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Informality in LAC – A Barrier to Growth and Social Welfare

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 Chapter I
 Chapter II
 Chapter III
 Chapter IV
 Chapter V
 Chapter VI
 Chapter VII
 Chapter VIII

  Office of the Chief Economist

Washington DC, May 23, 2007 Informality in employment can lead to a social balance that is less than optimal and in which many workers are unprotected against health- and employment-related shocks and poverty in old age.

In Latin America and the Caribbean alone, 56 percent of jobs in urban areas are informal, a trend which has caused concern in recent years. This can be explained in part by marked rises in real minimum wages in some countries as well as by inadequate macroeconomic policies, according to the World Bank report Informality: Exit and Exclusion.

The study describes two groups of informal workers: informal self-employed workers who account for 24 percent of urban jobs, and informal salaried workers who account for about 30 percent of total urban jobs and more than half of all informal employment.  The figures vary across countries in both cases.

The report suggests that the increase in informality during the 1990s could be related to changes in the labor market and social security regulations, weak law enforcement capacities, and greater availability of social protection schemes that do not require contributions from informal workers.

According to the report, informality has gained increasing attention as a possible drag on growth and social well-being, and as a force corrosive to the integrity of the region’s societies.  To reverse this trend, policymakers could focus on improving the conditions that promote formal sector productivity and addressing the barriers, costs and benefits for informal firms and workers to participate in the formal sector.

Exclusion or Exit?
The report, prepared by Guillermo Perry, Chief Economist for Latin America and the Caribbean at the World Bank, and World Bank economists Omar Arias, Pablo Fajnzylber, William Maloney, Andrew Mason and Jaime Saavedra, suggests that today informality can be seen from two standpoints: exclusion and exit. Exclusion means that informal workers are excluded from state benefits or the circuits of the modern economy. Exit suggests that many workers, firms and households choose their optimal level of engagement with the mandates and institutions of the state and after analyzing them, decide whether or not to shift into the formal sector.

Based on historical, institutional, and legal differences, the relevance of exclusion mechanisms can be higher in some LAC countries, while the same is true for exit mechanisms in others. The informal sector is extremely heterogeneous in the region and, in some cases, it is almost impossible to distinguish between exclusion and exit. 

Regardless of whether informality stems from policies, exclusion mechanisms, or cost-benefit decisions by firms and individuals that lead them to opt out of formal institutions, informality represents a fundamental critique of the Latin American state and its failure to adequately regulate the social security system and labor markets.

Reversing the Trend
Informality: Exit and Exclusion suggests that policy changes could reverse rising trends in informality. However, without improvements in the design of social security programs or in aggregate productivity, microfirms characterized by high turnover, weak growth prospects, and low productivity will continue to increase and to lack a direct exit to formality.

Other suggestions made by the report include the need to raise human capital levels to prevent unskilled workers from preferring self-employment; the design of social security nets; labor laws that take a more inclusive view of the labor market and of the cost-benefit analysis made by workers and firms to decide whether to interact with formal institutions.

Finally, the report points to the need to reduce those excessive regulations and taxes that create labor market segmentation.  It also stresses the importance of creating an efficient and inclusive social contract in which the great majority of individuals feel compelled to participate and comply with state mandates, thereby changing the pervasive culture of noncompliance that characterizes most countries in the region.