Principal investigator: Viviane Pires Ribeiro
Paper Title: Wages and Informality in Developing Countries
Authors: Costas Meghir, Renata Narita and Jean-Marc Robin
Location of the Intervention: Brazil
Sample Size: Not specified
Main theme: Labor market
Main Variable of 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 countries in the Organisation for Economic Co-operation and Development (OECD). Given the significant relevance of the informal sector to the economies of these countries, Meghir et al. (2015) developed an equilibrium wage distribution model with heterogeneous firms that decide to locate in the formal or informal sector and workers who randomly seek jobs both within and outside the sector. The study's results suggest that increased enforcement does not increase unemployment; however, it does increase wages, total output, and welfare, allowing for better allocation of workers to higher-productivity jobs and improving competition in the formal labor market.
Evaluation Context
Informality is extremely common in developing countries. However, its effects are not yet 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 excludes workers from a range of benefits, including health insurance and unemployment benefits. Furthermore, income and corporate taxes are not collected by the government, thus reducing the size of the tax base. Moreover, since smaller businesses can more easily evade regulation, informality can be seen as a subsidy for such businesses, which are often less productive. Therefore, understanding how these trade-offs balance and what they imply regarding the effects of informality is a fundamental policy issue for developing countries.
Intervention Details
The relative importance of job creation and deregulation through informality versus the effects of job search frictions is an empirical question. Thus, Meghir et al. (2015) use a model in which workers randomly search for jobs. 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): firms, which are heterogeneous in productivity, can choose which wage to offer and in which sector to operate. The model is motivated by the empirical observation that low-skilled workers are seen working in both formal and informal jobs and, due to productivity levels, some firms opt for informality while others become formal.
For the purposes of this study, workers aged 23 (where the chance of returning to full-time education is very low) to 65 years old were selected. These workers were either unemployed, employed (with or without formal contracts), or self-employed. A worker was considered formally employed if they were formally registered. The remaining workers – those employed without formal contracts and the self-employed – were considered informal. Over the sampling period, it was estimated that approximately 40% of the workers were informal, 50% formal, and the remainder unemployed. The study focused on the low-skilled labor market, selecting workers with eight years or less of schooling.
Methodology Details
Meghir et al. (2015) developed an equilibrium wage distribution model with heterogeneous firms that decide to locate in the formal or informal sector and workers who randomly seek employment 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 with high mobility between them. This allows for discussion of the relative merits of increasing enforcement in this context. The authors use data from Brazil, where informal employment accounts for approximately 40% of the workforce. The primary data source is the Monthly Employment Survey (PME), which provides a rotating panel of individuals sampled from the country's six major metropolitan regions.
The stationary equilibrium model is able to replicate the main characteristics of the data and provides a way to perform counterfactual analyses. That is, the model considers the simplifying assumption that workers are homogeneous within a submarket, but that firms are heterogeneous. Thus, a group of low-skilled workers is assumed to be homogeneous (conditional on gender and state of residence), who will typically engage in jobs requiring little training. The model explains the cross-variance of wages by the dispersion of productivity among firms. 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-skilled workers.
Results
The results suggest that in a market with search frictions, the informal sector has significant detrimental effects: by endogenously segmenting the labor market, it reduces competition for workers and makes it more difficult for workers to find employment in more productive firms. Increasing the costs of informality improves the allocation of workers to better firms, increases wages, and improves overall well-being. Interestingly, policies to reduce informality do not increase unemployment. One reason for this is that firms are receiving very high rents and can absorb the increasing cost of regulation.
In equilibrium, the lowest 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 the productivity distribution, formal and informal firms coexist, and profits are equalized between sectors (given productivity). The higher probability of detection for larger informal firms, along with regulatory costs, means that informal firms are much more prevalent at lower productivity levels and are much smaller. Formal firms 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 of workers matching with higher-productivity firms, thus reducing output.
Lessons in Public Policy
Meghir et al. (2015) offer a new perspective on informality that may 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 (inside and outside the sector) and may receive offers from formal or informal companies, which are heterogeneous in their productivity.
Search frictions imply that firms at a given productivity level can achieve positive profits in both sectors, accounting for compliance costs in terms of fines for those informal firms that are penalized. This is because, in a world where all firms are formal, a given firm 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, severance pay, etc.). Since search frictions prevent workers from immediately finding a better alternative, this can continue until there is a significant number of informal firms where wages are competitive enough to equalize profits between the formal and informal sectors. The extent of frictions in the formal and informal sectors determines the extent to which wages in the two sectors can diverge and the prevalence of informality at each productivity level.
The increased 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 enforcement does not increase unemployment and increases welfare by allowing the reallocation of workers to higher-productivity jobs. As a consequence, overall wages increase and inequality decreases. Clearly, these results hold labor market regulation in place, and it may still be possible that greater welfare gains could be achieved through deregulation. However, it appears that an intermediate world where the informal sector is tolerated at current levels of enforcement is not a welfare-improving policy.
References
MEGHIR, Costas; NARITA, Renata; ROBIN, Jean-Marc. Wages and informality in developing countries. American Economic Review, vol. 105, n. 4, p. 1509-46, 2015.
