indicates that out-of-pocket spending on health care ments had adequate information, and if there were no exter-
is relatively high in Latin America and the Caribbean, as nalities associated with inadequate risk management, then
compared to other regions (Baeza and Packard 2006).11 In there may not be a compelling reason for the state to inter-
Latin America and the Caribbean, 85 percent of all private vene. But private insurance markets are often missing--or
spending on health care represents out-of-pocket spending are extremely thin--in Latin America and the Caribbean.13
by households. This compares with 72 percent, on average, Information problems abound, as do negative externalities
in Europe and the OECD (which also have lower levels of associated with insufficient insurance.
private health spending, as a share of total health spending, In terms of information, workers and their families com-
than does Latin America). Moreover, the poor generally pay monly lack sufficient knowledge of the nature and extent of
a higher share of health costs out of pocket than the nonpoor. the health risks that they face, as well as the likely direct
And while participation in well-designed and well-func- (and indirect) costs associated with illness of the family
tioning risk-pooling schemes reduces the likelihood of breadwinner or another family member. They also have less-
falling into poverty in the wake of a health shock, relatively than-complete information on what their future needs will
few of the poor (or near-poor) in the region participate in be--for example, at retirement. This latter issue causes
effective risk pooling (Baeza and Packard 2006). what is commonly referred to as "myopia" in the pensions
Another result of low social security coverage in the literature. Information problems--such as adverse selection
region is that poverty among the elderly in Latin America and moral hazard--well-known in the economics of insur-
and the Caribbean is often very high. A recent 19-country ance literature, similarly plague those who would supply
study on old-age security found that the incidence of insurance or other risk-pooling instruments. Such problems
poverty among the elderly in the region, measured in terms can work to raise the price of risk mitigation mechanisms
of household per capita income, is often significantly higher beyond the reach of low-income groups; information prob-
than among the population as a whole (Bourguignon et al. lems are also notorious for causing the private market for
2004). Indeed, this was found to be the case in 11 out of 19 risk-pooling to fail--and even preventing these markets
countries studied. Elderly who fall outside the formal social from forming in the first place (Packard 2006). Informa-
security system find themselves at particular risk. Simula- tion-related problems are often aggravated in low-income,
tion analysis carried out by the authors suggests, however, high-poverty environments.14
that programs that provide minimum income support to the Insufficient risk management instruments can also have
elderly poor could have an observable, positive impact on important negative externalities that argue for public inter-
old-age poverty. This is consistent with real-life experiences vention. An individual's failure to manage risk can impose
in Brazil and Bolivia. In Brazil, as noted above, the rural costs on others in society in one of several ways. First, in
pension program is credited with contributing to observable countries where a significant number of people fail to
declines in old-age poverty in recent years.12 A recent study insure, governments face a "Samaritan's dilemma"; politi-
on Bolivia indicates that BONOSOL payments have had a cians cannot credibly refuse to come to the aid of a large
positive and significant impact on food consumption among number of people who suffer a loss, and the burden of these
recipient households, particularly in rural areas (Martinez losses is transferred onto current and future taxpayers
2005). (Packard 2006). But the external costs of individuals who
are not adequately insured can extend well beyond the tax
The role of the state burden; in the case of health, in particular, communicable
Together, the evidence suggests that although households diseases that go untreated due to lack of insurance (or finan-
rely on a number of private mechanisms for risk manage- cial protection) can have health, and therefore, basic welfare
ment, this reliance on informal mechanisms does not afford impacts on large swaths of society.15
192
I N F O R M A L I T Y, S O C I A L P R O T E C T I O N , A N D A N T I P O V E RT Y P O L I C I E S
In sum, missing or failed markets for insurance or other tics and endowments. For these workers, part of the explicit
forms of risk pooling, information problems, and externali- or implicit calculations may involve their perception of the
ties all serve to establish a role for the state in social relative costs and benefits of contributing to and affiliating
protection from an economic perspective. Moreover, well- with formal social security. Other individuals, such as
designed public intervention in social protection-- many informal salaried workers, find the choice to affiliate
discussed in greater detail later in the chapter--can itself to social security made for them by employers and firms
help to strengthen the efficiency of risk-pooling mecha- that have chosen (for whatever reason) to opt out of the sys-
nisms, through widening and deepening of the risk pool tem. Chapters 5 and 6 have addressed the issue of firms'
(which is often too small and fragmented, especially in relationships to informality. This chapter focuses in more
developing-country contexts). But there are also very valid detail on attributes of social protection programs and, more
reasons for public social protection that go beyond an eco- broadly, social protection systems (the agglomeration of
nomics rationale. Among the most important include valid social protection programs in a country) that affect how
distributional concerns in Latin America and the workers value the prospect of working in the formal versus
Caribbean's highly unequal societies (see de Ferranti et al. the informal sector. Understanding these factors can help
2004), and concerns for poverty reduction. Such justifica- policy makers design a smarter, more effective system of
tions, while not purely economic in nature, speak to the risk management for their citizens.
types of societies that Latin American policy makers would
like to foster (or as will be discussed in chapter 8, how to Costs, benefits, and the design of social
redefine the nature of the social contract in the region). security programs
A number of factors affect the locus of costs and benefits that
Challenges for social protection in the face workers see with respect to participation or nonparticipa-
of informality tion in formal social security programs, including physical
Given the high human costs associated with lack of access accessibility (proximity) of benefits and services for affili-
to appropriate risk management instruments, such as ated workers, the quality of services offered within the
health insurance and old-age security, and the clear ratio- scheme, workers' valuations of the sometimes-complex
nale for public intervention to ensure basic access, Latin bundle of goods and services that they are compelled to
American and Caribbean policy makers face an important "purchase" via payroll taxes, program rules that make it
challenge; to ensure that individuals and families have difficult for workers to qualify for certain benefits, and
access to suitable risk management instruments in the face design peculiarities that "force" affiliated families to pay
of significant levels of informality. At the same time, it is twice for the same services. These factors are now examined
important to note that ill-designed interventions may serve in turn.
to make things worse, not better. Indeed, as will be shown,
there is ample evidence of "government failure" in Latin Accessibility of benefits
America and the Caribbean that needs to be addressed as For many workers, particularly those in remote rural loca-
part of any actions to strengthen risk management among tions, the lack of program-authorized health facilities
the region's citizens. Therefore, an important, related chal- makes the choice of opting into the system untenable, even
lenge is to ensure that the design and implementation of if they would otherwise be inclined to affiliate with a social
risk management instruments (and related programs) are security system. The unavailability of the basic amenities
consistent with improved risk management for the people associated with social security makes the costs of contribut-
of the region, as well as with increased productivity and ing well above the benefits. Levy (2006a, 2006b) high-
sustained economic growth. lights that this is a critical issue facing millions of workers
As has been highlighted in earlier chapters, the informal in rural Mexico and in less-developed regions of that
sector is highly heterogeneous. Some individuals (for exam- country.
ple, many self-employed workers) are in that sector as a
matter of choice, the result of an explicit or implicit assess- Program quality
ment of the costs and benefits of formal versus informal Similarly, workers will also be inclined to favor informal
employment, and/or in light of their personal characteris- employment if they perceive that the value of services
193
I N F O R M A L I T Y
provided is low relative to its cost (that is, the cost of their minimum wage, if they do not have other sources of
payroll tax contributions). In the case of health, for exam- income. Thus, the value of a pension benefit for a worker
ple, workers may not value health insurance if the service at who earns close to the minimum wage would be practically
authorized health facilities is unpredictable, involves long the same, whether or not he contributes to social security--
waiting times, and is of low quality. To the extent that low although the worker can access the benefit earlier if he or
service quality drives some workers--particularly low-risk, she is a formal sector worker (Fernandes, Gremaud, and
high-income workers--to affiliation with health insurance, Narita 2006). In Mexico, while all workers (and employers)
this not only reduces participation in the system but serves are required to contribute to the housing subsidy, they are
to "fragment" the risk pool, hampering the effectiveness of unable in practice to access those funds, due to the nature
the insurance model. of the Mexican housing market (Levy 2006b; Mason et al.
forthcoming).16 In this context, again, workers will view
Perceived value of the "bundle of benefits" social security contributions--or at least the relevant com-
In Mexico, the benefit package offered by the Mexican ponent--as a pure tax on their earnings.
Social Security Institute (IMSS) has eight mandatory com-
ponents: health insurance, retirement pensions, disability Paying twice for the same benefits
insurance, professional risk insurance, life insurance, day Another common feature of formal social security in the
care centers for workers, sports and cultural facilities, and region is that members of the same family--for example,
housing credits. In Colombia, formal sector workers make husband and wife--are required to contribute individually
mandatory payroll tax contributions toward a number of for health insurance benefits, even though nonworking
benefits, including health insurance, pensions, and profes- wives (or husbands) would be covered by their working
sional risk insurance, as well as toward worker training via spouses' insurance. In other words, members of the same
the Colombian Training Institute (SENA), to the Colom- family are essentially required to pay twice for the same set
bian Institute for Family Welfare (ICBF), and to the Cajas of benefits when both work in the formal sector. In this
de Compensaci�n Familiar, which provide services ranging case, where one formal sector earner is already contributing
from cash subsidies to supermarkets to recreation for work- for health insurance, the contribution of the second earner
ers. While some workers may value all elements of this may be viewed as a pure tax on his or her earnings. Indeed,
package, others may value only some of them. For example, in Colombia, 44 percent of informal salaried workers and
while single mothers may value child care benefits very 54 percent of informal independent workers state that the
highly (indeed, they may be willing to pay more than they main reason they do not contribute to health insurance is
are asked to contribute via payroll costs), other workers-- that they are already covered by a relative's insurance plan
such as those without children--may not value it at all. In (see chapter 2, table 2.13). This particular design issue
cases where workers do not value one or more components has become increasingly important over the last few
of the benefits package, those components may be consid- decades as female labor force participation rates have risen
ered by the worker as a "tax" on their earnings. in the region. In the case of Argentina, Galiani and
In some cases, workers may face situations in which they Weinschelbaum (2006) argue that significant numbers of
perceive contributions for part or all of the package of ben- female entrants to the workforce chose to be informal
efits provided under social security as a "pure tax." In some because their husbands were already eligible for benefits,
cases, this may be an issue of government credibility. For and that this phenomenon led to a 13 percent increase in
example, if workers lack confidence in their government's informality between 1974�76 and 1999.
commitment or ability to actually provide promised
benefits--for instance, pension benefits to be paid 20 years Labor movements in and out of the formal sector
in the future--then workers may view making pension Latin American and Caribbean social security systems are
contributions as a pure tax. Moreover, certain aspects of also designed under the implicit assumption that workers
social security design may cause workers to perceive social will spend their entire working lives in the formal sector.
security contributions as a pure tax. In Brazil, for example, This approach is consistent with a long-standing view across
the Social Security Law (Lei Org�nica da Previd�ncia Social) Latin America that labor markets are highly segmented and
guarantees all Brazilians over the age of 67 a benefit of one that flows of workers between the formal and informal
194
I N F O R M A L I T Y, S O C I A L P R O T E C T I O N , A N D A N T I P O V E RT Y P O L I C I E S
sector jobs--and particularly from formal to informal sector
FIGURE 7.10
jobs--are small. As was discussed in earlier chapters, there
Distribution of Mexican workers' years insured by IMSS,
appears to be more mobility and a greater flow of labor in 1997�2005, for low- and high-wage workers in IMSS in 1997
and out of the formal sector than was envisioned in the
% of workers
design of either health insurance or pensions.
45
Data suggest, for example, that there is considerable 40
movement of individual workers in and out of the formal 35
and informal sectors, even over relatively short periods of 30
time. Analysis of Mexico's 2005 National Urban Employ- 25
ment Survey indicates that about 11 percent of high-wage 20
15
workers in the formal sector during the first quarter of
10
2005 (those earning more than three minimum wages) had
5
moved to the informal sector by the end of the year (Levy
0
2006a). About 16 percent of low-wage workers in the for- 1 2 3 4 5 6 7 8 9
mal sector (those earning less than three minimum wages) Years
had moved into the informal sector from the beginning to
Workers with 3 MW Workers with 3 MW
the end of the year. Flows moved in the other direction as
well; roughly 11 percent of both low- and high-wage work- Source: Adapted from Levy (2006a), based on Razu (2006).
Note: Of the almost 9 million workers analyzed, nearly 6 million
ers who were informal in the first quarter had moved into were "low-wage" workers, defined as earning less than three
times minimum wage, while roughly 3 million were "high-wage"
the formal sector by the end of 2005.
workers, defined as earning more than three times minimum wage.
Overall, movement of Mexican workers is greater
among low-wage workers than among higher-wage work-
ers. This can be seen from data on the duration of roughly
9 million IMSS workers in the formal sector between 1997 system, this means that, over any given time period, IMSS-
and 2005 (figure 7.10); only 11.6 percent of low-wage affiliated workers--especially low-wage workers--spend a
IMSS workers spent the entire nine-year period in the IMSS considerable amount of time without access to IMSS health
system. Moreover, on average, low-wage workers spent just insurance. This suggests that under Mexico's current social
less than half of the period (4.3 years) in the system. In con- protection system, some workers may spend some time
trast, over 42 percent of the higher-wage workers spent the periods covered by IMSS, and other periods covered by
full nine-year period in the system. These workers also ministry of health programs (for example, Seguro Popular)
spent a longer amount of time in the IMSS system over the with access to separate and mutually exclusive health facil-
period--6.5 years, on average. It is worth noting, however, ities. This represents significant inefficiency in the system.
that while higher-wage workers spent more than two years Similar conclusions can be drawn from data on years of
longer in the system than low-wage workers during the worker registration with the main social security institu-
period, they still averaged roughly 2.5 years out of the sys- tion in Uruguay, Banco de Previsi�n Social or BPS (Bucheli
tem over the period.17 et al. 2006). First, these data also suggest that there is con-
This mobility of labor has potentially important impli- siderable movement in and out of Uruguay's formal sector
cations for workers' access to benefits and, thus, the design during a person's normal working life. This can be seen
of social protection. For example, under current regula- in figure 7.11. If the data had a bimodal distribution--in
tions, IMSS workers are required to accrue 25 years of work which one group of workers never or almost never con-
experience "in the system" in order to qualify for the Mini- tributed to BPS and another group always or almost
mum Pension Guarantee (MPG). But if the years of IMSS always contributed over their working lives--then one
affiliation implied in figure 7.10 are representative, then it could say that the data show evidence of strong labor mar-
would take a low-wage worker roughly 50 years of work to ket segmentation. But, as can be seen from the figure, the
qualify for the MPG. For all practical purposes, therefore, data show a continuum of cases, with peaks around 17, 23,
the MPG would be unattainable. Moreover, to the extent 25, 30, 35, and 38 years of service, suggesting more
that the data reflect worker movement in and out of the mobility than segmentation.18
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I N F O R M A L I T Y
FIGURE 7.11 FIGURE 7.12
Density function for years of formal sector work among Cumulative distribution of years of formal sector service among
60-year-olds in Uruguay (accumulated ages 18�60) 60-year-olds in Uruguay (accumulated ages 18�60)
0.009 Percent
0.008 100
90
0.007 87%
80
0.006
70
0.005 60 62%
0.004 50
40
0.003
30
0.002
20
0.001 10
0 0
0 5 10 15 20 25 30 35 40 0 5 10 15 20 25 30 35 40 45
Years of service Years of service
Source: Bucheli et al. 2006. Source: Bucheli et al. 2006.
Second, the data suggest that there is a high risk that a For those workers--particularly low-income workers--
very significant share of the workers registered in the work who do not envision achieving the required vesting period,
history of the BPS will not be able to comply with the con- such rules may provide a strong disincentive to entering
dition of contributing 35 years to access the pension when the formal sector in the first place.21
they reach the usual ages for retirement (figure 7.12) Just how important are these factors? A large body of
(Bucheli et al. 2006). In contrast to Mexico, 35 years of empirical literature from Latin America and beyond shows
contributions are required not only to get a minimum pen- that high rates of payroll tax have a negative impact on for-
sion, but to attain the right to any pension at all (if the mal sector employment. For example, Packard (2002) finds
worker is below the age of 70).19 As can be seen from the that the higher payroll taxes for social security are associ-
figure, Bucheli et al. estimate that by age 60, roughly ated with lower numbers of contributors in the workforce.
87 percent of all workers will not have accumulated the Fiorito and Padrini (2001) arrive at similar results in an
35 years of service necessary under the law to qualify for analysis of labor taxes in developed economies.
pensions (figure 7.12). The authors estimate similarly that Several authors have estimated semi-elasticities of self-
72 percent of 65-year-olds will not have accumulated the employment with respect to a change in relative formal sec-
necessary number of years. tor earnings (Krebs and Maloney 1999; Loayza and
As in Mexico, the Uruguayan problem tends to be more Rigolini 2006; Maloney 2001). These authors find a range
serious among low-income workers than among high- of estimates, depending on methodology used,22 and this
income workers (and among private sector workers as has implications for the possible size of the impact. If, for
opposed to those in the public sector). Low-income workers example, one assumes that 10 percent of the formal sector
in Uruguay tend to be at the bottom of the distribution of earnings package is absorbed in unvalued benefits and per-
years of formal sector work, while high-income workers haps that another 10 percent of the value of earnings is tied
tend to be at the upper end of the distribution (Bucheli to inaccessible benefits (leading to a 20 percent decline in
et al. 2006).20 Bucheli et al. estimate that just over 50 per- the relative attractiveness of formal labor), then the
cent of 60-year-olds from the highest earnings quintile will authors' estimates suggest the size of the informal self-
achieve 35 years of formal service (and registration in BPS), employed sector would increase by between 0.6 and
but that almost no one from the lowest earnings quintile 6.0 percent, as a share of the workforce. In the case of
will. As such, low-income workers in Uruguay--as in Brazil, Fernandes, Gremaud, and Narita (2006) simulate
Mexico--face a particularly serious risk of not acquiring the impact of eliminating payroll taxes for unskilled work-
the years of service necessary to qualify for pension benefits. ers (those earning up to one minimum wage). If combined
196
I N F O R M A L I T Y, S O C I A L P R O T E C T I O N , A N D A N T I P O V E RT Y P O L I C I E S
with deductions of value-added tax (VAT) paid on capital In the last few years, however, several new social assis-
investment, these authors find that eliminating payroll tance programs have been launched or proposed for poor
taxes on unskilled workers would lead to a decline in infor- workers working in the informal sector. These include a
mality of 1.5 percent.23 subsidized package of financial protection in health, called
Seguro Popular, with an insurance premium that is 100
Adverse incentives within the broader social percent subsidized for extremely poor families; a pension
protection system program, MAROP (Mecanismo de Ahorro para el Retiro Opor-
The fact that there is greater mobility between the formal tunidades), that includes noncontributory transfers for the
and informal sectors than has generally been thought cre- elderly and savings incentives for those in Oportunidades
ates challenges not only for the design of specific social who work in the informal sector; and Fondo Nacional de
security programs, but for social protection systems as a Habitaciones Populares (FONAHPO), a program of housing
whole. As mentioned earlier in the chapter, the recent subsidies for poor informal sector workers.24 More recent
growth of social assistance programs has also led to increas- proposals are on the drawing board for universal health
ing fragmentation in social protection systems in the Latin insurance for all pregnant mothers and children under five
American and Caribbean region. A key benefit of this years of age, and subsidized child care for working mothers
approach has been that an increasing number of poor peo- in the informal sector.25
ple have access to programs that play an important social Several features are noteworthy about these recent or
protection or poverty reduction function, providing free emerging social assistance instruments--health insurance,
but relatively modest benefits to eligible families--those pension, housing, child care--relative to the IMSS pack-
whose livelihoods exist largely outside the formal sector. age. First, although the benefit packages are not as gener-
The main challenge relates to the fact that expanded social ous as those offered by IMSS, they are less costly than the
assistance programs provided freely (and sometimes pro- IMSS package and, in some cases, essentially free. Second,
vided conditionally on working in the informal rather than eligible beneficiaries can choose which of the programs
the formal sector) may themselves be creating disincentives they would like to participate in; there is no mandatory
to the formalization of the workforce who are taxed via bundle. And, third, beneficiaries must work outside the
payroll contributions to gain the right to social security IMSS (formal sector) system to be eligible for these pro-
benefits. grams. So, key questions that potential beneficiaries face
An example of this can be seen in the case of Mexico. As are: Do I search for a job in the formal sector where I can
noted, the benefit package offered by the IMSS has eight receive a bundle of benefits that I will pay for via my pay-
mandatory components, including health insurance, roll contributions? or, Do I stay in the informal sector and
retirement pensions, disability insurance, professional risk get similar--although somewhat less generous--benefits
insurance, life insurance, day care centers for workers, that are essentially free? The answers lie, in part, in how
sports/recreational and cultural facilities, and housing cred- highly workers value the net benefits of social security ver-
its, paid for in part by workers' payroll taxes. In 1995, the sus social assistance benefits. While this emerging system
government of Mexico launched a conditional cash transfer of assistance programs is too young to have enabled mea-
program, called Progresa (subsequently renamed Oportu- surement of its effects on formal versus informal employ-
nidades), which provided cash transfers to poor families on ment, the creation of a dual system--social insurance
the condition that families make specified human capital versus social assistance--may be creating incentives for
investments. The design of the program is oriented toward greater informal employment (or slower formal employ-
strengthening the human capital of the poor through ment growth) in Mexico.
incentives and investments in school-aged children. Fur- Levy (2006b) models the labor market decisions of util-
thermore, the design of the program is such that support ity maximizing workers between the formal and informal
will end prior to the time that a student-beneficiary gradu- sectors, given a predetermined and mandatory (take-it-or-
ates from school and prior to the time that he or she makes leave-it) bundle of social security benefits available to for-
a labor market decision (for example, agriculture versus mal sector workers, on one hand, and an unbundled
industry versus services, rural versus urban, informal versus collection of social assistance benefits available to informal
formal). sector workers on the other. Consistent with the situation
197
I N F O R M A L I T Y
in Mexico and elsewhere in Latin America and the between 2002 and 2005, during a period of strong
Caribbean, workers must pay for social security benefits via economic growth and formal employment growth in
payroll taxes, while social assistance benefits are available Argentina. The authors investigate whether male Jefes par-
for free to workers outside the formal sector. Workers may ticipants were less likely to accept formal jobs in this
differ in their valuation of social security benefits as a result booming economy than their nonparticipant counterparts,
of inherent differences in their personal preferences or due taking advantage of a short panel of data from the
to differences in the quality of program benefits and ser- Argentine household survey.
vices. When workers' valuations of the relative benefits dif- Gasparini, Haimovich, and Olivieri (2006) find some
fer, they self-select into formal and informal sector jobs, evidence of an informality-incentive effect due to Jefes.
affecting the composition of the labor market. A general Specifically, the authors find that the share of Jefes partici-
conclusion of Levy's model is that when social (protection) pants who found a formal job was significantly lower than
policy consists of many programs and policies with distinct the corresponding share of nonparticipants with similar
rules of access (formal versus informal job status) and forms observable characteristics. In some cases the difference is
of financing (payroll taxes versus general revenues), it can not only statistically significant but economically large.
