Latin America’s Informal Economy Dilemma

(photo: iStock/JohnnyGreig)

 

By Antonio David, Samuel Pienknagura, and Jorge Roldos

(Spanish)

Working as a street vendor, a rideshare driver, or a housekeeper in some Latin American countries can be considered as part of what economists call the informal economy. The latest estimates (based on contributions to social security) indicate that, on average, over 60 percent of active workers in the region are part of the informal sector.

In our latest Regional Economic Outlook: Western Hemisphere report, we explored the impact of informality on labor markets in Latin America during the ups and downs of the business cycle. We found that in economies with high informality, improving labor market institutions, such as excessively cumbersome dismissal procedures, can help countries get more efficiently back on track during hard economic times.

Informality and the business cycle

By looking at the link between changes in output and in unemployment, we find that the informal market plays a large role throughout the business cycle.

Our research shows that unemployment rates respond less to output fluctuations in emerging market economies, including those in Latin America, than in advanced economies.

Interestingly, the response of unemployment to cyclical variations in output is weaker when levels of informality are higher. In addition, we observed that informality in the region declines in periods of high growth and increases in periods of low growth.

This result suggests that entry and exit to the informal sector partly insulates workers from fluctuations in the business cycle, thus softening the impact of the cycle on unemployment rates. For instance, when an emerging market economy enters a recession, workers who would otherwise become unemployed, can find informal jobs instead.

 

 

Another interesting feature of labor markets in Latin America is that the rate of women in paid work does not fluctuate much with the ups and downs of the business cycle. However, female labor force participation tends to rise during crises, likely to support household incomes amid economic hardship.

The value of labor market flexibility

A flexible labor market is critical for the rebalancing of the economy in response to shocks and, thus, for economic growth. But in some Latin American economies, labor market regulations tend to be excessively rigid.

We find that it takes more time for countries in Latin America to adjust to shocks—such as droughts limiting agricultural activity or strikes affecting industrial activity—relative to other countries. This is partly related to the high number of workers in the informal sector. What lies behind this pattern? While informality is a multifaceted phenomenon with many determinants including low education levels and income per capita, high minimum wages and relatively stricter labor market regulations in the region are important factors accounting for the observed high levels of informality.

This is because stringent labor market regulations and minimum wages that are high relative to productivity, dampen a country’s labor market’s ability to adjust to shocks, particularly where the enforcement of rules is high.

This, in turn, affects medium-term growth. Why? Because stricter regulations and wages that are far off from productivity frequently hinder the efficient allocation of labor and other factors of production across firms and sectors amid shocks. They can impede and, in some cases, prevent workers from moving from one job to the next. They also influence a firm’s decisions both in terms of hiring and dismissing workers and investment—key factors that ultimately affect growth.

 

According to our estimates, the difference in the speed of adjustment between countries with rigid and flexible labor market regulations is 10 percentage points when government effectiveness is high. This, in turn, translates into economic growth rates that are 0.5 percentage points lower for countries with more rigid regulations.

Similarly, high minimum wages relative to labor productivity erode a country’s microeconomic flexibility. The effect of differences in minimum wages on the speed of adjustment is even larger. The difference in the speed of adjustment parameter between countries with low and high relative minimum wages is 16 percentage points when enforcement is high. This roughly translates into growth rates that are over 0.7 percentage points lower for economies with high minimum wages relative to productivity.

Working policies

Informality plays a crucial role in the dynamics of labor markets in Latin America. The results presented here imply that, in economies with high informality, focusing just on unemployment and job creation—as in advanced economies—may lead to a flawed reading of labor market performance.

Tackling high informality presents policymakers with difficult tradeoffs. On the one hand, informal jobs are relatively less productive than formal ones, they have no safety net and lower tax revenues. On the other hand, they may be the only source of income for low-skilled workers, especially in downturns. Informality provides a buffer in bad times, but it also lowers the speed of rebalancing to aggregate and sectoral shocks that require a reallocation of labor.

The results suggest that labor market policies need to strike a balance between equity and efficiency. Certain dimensions of employment protection legislation increase informality, most notably costly and cumbersome dismissal regulations. Similarly, minimum wage policies that do not incorporate productivity into the wage-setting mechanism may hamper an economy’s ability to respond to shocks.

Thus, policies that reduce firing costs, by making them more transparent, predictable, and less administratively burdensome, and that better align wages with productivity are likely to be an important way to tackle informality. Implementing these policies can ultimately improve the functioning of labor markets. But it is also important to safeguard workers’ well-being in times of economic hardship by strengthening unemployment insurance and other areas of the safety net.