C&B Notes

LatAm’s Informal Economy

Latin America’s informal economy, which employs nearly half of all workers and produces a huge portion of total wages in the region, is a response to a confluence of factors that are relatively easy to identify but have proven harder to change.

The term [informal sector] itself is vague.  It applies to firms and workers that stand outside a country’s tax and regulatory systems but is not synonymous with illegality.  In Peru, for example, it is not obligatory to register in the social-security system.  According to the ILO, half of informal workers are self-employed.  Others work in businesses that may be formal or informal, or are domestic servants.  Many businesses are partly formal and partly not. Workers sometimes drift in and out of informality.  Some economists say that informality is a result of low growth — but it may be cause as well as consequence.  Libertarians blame business taxes.  They and “institutionalists” point to coils of red tape.  Anthropologists note that some workers choose informal self-employment, for its flexibility and because they resent bad treatment by formal firms.  For Ms. Iparraguirre, it is the only steady work available.

In fact, all these explanations may be true.  The biggest problem, says Santiago Levy at the Inter-American Development Bank, is that Latin America has so many very small, not-very-productive family businesses, which tend to be informal.  The reason, he says, is the interaction of regulations, taxes and social-protection schemes, which means that businesses have no incentive to grow.  The preponderance of low-productivity firms means that the region is not getting the return it should from its big investments in education.

Take Mexico, where 57% of the workforce is informal, according to the statistics institute.  Mr. Levy notes that the typical Mexican business limits itself to a few members of an extended family who do not receive a contractual wage.  If the business does well and starts hiring outside workers, its costs and risks shoot up.  Social-security and other labor costs add 40% or more to wages. If trade dips, by law salaried workers cannot be laid off.  Official application of regulations can amount to “extortion”, says Luis de la Calle, another Mexican economist.

Piecemeal reforms haven’t worked.  In Peru, the share of the workforce in informal jobs fell from 80% in 2002 to a still huge 70% in 2013.  The reason for that modest decline was faster economic growth, especially in sectors with labor-intensive businesses, according to research by Juan Chacaltana of the ILO.  A new, low tax for small businesses had almost no effect.  Such tax reforms, which are popular among politicians, discourage firms from growing.  Colombia’s government slashed labor taxes, which seemed to work better.  Formal employment rose from 44% of the urban workforce in 2013 to 51% last year.

Latin America is paying a high price for having imported Bismarckian social-security structures to the tropics.  Workers and politicians resist labor flexibility in the formal sector because losing a job also once meant losing health care and pensions. But rigid labor rules and high costs keep the formal sector small.  Governments, in turn, have launched a patchwork of non-contributory benefits for the mass of informals, undermining the point of enrolling in social security.

Referenced In This Post