generate unanticipated labor outcomes; these resulting out- For instance, when carrying out the propensity score
comes can have adverse effects on productivity and long- matching with the radius method, during the 2003�04
term growth (Levy 2006b). period, the difference between male Jefes participants and
While the Mexico case may be particularly illustrative, Jefes nonparticipants in the share of workers moving to a
Mexico is by no means alone on this issue. Colombia has a formal job is 5 percentage points. The authors also find
subsidized health insurance regime (Regimen Subsidiado) that the informality-incentive effect is sensitive to the rela-
that is available to poor informal sector workers; Argentina tive wage offers in Jefes and in the formal sector. Specifi-
has an emergency employment program (Jefes de Hogar) in cally, the effect of Jefes on informality vanishes during the
which participation is conditional on not being employed 2004�05 period when the gap between the Jefes transfer
elsewhere. In fact, a recent study of the informality impacts (fixed in nominal terms) and wages in the formal sector
of the Jefes de Hogar program in Argentina provides some greatly widened.26
preliminary evidence of how important these incentive In sum, evidence from the Jefes program in Argentina
effects might be at the specific program level. In the midst suggests that the design of social assistance programs and
of one of the most serious economic crises of its history, the incentives they create do indeed influence workers'
Argentina implemented Jefes de Hogar (Jefes), a large decisions to seek formal versus informal employment.
poverty alleviation program. This program combines the Additional analysis in other country and programmatic
features of a workfare and a conditional cash transfer pro- contexts would be useful in deepening policy makers'
gram. Jefes is aimed at providing cash transfers to those understanding of just how strong are these incentive
unemployed household heads with children at school. The effects, both in absolute terms and relative to other factors.
belief that poverty is closely related to unemployment led In the meantime, several factors may be thought to affect
Argentina to include the unemployment requirement as a the relative strength of the incentive effects in a given con-
targeting device. text. These factors include the following:
In principle, conditioning on unemployment implies a
full taxation on outside incomes for the program partici- � The more generous noncontributory program bene-
pants; that is, getting a job means losing their program fits are relative to contributory program benefits,
benefits. Under certain circumstances, therefore, Jefes's the stronger the incentive problem. This could
unemployment requirement may create a disincentive for include relative wages, as in the case of Jefes, or the
beneficiaries to search for a formal job--although in prac- relative size of non-wage benefits, all other factors
tice, monitoring of Jefes's program requirements is not per- (including service quality) being equal.
fect, so the incentive effects may not bear out in reality. � Program incentive effects are likely to operate
The effect of Jefes on informality is, thus, an empirical mat- most strongly among workers at the margin of
ter. In this context, Gasparini, Haimovich, and Olivieri formal and informal employment decisions. In that
(2006) assess the impact of Jefes on labor informality context, social assistance programs (including
198
I N F O R M A L I T Y, S O C I A L P R O T E C T I O N , A N D A N T I P O V E RT Y P O L I C I E S
noncontributory health and/or pension benefits) are market failure, and government failure for the design of the
likely to have a smaller effect on labor market out- region's social protection systems.
comes. When they are well targeted toward the very
poor, and when the social security coverage gap is rel- Providing essential cover in health
atively large, formal sector employment is concen- For guidance on how governments should intervene to pro-
trated among those in the upper deciles. The issue of tect their citizens, it is useful to return to the comprehen-
incentives between social security and social assis- sive insurance framework discussed earlier in the chapter
tance is likely to be more important in the relatively (box 7.2). Baeza and Packard (2006) illustrate the applica-
more developed countries in the region, with tion of this framework in the context of health. Illness
moderate-to-high levels of both social security and comes in a variety of forms. Most frequent illnesses are not
social assistance coverage. serious, nor do they imply large costs or financial losses. In
� Certain types of social assistance programs may not fact, for 80�90 percent of health events that households
have strong incentive effects on the workers' deci- will experience in their lifetimes, people rarely go to the
sions to seek formal versus informal employment. doctor. Most symptoms--headaches, the common cold,
Programs such as Oportunidades in Mexico (or similar adult diarrhea, and even minor fever--last fewer than three
conditional cash transfer programs) that limit their or four days and can be easily treated with rest and nonpre-
focus to strengthening children's human capital--for scription pharmaceuticals. To mitigate the financial losses
example, education, health, and nutrition--but do from these relatively small, frequent symptoms, most
not try to influence labor market choices, would not households are better off relying on prevention (for exam-
be expected to create strong incentives for any spe- ple, good nutrition and good hygiene, preventive and
cific forms of labor market participation. primary medicine, and exercise) and saving (that is, indi-
� Conversely, those programs that tie participation to vidually assuming the cost of treatment and medication).
a particular labor market state--for example, work- However, for less frequently occurring, more serious ill-
ing outside the formal sector--would be expected nesses, the cost of treatment can increase rapidly. Indeed,
to more strongly affect informal-formal sector for conditions such as complicated flu, pneumonia, bacte-
decisions. rial bronchitis, or urinary infections, the cost of diagnosis,
treatment, and resolution can be substantial. Medical con-
Reengineering social protection to protect sultation becomes critical to identify more serious condi-
all citizens tions. To cover the potential financial consequences of
Poor access to basic risk management instruments, com- less-frequent sicknesses that are costly to treat, households
bined with the existence of market failures (information are better off relying on risk-pooling arrangements. As
problems, externalities) and pervasive government the cost of treating health events grows--and because the
failure, highlights an urgent need to rethink--indeed, direct and indirect costs of an illness and its treatment can
"reengineer"--social protection policy and systems in be impoverishing--it becomes critical for individuals and
much of Latin America and the Caribbean. Specifically, households to find an effective mechanism to pool risks
given the high and persistent levels of informality in the (Baeza and Packard 2006).
region, it will be important to rethink the traditional Bis- Yet, as noted above, private markets for health insurance
marckian model of social protection in which protection are thin or are missing in most Latin American and
depends on the specific form of the labor contract. The col- Caribbean countries, due in part to information failures.
lection of evidence suggests that a broader notion of who The small and fragmented risk pools created by existing
has access to basic risk management instruments is health insurance schemes are relatively inefficient. More-
needed--one based on assuring the basic protection and over, in the case of health, losses that go uncovered have the
welfare of countries' citizens rather than of workers, as tradi- potential to impose significant external costs on others. As
tionally and narrowly defined. Chapter 8 focuses in detail such, there is a strong case for public intervention to
on the nature and evolution of the social contract between strengthen risk-pooling mechanisms and to expand the
the Latin American State and its citizens. This section pool. Since public resources for health insurance tend to be
focuses on potential implications of informality, risk, heavily constrained in the region, there is a case for extending
199
I N F O R M A L I T Y
broad coverage via a package of minimum or "essential" direct package in Chile (box 7.3). It is important to underscore
cover of catastrophic losses with high external costs (Packard that the idea of general-revenue financing of health insur-
2006). To ensure the greatest possible coverage, such a ance should apply solely to minimum essential cover; both
package should be de-linked from the labor contract and the economics of insurance and a country's real-life fiscal
financed through general taxation. Since even moderate constraints dictate that additional coverage, if desired,
health costs can be catastrophic for the poorest households should be available on a contributory basis. In this context,
in the region, the exact composition of the package should there is a critical role for public policy in fostering more
reflect this fact. efficient health sectors, including the strengthening of both
There are a number of arguments in favor of de-linking insurance and provision functions.27
the provision of essential cover in health from the labor
contract and, instead, financing such provision through Strengthening old-age security
general taxation. General taxation is potentially the most There is also a case for providing essential cover to the elderly in the
efficient and also the most equitable financing mechanism form of a poverty prevention pension, focused on the poor, as part of a
for risk pooling, depending on the progressivity of tax broader multipillar pension system. As a form of social insurance,
collection instruments and subsequent patterns of public risk pooling would be central to the poverty prevention ele-
spending (Mossialos et al. 2002; Savedoff 2004, cited in ment, and, because of the social costs associated with people
Baeza and Packard 2006). Financing essential cover falling into poverty at an older age, there is a clear risk man-
through general tax revenues also has the benefit of ensur- agement rationale for de-linking access to this poverty pre-
ing that health risks are effectively pooled across the widest vention pension from the form of the labor contract, and
possible risk pool. In the case of essential cover, Packard financing it through general revenues (Packard 2006). At
(2006) argues that, given externalities, the social costs the same time, the comprehensive insurance framework
of individuals failing to cover themselves and their highlights the importance of individual saving as a core
dependents are high enough that "there is a clear risk man- element of a broader system of old-age security. Indeed, given
agement rationale to take the `choice to cover' out of the the high probability of income loss in old age, saving should be the
hands of employers and workers" (p. 25) by shifting financ- mainstay for earnings replacement during old age (Gill, Packard,
ing away from payroll contributions and toward general and Yermo 2004). Lessons from recent experience make clear
revenues. Moreover, in countries such as Mexico or Colombia that savings pillars should closely link benefits to contribu-
where subsidized health regimes have been put in place to tions and do so in a similar way for most workers, regardless
fill health coverage gaps left by the formal sector, general- of the status of the labor contract. In this context, the indi-
revenue financing alleviates the problem of misaligned vidual capitalization schemes that have been introduced in
labor market incentives associated with a system in Latin America over the last few decades are fully consistent
which payroll tax�financed social security for the formal with the saving objective.
sector "competes" with general revenue�financed (and In pursuing more effective protection against old-age
government-subsidized) assistance programs for workers in poverty in the face of informality, Latin American and
the informal sector (Levy 2006b). Caribbean countries face several important challenges
While national health systems in Latin America and the regarding the design and operation of the poverty preven-
Caribbean have long sought, in principle, to cover a wide tion and savings components, as well as the relationship
range of health conditions via the public health services, between the two. Recent policy research on pension reform
these systems have generally not conformed to sound insur- in Latin America and the Caribbean suggests, for example,
ance principles, nor have they been able to deliver on their that from an institutional perspective, the poverty preven-
promise with quality services. Overreach on the part of tion component is best financed and managed separately
government has led not only to low-quality service in the from the savings component. Among other things, the insti-
public health system, but unsustainable fiscal situations in tutional imperatives associated with managing a minimum
some countries. In recent years, however, several countries poverty reduction payment are distinct from those associated
have attempted to define more modest but implementable with the management and supervision of investments under
minimum-benefit packages, such as the Regimen Subsidiado individual capitalization schemes (Gill, Packard, and Yermo
in Colombia, Seguro Popular in Mexico, and the AUGE 2004). Moreover, weak design of one element can undermine
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I N F O R M A L I T Y, S O C I A L P R O T E C T I O N , A N D A N T I P O V E RT Y P O L I C I E S
BOX 7.3
Extending health insurance coverage by correctly aligning risk-pooling instruments
The question of how best to protect households from the with the population covered by FONASA. The pilot
financial consequences of illness and disability has been experience yielded positive results by increasing access to
the subject of lengthy debate in Latin America. The core the services included in the package. Since January 1,
of this discussion has focused on the trade-off between 2004, AUGE has been mandatory for all citizens and all
the breadth of coverage (how many households can count public and private providers of health insurance. Both
on some health protection) and the depth of coverage (the households covered by FONASA and those covered by
package of care they can count on). The constitutions the private health insurers (called ISAPREs) are entitled
of most Latin American countries guarantee the right of to the same minimum package of health services.
citizens to good health and access to health services. In While it is too early to assess the effect of the Chilean
theory, the public health system covers treatment of all reform on lowering vulnerability to poverty or easing the
health conditions. However, in practice, health systems burden of health expenses for the poor, the "explicit enti-
are financially constrained, and resort to rationing or tlements approach" embedded in the AUGE is already
lowering the quality of care in order to comply with having both intended and unexpected effects in Chile and
their budget constraints. At least until the mid-1990s, elsewhere in the region. For example, it has forced policy
constitutional mandates existed alongside a large, unsat- makers to revisit the breadth and depth discussion of
isfied demand for health care, and the promise of uni- health coverage. Before the reforms, all health services
versal health care was not accompanied by effective were theoretically available to all citizens, but, in prac-
instruments to achieve that. The casualties of this failure tice, nothing was actually guaranteed. The result was a
tended to be the poor. Beginning in the mid-1990s, limited and poor-quality package of services, particularly
however, several countries have introduced legislation for the poor.
and sector reforms to transform health benefit packages Under the new explicit entitlement approach, a basic
into well-defined and explicit entitlements guaranteed package of health coverage becomes legally binding for
to all citizens. These reforms typically include legal mech- governments, throwing open the debate of whether to
anisms for households to demand their entitlements guarantee a limited package to all or an extensive pack-
from the state. age (often focused on the most costly health care) to a few.
Since 2002, Chile has been gradually introducing a Moreover, these reforms have led to a much closer dia-
new health insurance package (Plan of Universal Access logue between ministries of finance and health because
with Explicit Guarantees, or AUGE). Rather than con- the legally binding nature of the package reduces the
tinuing to offer unrealistic promises to cover all health space for fiscal adjustment in the health sector. Errors in
needs, AUGE establishes a guaranteed minimum pack- defining the coverage of the package can thus have signif-
age of basic health cover for all Chileans, along with icant fiscal consequences, putting a premium on effi-
guarantees of attention within specified time periods, set ciency and management in the health sector. Indeed,
ceilings on co-payments, and full subsidies for the poor- although largely unintended, most related reforms have
est households. The new system is designed to eliminate provided governments with a powerful instrument to
rationing and improve service. AUGE levels out premi- focus on broader efficiency-enhancing reforms in the
ums and co-payments and reduces "cream skimming" by health sector. Guaranteeing a package requires clarity
insurers. It represents an enforceable "patient's bill of regarding the quality of delivery, which, in turn, requires
rights" for affiliates of FONASA (Fondo Nacional de complex monitoring systems, provider payment systems,
Salud), the National Health Service, and is set up to and contracts or quasi-contracts between the public
reduce waiting lines and other inefficiencies that can financing agency and health service providers.
increase out-of-pocket costs, particularly for poorer
households. AUGE was first tried out on a pilot basis Source: Baeza and Packard 2006.
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I N F O R M A L I T Y
the impact of another. For example, excessively generous or old-age security for all, including the poor and those
badly designed poverty prevention components serve to who work outside the formal sector. In doing so, it
reduce incentives for personal retirement savings and/or would move Chile from having two different
exacerbate incentives for informal sector employment. systems--a defined contribution pillar system and a
So what does this imply for the design of a poverty targeted social assistance pension--to a single inte-
reduction component of a pension system? Given institu- grated system. The reform seeks to establish an
tional and fiscal constraints that exist in the region--and appropriate mix of pooling and saving instruments,
that vary significantly across Latin American and Caribbean an effective institutional structure for supervision
countries--it is useful to draw on the discussion of incen- and management of the new system, and, impor-
tives above, and to distinguish between those countries tantly, incentive compatibility of the poverty preven-
with large coverage gaps, in which incentive issues may not tion and saving components of the system (box 7.4).
be so important in the short run, and those with moderate-
to-high levels of social security and social assistance cover- What about the design of the savings components in the
age, where the incentive effects are likely to have greater face of pervasive informality? A key issue here is whether
importance, even in the present. More specifically, these (or how) to mandate old-age savings among those who, by
incentives could include the following: definition, operate outside of countries' administrative and
enforcement mechanisms. Finding the appropriate balance
� For countries with large coverage gaps, it makes between the mandatory savings pillar (so-called pillar 2)
sense to focus first on the implementation of social and the voluntary savings pillar (so-called pillar 3) has been
assistance pensions that are well targeted to the poor the focus of recent analysis of multipillar pension schemes
(or extreme poor) and scaled to be fiscally sustain- in Latin America (Gill, Packard, and Yermo 2004). Part
able.28 In this context, an important design challenge of the argument for mandating savings revolves around
will be to set the level of the pension benefit large concerns about information failures and "myopia" that
enough to provide protection against poverty, but might lead workers and households to under-save for retire-
not so large that it creates significant adverse labor ment. Yet, working to ensure old-age savings opportunities
market or saving incentives in the future when the for those in the informal sector would seem to argue for
coverage gap between the social assistance pension strengthening voluntary savings instruments as part of a
and social security closes.29 An important message multipillar system. It also argues for providing greater flex-
here is that even in designing a well-targeted social ibility within the system to help raise the perceived bene-
assistance pension, policy makers should consider not fits of savings relative to its costs. In this context, there will
only short-term concerns about coverage, but also be gains from ensuring greater portability of savings and
longer-term concerns about incentive compatibility benefits as workers move in and out of the formal sector.
as the gap between contributory and noncontributory Providing greater flexibility in savings and investment
programs closes over time. options, perhaps based on people's stage of the life cycle--
� For countries with moderate-to-high levels of social for example, and allowing lower levels of mandatory contri-
security coverage, where incentive issues are likely to butions for younger workers, allowing younger workers to
be more important in the short term, the need to select investments with higher risk-return profiles, while
focus on the issue of incentive compatibility is more supporting lower-risk portfolios for older workers--may
immediate. In such cases, in addition to having a also serve to raise people's demand for retirement savings.
well-targeted (and well-means-tested) poverty pre-
vention pension, some progressive reduction in the Unbundling complex, multidimensional
benefit level with income would be advisable to help benefit packages
maintain appropriate incentives throughout the As previously noted, a number of countries' social security
broader system. In this regard, the pension reform systems require contributions to complex, multidimen-
recently proposed by the government of Chile may sional benefit packages. As has also been noted, to the
hold some valuable lessons for other countries in the extent that workers do not value one or more components
region. The Chilean proposal focuses on providing of the package, those components represent a tax on
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BOX 7.4
Old-age protection in the new millennium: Chile's proposed pension reform
In December 2006, the Chilean government sent to Con- Benefit structure under Chile's proposed pension reform
(workers' total pension as a function of their self-financed pension)
gress a draft law to reform the pension system. The pro-
posed reform contains a broad set of measures, including Total pension
the replacement of the existing targeted social assistance
pension (PASIS) with a new solidarity pillar, extension of
coverage to self-employed workers, norms to promote
gender equity, and several norms aimed at improving the
200
performance and supervision of the individual accounts
pillar. It is an ambitious and comprehensive proposal that
builds on the existing system.
To prevent old-age poverty, the current Chilean social
75
security system includes a minimum pension as part of
its contributory pension scheme, as well as a social assis-
tance pension. The minimum pension is available only to 0
0 200 Self-financed pension
individuals who have contributed for at least 20 years to
individual accounts, and there is some evidence that Source: Forteza 2007, based on Government of Chile 2006a, 2006b.
many workers will not achieve the required contribution
benefits to the self-employed as to salaried workers,
history before retiring. At the same time, the social assis-
including the solidarity benefits. Over time, participa-
tance pension is targeted to the poorest. Thus, there is a
tion of self-employed workers would become mandatory,
concern that a significant share of the population might
unless the person explicitly opts out. It is worth noting
end up with very low--or no--pensions.
that even though Chile currently has low coverage of self-
The proposed reform would create a new solidarity
employed workers, as in other Latin American countries,
pillar that provides benefits to individuals in the lowest
it does not have as high levels of informality among the
60 percent of income distribution who either have not
self-employed (since most of them are registered and pay
contributed to the system or have low contribution lev-
other taxes). As such, the enforcement challenges associ-
els. Those who have not contributed would receive a pen-
ated with expanding coverage among the self-employed
sion of Ch$75,000 (approximately US$142) per month.
in Chile look relatively less onerous than in other coun-
Those who have low contribution levels would receive a
tries in the region.
supplementary payment, such that the sum of their self-
The reform effort also seeks to promote reductions in
financed pension and the supplement would be no less
the commissions charged by the pension fund adminis-
than Ch$75,000 and no more than Ch$200,000 (approx-
trators and to increase the return of the investments.
imately US$380) per month. The size of the supplemen-
Current commissions are considered high and are attrib-
tary payment declines with the size of the pension that is
uted to the lack of sufficient competition. The Superin-
self-financed so that workers who can self-finance a pen-
tendent of Pensions will organize annual auctions of
sion of Ch$200,000 or more receive no supplement (see
new affiliates based on the level of the commission; the
box figure). Until that point, however, the total pension
administrator who offers the lowest commission will get
increases as the self-financed pension does, so that work-
the new affiliates. The administrator will be required to
ers receiving the supplement still have positive incen-
keep the commission offered to new affiliates for at least
tives to continue contributions.
18 months and extend this rate to all its affiliates. The
The participation of self-employed workers in the cur-
reform also seeks to raise the return of the funds by
rent pension system is voluntary in Chile, and only about
providing more flexibility to choose the composition of
5 percent of the self-employed have chosen to participate.
