What is the role of informality in developing countries?

Responsible researcher: Viviane Pires Ribeiro

Paper Title: Wages and Informality in Developing Countries

Authors: Costas Meghir, Renata Narita and Jean-Marc Robin

Intervention Location: Brazil

Sample Size: Not specified

Big topic: Job Market

Variable of Main Interest: Informality

Type of Intervention: Impacts of informality

Methodology: Economic model

The informal economy is a large component of many developing countries and even some Organization for Economic Co-operation and Development (OECD) countries. Given the great relevance of the informal sector to the economies of these countries, Meghir et al. (2015) develop an equilibrium wage distribution model with heterogeneous companies that decide to locate in the formal or informal sector and workers who randomly search within and outside the sector. The results of the study suggest that strengthening supervision does not increase unemployment, however, it increases wages, total production and well-being, allowing a better allocation of workers to higher productivity jobs and improving competition in the labor market. formal.

Assessment Context

Informality is extremely common in developing countries. However, its effects are still not well understood. In Brazil, for example, more than 40% of the entire workforce is employed in the informal sector. Companies operating in this sector do not comply with labor market statutes, including minimum wage laws and dismissal regulations, and do not pay social security contributions of any kind. It is often argued that, as a result, such companies are the engine of economic growth because they lead to effective deregulation of the labor market, improving flexibility and reducing labor costs.

However, informality means that workers are excluded from a series of benefits, including health insurance and unemployment insurance. Additionally, no income and corporate taxes are collected by the government, thus reducing the size of the tax base. Furthermore, since smaller companies can escape regulation more easily, informality can be seen as a subsidy for such companies, which in most cases are less productive. Therefore, understanding how these trade-offs balance each other and what they imply about the effects of informality is a fundamental policy issue for developing countries.

Intervention Details

The relative importance of job creation and deregulation through informality vis-à-vis the effects of search frictions is an empirical question. Thus, Meghir et al. (2015) use a model in which workers search for jobs randomly. Job offers take the form of a “take it or leave it” wage offer, which has been extended to allow for two sectors (formal and informal): companies, which are heterogeneous in productivity, can choose which wage to offer and in which sector operate. The model is motivated by the empirical observation that low-skilled workers are observed working in both formal and informal jobs and, due to productivity levels, some companies opt for informality while others become formal.

For study purposes, workers aged 23 (in which the chance of returning to full-time education is very low) to 65 years old were selected, who were unemployed, working as employees (with or without registration), or self-employed. A given worker was considered to be formal if he or she was a registered worker. The remaining workers – unregistered employees and self-employed – were considered informal. Throughout the sample period, it was considered that around 40% of workers were informal, 50% formal and the remainder were unemployed. The study focused on the low-skilled labor market, selecting workers with eight years of schooling or less.

Methodology Details

Meghir et al. (2015) developed an equilibrium wage distribution model with heterogeneous firms deciding to locate in the formal or informal sector and workers randomly searching in and out of work. The model was designed with Latin American economies in mind and, more generally, for economies where a substantial informal and formal sector flourish side by side and with great mobility between them. Allowing us to discuss the relative merits of increasing oversight in this context. The authors use data from Brazil, where informal work accounts for around 40% of the workforce. The main data source is the Monthly Employment Survey (PME), which provides a rotating panel of individuals sampled from the country's six main metropolitan regions.

The stationary equilibrium model is able to replicate key features of the data and provides a way to perform counterfactual analysis. In other words, the model considers the simplifying assumption that workers are homogeneous within a submarket, but that companies are heterogeneous. Thus, it is considered a group of low-skilled workers assumed to be homogeneous (conditional on gender and state of residence), who will normally be involved in jobs that require little training. The model explains the cross-sectional variance of wages by the dispersion of productivity between companies. In general, it is not possible to separately identify the contribution of unobserved worker and firm heterogeneity without corresponding employer-employee data. However, there is suggestive evidence that skill heterogeneity is much less important for low-educated workers.

Results

The results suggest that in a market with search frictions, the informal sector has important detrimental effects: by endogenously segmenting the labor market, competition for workers is reduced and it is more difficult to locate workers in companies with higher productivity. Increasing the costs of informality improves the allocation of workers to better companies, increases wages and general well-being. Interestingly, policies to reduce informality do not increase unemployment. One reason for this is that companies are getting very high rents and can absorb the rising cost of regulation.

In equilibrium, the lower part of the productivity distribution is filled only by informal firms, since regulatory costs (such as the minimum wage) are too high to make formal employment profitable. However, in a large segment supporting productivity distribution, formal and informal enterprises coexist and profits are equalized across sectors (given productivity). The greater probability of detection for larger informal firms, coupled with regulatory costs, means that informal firms are much more prevalent at lower levels of productivity and are much smaller. Formal companies are more productive, pay better and become larger. The end result is that search frictions increase the prevalence of low-productivity firms, which also reduces the likelihood that workers will match with higher-productivity firms, thereby reducing output.

Public Policy Lessons

Meghir et al. (2015) offer a new perspective on informality that can explain important facts, namely that low-skilled workers can be found in both the formal and informal sectors, and, in fact, move between both sectors, while at the same time , the informal sector pays substantially less than the formal sector. The key element of the model developed by the authors is the search frictions that generate profit opportunities for companies to advertise jobs in both sectors. Specifically, identical low-skilled workers search randomly (within and outside the sector) and may receive offers from formal or informal firms, which are heterogeneous in their productivity.

Search frictions imply that firms at a given level of productivity can earn positive profits in both sectors, accounting for compliance costs in terms of fines for those informal firms that are fined. This is because, in a world where all companies are formal, a given company can deviate and be informal, avoiding all the costs of regulation without having to fully compensate workers for the loss of benefits (social security contributions, compensation, etc.). ), since the search, friction prevents workers from immediately locating a better alternative. This may continue until there are a significant number of informal businesses for wages to be competitive enough to equalize profits between the formal and informal sectors. The extent of friction in the formal and informal sector determines the extent to which wages in the two sectors may diverge and the prevalence of informality at each level of productivity.

The greater allocation of workers to low-productivity jobs caused by informality reduces output and therefore welfare, despite reducing the coverage of costly regulation. The results show that reducing informality by increasing supervision does not increase unemployment and increases well-being by allowing the reallocation of workers to higher productivity jobs. As a consequence, overall wages increase and inequality decreases. Of course, these results hold labor market regulation fixed and it may yet be that greater welfare gains can be achieved from deregulation. However, it appears that an in-between world where the informal sector is tolerated at current levels of enforcement is not a welfare-enhancing policy.

References

MEGHIR, Costas; NARITA, Renata; ROBIN, Jean-Marc. Wages and informality in developing countries. American Economic Review, vol. 105, no. 4, p. 1509-46, 2015.