Social spending, regulations, labor supply and informality
This chapter will try to answer the question: to what extent governments’ decisions create
incentives for the households to provide their labor supply in a way that contributes in a
less-than-optimal way to productivity and growth?
A conceptual framework
First, in order to properly asses the scope of the question posed for this chapter it is worth
to describe first the relevant actors involved and their range of actions. The three main
entities that will play a role here are: the Government, Households and Firms:

The government makes decisions in three different arenas: fiscal, legislative and
institutional. On the fiscal arena the government decides how much money they
raise through taxation and how to spend it: investing in infrastructure, human
capital formation and social programs. In legislative terms the government
determines a set of rules-of-the-game for the labor market, the markets for
financing and the markets for final products. The institutional setup of the
economy depends on the decision making done in the two previous arenas and the
governments’ efforts to maintain macroeconomic fundamentals, rule of law and
socio-political stability.

Households make decisions on their labor supply, which involves: (i) to allocate
income-generation roles within the household (that is, decide who works and who
does not within the household and how intensively those who work do it), (ii)
decide the extent to which they take jobs that are covered by social security and
non-wage benefits, (iii) decide the extent to which they work under a dependant
relationship or they decide to be entrepreneurs (either with or without dependants)
and (iv) decide to form unions.

Firms make decisions on the capital markets, the labor markets and the markets
for their final products. On the capital markets they decide how to raise
investments and credit. On the market for their final products they decide the
scale of production and their competitive strategies. The extent to which firms
make decisions on the labor markets involves: deciding periodically on the
number of workers to hire and fire, the degree of formality in which they are hired
(social security coverage) and investments in their human capital accumulation
(training).
The diagram below graphically illustrates the description of the actors and their range of
actions
Dependance
relationship/
entrepreneurship
Formality
(SS coverage)
HOUSEHOLD
DECISIONS
GOVERNMENT
DECISIONS
PRODUCTIVITY
AND
GROWTH
Unions
FIRM
DECISIONS
Fiscal
Legislative
- Labor Market
- Spending (Social,
Infraestructure)
- Investment promotion
- Taxes
- Final goods
Institutions
Hiring
(formal/informal)
Investment,
R&D
Within this setup, the question of interest for this chapter can be properly contextualized
and put in perspective regarding the other chapters of the book: this chapter will inquire
for the impact of the social spending and legislative decisions of the governments
(extreme south-west of the diagram) on the labor decisions of the households (extreme
north of the diagram).
More specifically, the mechanism through which we hypothesize the impact gets
transmitted goes in the following way: if governments cover a substantial portion of the
social protection that workers get regularly covered through their jobs, the individuals
would have less incentives to look for jobs with social security benefits (i.e. formal).
Additionally, if the regulation is such that the firms’ cost of labor force gets reduced
substantially if they hire informally and/or firms’ benefits of formality are low, the firms
would also face important incentives to go underground.
A potential structure for the chapter goes as follows:
a) The potential link between uninsured risk, social protection policies and
productivity levels and growth. We will try to posit a model with which
understand some of the relationships among the decision of the actors enunciated
above.
b) The structure of social protection spending and labor regulations in the region.
c) Empirical evidence for the link between government decisions and household
decisions. Part I: cross-country evidence. Are the effects equal across types of
workers, types of firms, sectors and countries?
d) Empirical evidence for the link between government decisions and household
decisions. Part II: intra-country evidence.
e) Policy implications. Which countries/sectors/types of workers would benefit the
most from social policy reforms and what type of reforms would be necessary?
What can be measured?
The evidence that this chapter will gather to answer the question of interest can be
classified in two groups: cross and intra country.
For the cross country evidence we already accessed data on yearly social spending for
16 Latin American countries between the years 1990 and 2005 (for a shorter time span,
2000-2005, we have data for 20 countries). The data (which has been gathered by the
ECLAC’s Social Panorama for Latin America) groups social spending in four main
categories: health, education, housing and social security. The graph below shows the
evolution of social spending (measured in U.S. dollars of year 2000) per habitant in the
sample that comprises the longer time span. The same information on social spending is
also available as percentages of GDP.
Evolution of Social Spending (per capita)
Weighted average for 16 countries
[Dollars of 2000]
800
700
600
500
400
300
200
100
0
1990
1992
1994
1996
Social Security
1998
Housing
2000
Education
2002
2004
Health
Countries: Argentina, Brasil, Chile, Colombia, Costa Rica, Cuba, Dominican Republic, Ecuador, Guatemala,
Honduras, México, Panamá, Paraguay, Perú, , Uruguay and Venezuela
With this data, and based on information about: (i) socio-demographic characteristics and
participation in social programs (obtained from the National Household Surveys, stored
at the Bank’s MECOVI server), and (ii) eligibility rules of the social programs and social
spending; we will infer partitions of the “pie of social spending” per country by different
segments of the population. We will try to disaggregate it as much as possible for the
maximum possible number of countries. However, there is a balancing act to be played
here as the finer the level of disaggregation of social spending, the lower the number of
countries that we will be able to analyze in parallel.
On the other hand, based on information from the same National Household Surveys, we
will compute statistics abut the composition of the labor force per country: by the same
socio-demographic characteristics to be used in the previous paragraph and by
employment status, social security coverage and dependence relationship.
Additionally, we will gather comparative information on labor markets regulations for the
countries in the region. Fortunately, we will have a solid departure point for this aspect of
the data collection: the indicators of job security developed by Heckman and Pages
(2000, 2003). We will try to expand the countries and time span covered by the
indicators. It is worth noting that these papers already document a large negative effect of
job security regulations on employment.
With these sources we plan to craft a data set of social spending and labor market
participation for different segments of the population for a set of Latin American
countries. With this data set we plan to arrive to assessments of the type “countries that
spend more/less on xxx or regulate along the lines of aaa, bbb or ccc tend to have
higher/lower labor supply for yyy and zzz segments of their populations”.
For the intra country evidence we will explore an answer to the question with two
parallel approaches. On the one hand, we will analyze switches formality-informality and
dependant-entrepreneurship, as in Levy (2008) and Ñopo and Valenzuela (2007). We will
pay particular attention to the determinants of the switches and explore the role of
governments’ decisions within it.
For this purpose we count with panel data of workers from Chile, Nicaragua and Mexico.
On the other hand, we will explore the literature that exploits within country sources of
variation of social spending to identify changes in labor supply, as in Camacho and
Connoly (2008) and Pages et al. (in progress) or the role of labor regulation on turnover
and labor supply dynamics, as in Kugler (1999).
For this part of the chapter we will also receive inputs form Cesar Bouillon regarding
conditional cash transfers, welfare dependence and their role of labor supply decisions of
the households.
Logistics.
- On October 14th we will present an advance of the results at the BBL IPES’
seminar.
- By that time we should also have a clear idea of how much of the work required
to write this chapter we would like to outsource and how. Meanwhile, with Juan
Pablo and me, we are fine.