The proposed reform would extend the same program (Continued)
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I N F O R M A L I T Y
BOX 7.4
Old-age protection in the new millennium: Chile's proposed pension reform (Continued)
the portfolio. With more flexible supervision, administra- The pension system envisioned in the Chilean reform
tors will have more responsibility for returns on the represents a movement away from what is predominantly
funds. a single savings pillar to a more balanced multipillar, or
The reform would also modify the institutional multi-tier, system. The proposal strengthens and better
structure for managing and supervising the new system. integrates the assistance and redistributive components
Specifically, a new Social Security Institute (Instituto de with the individual savings component of the system. It
Prevision Social) would be in charge of the system of soli- improves the capacity of the pension program to protect
darity pensions while a Superintendent of Pensions the less fortunate, without neglecting incentives and
(Superintendencia de Pensiones) would supervise the whole avoiding strong fiscal impacts. The proposal also repre-
system, including the Social Security Institute. In under- sents a valuable contribution in terms of the policy-
taking the reform, the government of Chile envisions a making process. For example, there were extensive
five-year transition period, with a progressive roll-out of consultations with stakeholders conducted by the com-
the solidarity pillar. The fiscal implications of the reform, mission appointed by the government to develop the pre-
while not trivial, appear manageable. The presidential liminary set of proposals. In addition, the government
advisory commission overseeing reform of the social secu- chose to build its reforms on the existing system. The
rity system estimates that the new solidarity pillar will result is a balanced project that improves the existing
cost roughly 1 percent of GDP in 2025. The total fiscal system without disregarding the achievements made
cost of pensions in that year would thus grow from a pro- under previous reforms.
jected 1.6 percent of GDP in the absence of the reform to
2.5 percent of GDP with reform. Source: Forteza 2007, based on Government of Chile 2006a, 2006b.
workers' earnings, generating disincentives to formal sector If governments see the need to provide a housing benefit, at
employment. Such taxes adversely affect incentives for for- a minimum that benefit should be made voluntary or "elec-
mal employment. tive." However, the rationale for using payroll taxes as an
From the perspective of public social protection, some of instrument to finance such a benefit is unclear. If the objec-
the components included in these complex packages have tive is to ensure that the poor have access to adequate hous-
no clear risk-pooling or risk management rationale. Nor is ing, then a more efficient and appropriate way to provide
there clear economic justification as part of a social security that benefit would be through direct subsidies targeted to
package on the basis of providing public goods or positive the poor and financed by general revenues.
externalities. Similarly, there is no clear justification for Some countries, such as Colombia, also provide subsidies
payroll-tax financing. Take, for example, the cases of the to early childhood development financed through payroll
sports and recreation or housing-related benefits in Mexico. taxes. Although investments in early childhood development
Both of these benefits represent private goods; neither do have a strong "public goods" dimension, the rationale for
involves risk pooling or social risk management. financing them through payroll taxes remains unclear. They,
In such cases, social security packages would benefit too, are better financed through general taxation.
from "unbundling" of what might be called "nonessential"
elements. Unbundling would involve shedding--or Potential costs of social protection reform:
making voluntary--those elements of the current social Financing essential cover
security packages with no risk-pooling or risk management Reengineering Latin America's social protection systems
rationale, or that finance private as opposed to public and, in particular, ensuring minimum essential cover in
goods. The objectives of unbundling are to increase the health and pensions via de-linked social protection programs
benefits relative to the costs of social security packages and will have important fiscal implications for most countries in
focus social security on its core social protection functions. the region. First, de-linking implies eliminating payroll
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I N F O R M A L I T Y, S O C I A L P R O T E C T I O N , A N D A N T I P O V E RT Y P O L I C I E S
taxes (at least in these areas) and replacing them with rev- health, the expected fiscal impact of essential old-age cover
enue sources that are less distortionary, such as the VAT, or depends critically on several factors, including desired cover-
income or property taxes. Second, in most countries in the age levels, expected demographic changes, the proposed size
region, providing essential cover will imply the need for of the benefit, whether benefits are indexed to prices or
greater public resources to health and pension coverage. wages, and whether savings incentives are offered. For the
The precise amounts of additional resources required and purpose of this exercise, estimates were made using a pro-
the appropriate revenue source in each country will depend posed benefit of half a minimum wage (roughly equivalent to
on a number of factors, including but not limited to the size the extreme poverty line in Mexico), indexed to real wages.
of the coverage gap, the size of the benefit package being Under this scenario, and accounting for the aging of the
offered by the government, and the country's fiscal space. Mexican population, it is estimated that the incremental fis-
Calculating the fiscal impacts of providing essential cal costs of implementing a targeted social assistance pen-
cover is a difficult exercise, as estimates are sensitive to sion would be 0.3 percent of GDP between now and 2010,
changes in assumptions. In the case of health, for example, rising to 0.7 percent of GDP in 2050. Data from other coun-
estimating the cost of providing essential cover is tricky, as tries in the region suggest that the fiscal impact of extend-
the results are extremely sensitive to the definition of the ing pension coverage will vary depending on the program's
size and content of the benefit package. Moreover, in a design and the country's institutional characteristics--
number of countries, there are potentially important fiscal although the estimates are generally consistent with the
savings associated with micro-efficiency reforms in the findings for Mexico. The government of Chile, for example,
health sector that would be important to facilitating essen- estimates that the proposed solidarity pillar will translate
tial cover in health. Measuring the extent of those savings into a cost of around 1 percent of GDP by 2025 (box 7.4),
and how they offset the additional costs of expanding cov- while a forthcoming study on pensions in Brazil estimates
erage is also a challenge. Nonetheless, attempts to estimate that spending on the government's extensive rural and social
the potential costs are important, and can be useful in iden- assistance pension schemes is equivalent to about 2 percent
tifying general orders of magnitude of impact. of GDP (World Bank forthcoming).
Recent World Bank estimates in the case of Mexico What might such reforms imply from the perspective of
are illustrative. In terms of providing universal essential the tax system and, in particular, if such programs were to be
cover in health, it is assumed that the unit cost of such pro- financed via general taxes rather than through payroll taxes?
vision is equal to the unit cost of Seguro Popular, Mexico's Analysis was undertaken for Mexico to estimate the potential
subsidized health insurance program for the poor. Launched effects of financing these reforms via the VAT. Specifically, it
in late 2004, Seguro Popular covers a packet of basic health was assumed that all households would be taxed under an
care, including preventive, outpatient, inpatient, emer- increased VAT. It should be noted that the current VAT in
gency, and surgical interventions.30 This is a much more Mexico includes a number of exemptions, such as on food
modest package of coverage than is afforded by the health and medicines. Estimates of the impact on VAT rates were
insurance packages in IMSS and ISSSTE (the Social Security undertaken--with the assumption that these exemptions
Institute for Mexican civil servants at the federal level). In were kept in place as rates were raised.
this context, it is assumed that wealthier households would One concern sometimes voiced about raising the VAT is
be free to purchase additional (supplementary) health insur- its costs to the poor. To address potentially adverse impacts
ance in the private market, according to their preferences on the poor of an increased VAT, the estimates assume that
and willingness to pay. Under this scenario, it is estimated the poorest Mexicans are directly compensated for the addi-
that the additional fiscal costs of providing essential cover in tional tax impact.31 While direct compensation for higher
health (that is, costs above and beyond what the govern- value-added taxes would not be provided to the nonpoor, it
ment of Mexico currently spends on health care provision) should be noted that those working in the formal sector
would be approximately 1.3 percent of GDP. would simultaneously benefit from the fact that they would
The potential fiscal costs of providing a poverty preven- no longer have to contribute to the payroll tax. Moreover,
tion pension were also estimated for Mexico--specifically, given that part of the payroll tax is paid by employers, cur-
the costs associated with providing a targeted social assis- rent formal employees may be expected to receive part of
tance pension to all elderly among the extreme poor. As with the current employer tax burden back in the form of higher
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I N F O R M A L I T Y
salaries.32 While these latter benefits to formal workers exemptions of the VAT on capital goods, then the adverse
are noted, they were not included explicitly in the VAT effect on productivity and growth would disappear.
calculations. In considering a shift from payroll tax to general
Estimates of the cost of VAT financing of essential cover revenue�financed social protection, it is important to rec-
for all Mexicans were undertaken, including provision for ognize that policy makers in Latin America are not starting
the poorest 20 percent of Mexican households to be com- with a blank slate, but operate in a well-established policy,
pensated for their increased tax burden. This is equivalent institutional, and political environment. That said, most
to the roughly 5 million households currently covered OECD and many developing countries--all with their own
under the Oportunidades conditional cash transfer program, history of policies and institutions--have already started to
and the compensation could in principle be targeted using make the transition. Even countries with long traditions of
the Oportunidades beneficiary registry. These estimates sug- Bismarck-type social insurance systems, such as Spain, are
gest that to cover additional public spending equivalent to moving toward general taxation to finance minimum levels
1.3 percent of GDP--the amount necessary to provide of risk-pooling coverage (see box 7.5). In fact, countries
minimum essential cover in health--an increase in the VAT that have opted for general-revenue financing typically
rate of about 6.4 percentage points would be necessary, in started with fragmented voluntary and then mandatory
the absence of a payroll tax and under the current VAT social insurance systems similar to the types found in Latin
structure, including exemptions. That would imply an America and the Caribbean. Even in Germany, birthplace
increase from the current VAT rate of 15.0 percent to one of of the Bismarckian social insurance model, recent proposals
21.4 percent, a change that is not trivial. to reform segments of the welfare system aim at moving
In the case of providing a targeted social assistance pen- health finance toward general taxation.
sion, resource needs increase over time before leveling out, The legacy of past social protection policies creates
and this is reflected in the necessary VAT increases. Specifi- important challenges for policy makers in switching from
cally, financing a well-targeted social assistance pension today's model based on payroll taxes to a new model based
would require an increase of the VAT rate by approximately on general-revenue financing. However, lessons from recent
1.3 percentage points at present, but would require a reform countries, such as Spain, can provide some guid-
cumulative increase in the VAT rate of roughly 3.4 percent- ance; some experience with this type of shift also exists in
age points by 2050 (as the costs associated with providing a the Latin American and Caribbean region. Chile's pension
social assistance pension, under current assumptions, rise). reform of 1981 included shifting some elements of payroll
It should be noted, that, under both the health and pension tax�financed social insurance to general revenues, and was
scenarios, generalizing the VAT to include taxes on food accompanied by a substantial decrease of payroll taxes
and medicines--were such a move politically feasible-- (Gruber 1995). Thus, technical solutions exist for how to
would have a significant mitigating impact on the need to implement the shift to a social protection model that can
raise rates, even if compensation of the poor for broader cover all citizens.33
VAT taxation were included.
Relying on the VAT to finance a de-linked social protec- Managing the transition from here to there
tion system may not be the optimal solution in all coun- Latin America and the Caribbean countries exhibit a high
tries, however; indeed, other instruments, such as income or degree of heterogeneity in levels of social protection cover-
property taxes, may be more appropriate, given the specific age (the "flip side" of informality). They also demonstrate
context. Recent analysis suggests that in Brazil, for exam- great heterogeneity in social protection spending and the
ple, switching from a payroll tax to a VAT in its current capacity to dedicate additional resources to social protection
form could have a negative impact on economic growth in in the short-to-medium term. Social protection institutions
the long run (Fernandes, Gremaud, and Narita 2006). This and institutional capacity also differ from place to place. So
is because the VAT in Brazil does not completely exempt while some countries may be in a position--and have the
investment goods from the taxation, and this additional political will--to effect significant changes in the structure
taxation on capital goods has a long-term negative impact and financing of social protection in the near term, others
on growth. Nonetheless, Fernandes, Gremaud, and Narita will need to focus on more incremental challenges, as they
also find that, in Brazil, if measures were taken to permit move toward longer-term goals of ensuring universal access
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BOX 7.5
De-linking health coverage from employment status: Spain's shift to general-revenue financing of essential social insurance
The health-financing system in Spain underwent radical Consistent with the reforms introduced by the Gen-
changes in the 1980s and 1990s, when that country eral Health Care Act, the sources of funding for the
shifted from a social insurance system financed by payroll health care system were drastically modified in 1989.
taxes to a national health service financed by general tax- Beginning in that year, new budgets were financed
ation. Today, almost 100 percent of public expenditures 70 percent from general taxation and only 30 percent
in health are financed from general taxation. from payroll tax contributions.
Spain's transition to democracy and the constitution of In the mid-1990s, consistent with agreements
1978 gave new impetus to health care reform. A separate signed by political parties and trade unions (known as
organization was established within the social security the Pactos de Toledo), 100 percent of financing would
system for the administration of health care services. Most come from general taxation and individual contribu-
health care programs and organizations were consolidated tions were to be progressively phased out by 2000. In
under the umbrella of the Ministry of Health, which was 1999, one year ahead of schedule, the entire health care
established as an independent entity in 1981. budget in Spain was financed from general taxation.
In 1986, the General Health Care Act was approved Today, Spanish regions receive funding for health care
following almost four years of public and parliamentary as part of the general funding from the central govern-
discussion. The act provided a unified legal framework for ment. Funding is proportional to population adjusted
many of the previous piecemeal reforms and called for a for such factors as age distribution, number of tempo-
tax-based financing system. Publicly managed health ser- rary residents, and services provided to the national sys-
vices were consolidated in a single national organization tem or to neighboring regions. Supplemental funding
and in a small number of regional organizations (Catalu�a is also supplied from fiscal revenues raised in the
and the Basque Country), within the framework of the region.
newly decentralized state. The Spanish National Health Currently, only workers' compensation for work-
System was subsequently devolved to the 17 Autonomous related injuries and diseases is financed from individual
Communities that, since 2001, have fully managed their contributions of employers and employees.
Regional Health Services and together make up the
Spanish National Health System. Source: Fernandez 2004, in Baeza and Packard 2006.
to basic risk management mechanisms in health and old- To this end, governments in the region would benefit
age security. from taking several sets of incremental reforms in the short-
Indeed, in pursuing a long-term vision and strategy for to-medium term that would contribute in important
minimum essential cover in social protection, most coun- ways to the long-term goals of extending social protection
tries in the region will likely need to pursue a series of dis- in health and old-age security to all its citizens. These
crete measures, rather than "big bang" types of reforms. reforms are beneficial in their own right. At the same time,
This may be particularly pragmatic given that the needed they can help pave the way toward a system of essential cover
reforms require the support of a diverse set of institutional that facilitates greater mobility in the labor market, not
and political actors. In this context, it will be important to based on the informal-formal distinction but on sensible
ensure that any short-term measures countries take are con- design of social protection and on flexible, incentive-
sistent--or at least not inconsistent--with the governments' compatible labor market institutions. Key priorities include
long-term visions and agendas. This will be especially the following:
important if governments choose to pursue more inte-
grated social protection systems that align social objectives � Unbundling of complex, multidimensional benefit packages.
of better risk management with economic objectives of The objective of unbundling would be to increase the
higher productivity and growth. benefits relative to the costs and improve the public
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I N F O R M A L I T Y
goods content of social security packages. While � Strengthening program design to account for and enable
health and pension benefits would remain at the core of greater worker mobility. This should include:
the benefit package, unbundling would involve shed- revising overly burdensome vesting periods, where they
ding--or making voluntary--those elements of the exist, in the region's pension programs to facilitate
present social security packages that currently worker access and mobility. In this context, Latin
represent pure or partial taxes on workers or finance American and Caribbean countries should con-
"private" as opposed to "public" goods. sider adopting the types of points programs used
� Improving program/benefit quality in health and pensions. in some European countries that enable workers to
Again, the objective here would be to increase access pension benefits in proportion to their time
the relative benefits associated with participation in in service.
the social security system. Key areas for attention enabling spouses and/or secondary family workers to opt out
include: of specific benefits, suchashealthinsurance,soastoavoid
micro-efficiency reforms in the health sector of most coun- making families pay twice for the same coverage.
tries in the region. Recent studies of the health sec- fostering portability of health benefits and retirement
tor in the region (for example, Baeza and Packard savings across jobs, sectors, and occupations.
2006; Mason et al. forthcoming) highlight several � Establishing consistency and incentive compatibility of pro-
key areas that are critical to strengthening social gram structures and benefits across different parts of
(and financial) protection in health, including: countries' social protection systems (both within
* separation of the purchaser/insurer and health social security and across social security and social
care provider functions, assistance) to minimize adverse incentives and pro-
* moving from historical budget processes to ductivity effects. This includes efforts to "harmonize"
production-based budgeting and strategic rules, eligibility requirements, and benefits levels
purchasing, across programs and institutions--both in health and
* developing minimum benefit packages (essen- in old-age security.
tial cover) that are consistent with the funda- While the actions listed here constitute an important
mental principles of insurance, and short-to-medium-term reform agenda for most countries
* establishing--or strengthening--consumer choice in the region, these actions are particularly important in
among service providers. countries in which there is a high degree of integration and
efficiency reforms in the region's pension systems. Among movement between the formal and informal sectors, as well
the priorities are: as in countries where the gaps in coverage between formal
* lowering costs and administrative fees to affili- social security and emergent social assistance programs are
ates and improving risk management (Gill, relatively small.
Packard, and Yermo 2004); further reductions
in commissions, along with efforts to raise net Conclusion
rates of returns, would go far to improve the Nearly all countries in Latin America and the Caribbean
attractiveness of the funded savings pillars, remain characterized by "truncated welfare systems," in
* strengthening voluntary savings instruments for which those in the formal sector have access to an often gen-
old age, and erous multidimensional package of social security, while
* creating greater flexibility in the savings pillars, those outside the formal sector--whether in urban or rural
including greater portability and flexibility in areas--have much more limited access to government ben-
savings and investment options to reflect differ- efits and/or formal risk management instruments. Recent
ent stages of workers' life cycles (for example, progress in extending social security to uncovered portions
lower mandatory contributions for younger of the population has been disappointing, at best. Overall,
workers and/or greater flexibility in the invest- social security coverage has failed to increase (informality
ment-risk profile across the life cycle); such flex- has failed to decline) despite economic growth over the
ibility would help raise the implicit benefit�cost period; and coverage has actually declined in a number of
ratio among potential affiliates. countries over the last decade. Moreover, in nearly all
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I N F O R M A L I T Y, S O C I A L P R O T E C T I O N , A N D A N T I P O V E RT Y P O L I C I E S
countries in the region, coverage rates are significantly example, information problems and externalities)
lower among low-income than high-income workers. In abound. As such, there is a strong case for public
many countries, the poorest workers and families are practi- intervention to strengthen households' abilities to
cally excluded from the system. manage risk.
Partly in response to concerns about the truncated wel- � Third, alongside market failures that justify public
fare state, several countries in the region have launched or action, there is evidence of widespread government
expanded noncontributory assistance and/or poverty reduc- failure in the design and implementation of social
tion programs over the last decade to help breach the cover- protection. These problems serve to exacerbate peo-
age gap and provide support and coverage to the poor or ple's lack of access to appropriate risk management
extreme poor. A number of these efforts (for example, con- mechanisms. For example,
ditional cash transfer programs) have contributed in impor- at the level of specific programs, design problems
tant ways to the short-term welfare and long-term raise the costs of participating in social security
opportunities of the poor. These efforts are welcomed and relative to its benefits, causing some workers to
are to be encouraged. At the same time, the creation opt out of the system; design issues also serve to
and expansion of certain types of assistance programs, espe- hinder some workers' eligibility for benefits;
cially those that link eligibility to work in the informal at the level of social protection systems--the
sector (or to being unemployed), may be creating incentives constellation of contributory social security and
that constrain the growth of formal sector employment as noncontributory social assistance programs--
well as long-term economic growth in the region. These programs often compete, creating adverse labor
incentive effects are particularly serious in countries where market incentives and outcomes.
workers perceive that the benefits of affiliating with social � Finally, the combination of inaccessibility to basic
security are low relative to the costs. In sum, the region risk management instruments, market failure, and
faces both new and long-standing challenges in providing government failure creates an urgent need to rethink
appropriate risk management instruments to its people. and, in fact, "reengineer" social protection in the
Against this background, this chapter has reviewed the region--looking beyond the traditional Bismarckian
state and recent evolution of social protection in Latin model in which protection is based on one's labor
America and the Caribbean; examined the role and limita- contract to one that ensures protection to people on
tions of households' private risk management strategies the basis of citizenship.
and outlined the rationale for public social protection in
the region; analyzed the key challenges policy makers face So what does this imply for the future of social protection
in making adequate risk management instruments avail- in the region? Drawing from the economics of insurance,
able to the regions' citizens, both those working in the for- the chapter has outlined a long-term agenda for social pro-
mal sector and those in the informal sector; and proposed tection reform in the region. In the case of health, because
several key directions for policy to ensure that all citizens of shocks that go "uncovered" can impose significant external
Latin American and Caribbean countries are adequately costs on society, there is a case for providing a package of
protected from key risks, especially those associated with minimum essential direct cover, de-linked from the labor
health shocks and poverty in old age. Several key messages contract and financed through general taxation. In the case
emerge from the analysis: of old-age security, there is also a case to provide essential
cover in the form of a poverty prevention pension focused
� First, despite ample evidence that individuals and on the poor, and as part of a broader multipillar pension
their families engage in a number of private risk system that includes provisions for individual retirement
management strategies, many people in the region-- savings. Whether countries should focus first on a well-
particularly those in low-income households--remain targeted social assistance pension for the poor or on devel-
vulnerable to the impoverishing effects of health opment of a more integrated system of old-age security
shocks and to poverty in old age. depends on a number of factors, including the size of the
� Second, private insurance markets are generally thin current coverage gap, the country's fiscal space, and local
or missing in the region and market failures (for institutional capacity. In either case, it will be important
209
I N F O R M A L I T Y
for policy makers to ensure incentive compatibility 3. The framework is based on Ehrlich and Becker (1972) and
between the poverty prevention pension and the savings Gill and Ilahi (2000).
4. For a more detailed discussion of the factors that have driven
component, which should be the mainstay of earnings
increases in informality in the region, see chapter 4.
replacement during old age.
5. While the rural pension system in Brazil is formally contribu-
For a variety of reasons, including those related to fiscal tory, contributions are not linked to salaries or individual income,
and institutional capacity, movement to minimum essen- but to rural production. Benefits are not linked in any way to past
tial cover in health and old-age security--de-linked from contributions, but are defined in relation to the minimum wage, and
the labor market and financed by general taxes--represents the system is heavily subsidized. For a detailed discussion, see
Schwarzer and Querino 2002.
a long-term agenda for many countries in the region. In
6. Indeed, the BONOSOL program covers nearly 75 percent of
this context, it will be important for countries to orient
the population and in a very egalitarian manner. As can be seen in
their short-to-medium-term policy agendas in ways that figure 7.5, in the absence of this scheme (that is, relying only on con-
are consistent--or at least not inconsistent--with their tributory pensions), Bolivia would be among the lowest-coverage
longer-term vision. This will be critical if the region's countries in the region (Rofman and Lucchetti 2006).
governments are to align more effectively the objectives of 7. Absolute levels of coverage by Seguro Popular, which was
launched in 2004, have increased since the data shown in figure 7.6
better social risk management with those of higher produc-
were collected. Newer data suggest that Seguro Popular covered as
tivity and growth.
many as 11.5 million individuals by the first quarter of 2006 (Gaki-
To this end, governments in the region will benefit from dou et al. 2006). According to the October 2005 census, 21 percent
making incremental reforms that improve the efficiency of of Seguro Popular affiliates belong to the second income (wealth) decile
existing systems, as well as establishing greater consistency and 19 percent belong to the poorest decile. The fraction declined
and incentive compatibility across program benefit struc- sharply as income increases.
8. See Lindert, Skoufias, and Shapiro (2006), who present OECD
tures. Several sets of actions will contribute to short-term
data from 2001. Using a smaller sample of Latin American countries,
improvements in social protection while moving countries
they find that average public social protection spending in the region
in the direction of essential cover in the long term. This was approximately 5.7 percent of GDP around the late 1990s and
includes efforts to improve the benefit�cost ratios of pro- early 2000s.
grams via unbundling of complex, multidimensional bene- 9. To the extent that financing of expanded assistance programs
fit packages; undertaking microefficiency reforms in comes at the expense of infrastructure or other investments that
increase a country's competitiveness, such efforts may also have unin-
countries' health and pension systems; and harmonizing
tended negative effects on long-term growth (see Levy 2006b; World
rules, eligibility requirements, and benefits levels across
Bank forthcoming).
programs and institutions. Such measures will enable 10. As chapter 2 shows, obtaining access to health insurance
greater worker mobility and provide the foundation for through a relative is an important reason for not affiliating in
more effective social protection for all citizens. Colombia (table 2.13).
11. Notable exceptions to this are seen in Colombia and Uruguay
(Baeza and Packard 2006).
