Labor Informality

1. Labor Informality Bill Maloney LCRCE www.worldbank.org/laceconomist www.worldbank.org/wmaloney

2. Informality is a poor country issue, no matter how it is measured. 2 Measures of Informality vs Income per Capita Def: Legal/Social Protection Def: Productive

3. Why do we care? • Unprotected workers: issue of welfare, equity and efficiency • Productivity: firms too small? Barriers to growth? • Indicator of regulatory distortions • Low and distorted tax collections and poor provision of public services • Weak rule of law and Governance: A problem in our social contract?

4. Exit and Exclusion • Traditional exclusion view of informality • Labor: inferior jobs in a segmented market • Firms: denied access to services by high entry costs (de Soto) • Exit view: agents analyze costs vs. benefits of becoming formal • Labor: informality offers flexibility, avoidance of poorly designed benefits programs, and provides “decent” work • Firms: don’t need/want State programs, don’t pay for them • Larger firms and individuals: Why pay taxes if can avoid? • Both exist to varying degrees across countries but have different implications for policy

5. The Informal Worker Comparative Advantage and Constraints

6. 3 margins of informality Maloney 2006)

7. Intrafirm Margin-not central storyMost informal workers found in small firms • 75% of Mexican and Argentine in firms of at most 5 workers • However, expansion in large firms in Arg, Bra over 1990s The allocation of Informal Workers across firm size

8. Intersectoral (de Soto) Margin (firms) -How many are close to becoming formal? • Firm size determined by cost structure (Lucas 1978)- many may not be close to margin • MX: “Reason for not registering” (Woodruff and McKenzie 2006) • 75% “business is too small” • ~10%- cost of registration, compliance too high • Fajnzylber et al (2006): little “dynamism” in small firms • MX: lowering of registration/compliance costs leads to small and temporary change in registration- .2% of stock of informal. (Kaplan et. al 2006) • BR: Fajnzylber et al (2007) small reaction to SIMPLES program. • Evidence to date suggests that this is not the critical margin.

9. Intersectoral (worker) margin: Competing theories • Disadvantaged group of a segmented labor market • Formal: Protected sector/High productivity/Good jobs • Informal : Disguised Unemployment/Low productivity • Queuing to get job in the formal sector, worse in downturns. • Alternate view here: workers choose among differing job characteristics (Lucas again) • Unregulated largely voluntarily microfirm sector. • Entrepreneurs weigh pros and cons of formality • Firms may have little potential for growth • Similar to job-job transitions in US • Conditional wage comparisons are faux amis: Need to look at other indicators, in particular, labor flows

10. Two Distinct Types of Informal Worker Distribution of informal workers in Latin America % Not Contributing to Social Security System

11. Role of Each Changes across Life-Cycle • Informal Salaried • port of entry for youth • accumulate experience for Formal Salaried or independent work • Most in micro firms • Self Employment • prevalent among prime or older • have capital and skills to open a business Mexico: Employment as share of age cohort Cunningham (2007)

12. Microfirm Dynamics:Similar to mainstream firms Mexico United States 60 60 50 50 40 40 Percent Percent 30 30 20 20 10 10 Age Age 0 0 18-20 21-25 26-30 31-35 36-40 41-45 46-50 51-55 56-60 61-65 18-20 21-25 26-30 31-35 36-40 41-45 46-50 51-55 56-60 61-65 Entry Rate Exit Rate Self-employment Rate Entry Rate Exit Rate Self-employmentRate Firm Entry, Exit, Participation by Age MEXICO UNITED STATES SE Rate Exit Rate Exit Rate SE Rate Entry Rate Entry Rate Age Age

13. Workers tell us of both exit and exclusion Self-rated Poverty Relative to Formal Workers • Most (~2/3) of independent workers are voluntary • not queuing for formal jobs • value flexibility, esp. women • opting out of Social Protection • Most Informal Salaried are involuntary • would prefer to be FS or SE • Exceptions Dominican Republic, Mexico • youth: difficulty entering workforce Source: (Arias 2007)

14. Labor Dynamics- The New Frontier

15. Mainstream debate on Gross Worker Flows across the cycle • Implications for role of informality • Nature of the adjustment process • Blanchard and Diamond (1990) • Increase in unemployment was due to the increase in the number of people entering the unemployment pool. • Davis and Haltiwanger (1990, 1992) highlight the importance of job destruction in recessions • Stylized fact drives modern models of search such as Mortensen Pissarides (1994). • Shimer (2005) differs: Acyclical separation rates; Procyclical job finding rate

16. Data: Rotating Panels • Mexico 1987-2002, ENEU (Urban Employment Survey) • 16 major cities in Mexico • Brazil: 1980-2002, PME (Monthly Employment survey) • 5 large metropolitan areas • Permit following workers across: • Formal, Salaried, Informal Salaried and Informal Self employed sectors • Unemployment and inactivity • Following Geweke (1986) map discrete transitions probabilities to continuous time model.

