Do economic reforms hurt or help the informal labor market?

Why the informal labor market?

In developing and transition economies, the formal labor market is typically shallow, leaving a large share of the workforce outside of centralized collective bargaining arrangements and entitlements to institutionally recognized benefits. On average, 70% of the labor force is beyond the reach of these protections [8].

Urban informal sector employment in Southeast Asia, Eastern Europe, Africa, and Latin America ranges from 15% to 20% in Turkey and Slovakia to 80% in Zambia and about 83% in Myanmar. Figure 1 offers a cross-country comparison of informal employment between 2004 and 2010. Informal employment has been rising in African and Asian countries and falling in South American and European countries. Given this cross-country distribution, what happens to the level of informalization when economic reforms are implemented? For some countries, as discussed below, informal activities expand following reforms. The question then is whether wages fall with this expansion of the informal sector as laid-off workers in the formal sector move into the informal sector? Studies have found that when trade reforms result in the contraction of protected and often state-run formal industries and services and lead to layoffs and worker movement into the informal sector, wages can rise along with employment if capital is also able to relocate to the informal sector [3], [5].

Workers in the informal sector are sometimes identified as marginalized, underprivileged, and victims of the fallout of free-market mechanisms. However, while working conditions in the informal sector can be substantially below desirable standards and raising them to an acceptable level is important, this sector may still benefit from a more open and liberal economic environment. While many informal sector workers deal in non-traded commodities and services, such as street vending and domestic work, in many countries they produce intermediate goods, processed exports, and import substitutes under subcontract to formal firms (see [9] for a surprising array of commodities produced by informal producers in India). Other informal industries produce garments, leather goods, small tools, and machinery that they export directly—often bypassing formal regulations and procedures by trading informally across borders to adjacent areas. In addition, in most developing countries, agriculture, animal husbandry, and the production of primary commodities and non-durables are predominantly outside the formal sphere.

Industrial and trade reforms can significantly affect these extensive activities and the level of informal employment which is important for broadening the scope of policy options. Given the large share of employment in these sectors, even small positive gains in the real wage can increase the welfare of millions of people in developing and transition economies.

Effects of trade reform and capital flows on the informal labor market

Many developing countries have been experimenting with trade reforms for decades. As countries open their borders to foreign competition and governments reduce financial support to favored industries, the no longer protected industries contract, releasing large amounts of capital and labor to shift to more profitable ventures. At the same time, predominantly service-oriented industries that face less stringent labor laws and industrial regulations begin to expand. Because most of the laid-off workers in typical import-competing public or private enterprises are not a good fit for jobs in these (new) service industries, which rather recruit high-skilled professionals with advanced technical expertise, a large share of the newly available labor and capital flows into informal businesses.

When formal sector industries feel the impact of economic reforms and shift some of their production to the informal sector, productivity and wages will fall in the informal sector if there is no new investment to support the shift in employment to the informal sector. For example, when the informal sector uses labor-intensive production techniques to produce commodities that are easily substitutable for each other, capital mobility between formal and informal sectors will be low [3]. In contrast, when capital is free to move between sectors, along with labor, productivity and wages will rise. A similar outcome occurs when foreign capital is invested in formal production and service units in low-wage countries. To remain competitive in the face of rising wages for skilled workers in formal enterprises, these firms may outsource some of their production to informal firms, along with infusions of technology and capital.

While the empirical evidence at the country level for these theoretical impacts of trade and labor market reforms on informal labor is still slight, a few studies have enriched the scope and understanding. One study posits that trade liberalization has an ambiguous effect on the informal sector based on an industry-level comparison between Brazil, where little or no connection was found between trade policy and informality, and Colombia, where liberal trade policies led to considerable expansion of the informal sector [10].

The inconclusiveness of this relationship warrants a re-evaluation of the issue both theoretically and empirically. Consider, for instance, the comparison between formal and informal production and how the interaction of two policy interventions (tariffs and interest rates) can yield different results than each policy would individually. Lowering tariffs is likely to expand informal production, while lowering interest rates is likely to expand formal production. In both Brazil and Colombia import tariffs on manufactured goods went down steadily between 1984 and 1998 (Figure 2), yet the economic performance of the informal sector in the two countries diverged. In contrast, the real interest rate behaved differently in Brazil and Colombia: while Brazil started on a path of lowering the real interest rate, with large changes between years, Colombia raised and then lowered its real interest rate as shown in Figure 3. This suggests that the gradual but clear impetus to formal entrepreneurship through cheaper credits helped the formal sector to expand in Brazil, while Colombia’s reversals of policy did not help the formal sector grow as much.

While it is possible to conclude from Figure 2 and Figure 3 that both countries reduced tariffs over time, only in Brazil did the fall in the real interest rate (and in the lending rate) offset the negative effects of trade reforms on formal sector jobs. In Colombia, cutting the real interest rate as part of the reform package has not been as influential, leading to an expansion of the informal sector following trade liberalization.