Notes 12. This appears to be the case, notwithstanding important ineffi-
1. Depending on how programs are financed, legitimate efforts ciencies in Brazil's pension system. For more detailed analysis of the
to cover increasingly large segments of the population could also have strengths and weaknesses of the Brazilian pension system, see World
unintended negative effects on a country's long-term growth. For Brazilian Bank (forthcoming).
example, Levy (2006b) argues that increases in social protection 13. In Mexico, for example, only 2 percent of households have pri-
spending in Mexico have come at the expense of investments in infra- vate insurance (Mason et al. forthcoming), while in Colombia, less
structure that are necessary to keep Mexico's economy competitive in than 5 percent of formal independent workers and less than 1 percent
the global economy and, if continued, will have adverse effects on the of informal workers (either independent or salaried) have private
country's growth performance. Similar concerns have been raised health insurance (see ch. 2, table 2.12).
about the costs of high (and inefficient) levels of social protection 14. Indeed, in Bolivia, 42 percent of informal salaried workers and
spending on infrastructure investment and, thus, future growth and 55 percent of informal independent workers reported that the main
competitiveness in Brazil (see World Bank forthcoming). reason for not contributing to social security was lack of knowledge
2. This conceptual framework has been developed and extended about how the system works (see ch. 2, table 2.12).
progressively in a series of studies on social protection in Latin 15. High rates of immunization play a prevention role not only
America and the Caribbean, including Baeza and Packard (2006), de for those directly immunized, but also for society in general. As such,
Ferranti et al. (2000), and Gill, Packard, and Yermo (2004). they have a strong public goods element to them. So, too, do goods
210
I N F O R M A L I T Y, S O C I A L P R O T E C T I O N , A N D A N T I P O V E RT Y P O L I C I E S
that help prevent the transmission of sexually transmitted diseases 25. Universal health insurance for pregnant mothers and children
(for example, HIV/AIDS), such as condoms, which not only serve to under five years of age and subsidized child care for those working in
protect the individual users, but also help to slow the spread of such the informal sector were campaign proposals during the presidential
diseases more generally (Packard 2006). campaign of Enrique Calder�n and, at the time of this writing, were
16. Data collected by the IMSS between 1997 and 2005 indicate under development by the new Calder�n administration.
that roughly two-thirds of the almost 9 million IMSS-affiliated workers 26. While Gasparini, Haimovich, and Olivieri's (2006) results are
these are "low-income workers," earning less than three minimum illustrative, they need to be interpreted with some care. Their find-
wages (Levy 2006a). It is possible that most if not all of these workers ings are not robust to all econometric specifications tested. Moreover,
are unable to access the IMSS housing subsidy (or their related they note that the control group may well differ from the treatment
contributions). group in some dimensions that are not observed and cannot be con-
17. These figures almost certainly understate mobility across the trolled for in the data. If such factors affect the probability of finding
formal and informal sectors in the Mexican economy, as the data do a formal job, then their econometric results could be biased.
not capture rural workers. It is not uncommon for rural workers to 27. See the section titled "Managing the transition from here to
migrate for work--and move in and out of formality--on a seasonal there" later in this chapter. For more detail on leverage points for
basis (Levy 2006a, 2006b). improving health sector efficiency in Latin America and the
18. At first glance, these patterns appear to be at odds with other Caribbean, see Baeza and Packard (2006).
recent findings for Argentina and Uruguay, based on similar types of 28. Estimates of the likely fiscal costs of a well targeted social
administrative data. For example, Farall et al. (2003) and Bertranou assistance pension are presented later in the case of Mexico.
and S�nchez (2003) for Argentina and Lagomarsino and Lanzilotta 29. How social assistance pension benefits are adjusted for infla-
(2004) for Uruguay present bimodal densities of pension contribu- tion over time can also affect the incentive structure across programs.
tions (although with significant numbers of individuals in intermedi- If benefits are adjusted by the Consumer Price Index rather than by
ate cases, so there still appears to be a continuum of cases in their real wages, they will keep their value in terms of protection against
data). It is important to note, however, that these other analyses do poverty, but become an increasingly less attractive alternative to
not control for the age of the workers. This is important, as younger participation in the savings pillars as the economy and people's real
workers (aged 18�26) tend to be overrepresented among those with a incomes grow.
low density of contributions, while older workers (aged 40�48) tend 30. The unit cost of Seguro Popular was equal to Mex$8,500 in the
to be overrepresented among those with a higher density of contribu- fall of 2004. This included a cost of Mex$7,500 for the basic package,
tions. Once the age is controlled for, one finds the type of multimodal but an additional Mex$1,000 allocated for catastrophic health care. It
distribution found in Bucheli et al. (2006) and shown in figure 7.11. should be noted that although Seguro Popular is called "insurance," at
The authors thank Alvaro Forteza for clarifying this issue. present there are very few premiums charged to affiliates under the pro-
19. Only when the worker reaches age 70 is he or she entitled to a gram. In principle, premiums will be charged on a graduated scale,
special (small) pension--although even that requires a minimum of based on household income, with the poorest Mexicans receiving a full
15 years of contributions to qualify. (100 percent) subsidy, but with progressively wealthier households
20. As might be expected, Bucheli et al. (2006) also find that paying progressively higher premiums (see Mason et al. forthcoming).
achieving the required years of formal sector service is more difficult 31. A study by Levy and D�vila (2003) examines the option of
among private sector than among public sector workers. raising value-added taxes as a revenue-enhancing measure and then
21. Another related issue concerns the general lack of portability providing compensating transfers to the poor. They similarly find
in the region's pension systems, whether in and out of the formal sec- this approach a viable and efficient option.
tor, across the private and public sectors, or across specialized occupa- 32. Estimates of the potential costs of promoting health insurance
tional schemes that exist in some countries. Although there is little portability in Chile (Baeza and Copetta 1999) suggest that moving
or no direct evidence to date on the effects of the lack of portability of from payroll tax to general revenue-financing of health insurance
pensions on informality, it stands to reason that by curbing job could have a neutral fiscal effect or even lead to tax savings--at least
mobility, lack of portability also impedes entry (and exit) from the in the Chilean context--if greater formal sector participation and
formal sector. earnings due to the removal of payroll taxes translate into higher
22. Maloney (2001) and Loayza and Rigolini (2006) use cross- earnings, and, thus, more income tax revenues.
sectional estimation techniques on cross-country data, while Krebs and 33. For a more detailed discussion of informality, taxation, and the
Maloney (1999) do simulations based on labor transitions in Mexico. social contract, see chapter 8.
23. In the Brazilian case, if capital is not exempted, the authors
find a decline in physical accumulation that decreases the demand for
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213
CHAPTER 8
The Informal Sector and the State:
Institutions, Inequality,
and Social Norms
SUMMARY: This chapter argues that the state�society interactions underlying informality, whether leading to exclusion
or to exit, ultimately constitute an indictment of the overall effectiveness and legitimacy of the state. As noted before, bur-
densome business and labor market regulations, poorly designed social protection systems, and weak enforcement capabili-
ties bias the cost�benefit assessments of firms and workers in favor of informality. Furthermore, a collective perception of
ineffectiveness, unfairness, and illegitimacy of the state's actions, in terms of who it represents and serves, can give rise to
a social norm of noncompliance with taxes and regulations (a "culture of informality"), which further undermines the
state's capacity to enforce the law and to provide effective public services. This is partly related to the inability of the state
to redress the long-standing high inequality in the region, resolve social tensions, and uphold the rule of law; and it crys-
tallizes in a dysfunctional underlying "social contract." In Hirschman's terms, it is a lack of voice and loyalty. Thus,
addressing informality in Latin America requires bolstering the competency and legitimacy of the state by delivering the
correct set of "carrots" in more equitable public policies and programs to foster a sense of greater inclusion and responsive-
ness, while carefully considering the incentives created to become formal or informal, and by wielding adequate "sticks"
through political resolve and evenhanded enforcement of laws and regulations.
T HIS REPORT HAS VIEWED INFORMALITY other regulations. For instance, the high tax compliance
through the lens of the relationship between rates observed in developed countries cannot be explained
economic agents and the state. Several chap- only by the deterrent effect of the chance of being caught
ters have discussed how specific policies in evading and the ensuing penalties.
the areas of labor legislation, business regu- In Latin American economies, with large informal sec-
lation, social protection, and taxation can have a critical tors, the individual cost�benefit analysis leading to exit
impact on microlevel decisions that foster or preclude from taxation and other regulations, and from participating
agents' participation in the formal economy. These policies in the formal circuit of taxes and transfers, in the Hirsch-
define a comprehensive set of incentives to which individu- manian sense, may be influenced by a collective perception
als and firms respond by weighing the costs and benefits that the state's action is ineffective, inefficient, and unfair.
of participating in different markets and the enforcement In a social exchange view, willingness to comply with regu-
efforts and capabilities of the state. This chapter argues that lations may be affected by the individual perception of
these economic responses are also influenced by how the effectiveness of the government in providing services.
agents--individually and collectively--perceive and define Moreover, a collective perception--the "sentiment" within
a relationship with the state. In some situations, there are a group--about the performance of the state influences the
"social norms" that are influenced by the perception of the social norm regarding compliance. For instance, if more
effectiveness of the state and the collective projects it repre- people operate in the informal sector, it might be easier for
sents, and that foster willingness to comply with taxes and each citizen to do so; for a given level of state enforcement
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I N F O R M A L I T Y
effort, one person will be less likely to be sanctioned if lots inequitable and of low quality. Firms, workers, and citizens
of people also evade taxes or do not comply with other reg- in general make decisions based on the state's enforcement
ulations; the psychological/ethical costs of evading will be capacity and on their perceptions about the effectiveness of
lower if most people in one's peer group do so, and hence the state and of prevalent social norms. These decisions, in
one's tax morale and disposition to comply with regula- turn, affect the capacity of the state to enforce regulations
tions will be lower. This interdependent behavior might and provide high-quality public goods and services for all.
generate a social multiplier that might make a specific Alternatively, an economy may be in a "good equilib-
social norm more prevalent. This type of mechanism might rium" where a large mass of the economy operates formally
be behind what has been dubbed a "culture of informality" and public goods and services are provided effectively and
that prevails in many Latin American countries. where the government is able to enforce the agreed regula-
Informality is also a reflection of mechanisms that tions and taxes--which, in turn, is facilitated by a social
exclude large segments of the citizenry from education, norm that induces people to comply. Even if economies are,
health care, and judiciary services; and from economic in general, not "stuck" in any of these equilibria, in many
opportunities through a segmented labor market and cases they have features that resemble these feedback loops
imperfection in other factor markets. This exclusionary that might impede the reduction of informality.
process is related to the extremely high and persistent lev- Throughout this report we have described many features
els of inequality, which are rooted in differences in power, that relate to different measures or dimensions of informal-
voice, and influence; and which, as reported here, seem ity and that, indeed, are reflections of a systemic failure.
empirically highly correlated with informality. Among those features, we have
Latin America's low level of trust in the state, its culture
of informality, and often the design of its regulations and � low levels of participation in the social security system
policies reflect what we might call a "dysfunctional social � low coverage of many social insurance schemes, espe-
contract" under which the state is not complying with its cially among poor people
designated roles and individuals therefore see little point in � a large number of small firms (and larger ones) that
playing by its rules. We use the expression social contract to partially or completely evade tax, labor, and business
refer to some degree of societal consensus over basic aspects regulations
of the operation and role of the state relative to the private � low-quality regulation that increases red tape
sector and among citizens. In this usage, social contract refers � exclusion in the access to property rights, judiciary
to key aspects of a social equilibrium, including beliefs and services, and other public services
actions of citizens, organized groups, and state actors. � low-quality public provision of many social services
Among the aspects that enable us to characterize this con- (such as health care or education)
tract are the structure of taxation and social expenditures � low levels of trust in the state and in the fairness of
(Lledo, Schneider, and Moore 2004), the performance of the dominant arrangements
state in using citizen's taxes in delivering public goods, and � low and uneven enforcement
the structure and effectiveness of the social protection sys- � with exceptions, low levels of tax collection, related
tems (Birdsall and Menezes 2005; ECLAC 2006). to low compliance and low tax bases.
Heuristically, this situation may be characterized by a
"bad equilibrium" where certain norms are being upheld, Each of those features is, in itself, a reflection of a dys-
implicitly or explicitly. The state might be ineffective, able functional individual and collective interaction with the
neither to enforce well its regulations--the sticks--nor to state, intimately linked with the state's inability to perform
lure firms and individuals to formality by providing quality effectively and equitably its main roles--roles of remedy-
public goods and services for all--the carrots. ing market failures, coordinating the provision of public
Many Latin American countries seem to be in a situation goods, and maintaining a level and equitable playing field.
where the share of informality is high; trust in the state is Seen from a less state-centered perspective, the features
low; tax morale and regulatory compliance are low and, mentioned above may also be a reflection of dysfunctional
hence, enforcement of regulations and tax collection are social equilibrium in the "horizontal" relationships among
generally low; and public provision of public services is citizens--how they interact with and the degree to which
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they trust each other. In other words, several of the phe- simultaneously in several realms. As an illustration, con-
nomena that may be related to the notion of informality sider this nontaxonomic list:
are, in the end, a reflection of the way individuals interact
both with the state and with each other. 1. obtaining the protection of labor laws, paying contri-
In this chapter, we explore several characteristics of the butions, and getting social security benefits for the
social contracts that prevail in the different countries of the worker and his or her family
region. This chapter also will present suggestive evidence 2. avoiding the costs of being caught not complying
of the kind of feedback loops mentioned above. We dwell with regulations, given state enforcement technology
on the different manifestations of informality that concern 3. contributing to the provision of public goods and
the relationship between the individual and the state, services to society as a whole, and trusting the state
emphasizing how social norms and social interactions also in doing it
might affect the decision maker. We discuss and present 4. avoiding the peer-pressure cost of being singled out
some evidence related to perception and performance of the as a cheater.
state and how they correlate with informality. The chapter
then focuses on the roles of taxes and how tax compliance is To assess costs and benefits, the worker will take into
related to the real and perceived role and effectiveness of consideration a number of factors that have the state as the
the state. We also discuss the structure of taxes and trans- main actor. Among others, the informality decision might
fers and its relation to inequality and informality, as well as be affected by the following:
other elements that illustrate the exit or opting-out mecha-
nisms that are observed in the region. � The direct costs and benefits of formality: The assessment
of point (1), above, depends on the costs of labor market
Social norms, the state, and informality regulations and a comparison of those costs with the
Latin America's high level of informality is a manifestation valuation of the benefits provided to the individual
of disconnects between the state and citizens, in part as a (for example, comparing payroll tax payments with
result of failures of the state in its various roles. Here we health benefits received, as discussed in chapter 7).
present some evidence of firms' and individuals' perceptions Note, however, that what the government can pro-
of the performance of the state, and how these perceptions vide depends on its fiscal capabilities, which, in turn,
correlate with indicators of informality. To frame the analy- depend on the decisions of agents whether to be for-
sis of these correlates, we provide first a framework to dis- mal (and pay taxes and contributions). Massive opt-
cuss different dimensions of the decision to participate in ing out may generate a negative feedback loop that
the formal economy. might move the country to a bad equilibrium.
� State enforcement capacity: The assessment of point (2)
Dealing--or not--with the state will depend on the perceived capacity of the state to
Throughout the report, we have stressed the cost�benefit enforce labor, tax, and other regulations. This is a
analysis that individuals undertake in deciding what sector function of the enforcement technology used and the
to work in, whether to register their firm, and whether to perceived probability of being caught. This is influ-
pay their taxes or risk detection and punishment. In this enced by individual risk aversion and by the collective
section, we further explore how individual perceptions perception of this probability. In addition, however,
about the performance of the state and how social norms the formation of these collective perceptions may be
and social interactions might also impinge on these deci- influenced by social multipliers. Another negative
sions to opt in or out.1 Consider the case of a worker or feedback loop is possible here because low enforce-
a microentrepreneur who has two employment/business ment capacity implies fewer resources for the state.
opportunities that are somewhat comparable in some other � Individual perceptions about government effectiveness: The
dimensions (such as net earnings), but that differ in the fact assessment of point (3), above, might depend on how
that one is formal and requires complying with all regula- effective and fair the individual perceives government
tions, and the other is informal. From the individual point institutions to be in fulfilling its role. The individual
of view, the occupational choice entails having a position might not be amoral and might decide to comply
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I N F O R M A L I T Y
with regulations not only as a result of the cost�benefit from paying directly through taxes, in part because it is too
analysis of a utility maximizer, but might also be costly for the state to go after them. At the same time,
factoring in the degree of citizen/taxpayer satisfaction however, they are excluded from the benefits of being pro-
with, confidence in, and trust in government. A per- tected by the systems regulated by the state or are excluded
ception of state incompetence, unfairness, and corrup- from receiving public services. Among many others, an
tion may affect willingness to comply. The literature example of this exclusion is the inadequate access that the
finds that, in collective action settings, individuals poor have to the judiciary. If, for instance, individuals do
adopt not a purely materialistic, calculating posture, not perceive that property rights will be enforced, commu-
but a more complex, emotional, and reciprocal stand.2 nities will maintain traditional mechanisms to enforce
� Social norms and the social multiplier: The assessment of property rights.3 Another example of exclusion is the exis-
point (4) depends on what others believe about the tence of large segments of the population that are not cov-
role and performance of the state, that is, the social ered by any social protection mechanism, the so-called
norm--the pattern of behavior that constitutes a cus- truncated welfare state discussed in chapter 7. And, in a
tomary rule that coordinates actions among people most extreme case of informality generated by an exclu-
(Young 2006) and is sustained by social approval-- sionary process, large segments of the country, often in
that influences collective behavior toward the state. rural areas, have never been reached by the state. A serious
Deterrence is not enough to explain the observed lev- manifestation of this is the problem of unregistered births
els of tax and regulatory compliance, and at least parts and undocumented citizens which is still significant in
of those levels are explained by social interactions. several countries, as the evidence available for Bolivia,
Moreover, if one's own behavior changes not only Brazil, the Dominican Republic, Nicaragua, and Peru
because of the influence of an exogenous determinant demonstrates (see box 8.1).
but also because of the change in the behavior of a A perception that there is an incompetent state due to cor-
reference group, the result is a social multiplier. ruption or ineffective governance generates low trust in the
state. In addition to directly reducing the benefits of
The revision of these dimensions of the formality deci- engaging in formal interactions, this might reduce the
sion illustrates that informality connects to issues pertain- willingness to comply voluntarily with regulations. Invest-
ing to the reality of and perception about the state. The ment climate survey data concerning the efficiency of gov-
answer to each of the questions above depends on some ernments to deliver services show that Latin America
characteristics and capabilities of the state and the services appears to fare particularly poorly,4 featuring the lowest
it provides, which affect the assessment of the private proportions of firms being satisfied with the efficiency of
benefit of engaging with the state. But it also depends on government services (panel [a] of figure 8.1). Across coun-
a system of individual and collective beliefs about the tries, there is a negative relationship between a proxy of
effectiveness and fairness of the existing arrangements. informality and governments' effectiveness (even after con-
trolling for the level of development). Panel (b) of figure 8.1
Informality and performance and perceptions shows significant negative correlation between a proxy for
about the state government effectiveness5 and a proxy for informality.
Many Latin American states share the characteristics of what Informality also tends to be higher in countries that are
can be called an exclusionary state, in itself another manifes- perceived as more corrupt (figure 8.2). As discussed in
tation of an imperfect social contract. It is a contract as long chapter 6, data for five Latin American countries suggest
as it is an implicit arrangement through which the society that the perception of corruption is positively and signifi-
has given the state some of the roles mentioned above. cantly related to informality.6 Companies reporting that
However, in Latin America this contract is failing to bribing government officials to "get things done" is a com-
define social and economic arrangements that are inclusive mon practice in their line of business exhibit higher rates of
and that provide fair rights and responsibilities to all. This revenue and worker underreporting (see table 6.1). This
generates a perception that the state is not complying fully could be interpreted as firms hiding some of their activities
with its role in the social contract. Manifestation of this is a from corrupt officials. But a complementary explanation is
political equilibrium where certain groups are exempted that firms that view the government as corrupt are less
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BOX 8.1
The extreme of informality and exclusion: Being undocumented
A significant share of the population in several Latin an indication that a key reason for the high rates is the
American countries lacks official identity cards, and in this prohibitive cost of traveling to an urban center where
sense is largely invisible to the state. This is an extreme of there is a government office. Other reasons that are often
the continuum of informality by which groups of individ- suggested are a lack of knowledge of the importance of
uals are absent from the formal circuits of the economy birth certificates and the legal quagmires surrounding
and any interaction with the state. Lack of documentation registration (for example, if parents are undocumented, it
can have serious consequences, such as making an individ- may be very difficult or impossible to register a child).
ual vulnerable to exploitation by employers because of the The effects of not being registered are serious. Using
inability to seek legal redress, preventing access to basic household surveys, Duryea, Olgiati, and Stone (2006)
public services and transfer programs, and curtailing the found that for the nearly 300,000 children between 7 and
accumulation of human capital through public education. 9 years old who did not matriculate in Brazil, the main rea-
Due to the nature of the phenomenon, regional estimates son cited for not enrolling was the lack of documentation.
of the magnitude of this population are hard to come by. Econometric analysis for the Dominican Republic found
However, some representative statistics are available. The that lack of documentation was one of the strongest
Inter-American Development Bank (IDB 2006) reports predictors of school enrollment in higher grades. The
that demographic and health surveys conducted in International Program on the Elimination of Child
Nicaragua in 2001 showed that 17 percent of people over Labor�International Labour Organization found that
15 years of age did not have a national identity (ID) card. 50 percent of children living in Velleda Morales, a largely
In the Dominican Republic, a 2004 living conditions sur- indigenous community in Honduras, did not attend school
vey estimated that about one-fourth of the poorest seg- because they lacked a birth certificate. The inability to
ment of the population lack birth certificates and identity increase one's human capital through education has long-
cards. A survey for a planned project in Argentina indi- term consequences on earnings potential. In contrast, the
cates that 14 percent of potential beneficiaries lacked Inter-American Development Bank (IDB 2006) reports
national ID cards in one municipality and 17 percent in that access to health care services for nondocumented
another municipality. The UK Department for Interna- people is much easier in most Latin American countries
tional Development found that, in 2002, between than access to education--with the exception of Colombia
750,000 and 2 million Bolivian citizens were "function- where health services require two forms of identification.
ally undocumented." Furthermore, it was found that, in Countries in the region have responded to the regis-
some areas of Bolivia, 90 percent of the population lacked tration crisis by combining social targeting programs and
a valid form of identification, and the majority was not registration initiatives. The Inter-American Develop-
included in the civil registry at all. ment Bank (IDB 2006) presents a number of examples,
Undocumented adults were, in most cases, once undoc- such as Chile where registration has become a part of the
umented children who have continued living in a state of nationwide Chile Solidario program that offers, among
official nonexistence. Statistics for birth registrations are other things, health care services, counseling, and educa-
more readily available in the region, Duryea, Olgiati, and tion services to poor families. Similarly, the Brazilian
Stone (2006) find that the lack of birth registration varies government has introduced special boats that offer a mul-
from 8.4 percent in Peru to 25.8 percent in the Domini- titude of services to isolated populations living deep in
can Republic. They also find that birth underregistration the Amazon region, including medical services, birth
rates are much higher in rural areas than urban areas. In registration, civil marriage, voter registration, and mili-
Peru and Bolivia, rural rates are between 25 and 40 per- tary conscription. Similar initiatives are being developed
cent higher than in urban areas; however, in Nicaragua, in the Dominican Republic. Despite these initiatives,
rural rates were 200 percent higher than urban rates. additional government efforts and innovations are needed
Furthermore, the highest birth underregistration rates in to include these invisible segments of the population in
Nicaragua are found in areas suffering extreme poverty, the mainstream of the economy and the social contract.
