Informality: What it is, What to do about it?

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 • Poor labor market outcomes in many countries: unemployment, under-employment, 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 • 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: • 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? • Multiple definitions, only some overlap: • 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: • Exclusion • Choice

What causes informality? • 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 causesInformality? • Choice: • 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? • 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. • There is high mobility between formal and informal jobs Maloney (99, 05), IADB (03) ARG, MEX, BRA • For Mexico, some evidence suggestssegmentation for skilled but not for unskilled labor Gong X. and A. van Soest (02, 04) • 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. • Minimum wages are equally or more binding in informal than in formal sector. Maloney and Nuñez (2004) • 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: • 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 • 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 LAC Household Surveys

New evidence based on SS coverage in LAC • 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: • 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 • Whether is Exclusion or Choice has important implications for policy design: • Exclusion: Basing social protection provision on labor market participation limits access. Need to delink social security provision from labor market. • Choice: System is poorly designed. Systems need to be amended to attract more participants • 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? • Individual and household characteristics account for more than 30 percent of explained variance in SS participation. • Yet, coefficients in a Probit need to be interpreted carefully, for instance: • 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? • We compare the choices of the self-employed for whom participation is voluntary and unrestricted by employers with the choices of salaried employees (compulsory). • 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? • But also evidence suggests exclusion for some workers: • 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 • 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 • 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— • Seeks to analyze whether results found for some countries in LAC generalize to other countries in ECA and also LAC • Seeks to understand what drives cross country differences: • 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 • It follows recent literature: • Examines mobility patterns: Computing transition matrices, estimating multinomial dynamic logits • Examines wage, consumption and welfare differentials across transitions: Estimating wage change models. • Focuses on countries for which panel data exists

Issues for discussion: • 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?

Informality: What it is, What to do about it?