Informality:
What it is,
What to do about it?
Carmen Pagés &
Stefano Scarpetta
The World Bank
December , 2004
The WB work on the labor
market research strategy
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Poor labor market outcomes in many
countries: unemployment, underemployment, exclusion
Over the past two years we have
launched a thorough analysis of the
functioning of LM and policy
challenges
Regional stock taking papers prepared
and discussed in November 2004
In all of these regional papers,
informality has emerged as one of the
key policy issues
Informality is persistent even in
countries with sustained growth
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How do we measure informality?
 Great heterogeneity within most informal
economies
What drives drive/cause the different “types”
of informality?
 Exclusion vs choice,
 … also related to regulations in product
and labor markets
Need to understand the consequences of
informality on individuals and the economy
Can we design social protection schemes for
those excluded from the formal sector?
This presentation:
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What is informality?
Theories of informality
Recent empirical evidence
New evidence based on social
security coverage in LAC
Extending evidence to other regions
First problem: What is informal
employment?
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Multiple definitions, only some overlap:
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Self-employed and workers in household
enterprises (<5 w)
Workers without formal contract
Workers without access to social
protection and other mandated benefits
Workers employed in registered firms
Cross-country data is not comparable
New forms of informality?: Part-Time,
Temporary, fixed-term contracts.
What causes informality?
Two groups of
(not necessarily
competing)
theories:
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Exclusion
Choice
What causes informality?
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Exclusion: Wage rigidities
prevent market clearing. In
economies without UI,
workers resort to informal
jobs to survive
 Informal jobs are worse
type of Jobs.
Harris-Todaro (1970); Fields (1972)
What causes Informality?
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Choice:
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Firms: Costly regulations push firms to
become informal  Firms may do
better, but informal sector jobs are bad.
Productivity costs for firms who want
to remain inconspicuous.
Workers: Workers move voluntarily to
informal jobs to improve their lot (less
taxes, more independency and
flexibility)
Maloney (1999)
What is the empirical evidence?
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Traditionally, empirical evidence on
informal employment focused on
testing for wage differentials.
But many problems in this
estimation due to self-selection
issues
Maloney 1999 convincingly argues
against wage differentials as valid
evidence  wage differentials do
not measure welfare differentials.
Recent empirical evidence for LAC
does not fit with exclusion hypoth.
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There is high mobility between formal
and informal jobs
Maloney (99, 05), IADB (03) ARG, MEX, BRA
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For Mexico, some evidence suggests
segmentation for skilled but not for
unskilled labor
Gong X. and A. van Soest (02, 04)
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For Mexico, flows from F to I and from I
to F decline in recession/increase in
expansionary times. Transitions during
recessions were to U not to I.
Bosh and Maloney (05)
Recent empirical evidence for LAC
does not fit with exclusion hypoth.
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Minimum wages are equally or
more binding in informal than in
formal sector. Maloney and Nuñez (2004)
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Wages decline with social security
tax increases; wages are lower in
jobs that provide access to social
security.
Marrufo (2004)[Mexico] Gruber (1997) [Chile] and
Edwards and Edwards (2002) [Chile], Mondino and
Montoya (2004) [Argentina]
In summary:
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Some evidence of segmentation (for
high skilled workers), but much
evidence does not fit with simple
theory that workers move to
informal jobs to eke a living
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Evidence only available for a few
Latin American countries, need to
come up with evidence from other
regions/countries
New evidence based on SS
coverage in LAC
Proportion of workers contributing to social security
Chile
Brazil
Costa Rica
Argentina
Mexico
Venezuela
El Salvador
Colombia
Nicaragua
Peru
Paraguay
0
10
20
All workers
LAC Household Surveys
30
40
50
60
Salaried workers - Private sector
70
80
New evidence based on SS
coverage in LAC
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We examine what explains the patterns of
coverage at the individual level for a sample
of 11 LAC countries using micro data.
Want to understand why so few people
participate. Is it that:
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They choose not to participate? (they don’t
value the protection offered by SS, i.e.
costs>benefits, or they are myopic)
They are rationed because they could not find
a good job with benefits?
New evidence based on SS
coverage in LAC
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Whether is Exclusion or Choice has important
implications for policy design:
1.
Exclusion: Basing social protection provision
on labor market participation limits access.
Need to delink social security provision from
labor market.
2.
Choice: System is poorly designed. Systems
need to be amended to attract more
participants
3.
Choice: People are myopic. Need to
improve enforcement.
Public discussion emphasizes 1 in developing
countries and 3 in more developed ones.
In all countries less advantaged workers are
less likely to participate in SS. Exclusion?
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Individual and household characteristics
account for more than 30 percent of
explained variance in SS participation.
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Yet, coefficients in a Probit need to be
interpreted carefully, for instance:
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Importance of individual characteristics like
education may just reflect high correlation
between education and some job
unobservables (i.e. having a formal contract)
From a Probit alone is difficult to infer Choice
or Exclusion.
Less advantaged salaried workers are less
likely to participate in SS. Exclusion?
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We compare the choices of the self-employed
for whom participation is voluntary and
unrestricted by employers with the choices of
salaried employees (compulsory).
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We find contribution patterns of self-employed
to be highly similar to the ones of salaried
workers. Correlation above .7 (1%) in all
countries examined.
We interpret these findings as evidence that
there is an important component of CHOICE
…Less advantaged workers are less
likely to participate in SS. Exclusion?
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But also evidence suggests exclusion for
some workers:
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Salaried Workers with earnings below the
minimum wage
Salaried Workers in part-time jobs
Externalities among different forms of evasion,
evading on MW leads to evasion in SS;
Also, part-time work seems to be an
instrument of evasion
Implications of new evidence
based on SS coverage
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Evidence of both choice and exclusion.
Need to learn more on whether
individuals/households are myopic, or
rather find alternative (and better) ways to
protect themselves against risks
Need to consider effect of MW on
informality.
Need to make part-time work less prone
to evasion.
Implications of new evidence
based on SS coverage
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If people opt out because they the current
system don’t satisfy their needs,
Increasing enforcement may reduce
welfare and employment.
If people opt out because they are
myopic, more enforcement may increase
welfare & formality, but at the cost of
lower employment.
Given low capacity to enforce, social
security programs may need to be more
self-enforceable.
Ongoing project—
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Seeks to analyze whether results found for some
countries in LAC generalize to other countries in
ECA and also LAC
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Seeks to understand what drives cross country
differences:
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Differences in levels of informality: High in LAC, low in
ECA.
Differences in mobility and wage differential patterns
Seeks to identify who are the vulnerable workers
in the labor market and which policies can better
help them.
Ongoing project
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It follows recent literature:
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Examines mobility patterns: Computing
transition matrices, estimating multinomial
dynamic logits
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Examines wage, consumption and welfare
differentials across transitions: Estimating
wage change models.
Focuses on countries for which panel
data exists
Issues for discussion:
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What drives drive/cause the different “types” of
informality?
 Exclusion vs choice,
 … related to regulations in product and labor
markets
Need to understand the consequences of
informality on individuals and the economy
What are the most promising avenues of research?
Can we design social protection schemes with a
wider reach?