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I N F O R M A L I T Y
FIGURE 8.1
Informality and government effectiveness
a. Firms with favorable b. Correlation of informality
perception of government's effectiveness with government effectiveness
Percent Share of self-employed
70 coef .074, t 4.65
0.2
60
50 0.1
VEN BOL
COL
40 PER HON
GUA JAM
CHI
0 ECUARG BRA COS
30 MEX PAN
SAL
20
0.1
10
0 0.2
East Asia Middle South Asia Europe and Sub- Latin America 1.5 1.0 0.5 0 0.5 1.0 1.5
and East and Central Asia Saharan and
the Pacific North Africa Africa the Caribbean Goverment effectiveness
Source: Author's estimates, based on World Bank World Development Indicators and Worldwide Governance Indicators, (2005); and
investment climate surveys.
Note: Figure b shows partial correlations controlling for gross domestic product (GDP) per capita at purchasing power parity (PPP). Government
Effectiveness Index measures the quality of public service provision, the bureaucracy, the competence of civil servants, the independence of the
civil service from political pressures, and the credibility of the government's commitment to policies. Higher values correspond to a more
effective government. Firms' perception of government effectiveness is defined as the proportion of firms that report that their government is
efficient in delivering services.
FIGURE 8.2 FIGURE 8.3
Informality and corruption Share of firms confident that the judiciary will enforce
contractual and property rights
Share of self-employed
coef .07, t 4.56 Percent
0.4
90
80
0.2 70
60
VEN BOL 50
PER COL
0 GUA HON 40
ARG ECU CHI
BRAPAN
JAM
COS
MEX
SAL 30
20
0.2
10
1.0 0.5 0 0.5 1.0 1.5
0
Control of corruption index
and ca Asia
Africa Africa and
Source: Author's estimates, based on World Bank World East OECD c Asia
Asiacifi
Development Indicators and Worldwide Governance AmeriCaribbeanSouth
Pa Europe
East
Indicators, (2005). MiddleNorth Central the
and the Latin
Sub-Saharan and
Note: Figure shows partial correlations controlling for GDP per
capita at PPP. The control of corruption index is a measure of
Source: Investment climate surveys, (2005), as reported in
perceptions, where corruption is defined as the exercise of public
World Bank (2007).
power for private gain, with higher values corresponding to less
perception of corruption.
willing to pay taxes and finance the state. As will be dis- generates very low levels of trust in the judiciary. On aver-
cussed later, this unwillingness relates to the discussion of age, firms in Latin America are less confident that their
the so-called tax morale. judicial system will enforce contractual and property rights
Many judicial systems in Latin America are perceived as disputes than are firms in other regions of the world
incompetent, inefficient, and unfair; and this perception (figure 8.3). Within the region, there are large differences,
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T H E I N F O R M A L S E C T O R A N D T H E S TAT E : I N S T I T U T I O N S , I N E Q U A L I T Y, A N D S O C I A L N O R M S
with more than 70 percent of firms being confident in the Latin American countries, is clearly negatively correlated
judicial system in Chile and Costa Rica compared with less with informality, even after controlling for GDP. More gen-
than 30 percent in Ecuador and Guatemala. Evidence pre- erally, an indicator of the rule of law from the WGI data-
sented by Biebesheimer and Payne, (2001) shows that base, which reflects perceptions of enforcement capacity, of
although 65 percent of citizens were reasonably confident the efficiency of the police and judicial systems, as well as
in their judicial systems in Europe, only 35 percent the popular observance of the law, is negatively correlated
expressed such confidence in Latin America. In questions with informality. Broadly, Latin American countries follow
asked in recent investment climate surveys, which included closely the regression line in these graphs.
a larger sample of small firms, the percentage of firms that
perceived courts as fair, impartial, and uncorrupt was less
FIGURE 8.4
than 25 percent in Panama, Mexico, Argentina, Bolivia,
Share of firms that consider the court system fair,
and Peru (figure 8.4). impartial, and uncorrupt
As discussed by Ronconi (2006), there is ample evidence
Percent
that people do not trust the judiciary, in part because
70
judges are perceived as corrupt and as benefiting the
60
wealthier side in a lawsuit (Eyzaguirre 1996). Although
50
systematic evidence is lacking, he argues that it is plausible
that low levels of trust in the system translate into fewer 40
employees whose labor rights might have been violated 30
bringing their cases to courts because those employees have 20
low expectations of success or because they perceive that 10
they will lack the financial resources to pay for their
0
defense--a perception that often is justified. This percep-
ama ina
tion reduces the probability that employers will be fined Peru
Uruguay Pan Mexico Bolivia
Colombia Argent
and, hence, induces a social norm of noncompliance.
As observed in figure 8.5, impartiality of courts, which Source: Author's estimates, based on investment climate
surveys (2005).
the previous figures show is perceived as low in a sample of
FIGURE 8.5
Informality and state competence indicators
Share of self-employed Share of self-employed
coef .03, t 4.3 coef .073, t 4.32
0.2 0.2
0.1 0.1
VEN VEN
PER BOL COL COL BOL
PER
GUA HON
JAM HON
ECU GUA JAM
BRA CHI CHI
0 ARG ECU
PAN MEX COS 0 ARG
MEX BRA PAN COS
SAL SAL
0.1 0.1
0.2 0.2
4 2 0 2 4 1.0 0.5 0 0.5 1.0 1.5
Impartiality of courts Rule of law index
Source: Author's estimates, based on World Development Indicators (2005); Fraser Institute (2004); and Worldwide Governance Indicators (2005).
Note: Figure shows partial correlations controlling for GDP per capita at PPP. Impartiality of courts is defined as the degree to which a trusted
legal framework exists for private business to challenge the legality of government actions or regulation. The rule of law index measures, in
broad terms, the respect of citizens and the state for the institutions that govern their interactions.
221
I N F O R M A L I T Y
A related view of informality posits that it is the conse- (table 8.1). The first two variables, business flexibility and
quence of weak Latin American states that assign them- law and order, that represent the opportunity cost of infor-
selves an unbearable and unmanageable regulatory load, mality, and government expenditures (which the authors use
with a scope that goes beyond their enforcement capacity-- as a proxy for the capacity to enforce) that represent the direct
what Centeno and Portes (2006) call a frustrated state.7 cost of informality all have the expected signs and are signifi-
Chapters 1 and 2 reviewed the evidence supporting the cant when they replace GDP in the specification. When the
belief that regulatory barriers to entry are positively related four variables are included, significance is lost because of the
to informality. Djankov et al. (2002) and Loayza, Oviedo, strong correlation with GDP per capita.
and Serv�n (2005), for example, find that regulatory barri- Within the same theoretical framework, a simple empir-
ers to entry are positively related to informality. ical exercise was conducted to analyze alternative institu-
Loayza and Rigolini (2006) put several of the elements of tional indicators and alternative variables to approximate
this literature in a theoretical framework and hypothesize informality, namely, the share of the informal economy, the
that the size of the informal sector increases with the regula- ratio of self-employment to total employment, and the
tory burden but decreases with the efficiency in the provision ratio of workers without contribution to pensions or social
of services and with compliance enforcement. This long-run security to the total number of workers.9 Even controlling
relationship is tested empirically through a regression in for GDP per capita, in most cases the institutional variables
which informality, proxied by the ratio of self-employment have a significant and negative sign (table 8.2). The
to total employment, depends on the flexibility of the busi- dummy for Latin America is significant in specifications
ness environment, the quality of public services (such as the for two of the proxies of informality.10
prevalence of the rule of law, the efficiency of police and judi- A final strand of the literature emphasizes the possible
cial systems), and an indicator of the government's ability to existence of a captured state, where a political equilibrium is
monitor taxes and enforce regulations, proxied by govern- preserved such that elites (business, public sector, or labor)
ment expenditures as a percentage of GDP.8 As generally interact explicitly or implicitly with the state to maintain
found in the cross-country literature, GDP explains approxi- rents, even if that implies the exclusion of certain segments
mately 80 percent of the variation of this proxy of informality of the population. The typical situation is that of a populist
TABLE 8.1
Long-run informality relationships
OLS
Self-employment rate
(as ratio to total workers) (I) (II) (III)
GDP per capita (in logs, annual) 0.0759*** 0.0516***
0.0043 0.0060
Business flexibility (index from Fraser Institute, 0.0293** 0.0167*
range: 0�10, country average) 0.0111 0.0092
Law and order (as % of GDP, country average) 0.0457*** 0.0191***
0.0072 0.0050
Government expenditure (as % of GDP, country average) 0.0050** 0.0015
0.0022 0.0015
Constant 0.9065*** 0.6954*** 0.9030***
0.0388 0.0666 0.0424
Observations (n) 525; 42 525; 42 525; 42
R2 0.80 0.72 0.85
Source: Loayza and Rigolini 2006.
Note: OLS = ordinary least squares. Robust, country clustered estimations, standard errors.
* significant at 10 percent.
** significant at 5 percent.
*** significant at 1 percent.
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T H E I N F O R M A L S E C T O R A N D T H E S TAT E : I N S T I T U T I O N S , I N E Q U A L I T Y, A N D S O C I A L N O R M S
TABLE 8.2
Indicators of informality and institutional indicators
Definition 3:
Definition 1: Definition 2: Share of persons without access
Share of informal Economy Share of self-employed to pension
Indicators (I) (II) (III) (I) (II) (III) (I) (II) (III)
GDP (in logs) 5.23 3.12 3.83 7.88 7.60 6.68 22.70 21.67 23.53
(3.72)*** (2.20)** (2.49)** (5.55)*** (5.05)*** (4.41)*** (10.41)*** (9.11)*** (9.28)***
Regulatory quality index 3.42 3.44 5.59
(1.96)* (2.00)** (2.07)**
Rule of law 6.19 3.60 6.36
(3.69)*** (2.05)** (2.33)**
Government effectiveness 5.03 4.82 3.79
(2.78)*** (2.75)*** (1.28)
Latin America 8.89 6.34 7.52 2.45 0.71 0.74 14.06 11.97 13.61
(3.27)*** (2.33)** (2.74)*** (1.07) (0.28) (0.31) (3.69)*** (2.99)*** (3.38)***
Observations (n) 110 110 110 60 60 60 98 98 98
R2 0.47 0.52 0.49 0.74 0.74 0.75 0.82 0.82 0.81
Source: Author's estimates, based on World Development Indicators and Worldwide Governance Indicators, 2005.
Note: Absolute value of t-statistic is shown in parentheses. Regulatory Quality Index: higher values correspond to a more effective
regulatory policy.
* significant at 10 percent.
** significant at 5 percent.
*** significant at 1 percent.
government, with a political base in the middle and low- Some stylized facts of the tax structure
middle class, that is unwilling to eliminate subsidies to Tax revenues in Latin America remain below the interna-
public services, even if that crowds out expanding the tional norm. Figure 8.6 shows that almost all Latin
services to poorer segments with less political clout. American countries lie below the regression line relating
tax collection to per capita GDP. Lledo, Schneider, and
The tax side of the social contract Moore (2004) show that the average tax take has been per-
in Latin America sistently smaller in Latin America than in OECD coun-
Tax compliance is one of the main components of the deci- tries, while it has been fairly similar to the Asian average
sion to engage in the formal economy. In fact, as mentioned (see table 8.3). The median country in the region collects
in chapter 6, some of the private "benefits" of informality 4 percentage points of GDP less than would be expected,
are related to cost savings derived directly from eluding the given its level of development (Perry et al. 2006). The
payment of taxes and avoiding the often complex adminis- average figure for the regions stands at 14.2 percent of
trative procedures associated with tax and regulatory GDP in 2000�03 (15.8 percent of GDP including
compliance. The large informal sector both reflects ineffi- social security contributions). Only Brazil, Nicaragua,
ciencies and inequities of the tax system and defines the Trinidad and Tobago, and Jamaica have tax burdens--
magnitude of the challenge to improve tax collection in the without social security contributions--above 20 percent.
region. As long as tax compliance is a social transaction Guatemala, Paraguay, and the Rep�blica Bolivariana de
between citizens and the state, it is a key element of the Venezuela barely reach 10 percent.
social contract. We review here the main features of the tax Indirect taxes, in the form of taxes on domestic and
system in Latin America and discuss tax compliance behav- internationally traded goods and services, represent the
ior and selected policy issues. bulk of Latin American tax revenues. They make up about
223
I N F O R M A L I T Y
observe and monitor incomes; and it is consistent with a
FIGURE 8.6
concentration of taxes on businesses, presumably medium-
Central government tax revenue and GDP per capita
size and large businesses that are easier to monitor. The per-
Total tax revenue (% of GDP) centage of corporate income tax revenues triples the
30 percentage of personal income tax revenues. Further, when
benchmarked by GDP per capita, Latin American collec-
25 JAM
tions of personal income taxes appear unduly lower than
20
HON CHIARG those in comparable countries. It is interesting to note that
URU
DOMBRA
15 BOL NIC VEN in all regions, except Latin America and Africa, direct taxes
PERCOL COS
ECUGUA PAN MEX
10 have increased their share during the last decades.
Tax collection has been rising modestly in most of Latin
5
6 7 8 9 10 11 America since the early 1990s (Lora 2006b). Most of the
Log GDP per capita increase in tax collection since the late 1980s is explained
Source: Author's estimates, based on World Development Indicators by value-added tax (VAT) collections, which increased from
(2006) and Tanzi (2000).
2 percent of GDP in the mid-1980s to an average of 5 per-
cent in 2003,11 becoming one of the most important
60 percent of total tax revenues--almost twice as impor- sources of revenue for governments in the region. The
tant as taxes on income, profits, and capital gains. By income tax collection, however, remained flat at around 4 per-
comparison, in developed countries tax revenues from cent of GDP during the same period, while revenues from
international trade and from domestic goods and services trade, excise, and other taxes fell sharply (figure 8.7).
make up 40 percent of total tax revenues (see table 8.4). Part of the trend observed in VAT collection is related to a
Undertaxation of income, wealth, and property is a persis- small increase in the VAT rate since the mid-1980s, reaching a
tent characteristic of Latin American tax systems. In Latin median rate of 15 percent by 2003 (figure 8.8). There is still
America, direct taxes are about a third of tax collections; great rate disparity in the region, with rates ranging from
in Europe, half; and in North America, that share reaches 5 percentinPanamato25percentinBrazil.Tarifftaxratesand
80 percent. All the difference is explained by individual dispersion fell sharply as a consequence of trade liberalization.
income taxes. These are a third of total tax collections in Corporate and personal income tax rates also experi-
Europe and more than 60 percent in North America. In enced important changes. Corporate rates decreased from
Latin America, the share is in the single digits--lower than 41 percent in 1985 to 29 percent in 2003. To encourage
any other region of the world. The share of corporate direct investment in an environment with higher capital mobil-
taxes, however, is not small, and it is only below that in ity, these rates were set below the maximum rate in devel-
Asia. This situation is a reflection of a very low capacity to oped economies. The personal income tax shows quite
TABLE 8.3
Comparative perspective of tax burdens and structures (percent of GDP)
Tax revenue Direct Domestic indirect International trade
Economic region 1975�85 1986�97 1975�85 1986�97 1975�85 1986�97 1975�85 1986�97
OECD 28.3 34.2 9.9 12.4 8.6 10.5 1.0 0.5
Asia (South and Southeast) 14.0 15.8 5.3 5.6 4.2 5.8 4.0 3.4
Africa 17.6 18.8 5.7 6.3 4.3 5.7 6.4 5.6
Latin America 14.9 15.2 3.8 3.4 5.0 5.5 3.1 2.2
Caribbean 23.3 22.4 6.4 0.0 6.7 6.2 6.3 5.4
Source: Lledo, Schneider, and Moore 2004.
Note: Total tax revenue includes social security contributions.
224
T H E I N F O R M A L S E C T O R A N D T H E S TAT E : I N S T I T U T I O N S , I N E Q U A L I T Y, A N D S O C I A L N O R M S
TABLE 8.4
Tax structure by region, selected years, 1975�2002 (percentage of total tax revenue)
Income taxes Domestic goods and services
General International
Region Total Individual Corporate Total consumption Excises trade
North America
1975�80 78.4 56.9 20.5 15 7.7 6.5 6.6
1986�92 78.8 63.5 14.4 17 9.8 6.3 4.3
1996�2002 83.3 66.3 15.8 14.8 8.8 5.1 1.8
Latin America
1975�80 32.7 11.1 17.6 40.4 17.1 19.3 26.8
1986�92 31.1 8.5 17.6 47.3 20.9 21 21.5
1996�2002 30.4 6.2 18.5 56.3 34 16.1 13.3
Western Europe
1975�80 42.7 33.3 8.5 50.6 28.6 16.5 6.7
1986�92 43.4 32.9 9.3 53.4 33.4 14.9 3.2
1996�2002 47.2 32.8 13 52.4 31.8 15 0.3
Asia
1975�80 38.8 22.9 20.5 37.2 14.3 18.3 24.1
1986�92 39.3 20.8 19.2 39.5 17.4 16.7 21.2
1996�2002 46.9 24.2 21.4 40.2 19.6 15.3 12.9
Africa
1975�80 32.1 14.6 16.1 29.7 18.4 13.5 38.2
1986�92 27.4 14.6 11.4 31.9 18.3 11.9 40.7
1996�2002 30.7 17.7 11.6 36.2 21.8 11.3 33.2
Source: Bird and Zolt 2005.
varied approaches in the region. For example, Bolivia has a rose from 24 percent in 1985 to 34 percent in 2000, while
flat rate tax of 13 percent, whereas Colombia has a number income tax productivity also increased but at a lower pace
of progressive rates (132 in all), ranging from 0.26 percent (figure 8.9). These average figures show still very low levels
to 35 percent; Chile similarly has a very progressive sched- in the region, although they hide a great deal of hetero-
ule with eight brackets and with minimum and maximum geneity. There is great disparity in the region in the overall
rates of 5 percent and 40 percent, respectively. Personal effectiveness in using the existing tax structure. For exam-
income maximum rates also decreased sharply in the ple, as shown in figure 8.10, VAT productivity ranges from
period. On the other hand, personal exemption levels a high of 0.64 in Chile to a low of 0.17 in Guatemala.
increased from an average of 60 percent of GDP per capita Differences in productivity across countries are probably
in 1985 to 230 percent in 2003 (an unusually high level by linked to different VAT structures and to tax expenditures
international standards), and the income levels taxed at (that is, to multiple tax exemptions and to deductions
maximum rates (the cutoff for the upper-income bracket) granted to specific sectors, particular geographic regions,
were lowered sharply. It is important to note that, in some or, in some cases, to specific taxpayers (see table 8.5), as
countries, the personal income tax exemption allows not well as government's ability and willingness to administer
only for the poor but also for many middle-income and rich efficiently the existing taxes. Exemptions are particularly
workers to be exempted from income taxes. pervasive in the region and are a manifestation of state
Overall tax productivity (the ratio between real and capture by specific groups. In addition to direct loss of rev-
potential tax collection, given the basic or maximum rate) enues, these loopholes and distortions usually create oppor-
has increased during the last 15 years. VAT productivity tunities for tax elusion. There are also important differences
225
I N F O R M A L I T Y
FIGURE 8.7 FIGURE 8.8
Tax revenue of Latin America and Caribbean countries Average tax rate of Latin America and Caribbean countries
Total tax revenue
% of GDP Percent
16 60
Mean
50
15
40
30
14 Median
20
10
13
0
5
12 1985 1995 2003 1985 1995 2003 1985 1995 2003 1985 199 2003
7 8
198519861987198819891990199119921993199419951996199 199 199920002001200220032004 Tariff Corporate income tax rate
VAT Individual income tax rate
Total tax revenue by tax type
% of GDP
16 Source: Lora 2006b.
14
12
The cross-country literature also supports the view that
10
the higher the tax burden, the larger the informality. In
8
cross-country studies, Johnson, Kaufmann, and Zoido-
6 Lobat�n (1998), using indicators of perceptions of the tax
4 burden--including both how high tax rates are and the
2 discretionary power of authorities in administering and
0 operating the system--find a large positive effect on infor-
7 8 mality. They also show that what matters to explain
198519861987198819891990199119921993199419951996199 199 199920002001200220032004
informality are the administration and operation of the tax
Other taxes Excise taxes Trade taxes system rather than the established rates as a key correlate.
Income taxes VAT Friedman et al. (2000) find that higher tax rates are not
correlated with a larger informal sector. In fact, the oppo-
Source: Based on Lora 2006b.
site might be true: countries with high tax rates may be
those with high benefits of formality.
in the administration capacity. Chilean tax administration
practices would appear to be over three times more effective Tax compliance behavior
than those in Guatemala in raising VAT revenues (Alm and From a utilitarian viewpoint, individuals regard tax obli-
Martinez-Vazquez 2007). gations casually and display no particular moral aversion to
From a different perspective, the productivity of VAT is evading if they feel they can safely do so. The taxpayer is an
undercut by informality and difficulty in bringing small isolated expected utility maximizer who makes rational
businesses and individuals supplying certain services into portfolio decisions under uncertainty, given an informa-
the system. As observed, there is a clear inverse correlation tional set. In this view, people pay taxes exclusively
between VAT productivity and informality (figure 8.10). depending on their perception of being detected and sanc-
So the relatively low level of tax collection in Latin America tioned (Alm et al. 1995; Cowell 1990). They do not relate
is a result of tax systems characterized by poor capacity of tax payment to perceptions of the quality or fairness of the
administration, excessive exemptions, and narrow tax bases. public services received, to perceptions of a moral obliga-
As will be discussed in the following section, however, the rich tion, or to any social norm. If enforcement is weak and the
in Latin America pay a much larger share of taxes than the possibility of a sanction is low, predicted tax evasion would
share paid by the rich in developed countries. be high. The policy implication of this approach is that
226
T H E I N F O R M A L S E C T O R A N D T H E S TAT E : I N S T I T U T I O N S , I N E Q U A L I T Y, A N D S O C I A L N O R M S
FIGURE 8.9
Average VAT and income tax productivity in Latin American countries
VAT productivity Income tax productivity
Percent Percent
38 16
36 15
34 14
32
13
30
12
28
11
26
Income tax revenue GDP
24 VAT revenue (GDP imp exp) 10
personal income tax rate
22 VAT rate 9 corporate income tax rate
20 8
2 3 4 5 6 7
1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 1985 1986 1987 1988 1989 1990 1991 199 199 199 199 199 199 1998 1999 2000 2001 2002
Source: Lora, Cardenas, and Mercer-Blackman 2005.
