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

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

3. 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. 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: dont need/want State programs, dont 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. 5 The Informal Worker Comparative Advantage and Constraints

6. 6 3 margins of informality Maloney 2006)

7. 7 Intrafirm Margin-not central story

8. 8 Intrafirm Margin-not central story Most informal workers found in small firms The allocation of Informal Workers across firm size 75% of Mexican and Argentine in firms of at most 5 workers However, expansion in large firms in Arg, Bra over 1990s

9. 9 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.

10. 10 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

11. 11 Two Distinct Types of Informal Worker Distribution of informal workers in Latin America % Not Contributing to Social Security System

12. 12 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)

13. 13 Microfirm Dynamics: Similar to mainstream firms MEXICOUNITED STATES Firm Entry, Exit, Participation by Age SE Rate Exit Rate Entry Rate SE Rate Exit Rate Entry Rate Age

14. 14 Workers tell us of both exit and exclusion 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 Self-rated Poverty Relative to Formal Workers Source: (Arias 2007)

15. 15 Labor Dynamics- The New Frontier

16. 16 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

17. 17 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.

18. 18 Worker transitions often suggest voluntary entry Mexico Self Employment to Formal Salaried Formal Salaried to Self Employment Source: Bosch and Maloney (2008)

19. 19 And perhaps exclusion after reforms in Brazil Brasil SE to Formal Formal to SE Constitutional and Commercial Reforms Bosch, Goñi, Maloney (2007)

20. 20 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)

21. 21 Job separations: IS most volatile 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! Source: Bosch and Maloney (2008) IS SE FS

22. 22 Job Finding Rates: FS most volatile 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. Mexico Brazil IS FS SE IS FS SE Source: Bosch and Maloney (2008)

23. 23 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.

24. 24 Why is informality sometimes Procyclical Procyclical/IntegratedCountercyclical/Segmented

25. 25 Why is informality sometimes Procyclical Procyclical/IntegratedCountercyclical/Segmented

26. 26 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

27. 27 What drives longer term behavior?

28. 28 Why does it decrease with development? 2 Measures of Informality vs Income per Capita Def: Legal/Social ProtectionDef: Productive

29. 29 But nature of regulation matters too Bad quality services and protections- why bother being formal But regulation matters too Loayza et al (2006) poor govt and heavy regulation increase size

30. 30 Brazils 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)

31. 31 Constitutional change or trade reforms? Regression analysis

32. 32 Actual and predicted size of the formal sector in Brazil

33. 33 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 SMEs, Improve quality and fairness of institutions and policies and even handed enforcement: move social norms towards a culture of compliance. A potential virtuous circle