However, several other variables need to be considered as well in evaluating such results. In a large democracy like India, for example, informal activities are extensive and make a large contribution to national and regional income. With so many people directly and indirectly involved in the informal sector, further expansion of the sector as a result of economic reforms could put protection of property rights, enforcement of legal contracts, and the effectiveness of a weak legal system under heavy pressure. Many developing and transition economies around the world seem to be at risk of these outcomes [11].

The government’s role in the emergence and growth of the informal sector

In a democracy, the threshold between legal and extralegal can be a political choice, a thesis that has been somewhat neglected in discussions about the creation and persistence of dual (formal and informal) labor markets. One argument posits that lack of property rights and legal contracts in the informal sector blocks development [1]. Policies that guarantee property rights and enforce legal contracts, therefore, would release capital for investment and growth. Another study examines the intricacies of contractual arrangements to reflect on the boundaries between legality and extra-legality, which are often porous [11]. Other studies focus on the political rationale for perpetuating informal arrangements, proposing that democratic states with a high incidence of poverty and weak social welfare institutions may use the informal sector as a substitute for social security and a testing ground for innovative redistribution strategies other than tax policies. In that context, how strongly property rights are enforced becomes a strategic political variable. Allowing extralegal activities to flourish in a thriving informal sector may be a deliberate government strategy in a poor country since it helps to reduce problems of unemployment and poverty. In such cases, government policies can determine to some extent the size of the informal economy [12].

Thus, the jury is still out on whether the state as an authority can set limits on the use of public space for private consumption in developing countries. Multiple channels have been proposed as leading to informality among firms. For example, the quality of the legal framework is crucial for determining the size of the informal sector. If the legal system functions properly, then taxes and regulations are of limited importance to the size of existing informal firms or to expansion of the whole sector. Firm size and the degree of informality have been found to be negatively correlated, although stringent legal norms may still push larger firms into the informal sector. Examination of tax registration for firms in Bolivia, which has the largest informal sector in South America, finds that it leads to lower profits for smaller and larger firms but higher profits for mid-size firms. Very small (one-person) firms have little to gain from formalization. Neither do firms with up to six workers, which end up paying more in taxes without benefiting from an expansion in customers. The firms in the middle, in contrast, can grow bigger and reap higher profits as a result of the boost to their reputation and consumer confidence that comes from demonstrating compliance with tax laws.

Because the nature of informality is not the same in every society, neither is the appropriate role for government. In some societies, the level of governance has a substantial impact on the incomes of informal workers, while in others it has little impact. The fear of social unrest and political collapse may drive policies of extensive patronage of the informal sector. A democratic government facing a high level of poverty might choose lower taxes and weak governance as instruments to increase informalization of the economy. Such policies would then be an instrument of redistribution, working where lower taxes might not, and serving as a back-door approach to development. In societies where a change in the degree of governance has negligible impact on the incomes of informal workers, however, governments might choose higher levels of governance and tax rates.

Role of monitoring in the formal and informal sectors

Labor markets in many developing countries suffer from a range of rigidities, from regulations governing the hiring and dismissal of workers and working hours to minimum wage legislation and the strength of labor unions. If hiring and firing workers is costly and if businesses cannot easily be dissolved, for example, employment in the formal sector may decline and firms may resort to hiring workers under informal arrangements, especially if monitoring is weak and corruption is common. Thus, labor market reforms are expected to boost formal industrial employment by making labor market regulation more flexible. Although such policies apply directly only to the formal sector, which is small in developing countries, a more employer-friendly policy will lead to a rise in the informal wage by boosting demand for labor in the formal sector and drawing workers from the pool of informal workers.

The picture is more complex than this, however. Whether a particular reform benefits informal workers depends on whether and how capital moves across sectors. Formal and informal labor markets are closely linked in many ways, through the separation of different stages of production, outsourcing, and movement of labor and capital between the two segments.

If capital is homogeneous and freely mobile between the formal and the informal sectors, then labor market reforms that are favorable to capital will increase the relative return to capital in the formal sector, drawing in more capital and labor from the informal sector. Depending on the degree and speed with which capital relocates, reforms may lead to a rise or a fall in informal wages and employment. But when capital movement between the sectors is restricted by legal requirements or by information shortcomings, stringent labor market regulations also hurt informal workers. The logic is simple. With inadequate employment options in underdeveloped formal sectors, workers crowd into the informal sector, and with inadequate movement of capital, productivity and wages fall. However, if capital can move freely, aggressive action by trade unions in the organized sector will push capital toward the informal sector, thereby raising the informal wage despite the sector’s large absorption of workers. In that case, the interests of organized and unorganized workers will converge.

How well this process works also depends on the extent of government monitoring of regulations and the quality of governance. Additionally, in monitoring compliance, policymakers need to consider differences in worker productivity and skills. Where productivity and skills differ, and workers with high productivity and skills are matched with formal sector jobs while workers with low productivity and skills are matched with informal jobs, perfect substitution of workers across firms in response to changes in formal or informal sector wages would not be possible. However, if informal workers are less productive than the formal sector workers, stricter enforcement will reduce employment in both formal and informal sector firms. Consequently, the state as monitoring authority would need to be concerned with minimizing the fall in employment if it chooses to implement stricter enforcement.