FIGURE 8.10
VAT productivity and informality indicators
VAT productivity as percentage of GDP VAT productivity as percentage of GDP
CHI CHI
60 60
ECU ECU
50 50 PAR
VEN HON VEN
HON
BRA URU URU BRA
40 40
COS COS
ARG PER ARG PER
30 PAN 30 PAN
COL COL
MEX MEX BOL
20 BOL 20 NIC
DOM NIC GUA DOM GUA
20 30 40 50 60 70 40 50 60 70 80 90
Share of informal economy Share of people without access to pension
Source: Author's estimates, based on Alm and Martinez-Vazquez (2007), and World Development Indicators, 2005.
TABLE 8.5 compliance with taxes--and presumably with most
Tax exemptions in Latin America (percent of GDP) regulations--will depend on the economic consequences of
detection and punishment; therefore, greater compliance
Country Total
will depend on deterrence mechanisms.
Argentina 2.4 But tax compliance seems influenced by factors beyond
Brazila,b 1.4 economic ones. For instance, in the United States, the
Chile 4.2
Colombia 9.2 percentage of individual income tax that is audited is quite
Ecuador 4.9 small, often less than 1 percent; typically, it is even lower in
Guatemala 7.3
Mexicoa Latin America (Alm and Martinez-Vazquez 2007). And, in
6.3
Peru 2.5 any case, very few noncompliance complaints are punished
Uruguay 5.3 effectively (Tanzi 2000). Given the level of fines and audit
rates in most countries, and the available estimates of risk
Source: Based on G�mez-Sabaini 2005. aversion, deterrence models are not able to predict the
Note: GDP = gross domestic product.
observed levels of compliance (Alm and Torgler 2006; Feld
a. Corresponds to federal or central government.
b. Contributions from profits and social security are included. and Frey 2007), and differences in public attitudes toward
227
I N F O R M A L I T Y
tax laws seem to play a role. In some nations, individuals between states and citizens and, as such, views this
tend to view paying their taxes as an important civic oblig- exchange as the "bedrock of the social contract" (p. 290).
ation and, for that reason, are motivated to pay. These social norms of tax compliance are measured in
An individual's compliance is related to her or his belief the empirical literature by what is termed tax morale.12 For
that compliance is the social norm. Perception of fairness, example, Torgler (2005) performs a multivariate analysis of
trust, and legitimacy in the system might influence a social tax morale for Latin America using data from the Latino-
norm that leads to higher voluntary compliance. Citizens barometro. The 1998 data come from approximately 15,000
perceive their taxpayer relationship with the state as one of individuals in 10 countries in the region. He finds that
exchange or as a contract. They will avoid taxes if they per- Mexico stands out as a country with low tax morale, while
ceive they are not getting quality government services for South American countries generally have lower tax morale
the taxes levied on them. Cowell (1990) posits also that the than do Central American and Caribbean countries. Also,
degree of taxpayers' satisfaction with the government he shows that a large majority of individuals perceive tax
affects evasion decisions. If they perceive that this relation- collection as largely arbitrary and unfair (only 23 percent of
ship is not in equilibrium, moral costs of evading fall and those surveyed by Latinobarometro in 2003 thought tax col-
tax morale is crowded out (Torgler 2005). Using survey and lection was "impartial"). Spicer and Becker (1980) provide
tax return data from a sample of 800 well-off taxpayers in evidence of a "fairness effect" whereby those who believe
New York, Scholz and Lubell (1998) found that trust in they are not being treated fairly by the tax system are more
government and in fellow citizens' keeping their side of the likely to evade.
social contract significantly influences tax compliance Cross-country data provide suggestive evidence of the
"even after controlling for the influence of any internalized relationship between willingness to comply with tax regu-
sense of duty and self-interested fear of being caught" lations and perceptions of government's performance. Fig-
(p. 412). Bergman (2002) discusses the contrast between ure 8.11 shows a clear negative correlation between tax
northern Europe, where tax evasion historically has been morale and the perception that the government is run
lower than in Italy, Greece, and Portugal. He also discusses according to the interests of a few, a measure of state cap-
how, on the Iberian peninsula, democratization and the ture. There is also a positive correlation between tax morale
expansion of the welfare state led to improvements in com- and the perception that the government spends taxpayers'
pliance. This strand of the literature views tax compliance money wisely. In both cases, correlations are significant
as influenced by a "social exchange," a social transaction even after controlling for GDP.
FIGURE 8.11
Tax morale, state capture, and perception that the government spends taxpayers' money wisely
Tax morale Tax morale
0.2 COS coef .88, t 2.8 0.2
COS coef .66, t 1.85
SAL VEN
GUA GUA SAL
0.1 BRA 0.1
PAR PAR BRA
NIC NIC HON
COL ARG ARG
HON COL
0 0
CHI CHI
MEX
URU
PAN MEX
0.1 ECU URU 0.1
PER PAN
ECU PER
BOL BOL
0.2 0.2
0.15 0.10 0.05 0 0.05 0.10 0.15 0.10 0.05 0 0.05 0.10 0.15
State capture Government spend money wisely
Source: Author's estimates, based on data from World Development Indicators (2005), and Latinobarometro (2004).
Note: Figure shows partial correlations controlling for GDP per capita at PPP. State capture is proxied by an indicator of the perception about
the economy being run according to the interests of a few. To construct the indicator we ask: "In general terms, would you consider that the
country is governed according to the interests of a few or is governed for the benefit of the country?"
228
T H E I N F O R M A L S E C T O R A N D T H E S TAT E : I N S T I T U T I O N S , I N E Q U A L I T Y, A N D S O C I A L N O R M S
But perceptions of individuals regarding the effective- transition to a democratic system after 1975 and after join-
ness and fairness of state actions may change through time. ing the European Union. The country has adopted major tax
For example, Martinez-Vazquez and Torgler (2005) studied policy and tax administration reforms, an extensive redirec-
changes in tax morale in Spain, using data from the World tion in public expenditures with the development of a social
Values Survey and the European Values Survey, to analyze welfare system, and a significant push for decentralized gov-
the evolution at four benchmark years: 1981, 1990, 1995, ernance. Martinez-Vazquez and Torgler argue that Spain
and 1999/2000. Spain has undergone fundamental changes succeeded in designing general institutional reforms,
in the role and effectiveness of the public sector since its including tax policy and tax administration reforms, as well
BOX 8.2
Local taxation and social norms
Sokoloff and Zolt (2005) maintain that, in the 19th cen- In the 20th century in North America, the federal
tury, North American and Latin American economies government's share of taxation started to increase, and, at
raised national/federal-level taxes in a very similar way, both the national and the local levels, the structure of
with high reliance on trade and excise taxes. Where the two taxation shifted to one that relied on property, income,
areas differed was in taxation at the local level. Local gov- and sales taxes. In Latin America, however, local govern-
ernments were far more prominent in North America, and ments and local taxation never grew significantly. Most of
they relied for their revenue primarily on property taxes-- the increase in taxation there occurred at the national
a fact that suggests a rather progressive taxation structure. level and was much more timid. As shown in table 8B.1,
Local governments grew on the basis of these resources and there was basically no significant increase in the tax take
were given by local communities the task of providing as a percent of gross domestic product during the first six
public education and investing in roads and other infra- decades of the 20th century, and only between the 1970s
structure. This dynamic suggests closer local control, and the 1990s was there some increase. This increase in
higher accountability, and the generation of a social norm taxation involved greater reliance on consumption taxes
that induced people to pay taxes. In Latin America, local in the period, reaching basically half of the tax collection
governments were much smaller, and both local and in the 1990s. Property taxes made a very small contribu-
provincial or national governments did not rely on prop- tion to revenues collected.
erty taxes; rather, they relied on mechanisms that placed a
smaller relative burden on the elites (see table 8B.1).
TABLE 8B.1
National-level government tax revenue in Latin America, 1900�2000 (percent of GDP)
Country 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000
Argentina 10 7 5 7 8 10 10 8 13 10 14
Bolivia -- -- -- -- -- -- 5 10 5 14 18
Brazil 10 11 9 8 10 7 7 10 10 24 23
Chile -- -- -- -- 9 11 17 16 32 21 24
Colombia -- -- -- -- 4 7 8 10 12 13 14
Costa Rica -- -- -- -- -- 10 12 14 18 23 21
Mexico 5 4 6 7 9 8 9 16 16 15
Peru -- -- -- -- -- 11 16 16 17 13 16
Uruguay -- -- -- -- -- -- -- -- 22 24 28
Venezuela, R. B. de -- -- 8 9 12 18 27 19 26 24 20
Source: Sokoloff and Zolt 2005.
Note: -- = not available.
229
I N F O R M A L I T Y
as in changing the extent to which citizens identify them- differences in taste or temperament. Inconvenient though
selves with the state and the national institutions of the it might appear for neat, individualistic models of eco-
country itself--processes that had a strongly positive effect nomic behavior, people do seem to take into account the
on tax morale and practically doubled the tax effort for gen- `climate' within the group or groups to which they
eral revenues in the country (from 22 percent of GDP in belong" (p. 102). This relates to the literature of strong rec-
1976 to 40 percent of GDP in 2002). Concomitantly, a iprocity, which is the behavior of so-called emotional and
major increase in formal employment was observed during moral reciprocators who condition their contributions to
the 1990s, and tax revenues collected from small firms collective goods on the contributions of others, even in
increased dramatically (Farrell 2006). fleeting transactions with multiple actors whose behavior
The cross-country correlations presented above suggest they cannot keep track of and whose identities they can
that willingness to pay taxes is related to perceptions about never discern (see also Falk and Fischbacher 2005).
the performance of the state, among other things. Bergman Schelling (1978) initially posited the idea that interdepen-
(2002) goes a step further and tries to test explicitly tax dent behavior can generate multiple equilibria through a
compliance at the country level using micro data surveys in "social multiplier effect" in which one person's behavior
Chile and Argentina. He finds that, in Chile, citizens com- influences his or her neighbor's behavior (Glaeser, Sacerdote,
ply more and are more willing to abide by the rules. Confi- and Scheinkman 2003).13 An individual's perception of
dence in public institutions generates trust in their ability the extent of evasion is a powerful predictor of compliance
to use public resources to fund social policies and fight behavior: the higher an individual believes the rate of tax
poverty. In Argentina, on the other hand, there is lower cheating will be, the more likely he or she is to cheat as
satisfaction with less trust in public institutions, and this is well. Individuals prefer to contribute if they believe others
behind the observed lower levels of solidarity (see box 8.3). are inclined to contribute, but free-ride if they believe that
In a related report, Bird, Martinez-Vazquez, and Torgler others will do so (see, for instance, Alm, S�nchez, and De
(2006) explore the role of governance and, more generally, Juan 1995; Andreoni, Erard, and Feinstein 1998; Kahan
the quality of the responsiveness of governments to citi- 2005; and Sheffrin and Triest 1992). These behaviors that
zens' demands over tax effort. Their basic hypothesis is condition tax compliance and the incentives to informality
that although traditional "supply factors" (such as trade on "what others do" tend to generate strategic comple-
openness, sectoral composition of output, GDP per capita, mentarities:14 if more people operate in the informal sec-
and structure of tax bases) clearly matter in explaining tax tor, it might be easier for anybody to do so; for a given
effort, there is also a need to account for citizen attitudes in level of state enforcement, an individual will be less likely
response to government performance as shaped by societal to be sanctioned if other people also evade taxes. Con-
institutions. To account for such "demand factors," or soci- versely, given specific changes in tax policy, each person's
etal institutions, they study the explanatory power of tax compliance might increase not only because of the pol-
quality of governance indicators (including government icy change, but also because of the change in peers' behav-
effectiveness, rule of law, control of corruption, regulatory ior. Levi (1998) provides a double contingency approach:
quality, and voice and accountability). Using a cross- citizens will pay taxes according to a social norm of reci-
section of developed and developing countries, and control- procity between taxpayers and the state; at the same time,
ling for the above-mentioned supply factors, they show they will comply based on the perceived fairness of a
that these "demand" factors matter and that the quality of collective behavior.15 Using data from Latinobarometro,
institutions have a strong positive effect on tax effort. Torgler (2005) finds that knowing about other individuals
In addition to this "social exchange" mechanism--that avoiding taxes has a significant negative effect. He finds
is, I comply because I trust in the state, and the govern- that if people trust that others will obey the law and
ment is responsive, and so I have a moral obligation--tax if people trust the president of the country, tax morale
compliance decisions are also affected by social interac- is higher.
tions (Andreoni, Erard, and Feinstein 1998). In a multi- The interaction of trust among individuals, a perception
country study of tax compliance, Cowell (1990) reports, of fairness in existing institutional arrangements, and a
"These systematic differences among countries and among perception that the state fulfills its part of the social con-
groups within one country cannot be dismissed as innate tract do not seem to hold in Latin America, and the state
230
T H E I N F O R M A L S E C T O R A N D T H E S TAT E : I N S T I T U T I O N S , I N E Q U A L I T Y, A N D S O C I A L N O R M S
BOX 8.3
Tax compliance, social norms, and trust in the state: The contrasting cases of Chile and Argentina in the late 1990s
Bergman (2002) contributes to the literature on compli- TABLE 8B.3.1
ance by providing us with two interesting case studies. He Determinants of reported willingness to increase tax burden, Chile
uses a multivariate ordinary least squares regression to
determine the relationship between trust and perception Independent variable Coefficient
variables taken from surveys conducted in Chile and
Collective perception of honesty 0.079**
Argentina and the "reported willingness of taxpayers to It is justified to cheat 0.130***
comply with taxes in order to fund social policies" (p. 294). Trust in and approval of public services 0.163***
Perception of detection capability 0.036
The surveys Bergman used were conducted in R2 0.12
Argentina in 1997 on a sample of 549 individuals, and
in Chile in 1998 on a 1,200-person sample. In both Source: Bergman 2002.
countries, 70 percent of the active population paid taxes. ** significant at 5 percent.
*** significant at 1 percent.
In the 1990s, Chile's level of value-added tax (VAT) eva-
sion averaged 22 percent, compared with a rate of 55 per- TABLE 8B.3.2
cent in Argentina during the same period. Seventy OLS--effects of attitudes and tax experience of the willingness to
percent of Chilean taxpayers report VAT evasion as very comply, (controlled for age and gender), Argentina
hard or somewhat difficult. This is in contrast to 67 per-
cent of Argentines who "agree or strongly agree with the Independent variable Coefficient
statement, `People think that in this country evading
Satisfaction with public services 0.173***
taxes is easy'" (p. 269). In addition, both countries show Tolerance of cheating 0.211***
a different prioritization of social welfare. In Chile, 76 Feels guilt at evasion 0.289**
Social sanction by peers if taxes are not paid 0.144**
percent of respondents somewhat agreed or totally agreed R2 0.26
with the statement "I am ready to pay more taxes if they
are channeled to benefit the poor." Argentina's survey Source: Bergman 2002.
shows wide dissatisfaction with social services. Bergman ** significant at 5 percent.
*** significant at 1 percent.
(2002) reports that Argentines "do not challenge the
legitimacy of the tax system" (p. 269), but are dissatisfied negative coefficient; and, finally, the detection variable
with the quality of public services. again seems to have no effect. Social sanctions and
Using that information Bergman finds that, in Chile, guilt--variables not available for Chile--show, surpris-
both perceptions of others' honesty and disapproval of ingly, that there is a lack of social norm and individual
cheating are correlated with citizens' willingness to increase guilt to pay taxes (see table 8B.3.2).
their tax burden, and are statistically significant (see table Bergman concludes that there is a strong link between
8B.3.1). Trust in public agencies (police, public health, citizens' satisfaction with public services and their will-
courts, customs, and treasury) also has a positive effect on ingness to comply with tax responsibilities or to increase
willingness to pay more taxes. The model does not find their tax share in Argentina and Chile.
any effect on the responses caused by the individual's sub- Chile has a higher level of "social solidarity" (that is,
jective estimate of the tax authority's detection capacity. willingness to pay higher taxes) as a result of the popu-
In the case of Argentina, the dependent variable is lace's trust in public institutions' commitment to allevi-
actually less stringent because it inquires only about the ating poverty. In contrast, Bergman concludes from the
willingness to comply with taxes--not to increase one's tax Argentine empirical analysis that the lack of satisfaction
burden--to fund social programs. Satisfaction with the and trust in public sector institutions is behind the low
performance of public services (health, education, secu- levels of solidarity. Moreover, legal enforcement there is
rity, and infrastructure) has a positive influence on will- perceived as weak, as is social enforcement of norms.
ingness to comply; tolerance of cheating has a significant Source: Based on Bergman 2002.
231
I N F O R M A L I T Y
might lack the legitimacy for citizens to feel obliged to matter of political will because the technology is available
comply with these regulations. Even if systematic micro and administrative capacity increases are definitely within
evidence is still scarce in the region, the cases of Chile and the range of options of the much-modernized Latin Ameri-
Argentina suggest a large contrast in the social norm that can tax systems. As an example, in 1947, the United States
prevails in those countries. In the same way, attitudes data had a GDP per capita that was lower than the one in
from Latinobarometro suggest that there is high variance of Argentina and somewhat above the ones in Chile, Costa
tax morale in the region. Low tax morale leading to tax eva- Rica, and Mexico in 2000. However, in that year the United
sion is related to the Hirschmanian exit option: if the state States already raised 56.6 percent of its revenues from per-
does not give people public goods that they value, and sonal and corporate income taxes (Schmitt 2005). In Latin
there is no societal pressure for contributing to or partici- America, that figure today is 30 percent. In table 8.6, survey
pating in the circuit of taxes and transfers established by data reveal some of the problems faced in Latin America.
the state--and, consequently, there is a social norm of non- Levels of bribery and corruption are, in general, higher than
compliance--then people will have a strong incentive to go in other regions. Underreporting and evasion seem also to
and remain underground. This is illustrated in figure 8.12, be higher, as sales amounts reported to authorities by a typ-
which suggests that tax morale is, as a consequence, ical firm in Latin America are about three-fourths of actual
robustly negatively related to informality in Latin America, sales, with East Asia and the Pacific the only region where
using two different indicators of informality. This suggests that figure clearly is lower.
that countries with high informality tend to be those where There is large scope to increase collection through
the social norm is not conducive to complying with tax improvements in tax administration and tax policy. Bird,
regulations. In the case of Latin America, in addition to the Martinez-Vazquez, and Torgler (2006), Schmitt (2005), and
problems of perception that the state is weak and does not Tanzi and Zee (2000) discuss several areas where the tech-
respond to the interests of the majority, the social norm nology is available, and the challenge is more in the politi-
may be affected by the operation of tax administrative sys- cal realm. Among others, Latin American tax authorities
tems. If there is a widespread perception that the govern- have to move aggressively in professionalizing tax adminis-
ment is not willing to fully detect and penalize evaders, tration management and in putting firewalls between tax
then noncompliance is legitimized and the prevailing administration decisions and tax policy decisions. Signifi-
social norm is reinforced. cant progress has already been made in areas like computer-
Latin American countries currently lack the capacity to ization, control of large taxpayers, and use of withholding
enforce tax collection as in OECD countries. In a way, it is a systems, together with third-party information. In addition,
FIGURE 8.12
Tax morale and informality indicators
Tax morale data from Latinobarometro Tax morale data from World Values Survey
Tax morale Tax morale
0.2
VEN coef .004, t 1.94 0.2 coef .01, t 2.99
COS
GUA
0.1 0.1
NIC HON BRA ARG
MEX
COL CHI
ARG VEN
0 0 PER
CHI
MEX URU
0.1 BOL
ECU 0.1
PER PAN
0.2 0.2
20 10 0 10 20 20 10 0 10 20
Share of informal economy Share of informal economy
Source: Author's estimates, based on data from World Development Indicators, 2005, World Values Survey, and Latinobarometro, 2004.
Note: Figure shows partial correlations controlling for GDP per capita at PPP.
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T H E I N F O R M A L S E C T O R A N D T H E S TAT E : I N S T I T U T I O N S , I N E Q U A L I T Y, A N D S O C I A L N O R M S
TABLE 8.6
Comparative efficiency and corruption in tax administration: Survey evidence for 2005�06
Middle East
East Asia Europe and Latin America and North Sub-Saharan
Indicator and Pacific Central Asia and Caribbean Africa OECD South Asia Africa
Taxes
Average time firms spent in meetings 4.91 2.78 2.89 3.52 1.65 3.37 5.08
with tax officials (days)
Time to prepare and pay taxes (hours) 270.06 437.92 548.80 281.36 197.19 331.71 394.00
Corruption
Unofficial payments for typical firm 1.81 0.76 1.48 2.72 0.13 1.28 1.64
to get things done (% of sales)
Firms expected to give gifts in meetings 33.59 42.84 30.40 40.09 28.26 44.27 18.86
with tax inspectors (% of total)
Value of gift expected to secure 1.82 1.36 4.08 1.30 0.55 2.04 3.52
government contract (% of contract)
Informality
Sales amount reported by a typical firm 69.30 89.35 76.51 73.55 93.55 93.7 78.39
for tax purposes (% of total)
Source: Alm and Martinez-Vazquez 2007; data from the World Bank Enterprise Surveys.
Note: OECD = Organisation for Economic Co-operation and Development.
in most countries in the region, significant efficiency gains staffed, and compounded with a legal system too weak to
can be obtained by eliminating or lowering exemptions that criminalize evasion effectively. Many of the steps that can
create loopholes in value-added, income, and property taxes. be taken to improve capacities on this front are technically
But incentives to register with the tax authorities are feasible in almost all countries. Although it is difficult to
necessary to increase the tax base--both carrots and sticks. disentangle their deterrent effects empirically, there is con-
Examples of carrots are programs like the earned income sensus that auditing, fines, and business closures are essen-
tax credit that provides tax credits to the labor income of tial tax enforcement tools. In one of the few studies in Latin
families whose annual earnings remained below a certain America, Bergman (2003) examines the cases of Argentina
threshold, often gradually phased out (see box 8.4). These and Chile, two countries that, as noted before, at the begin-
types of programs have had tremendous success in reducing ning of the 1990s, found themselves with very similar tax
poverty in OECD countries, and have the virtue that trans- policies and macroeconomic conditions but that have since
fers are implicitly conditional on the family having some- diverged in their tax compliance; today, Argentina has
one in regular employment. approximately double the VAT evasion of Chile, which is
Another example of policies oriented to lure the taxpayer 22 percent. Bergman posits that the key reason for this has
is changing the tax administrator's approach to a "service been the inability of Argentina's tax system to create a per-
paradigm" so as to enhance its role as a facilitator and a manent, credible threat to the noncompliant. Argentina has
provider of services to taxpayers. This might comprise granted a total of 24 major amnesties since 1974, and sur-
actions promoting taxpayer education, developing services veys show that the population believes bribing auditors is
to assist taxpayers in filing returns, broadcasting advertise- common and tax audits have low detection rates. Further-
ments that link taxes with government services, lowering more, audits in Argentina have been performed almost
compliance costs, simplifying taxes and their payment, exclusively on large taxpayers, and smaller firms are aware of
and promoting a taxpayer--and a tax administrator--"code that fact. In contrast, Chile has had no major amnesties, and
of ethics." the population perceives it is very hard to bribe auditors.