17. Worker transitions often suggest voluntary entry Mexico Formal Salaried to Self Employment Self Employment to Formal Salaried Source: Bosch and Maloney (2008)

18. And perhaps exclusion after reforms in Brazil Brasil Formal to SE SE to Formal Constitutional and Commercial Reforms Bosch, Goñi, Maloney (2007)

19. The Role of Informality in the Adjustment Process • Modern literature focuses on dynamics • “Stock” of unemployment, informality a function of job finding and separation rates • US literature- • Volatility of job finding rate across cycle higher than of separation rate. • So movement in unemployment due to less hiring, rather than more firing (Shimer)

20. Job separations: IS most volatile IS IS SE SE FS FS Source: Bosch and Maloney (2008) • Formal job separations similar to the US. (Countercyclical, low volatility) • Job separation in the informal salaried sector is much higher than in the formal sector, and jump more in downturns. • In MX: U driven by IS separations!

21. Job Finding Rates: FS most volatile Mexico • Job Finding in the formal sector is high volatility and highly pro-cyclical similar to the US. • Job finding rates in the Informal sectors are reasonably constant. Brazil IS IS FS FS SE SE Source: Bosch and Maloney (2008)

22. Updated view of cyclical adjustments of LDC labor markets • Volatile Formal JF + Constant Informal JF means informal often expands in downturns. • But, why do JF patterns differ across sectors? • Exactly analogous to US debate. • Shimer (2005):standard search models cannot explain the magnitude of the fluctuations in job finding rate. • Efforts to fix models • Shimer: extreme wage rigidity? • Mortensen and Nagypal (2005):maybe not-information assymetries etc.

23. Why is informality sometimes “Procyclical” Procyclical/Integrated Countercyclical/Segmented

24. Why is informality sometimes “Procyclical” Procyclical/Integrated Countercyclical/Segmented

25. Implications • Shows net voluntary entry • Modeling (Fiess, Fugazza, Maloney (2007) • Depend on positive shocks • To Formal/Tradable • To Informal/Nontradable • FS rigidities less binding in booms • Increase in Informality in early 1990s • Boom in nontradables: • REER appreciation due to boom in capital inflows: • opening of Capital account, Exchange Rate Based Stabilization, improved expectations due to reforms

26. What drives longer term behavior?

27. Why does it decrease with development? 2 Measures of Informality vs Income per Capita Def: Legal/Social Protection Def: Productive

28. But nature of regulation matters too • Bad quality services and protections- why bother being formal • But regulation matters too • Loayza et al (2006) poor gov’t and heavy regulation increase size

29. Brazil’s increase? Constitutional change or trade reforms? Dynamic Panel: 18 Industries, Yearly 1983-2002 Trade Liberalization: • Import Penetration: Muendler (2002) • Real effective trade protection rates: Kume et al. (2003) Constitutional Changes: • Firing Costs: average tenure (in years) of workers fired (average 1983-1987, source: PME) • Overtime: proportion of workers working more than 44 hours (average 1983-1987, source: PME) • Union density: % of unionized workers (average 1986 and 1988, source: PNAD)

30. Constitutional change or trade reforms? Regression analysis

31. Actual and predicted size of the formal sector in Brazil

32. Policies to Reduce Informality • Reduce opportunity cost of informality: raise productivity in the formal sector • improved Investment Climate • higher human capital accumulation • Remove segmenting distortions in labor markets where applicable • Tilt the benefit/cost ratio of firms and workers to opt for formality: • removing distortionary incentives in Social Protection Systems, • reducing cost of doing business for all firms • improving services associated with formality especially for SME’s, • Improve quality and fairness of institutions and policies and even handed enforcement: move social norms towards a culture of compliance. A potential virtuous circle