Informality, a Symptom of Institutional Failures and a Barrier to Development

Contacts:
In Washington: Gabriela Aguilar (202) 473-6768
gaguilar2@worldbank.org
Stevan Jackson (202) 458-5054
sjackson@worldbank.org

WASHINGTON, May 23, 2007 – The high levels of informality in Latin America and the Caribbean are a sign of institutional flaws and, at the same time, they restrict opportunities for growth and social welfare and undermine the integrity of the region’s societies, according to a new World Bank report.

The report entitled Informality: Exit and Exclusion suggests that to reduce informality, policymakers should focus their efforts on improving the conditions that promote formal sector productivity and growth and addressing the barriers, costs and benefits for informal firms and workers to participate in the formal sector.

“A better investment climate would help formal businesses to grow and increase their wages, thus reducing the attractiveness of staying informal,” said Guillermo Perry, Chief Economist of the Latin America and the Caribbean Region at the World Bank. “Improving skills among the poor will enable a greater number of workers to find better paid jobs in a more dynamic formal sector,” he added.

At the same time, there is a need to use a combination of sticks (improved enforcement) and carrots (perceived benefits) to create the incentives that induce more workers and firms to become formal. For instance, through actions to facilitate new business registration, the simplification of tax laws, expansion of the benefits of formality (credit and market access, legal security, business development schemes), removal or reduction of labor market inflexibilities, improvement in the design and coverage of social security and social protection programs, with an evenhanded and determined law enforcement. 

Based on the report, prepared by Perry and World Bank economists Omar Arias, Pablo Fajnzylber, William Maloney, Andrew Mason and Jaime Saavedra, while informality in the region is not considerably higher than in other developing countries with similar per capita income, it did increase remarkably during the nineties.

In some countries, informality increased due to a higher incidence of labor taxes, minimum wages or social security regulations, while there was an expansion of social protection schemes that did not require contributions from informal workers. In others, this was due to inadequate macroeconomic policies that led to artificial economic expansions in the early ‘90s in sectors prone to informality, to the use of ad-hoc temporary labor contracts, to the weakening of labor and tax enforcement, and, to a lesser extent, to the impact of trade reforms and the increasing participation of women in the labor market.

Informal employment (not registered with social security) accounts for 56 percent of urban employment in the region and comprises two groups:

1. Self-employed informal workers (the self-employed and owners of microenterprises) who account for 24 percent of urban jobs—from 20 percent or less in Argentina, Brazil, Chile and Uruguay, up to over 35 percent in Bolivia, Colombia, Peru, Dominican Republic and Venezuela.
2. Wage-earning informal workers, who account for about 30 percent of urban jobs and more than half of total informal employment —and vary from 17 percent in Chile, up to a high of over 40 percent in Bolivia, Ecuador, Guatemala, Mexico, Nicaragua, Paraguay and Peru.

While most self-employed workers choose their jobs voluntarily and are not actively looking for a formal job, most informal wage-earners take those jobs because they did not find a position as a formal wage-earner or self-employed, and were reportedly willing to change their occupation.

The first group corresponds to the “exit” view of informality, by which workers and firms choose the extent of compliance with state mandates and institutions based on a cost-benefit analysis of becoming formal.  This rationale also explains the behavior of many small firms and also of larger companies.

The exclusion view of informality applies to the second group, where companies and firms cannot access key state-provided benefits or those offered by the modern circuit of the economy, due to excessive regulations, labor market segmentation or lack of voice in the State affairs.

“Either due to absolute exclusion or market segmentation or due to a voluntary decision to exit formality, informality can lead to a social imbalance in which many workers become vulnerable to health- and employment related- shocks and to old age poverty. Many companies remain below their growth potential to avoid being detected,” stated William Maloney, World Bank Economist. “In either case, there is a strong need for reform, but there is not a one-size-fits-all solution.”

The informal sector in the region is extremely heterogeneous and exclusion and exit factors can have different weights across countries and over time. Regardless of whether informality stems from inadequate policies, exclusion mechanisms, or cost-benefit decisions by companies and workers, it represents an indictment of the Latin American state to the extent that it is failing to fulfill its expected duties of ensuring legal and economic security, equal opportunities and an adequate provision of public goods.

To reduce informality in the region, the report stresses the need to adopt an integrated approach that promotes aggregate productivity and improves the incentives for formality embedded in business, tax and labor regulations and in social security and protection schemes. Furthermore, the report calls for making progress in the process of building more accountable, efficient and inclusive states which are able to create the conditions for a social contract based on a generalized social norm of compliance with the law.

For more information on the Informality: Exit and Exlusion report visit:www.worldbank.org/lac