On the side of "sticks," audits and penalties are core Although it also focuses more on high-level taxpayers,
instruments of tax enforcement policy. The audit function Chile's audit selection system includes in its design a larger
in most of the region is weak, often underfunded, under- number of smaller firms. The efficacy of audits has been very
233
BOX 8.4
Earned income tax credits: Transfers that encourage formal employment
Fighting poverty and creating incentives to work are also differ among countries (see figure 8B.4.2); indeed, the
challenges faced by many governments. One experience Dutch have chosen not to phase out at all when the maxi-
that potentially can offer insights for Latin American mum credit level is reached. Their motivation has been to
countries is the earned income tax credit (EITC). In respond to the key theoretical criticism of the labor tax
1975, the United States introduced an innovative social credit, which is that it might provide disincentives
policy tool that used employment incentives as opposed to working or earning more in the phase-out range
to public assistance to aid low-income people by provid- (Hoffman and Seidman 2003; Hotz and Scholz 2003).
ing tax credits to the labor income of families whose
FIGURE 8B4.1
annual earnings remained below a certain threshold.
Value of the EITC, by income, unmarried filers,* 2005
More than 30 years later, the EITC has become the
Credit value
largest antipoverty program in the United States: in
4,500 $4,400
2005, 22 million poor working families benefited from
4,000
the $34 billion in credit. Other countries, such as Belgium,
3,500
Canada, France, the Netherlands, New Zealand, and the
3,000
United Kingdom have since introduced their own ver- $2,662
sions of earned income tax credits. Using such credits in 2,500
countries with large informal sectors could induce large 2,000
segments of the population to register, increasing the 1,500
ability of the state to observe income for tax or transfer 1,000
purposes. 500 $399
The basic design of the credit is this: for each addi-
0
tional earned dollar, workers receive a tax credit, up to an 0 5,000 10,000 15,000 20,000 25,000 30,000 35,000
Income (US$)
income level considered by the government as the
national poverty threshold; after this, the credit plateaus No children One child Two or more children
and steadily phases out until an earnings ceiling is reached Source: Holt 2006.
where eligibility stops. Different thresholds apply to dif- Note: Data from Internal Revenue Service. (*) Married couples filing
jointly are eligible for slightly higher credit amounts in the "phase-
ferent numbers of children (see figure 8B.4.1). Schedules out" range of the EITC.
FIGURE 8B4.2
Labor tax credits in selected countries, 2001
Tax credit (in US$)
4,500
4,000 WFTC
EITC
3,500
3,000
2,500
2,000
1,500
1,000 LTC
500
PPE
0
0 1,800 3,600 5,400 7,200 9,000 10,800 12,600 14,400 16,200 18,000 19,800 21,600 23,400 25,200 27,000 28,800 30,600
Income (US$)
Source: Detragiache 2001.
Note: WFTC working families tax credit, UK; EITC earned income tax credit, USA; LTC labor tax credit, the Netherlands;
PPE prime pour l'emploi, France.
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Other internationally differentiating characteristics are been split into the child tax credit and the working tax
whether the annual credit is refundable or if it applies credit, was that the credit encouraged more hours of work
only to cover one's tax burden, whether families without by entitling only individuals working more than 16 hours
children are eligible, and whether there is a minimum a week to the credit and providing small additional credit
number of hours one must work to be eligible. for those working more than 30 hours a week.
The U.S. EITC has been studied extensively, and the The earned income tax credit model's ability to be tai-
foremost objective of the credit--to reduce poverty--has lored to fit specific country environments is a characteris-
been a widely documented success. Between 1995 and tic that makes this formula attractive. In the Latin
1999, the EITC was responsible for an overall reduction American and Caribbean context, over the medium term,
in the U.S. poverty rate of 1.5 percentage points tailored credits could be not only a potent tool for
(Hoffman and Seidman 2003). Estimates suggest that, poverty reduction but also an instrument to combat the
without the EITC, the poverty rate among children in the region's high level of informality. People would have
United States would be 25 percent higher (Greenstein greater incentives to register with tax authorities to
2005). Indeed, the credit has been so successful that, by receive the credit, providing corresponding incentives for
2006, 18 individual states in the United States had insti- individuals working in informality to exert pressure on
tuted similar credits for state taxes. The program has also their employers to become formal. In addition, disbursal
positively affected participation rates among one of the of the credit using official financial intermediaries could
most vulnerable populations in the United States, single be used as a tool to encourage participation in the finan-
mothers. Meyer (2001) finds that 60 percent of increases cial system. In terms of innovative regional design and
in single-mother labor participation between 1984 and targeting, we can envision, for example, that poor fami-
1990 are due to the EITC and other tax. lies involved in the care of the elderly would receive an
The EITC is not the only tax credit model that seeks adjusted credit in the same way that families with chil-
"to make work pay." In 1999, the United Kingdom intro- dren currently do. A primary issue would be the develop-
duced the working families tax credit (WFTC). Brewer ment of good targeting systems in the absence of good
et al. (2005) find that the WFTC was responsible for a income indicators to ensure that the poor are the ones
5.11 percent increase in the labor supply of single mothers receiving the working credit. Targeting models currently
in the United Kingdom between 1999 and 2003. The used in conditional cash transfer systems, for example,
direct poverty effects of the WFTC have been more could provide guidance as to how, in the Latin American
ambiguous. A key feature of the WFTC, which has now context, a working credit initiative could be realized.
different, with Chile focusing on enhancing compliance by effects on tax evasion in a country where tax authorities do
matching computerized and third-party information. not have the ability to produce a credible threat of detec-
Argentina relied more on penal sanctions that end up tion and evenhanded enforcement of sanctions.
being less effective, given the low expected probability of
being detected. Inequality, taxes, and transfers
Bergman (2003) provides complementary evidence of One of the elements that influence the social norms related
the specific impact of audits on tax evasion in Argentina. to compliance with regulations is the perception of how
He finds that, in both Argentina and Chile, audited and resources given to the state will be used. On one hand,
sanctioned taxpayers decreased their future compliance in deficient public services encourage people to opt out of pub-
subsequent years, presumably in an effort to recoup the lic service systems. On the other hand, a state that is per-
losses prompted by the audit fines, but the decrease was ceived as unfair will lack legitimacy. One element that feeds
more moderate in Chile. The author attributes this to the the perception of unfairness is the real and perceived
fact that, in Chile, the threat posed by the tax authorities is structure of incidence of taxes and transfers along the
considered credible, as discussed above. The conclusion of income scale. Are taxes excessively concentrated and
this analysis is that tools of deterrence may have unforeseen deemed unfair by some? Are transfers--public expenditures,
235
I N F O R M A L I T Y
in general--excessively concentrated? Are there segment of services, such as to the judiciary and to police protection.
the population that are excluded from the taxes and transfer Very much to the point of this report, informal workers are
mechanism? Are public resources used to equalize opportu- one of the key excluded groups.
nities in a way that is consistent with the implicit social In an exercise that aggregates social spending, Breceda,
consensus? Do they generate an exclusionary mechanism Rigolini, and Saavedra (2007) compare patterns of progres-
that leaves part of the population out of the social contract siveness for a sample of Latin American countries with the
and consequently renders the state less legitimate? United States and the United Kingdom. They find that, in
We discussed above some stylized facts of the tax side of addition to significant differences in average levels, there is
the equation. As we saw, tax collection in the region is below a strong contrast between Latin America and the United
its expected value, given the level of development. However, Kingdom in terms of the progressiveness of social spend-
social spending does not show a clear pattern. Overall, the ing. In Latin America, social spending is slightly biased in
ratio of social spending to GDP in Latin America seems to be favor of the rich: on average, social spending to the poorest
in line with the region's level of development. There is, how- quintile corresponds to 92 percent of social spending to the
ever, a large variance within the region (Lindert, Skoufias, richest quintile, against 233 percent for the United
and Shapiro 2006). Argentina, Brazil, and Uruguay spend Kingdom.16 Latin America seems, therefore, to be closer to
around 20 percent of GDP in social areas, whereas, at the U.S. model, which has a ratio of 107 percent. Although
the other extreme, the Dominican Republic, Ecuador, variation in the Latin American sample is quite large (in
Guatemala, and El Salvador show social expenditures below Honduras--the least progressive state in the sample--the
7 percent of GDP. Mexico stands out as a richer country with poorest quintile receives 57 percent of what the richest
relatively low social expenditures as a percentage of GDP. quintile receives, whereas in Colombia the ratio climbs to
Similar to the small increase in taxes observed since 1985, 108 percent), all countries remain far away from the pro-
there is clear evidence of a slightly larger increase in social gressiveness of the European welfare states, and all are less
expenditures. Without exception, social expenditures have progressive than the United States.
increased in all the countries of the region, particularly in The key element of this discussion for the issue at hand
countries that started at a low basis in the early 1990s. For is that there is a large segment of the population for which
the region as a whole, the increase was from 12.8 percent of the state is not providing basic services, for which the state
GDP in 1990/91 to 15.1 percent in 2002/03. is not a guarantor of minimum opportunities, and for
Despite this increase in social spending, patterns of which the provision of public goods is insufficient and,
regressivity remain and within-country inequities continue equally important, inequitable.
to be very large. In education, spending is mostly progres-
sive, except for tertiary education, and has increased in all Inequality and the system taxes and transfers
countries. But, despite the improvements, quality indica- It is well known that Latin America is the most unequal
tors perform poorly and within-country variance is region in the world, as measured by income distribution
extremely large. In the case of health care, Latin America (de Ferranti et al. 2004; Perry et al. 2006). Recent research
has witnessed undeniable progress in the provision of basic work at the World Bank (2006) has shown that inequality
services, such as basic health and nutrition services, and of opportunities is one of the key factors. Differences across
indicators like maternal mortality and immunization rates individuals in access to assets, public goods, services, and
have improved dramatically. But, again, differences in the voice (for which individuals could hardly be responsible
quality of access by income groups are still extremely large because the differences arise at the moment of birth)
(see de Ferranti et al. 2004; World Bank 2006). Spending determine differences in their ability to contribute to
on social security, which has expanded the most, is fairly development and to build their own future. Accumulated
regressive. The pension system is the worst offender, and differences in opportunities translate eventually, among
one of the biggest problems, as explained in chapter 7, is the other ways, to differences in income.
low coverage. Some social assistance programs are fairly pro- A significant part of the observed inequality is due to the
gressive, but, in general, they represent a small fraction of effects of state intervention (or lack thereof) more than to
spending. In addition, in Latin America there is abundant pure market outcomes. As discussed in Perry et al. (2006), if
evidence of deficiencies and inequities in access to other income inequality in Latin America is compared with that
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T H E I N F O R M A L S E C T O R A N D T H E S TAT E : I N S T I T U T I O N S , I N E Q U A L I T Y, A N D S O C I A L N O R M S
of Europe, there is evidence that a significant part of the dif- many European countries (as a proportion of their income),
ference between the levels of disposable income inequality given the high inequality, their contribution to total tax
in the two regions is due to the different impact of taxes and revenues is much larger (despite the elements of state cap-
transfers: they reduce market income inequality consider- ture mentioned above, including the high level of tax
ably in Europe, and very little in Latin America.17 Interest- exemptions that, in many cases, favor the rich dispropor-
ingly, the same can be said even when comparing the Latin tionately). This may place a strain on the social contract
American countries with the United States, a country that because the richest quintiles have to pay for most of the
has the reputation of not being too distributive (Alesina and state provision of public services without seeing sizable
Glaeser 2004). The inability or unwillingness of Latin benefits in return. These findings give further support to
American political and economic systems to improve the the argument that an increase in the efficiency of the sys-
distribution of income is not a new event, nor has it passed tem and an increase in the tax base are the key avenues to
unnoticed by previous observers. For instance, Kuznets increase tax collection in the region.
(1955) argued about the "the failure of the political and Other studies that look only at taxes find small progres-
social systems of underdeveloped countries to initiate the sivity and, hence, a small redistributive effect of taxes in
governmental or political practices that effectively bolster Latin America (Chu, Davoodi, and Gupta 2000). More-
the weak positions of the lower-income classes" (p. 24; cited over, Engel, Galetovic, and Raddatz (1999) find that, in
in Beramendi and D�az-Cayeros 2006). Chile, which has the highest tax productivity of the
Breceda, Rigolini, and Saavedra (2007) present an inci- region, taxes are slightly regressive. They argue that the
dence analysis of both social spending and taxation for more unequal the pretax distribution--as is the case in
seven Latin American countries, and make the comparison Chile and most of the region--the less the redistributive
to the United Kingdom and the United States. Consistent effect of progressive taxation. A lot more is achieved
with previous studies, they find that, in Latin America, through better taxation, fewer loopholes, and higher levels
absolute levels of social spending are fairly flat across and quality of spending.
income quintiles--and in some countries they are even An unfortunate characterization of Latin America is one
regressive (see figure 8.13). Nonetheless, they find taxation of low-quality, ineffective provision of public services that
to be quite progressive, particularly income and value- reflects an unresolved problem of high inequality of oppor-
added taxes. On average, the richest income quintile in tunities and is correlated with an extremely high level of
Latin America pays 22 times more taxes than the poorest inequality of current incomes. This is within a context of a
quintile. This remains close to the difference in the United taxes and transfers framework that does not redistribute
States (19 times) and much higher than in the United effectively.
Kingdom (6 times). Moreover, in Latin America, the share In addition to how inequality interacts with the taxes
of taxation paid by the richest income quintile averages and transfers structure, there are several channels through
61 percent. This remains significantly higher than the which inequality might be linked explicitly to informality,
share paid by the richest quintile in the United Kingdom although the intuitive relationship is not well studied yet.
(43 percent), and similar to what the richest quintile Ahmed, Rosser, and Rosser (2004) find that the informal
contributes in the United States (58 percent). sector share is a significant determinant of income inequal-
Both features make the structure of social spending and ity in a sample of 52 countries (as cited in Davis [2007]).
taxation in Latin America closer to that of the United Chong and Gradstein (2007), explore the opposite chan-
States than to that of the United Kingdom (where social nel, which is of inequality as a mechanism that generates
spending is more progressive and taxation is less so). The more informality. They model and test that relationship
comparison, therefore, strongly indicates that Latin Ameri- empirically and find a significant positive relationship. Fur-
can countries resemble a minimalist welfare state similar to ther, they argue that the effect of high inequality may be
the one in the United States, more than a Europe-like one. exacerbated in the context of low institutional quality. The
The extremely high inequality levels observed in Latin reason they postulate is that, given market imperfections,
America make the transition difficult toward a more pro- when institutional quality is low, protection of property
gressive welfare state. In particular, although the rich in rights in the formal sector is weak and resources largely are
Latin America are taxed equal to or less than the rich in up for grabs. "Poor individuals whose endowments are
237
I N F O R M A L I T Y
FIGURE 8.13
Social spending and taxation by income quintiles
Argentina Honduras
Amount per capita as % of GDP per capita Amount per capita as % of GDP per capita
25 25
15 15
5 5
0 0
5 5
15 15
25 25
35 35
45 45
55 55
65 65
Quintile 1 Quintile 2 Quintile 3 Quintile 4 Quintile 5 Quintile 1 Quintile 2 Quintile 3 Quintile 4 Quintile 5
Mexico Peru
Amount per capita as % of GDP per capita Amount per capita as % of GDP per capita
25 25
15 15
5 5
0 0
5 5
15 15
25 25
35 35
45 45
55 55
65 65
Quintile 1 Quintile 2 Quintile 3 Quintile 4 Quintile 5 Quintile 1 Quintile 2 Quintile 3 Quintile 4 Quintile 5
United States United Kingdom
Amount per capita as % of GDP per capita Amount per capita as % of GDP per capita
25 25
15 15
5 5
0 0
5 5
15 15
25 25
35 35
45 45
55 55
65 65
Quintile 1 Quintile 2 Quintile 3 Quintile 4 Quintile 5 Quintile 1 Quintile 2 Quintile 3 Quintile 4 Quintile 5
Other social spending Cash transfers Health Education
Other taxes VAT sales tax Income tax
Source: Breceda, Rigolini, and Saavedra 2007.
238
T H E I N F O R M A L S E C T O R A N D T H E S TAT E : I N S T I T U T I O N S , I N E Q U A L I T Y, A N D S O C I A L N O R M S
relatively limited are at a disadvantage in extracting a larger
FIGURE 8.14
share of the resources, hence, find it beneficial to move into
Informality and inequality
the informal sector, where although less productive, they are
able to fully retain their production output. High inequal- Share of persons without pension
40
ity, exacerbated by low institutional quality, magnifies this coef .72, t 3.54
effect, implying a positive relationship between inequality PER
ARG PAR
20 ECU MEX BOL
and the size of the informal sector" (p. 160). NIC DOM GUA
VEN HON
This result is very relevant in the context of Latin Amer-
0 URU SAL
BRA
ica. Income inequality reflects itself in differences in voice, COL
JAM CHI
PAN
power, and influence. The lack of influence usually leads to COS
20
capture and to a perception that the state is run according
to the interests of an elite. Among other effects, this leads 40
to lower tax morale and higher informality. Precisely, better
institutions might be hampering the possibility that 60
inequality of income may lead to inequality of power.18
80
Bird and Zolt (2005) show evidence of a negative effect of
20 10 0 10 20
inequality on tax effort. They argue that highly unequal Gini coefficient
distributions of income, typical of Latin America, can lead Source: Author's estimations, based on World Development
to low levels of solidarity by the elites toward poorer Indicators (2005).
Note: Figure shows partial correlations controlling for GDP per
groups. For example, low tax effort in Central America is capita of PPP.
often interpreted as the unwillingness of a small elite to
finance publicly provided goods because they can opt out
and finance their own services. selves, can explain a high share of the variation in informality.
But an argument that is valid for the elites who might It is then difficult to disentangle the independent effect of
influence policies in their favor is not valid for the relatively inequality on informality from the effect of institutional vari-
rich or the middle class. When there is extreme inequality, it ables. The evidence presented by Chong and Gradstein
is more difficult to collect revenues in a fair and efficient way. (2007) is suggestive, but more analysis is needed to under-
In Latin American countries, despite paying proportionally stand better how the institutional setting may affect the
less than their peers in richer countries, the relatively rich channel through which inequality affects informality.
(that is, the small middle class that exists in Latin America)
pay a disproportionate share of all revenues. And, given that Informality: A reflection of a broken
services provided by the state are of low quality, what they social contract?
get back from the state is not aligned with what they pay-- Is Latin America in a "bad" equilibrium?
although they may be getting more service from the state Economies can land in different equilibria if social norms
than the poor are getting. This misalignment implies that and social interactions that lead to specific collective behav-
the opportunity cost of tax compliance is even higher. iors are strong.19 You make the queue or skip the line. You
We performed several cross-country estimations to test stop at the red light or you keep moving. As discussed
the robustness of the result of a positive relationship between above, tax and regulatory compliance, one of the consum-
inequality and informality, given the level of development mate collective action problems of public policy and a key
and other institutional characteristics. As shown in fig- factor behind informality, may be affected by social interac-
ure 8.14, the two variables are positively related after control- tions. Individuals will be more inclined to pay taxes if they
ling for GDP, and the results are robust to using different believe the government is complying with its fair share of
informality indicators. We wanted to further analyze whether the social contract and is using public resources effectively.
the effect of inequality is conditioned by institutional charac- They will be more willing to comply if they believe others
teristics. However, the econometric analysis (not reported) do so, prompting still others to comply, and so forth and so
shows that both inequality and GDP are highly correlated on until a highly cooperative state of affairs takes root.
with institutional and structural variables that, by them- Conversely, people will be inclined to evade tax obligations
239
I N F O R M A L I T Y
if they believe others are inclined to do so. Such interde- fair deal--through different mechanisms--by the current
pendencies tend to generate patterns of collective behavior arrangements, and that they are justified in avoiding mak-
with specific reinforcing mechanisms. ing a contribution to the system whenever possible.
Latin America seems to be in an equilibrium in which From both ends of the socioeconomic scale we tend to
trust in the state is low; tax collection and compliance with observe a large amount of exit, in Hirschman's terminol-
regulations are low in most countries; and public provision ogy. We can use a cost�benefit decision scheme, like the
of public services is inequitable and of low quality, both one we presented in the second section of this chapter, now
directly because of lack of resources and because of low gov- from the point of view of a citizen from the highest income
ernment effectiveness, even given the available resources. quintile who is considering his or her relationship with
This unfortunate characterization reflects an unresolved the state and with society at large when it comes to decid-
problem of high inequality of opportunities correlated with ing whether to evade taxes. In many Latin American coun-
an extremely high level of inequality of current incomes. tries, such a "rich" citizen is likely to opt out of public
This happens in the context of a structure of taxes and services and into the higher-quality private provision of
transfers, that does not redistribute effectively. old-age insurance,20 security services, education, and
Low taxes are mostly related to low tax productivity. health care. A citizen is likely to feel that such state
And, as discussed above, this is mainly related to low tax services are of very little value to him or her. When assess-
compliance, narrow tax bases, and excessive exemptions. ing how valuable such state services are for the population
The empirical analysis presented above suggests that tax at large, he or she is likely to share the perception that
compliance is affected by deterrence and by a complex of these things that are of little worth to him or her are not
factual beliefs and emotional dispositions, whereby social useful, effective, of high quality, or fair for citizens in other
norms are not necessarily conducive to complying with strata. This negative view of the worth of state services is
taxes and other regulations--a fact that has been proxied by likely to be compounded by a generalized perception of
low tax morale. The evidence in Latin America also points patronage and corruption in the government generally and
to a negative relationship between tax morale and informal- in social assistance particularly; and by the social norm
ity. These actually are different sides of the same coin. Low externalities that provide an implicit validation of wide-
willingness to pay taxes and incentives to operate infor- spread tax evasion.21 In some Latin American societies,
mally are shown to be empirically correlated with percep- such as Argentina, we see an increase in socioeconomic
tions of incompetence of the state (proxied by indicators of segregation, which might bring further difficulties for
government effectiveness, rule of law, impartiality and fair- weaving together a social contract down the road. Poor
ness of courts, for example). Evidence also suggests the and rich citizens tend to live in worlds further apart in
importance of fairness in the use of public resources. In this terms of the schools their children go to, where health
context, informality is fueled by a structure of regulations services are received, and where their homes are located,
that, in a cost�benefit analysis, may provide a rationale for with gated communities and shanty towns as clusters, each
firms and workers to operate underground, as discussed in time placed farther apart.
chapter 5, fostered by a social norm not conducive to com- However, many of the rich, usually the richest of the
plying with regulations and by weak social and administra- rich, may also be capturing the state and using its relatively
tive sanctions. In this context, there are multiple examples larger influence to maintain tax privileges or lobby to
of ways in which both the poor and the rich might feel maintain oligopolistic structures. Corporatist groups and
excluded and find it convenient to opt out, usually partially, certain unions may use political pressure to maintain privi-
from the system. leges that perpetuate unequal structures of power and of
opportunities. In any of these cases, we are confronting
Opting out . . . but not completely weak and incompetent states--not necessarily small
Telling the story in terms of the beliefs and actions of agents states--on one side, incapable of constraining the influence
at different levels of the socioeconomic scale, we might say of powerful groups (Guerrero, L�pez-Calva, and Walton
that, in many Latin American countries, the rich, the mid- 2006) and, on the other side and related to this, incapable
dle class, and the poor might feel they are not getting a of providing services and public goods in a fair manner.
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T H E I N F O R M A L S E C T O R A N D T H E S TAT E : I N S T I T U T I O N S , I N E Q U A L I T Y, A N D S O C I A L N O R M S
Poor people feel even more disengaged. The Hirschman- incorporation and looked like the construction of a social
ian notion of exit applies also to the lower end of the socioe- contract that allowed for the inclusion of increasing seg-
conomic distribution: the poor do not pay many taxes, but ments of the population. But that welfare system reached
they also do not get much from the state (see box 8.5). full coverage, was strongly stratified, and turned out to
They feel an adverse differential access to public goods, to be financially unsustainable. Many segments of society,
property rights, to protection under the law, and to judi- including rural citizens and urban marginal areas, never
ciary services. This fosters the use of informal mechanisms participated.
and reduces the incentive to participate in the formal cir- As a result of an explicit agenda to improve fiscal sus-
cuit. The poor will organize themselves for self-protection tainability and to insert some "market principles," that sys-
as well, will invade public property, and, in some unfortu- tem and the political institutions behind it were reformed.
nate cases, will take justice into their own hands. Poor The social security system was reorganized along market
citizens are more likely than their wealthier neighbors to be principles. It is not clear yet that the new system will
informal, to participate in clientelistic networks, and to imply a fast incorporation of segments that traditionally
have a negative view of the state and the extant social have been left out. Moreover, the evidence shown in this
arrangement. A difference with respect to the wealthy is report and elsewhere points to increasing informality in the
that, in many cases, the poor have never been part of the 1990s.
formal system anyway. More than "exiting" the system, the But different countries seem to be going in different
poor have never entered the system. This situation is part of directions, and societal consensus regarding the potential
a culture of informality in which the state is basically future path varies. In Argentina, for example, there is evi-
absent and a social contract is basically broken. dence of increasing inequities in access to social protection
It is easy to see that precisely these attitudes have and less clarity about the effectiveness of the current
important reinforcement effects. The low willingness to arrangements. One possible reading is that now we have a
contribute is part of the explanation of the fiscal limitations patchwork of elements of the previous covenant, mixed
that impinge on the low quality and coverage of the ser- with the recent add-ons, in the form of social assistance
vices provided by the state and that, in turn, feeds back programs that were effective during the time of the crises
into low trust in the state and low tax morale, as discussed and efficient in some dimensions, but that have not yet
above. There is no clear evidence that the process of opting added up to anything coherent, let alone an integrated set
out is increasing, but there also is no evidence at all to the of social policies that has garnered societal consensus. Some
contrary. At least it is safe to say that some people opt out interactions between increasing informality and a transfor-
(exit) from a more inclusive social contract, while others mation of politics seem to be feeding a negative loop.
continue to be excluded from it. It happens not only in the Countries such as Argentina that, several decades ago,
"flat" horizontal sense, but also in a "vertical" sense in seemed to define crucial political decisions in a centralized
which whole groups "collectively" exit through what one bargaining arena defining national policies now are moving
might call "local" reciprocity dynamics. to an increasingly territorialized model of construction of
The specific experience regarding all the different political power in which focused social assistance programs,
aspects of exit and exclusion that are behind the large informality, clientelism, and new forms of political partici-
informal sector in Latin America varies notoriously. Below, pation (such as piquetes) seem to reinforce each other.
we describe briefly three particular cases to illustrate this Chile is a very different case. It is the only economy in
heterogeneity. the region that has been able to attain very low levels
of extreme poverty, with a Chile Solidario program that
Heterogeneity in Latin America has more beneficiaries in 2003 than what the Encuesta de
Most Latin American countries attempted at some point in Caracterizaci�n Socioec�nomica Nacional survey reported as
the 20th century to form a social contract that centered on extreme poor. One of the key--and first--elements of the
the labor market, with some strong institutional actors, Chilean process that started with the return to democracy
such as unions. That model, linked to the development in 1990 was its ability to negotiate a tax reform as one of
model in vogue at the time, provided some progressive its first steps. It was able to convince the elites (businesses
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I N F O R M A L I T Y
BOX 8.5
Expansion of private security services in Managua
Hirschman (1970) posits that when discontent with the has seen an annual growth in the rate of crime of approxi-
performance of an organization to which one belongs, a mately 10 percent since 1990. Crimes against people rep-
person has two options: "exit" the organization and find resent the greatest increase--362 percent over 13 years.
another whose performance is superior, or "voice" one's Rodgers reports that ". . . regionally, the Nicaraguan
dissatisfaction in the hope of prompting the organization police force has the lowest number of police personnel
to improve. In that framework, the phenomenon of per capita and per crime, the lowest budget per crime, the
wealthier Latin American citizens seeking alternative lowest budget per police officer, and the lowest average
health care, education, and security providers is seen as salaries in Central America. As crime has exploded in
their exercise of the exit option. In a flight to quality, they the capital so has the private security market" (p. 117).
abandon the state and seek private providers. Such aban- He states that, in 1990, there was one registered private
donment can have far-reaching effects on the state. Citi- security firm in the capital. This number climbed to 14 in
zens may be less inclined to pay taxes for services they 1996 and was 56 in 2003. In that same year, 9,017 people
don't use or value, so the state's capacity to perform its were registered as private security guards. The increasing
duties will be weakened. The provision of public security trend has not abated, despite the government's efforts to
to a nation is one of the oldest and most firmly established increase resources for the police force and a 33 percent
responsibilities of the state. Centeno and Portes (2006) increase in the number of officers between 2000 and 2005
aptly describe the state of public security in the region at (G�mez 2005). Recent statistics show that, in 2005, there
the dawn of the 21st century in these terms: "In Latin were 67 private security companies covering 4,153 loca-
America, the incapacity of the state to protect the citi- tions, with 9,329 guards and 6,805 weapons. Gom�z
zenry has led to the massive growth of private security ser- delves further into the phenomenon of private security in
vices, the withdrawal of the wealthy into fortress-like Nicaragua to reveal a crossover between public and pri-
gated communities. . . . In the absence of credible enforce- vate security provision. He observes that some of the
ment of rules, people take things into their own hands . . ." highest-ranking former police officers have become active
(p. 14). in providing private security.
Rodgers (2004) explores issues of security, criminality, The message seems to be that when the state doesn't
and spatial segregation in Managua, Nicaragua. The city deliver, people take things into their own hands.
and high-income earners who would pay about two-thirds extremely high and, symptomatically, very high in the
of the new tax burden) that, in the midst of uncertainty, it policy agenda.
was a small price to pay for the return to socioeconomic The opposite of Chile might be Guatemala, where trust
peace. The combination of tax reform and explicit social in institutions is low and the presence of the state in several
policy objectives made this a step toward building a social socioeconomic realms is very limited. Tax collections are
contract. The reform was approved by Congress six weeks among the lowest in the region, and informality is around
after the new Concertaci�n government started (box 8.6). 80 percent. The peace accord signed in 1996, after 30 years
Chile reformed its pension system and has recognized that of civil war, included a political pact for the reconstruction
the increase in coverage is still too small. It is therefore of the country; and it established the need for increasing
proposing a package of reforms to the system aimed at tax collection by at least 50 percent before 2000 (that is, to
achieving universal coverage in a way that would be incen- 12 percent of GDP). The increase in tax collection was
tive compatible with keeping individual savings as the earmarked for education, health care, housing, and justice.
mainstay of the system and that is fiscally sustainable (see In 1998, the government rescheduled the agreement. In
chapter 7). Trust in institutions is high and tax productiv- 1999, a large commission prepared the draft of the new fis-
ity is the highest in the region. Informality is less than 15 cal pact. During 2000, the negotiations among all political
percent. Inequality of income in Chile, however, is still parties, the business elites, and other organizations failed,
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T H E I N F O R M A L S E C T O R A N D T H E S TAT E : I N S T I T U T I O N S , I N E Q U A L I T Y, A N D S O C I A L N O R M S
BOX 8.6
Negotiating tax reform and the start of the social contract, Chile, 1990
In a difficult transition environment, the center-left Con- In addition to this negotiation strategy, led by
certaci�n coalition, which won Chile's first democratic elec- Alejandro Foxley (then minister of finance), policy suc-
tion in 17 years, successfully passed a tax reform bill within cess resulted from Concertaci�n's willingness to be moder-
the first months of the new party's term, earmarking greater ate, as evidenced in the final substance of the reform.
tax revenue for increased social expenditures. Boylan Initially Concertaci�n wanted to raise the percentage of
(1996) identifies two main reasons for this unexpected pol- gross national product tax revenue to 3 percent rather
icy success: a willingness to be moderate and an engaged than 2 percent. The RN negotiators pushed for the
negotiation strategy. The final version of the tax package reduction of the corporate tax increase from 20 to
consisted of four main components. It included an increase 15 percent. From the RN's perspective, the business
in the corporate tax rate from 10 to 15 percent and a change elite's foresight that the "social debt" of the years of dic-
in the progressive income tax categorization system that tatorship had somehow to be paid and its realization
put more people in the highest bracket. Third, to control that, compared with other taxes in the region, the pro-
tax evasion, the highest contributors in the agriculture, posed taxes were not high played a role in ensuring the
transportation, and mining sectors were no longer taxed on successful negotiations and passage of the reform.
estimated profits but on actual profits. Finally, the VAT Finally, Concertaci�n accepted the RN's proposed increase
increased from 16 to 18 percent. in the VAT, thus showing a willingness "to tax their
Boylan (1996) argues that it was crucial that the own," not only the business elite. In terms of selling the
details of the tax reform were negotiated in extraparlia- reform to the general public, the earmarking of the addi-
mentary meetings with a targeted group from the major tional revenue to explicit social policy gave a sense that
opposition party. The targeted politicians of Renovaci�n the reform was a step toward building a social contract.
Nacional (RN), a party whose agrarian base strongly iden- Furthermore, Boylan (1996) argues that Chilean tax
tified with the outgoing regime, were known for their reform was more than a targeted policy success: the
technical competence, consensual approach to politics, moderate and risk-averse strategy followed by the new
and their desire to transform the right into a democratic government "played a crucial role in soldering the frag-
force. Concertaci�n was thus able to develop the tax reform ile rule-making environment at the delicate moment of
with a small, less hostile faction of opposition, who then regime change" (p. 8).
sold the reform to the rank and file of their party. This
way, by the time the reform was introduced into parlia-
ment, it was almost a fait accompli. Source: Based mainly on Boylan 1996.
among other reasons, because of the lack of leadership in failed to increase coverage. Minimum pension programs
the executive (ICEF 2005). Some changes implemented in have been launched in several states, and the flagship
2001 were harshly resisted by the business elites, which antipoverty program, Oportunidades, covers 80 percent of
in that year alone presented 31 constitutional appeals the poor and is considered an international best practice.
against tax increases. The courts lined up with business But further expansion of minimum pension programs or
interests, and the tax take is still around 11 percent of any other initiative aimed at universalizing social insurance
GDP. No need to continue the narrative. Point made. clashes with a hard budget constraint. The Fox administra-
Mexico is an intermediate case. Filgueira (2005) classi- tion was never able to pass a tax reform, and Mexico is the
fies it among those dual social states with a large social pro- OECD country with the lowest tax collection--well below
tection system that covers a bit less than half of the what would be expected for its level of development. Trust
population and with rigid labor legislation that hampers in institutions is weak, and the social norm regarding tax
formal job creation. Mexico reformed its private pension compliance is probably behind the low VAT productivity
system, which has made it financially healthier but has of 24 percent. Organized public sector labor is politically
243
I N F O R M A L I T Y
very strong, and neither labor reform nor public pension expand the tax base, incorporate more citizens in the formal
sector reform has been possible politically. Still, the coun- economy, and increase tax compliance. The rich in Latin
try is looking to improve the quality of its public perfor- America contribute a much larger share of the tax collection
mance, and tax reform is again on the agenda. than what is observed in richer regions, and further increases
in tax rates might not be socially tolerable or economically
Conclusions efficient. Furthermore, in attempting to increase tax collec-
We have discussed here that to understand informality it is tion, the region faces the challenge of reducing exemptions,
critical to understand several interaction mechanisms which often is a reflection of state capture. On the other
between the state and the citizens. Individuals explicitly or hand, Latin American governments would have to improve
implicitly decide whether and how to engage with the their performance--both the quality of their expenditures
mandates and institutions of the state, weighing costs and and the mechanism for citizens to monitor them. Recent
benefits and state enforcement capabilities. These decisions mainstream literature is less pessimistic about the effect of
are conditioned by social norms shaped by how agents indi- taxes (and therefore the size of government) on growth, sug-
vidually and collectively perceive and define a relationship gesting that Latin America may be on the side of the curve
with the state. As documented here, cross-country evidence where taxes, as a whole, may be growth enhancing through
based on opinion surveys and investment climate surveys, as the public-goods channel. This implies that increases in
well as on a few comparative studies, suggests that percep- both taxes and expenditures in Latin America might be
tions of government effectiveness and of the performance of growth enhancing, but only if government effectiveness
services like the judiciary system in Latin America are below increases dramatically. This will facilitate establishing the
those observed in other regions. And, as summarized here conditions for a gradual change in individual and collective
and discussed extensively in the literature, informality is beliefs and attitudes regarding the real and perceived rela-
negatively related to institutional quality indicators. This tionship between citizens and the state, which is essential to
environment is consistent with a social norm that is not start reducing the high levels of informality in the region.
conducive to complying with regulations. The strong interest in initiatives to improve government
Taxation, which lies at the heart of a social contract, is effectiveness suggests that many countries are steering in
one of the areas that has been most studied regarding the the right direction.
role of social norms. As discussed here, tax morale--a social Reducing informality is a daunting task and a critical
norm about a citizen's willingness to pay taxes--seems to development challenge for the region. It requires not only
be correlated with several measures of state performance increasing overall productivity and growth in the economy
and with informality, both in Latin America and globally. and improving regulations in labor and product markets,
Low willingness to pay taxes and incentives to operate in- but also pursuing a long-term agenda that could move
formally are related to perceptions--supported by reality-- countries faster to a better equilibrium. In other words, it is
of incompetence of the state and lack of fairness in the use an agenda that includes building a better social contract
of public resources. Moreover, the high and persistent lev- from which fewer people are excluded and in which there
els of inequality, and the prevalence of a structure of taxes are fewer incentives to opt out from it. As has been
and transfers that is not efficient in leveling the playing described throughout the chapters of this report and in the
field and improving the equality of opportunities, fuel a ever-expanding body of literature on informality, the policy
perception of state ineffectiveness. Many among both the agenda in the areas of labor, credit, business services, cost of
rich and the poor, through different mechanisms, may find registration, taxes, business regulation, property rights,
it convenient to opt out, which leads to higher informality. and access to judiciary service, among others, is critical to
Tax collection is low, given the region's level of develop- making progress in fostering access to the formal economy.
ment, which reveals that higher levels of taxation might be Policies in these areas, if designed in a consistent and
needed to move toward the path of development. But this integrated fashion, can help reduce informality as part of
begs the question, How and why should taxes be raised the concomitant process of increasing productivity and
when much of the region perceives that the performance of incomes. But those policies should be part of a road map so
the state is bleak? On one hand, even if the objective of rais- that partial steps might be taken over time, using political
ing taxes is taken at face value, the main challenges are to windows of opportunity for reform.
244
T H E I N F O R M A L S E C T O R A N D T H E S TAT E : I N S T I T U T I O N S , I N E Q U A L I T Y, A N D S O C I A L N O R M S
Notes cheat on taxes if you have the chance?" Tax morale variables used are
1. The following two sections draw heavily on Saavedra and expressed as the percent responding that it is never justified.
Tommasi (2007). 13. Methodological difficulties in the ability to identify and
2. This discussion also relates to the fact that the willingness to calculate precisely social interaction parameters, in general, have
contribute to finance welfare support is heavily influenced by percep- been discussed in detail by Manski (2000). Glaeser, Sacerdote, and
tions about how deserving the recipients are, by how "close" the per- Scheinkman (2003) review the scarce recent empirical work that tries
son feels to the recipients (ethnically, culturally, and so forth), and by to identify social multiplier effects. Their results suggest that social
perceptions about the adequacy of state services and the like (Fong, interactions may be large. They posit that, if one person's proclivity
Bowles, and Gintis 2005; Lindert 2004). to certain behavior influences his or her neighbor's behavior, policy
3. This is an example of opting out, which is discussed in more changes to address that behavior will have a direct effect and an indi-
detail later in the chapter. rect one through social influence. "The presence of positive spillovers
4. The investment climate surveys used for these calculations or strategic complementarities creates a social multiplier where
contain 11 countries from Latin America (Bolivia, Brazil, Chile, aggregate coefficients will be greater than individual coefficients"
Costa Rica, Ecuador, El Salvador, Guatemala, Guyana, Honduras, (p. 2). Empirically, the estimated ratio of aggregate coefficients
Nicaragua, and Peru). The sample contains 42 percent of small (estimated, say, at the city level) to individual coefficients is the social
firms (20 employees or fewer), 38 percent of medium-size multiplier. The writers apply this approach to three settings. They
firms (21�100 employees), and 20 percent of large firms (more than find that, among Dartmouth University students, one predetermined
100 employees). variable had a bigger impact on joining a fraternity at higher levels of
5. Data from the World Bank's Worldwide Governance Indica- aggregation. Using crime data, they find a very large social multi-
tors (WGI) database are used extensively in this chapter. See plier; and, using data on wages and human capital, they find a social
Kaufmann, Kraay, and Mastruzzi (2006). The Government Effective- multiplier at higher levels of aggregation. Another good overview is
ness Index is a measure of the quality of public service provision, the provided in Gintis et al. (2005).
quality of the bureaucracy, the competence of civil servants, the inde- 14. In game theory parlance, the strategies of players A and B are
pendence of the civil service from political pressures, and the said to be strategic complements if when player A increases a component
credibility of the government's commitment to policies. of his or her strategy, player B will want to do so also. In other words,
6. The Control of Corruption Index from WGI is a measure of per- the cross derivative of the payoff function of B with respect to the
ceptions, where corruption is defined as the exercise of public power for action of A and his or her own action is positive. Strategic comple-
private gain, with higher values corresponding to less corruption. mentarities, if strong enough, lead to multiplicity of equilibria.
7. They argue that the liberal reforms implemented in the mid- 15. The prospect of shame or potential stigma and guilt has a
1980s were an attempt to reduce the regulatory intent and, at the similar effect. The more likely an individual believes it is that he or
same time, increase regulatory capacity. she will be condemned by others if caught, the more likely he or she
8. It should be noted that this last variable can be interpreted is to refrain from evading (Grasmick and Scott 1982; Kahan 2005).
plainly as the size of the state, which may or may not be correlated 16. The authors make these calculations with and without pen-
with enforcement capacity. sions. These figures exclude pensions because of the problems that
9. Share of informal economy (informality definition 1 through- exist in calculating how much people who receive the transfer had
out the text) is the Schneider measure of the average size of the infor- paid during their working lives. In any case, the inclusion of
mal economy. The share of self-employed (informality definition 2) is pensions--evenly if precisely calculated--will imply that social
the ILO measure of self-employed workers in the workforce. The spending would be even more biased toward the rich.
share of person without access to pension is computed based on 17. For further discussion, see Go�i, L�pez, and Serv�n (2006).
WDI and Centro de Estudios Distributivos Laborales y Sociales 18. High quality of institutions may explain the fact that, in
for 14 Latin American countries (informality definition 3). These Chile, high income inequality is not translated into lower trust in the
definitions are similar to those discussed in chapter 1. state, low tax morale, and, consequently, high informality.
10. This is probably capturing Latin American higher levels of 19. This section draws heavily on Saavedra and Tommasi (2007).
inequality because the coefficient is not robust to the inclusion of that 20. In the specific case of pensions, privatization from pay-as-you-
variable. go systems has not always implied an increase in trust in the system
11. This increase is after several years of declining tax revenues and uncertainty about future benefits, and political--and, in many
caused by low growth, high inflation, and ineffective collection countries, economic--risk has not diminished (Kay 2003; Spiller and
efforts. Tommasi forthcoming); so "private options" may imply alternatives,
12. Tax morale information is collected in the World Values Survey such as old-age savings accounts in foreign financial institutions,
and the Latinobarometro, which are representative surveys collected in other assets, or reliance on family networks for the provision of
80 (worldwide) and 17 (Latin American) countries. At the national protection in old age.
level, these surveys have a sample size of at least 1,000 observations 21. In many cases, like Argentina--and unlike Chile--(Bergman
per country. Both the values survey and Latinobarometro ask the ques- 2002, 2003), there is a negative peer-pressure effect in which tax
tion, "Could you tell me in a scale from 1 to 10 (where 1 is never jus- evasion has wide social acceptance, particularly among the better-off
tified and 10 is totally justified) whether you think it is justified to populations.
245
I N F O R M A L I T Y
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nformality is a manifestation of a flawed relationship between citizens
I
and their state. While the term means different things to different peo-
ple, it almost always has negative connotations--including inferior
working conditions, low productivity businesses, unfair competition, and
disrespect for the rule of law. It is not surprising then that the rise observed
in informality in Latin American and Caribbean countries over recent decades
has garnered attention as a potential brake on improvements in growth and
social welfare, and as a force corrosive to the integrity of society.
Informality: Exit and Exclusion analyzes informality in Latin America,
exploring root causes and reasons for and implications of its growth. The
authors use two distinct but complementary lenses: informality driven by
"exclusion" from state benefits or the circuits of the modern economy,
and driven by voluntary "exit" decisions resulting from private cost-benefit
calculations that lead workers and firms to opt out of formal institutions.
They find both lenses have considerable explanatory power to understand
the causes and consequences of informality in the region. Informality: Exit
and Exclusion concludes that reducing informality levels and overcoming
the "culture of informality" will require actions to increase aggregate pro-
ductivity in the economy, reform poorly designed regulations and social
policies, and increase the legitimacy of the state by improving the quality
and fairness of state institutions and policies. Although the study focuses
on Latin America, its analysis, approach, and conclusions are relevant for
all developing countries.
Informality: Exit and Exclusion will be of value to professionals and academ-
ics studying labor market, social protection, tax, microenterprise develop-
ment, and urban public policies, and to those working in government,
international organizations, research institutions, and universities.
ISBN 0-8213-7092-8