A1 - [Ulyssea 2020] - Informality: Causes and Consequences for Development

 

ANALYSIS OF ARTICLE

The Article provides a comprehensive analysis of contemporary literature on the subject.

Size matters, as informal firms tend to be smaller; once they grow, they get increased pressure to formalize, whereas to get access to credit, whereas the value chain (vendors, Customers) lead the firm to do so. Formality entry costs, ongoing costs (e.g., lower taxes) have limited impact, and enforcement has higher impact. Effects on the firm productivity are not clear.

For the worker, the trade-off between labor regulations / social security and informality maybe tackled with education and a redesign of social security. Unemployment insurance serves to define the reserve utility tied to formalization decisions.

 

 

SUMMARY OF ARTICLE (provides an overview of the Article, with copy & paste of contents, aiming to summarize its contents).

Author provides a definition of margins of informality [Ulyssea 2018]:

1. Extensive margin, based on whether firms register and pay entry fees to be legal.
2. Intensive margin, based on whether legal firms hire workers without a formal contract.

Informality can be an elusive concept. Author uses the above to tackle informality, focused on firms and workers.

Section 2 (Informality Facts) – how to measure informality. Micro data, either from surveys or tax audits [Perry et al. 2007]

·         Firms – informal firms are systematically smaller on average, pay lower wages, run by less educated individuals, hire less educated works, earn lower profits

o   Duality – credo that formal & informal firms operate in separate economic spaces. Evidence on literature showing it does not occur. [Ulyssea 2018], [Maloney 1999]

o   Margins – evidence that the cost of operating informally increases with firm size (larger firms are more visible to governments; larger firms need access to formal credit markets). Intensive margin represents a substantial fraction of informal employment (e.g., 56% in Mexico [De la Parra, 2016], 40% in Brazil and 32% in Peru [Cisneros-Acevedo 2019])

o   Dynamics – most of studies are based on formal firms. Impact of informality on the firm life cycle behavior lacks more studies, [Ulyssea 2019] maybe one of these studies and it pledges that dynamic selection (less productive firms exit as they age and more productive survive and grow) is weaker in the informal sector

·         Workers – informal employment follows a U-shape (larger among younger and older workers).

o   Wage Gaps – large literature available, e.g., [Funkhouser 1996], [Maloney 1999], [Gong & Van Soest 2002], [Pratap & Quintin 2006], [Perry et al. 2007], [Gasparini & Tornarolli 2009], [Botelho & Ponczek 2011]. However, [Ulyssea 2018] shows that the wage gap between formal and informal workers in Brazil vanishes.

o   In and out of informality – literature on how ins and outs behave over the business cycle. Formal sector pro-cyclical, as well as informal-to-formal transition.

Section 3 (Causes) – literature available with cross-country data investigating the correlation between informality and potential determinants such as formal entry cost levels, labor and tax regulations, corruption, and institutional quality. Author presents the following empirical literature trying to define causal effects of potential determinants:

·         Firms – Author proposes a framework to capture the determinants for margins of informality (extensive and intensive). Framework contains the profit function of formal and informal firms based on productivity. Author than proposes the valuation of both formal and informal firms, modelling that there’s a constant for the fixed registration costs that is the difference between the values of formal and informal firms. One conclusion is that regulators shall reduce the cost of formalization as the best incentive to formalize informal firms. Second option is to increase benefits of formality (e.g., lower cost to access credit) and third option is to increase costs of informality (e.g., increase of government inspections).

o   Evidence from Experimental (quasi-experimental) studies – Most of formalization policies focused on reducing formality costs, with emphasis on reducing registration costs [De Soto 1989], [Djankov et al. 2002], [Bruhn & McKenzie 2014]. Results indicate that reducing costs have no effect on formalization.

o   Interpreting the evidence – (1) reducing costs of entering the formal sector has limited results, (2) reducing ongoing costs is more effective but with limited results, and (3) greater enforcement result in larger formalization effects. Why lower costs have limited effects? [La Porta & Shleifer 2014] explains it:

§  Informal sector as a reservoir of potentially productive entrepreneurs kept out of formality by high regulatory costs [De Soto 1989]

§  Informal firms as parasite firms – prefer higher profits than formalizing, [Levy 2008] – that’s why enforcement is effective

§  Informality as a survival strategy for low-skill individuals too unproductive to ever become formal [Ulyssea 2018]

o   Other potential channels – Credit channel, with [Catão et al. 2009] showing empirical evidence with positive association between formalization rates and 2-digit industry level and financing deepening. [D’Erasmo & Boedo 2012], [D’Erasmo 2016], [Lopez-Martin 2019] use general equilibrium models with different forms of financial frictions. [Straub 2005] and [Quentin 2008] analyze the credit channel.

Another channel is the Tax Structure, [De Paula & Scheinkman 2010] analyze this transmission channel. Using a Brazil tax credit mechanism (ICMS), they show the formality of a firm suppliers and buyers is correlated to its own formal status.

Concern that competitive pressure could induce allocation of firms and workers from formal to informal [Goldberg & Pavcnik 2003], e.g., on trade-opening episodes. Several articles show positive effects of trade opening (tariff reduction) on informal employment in Argentina and Brazil: [Paz 2014], [Cruces et al. 2018], [Dix-Carneiro & Kovak 2019], [Ponczek & Ulyssea 2019]. [McCaig & Pavcnik 2018] show a positive esport shock in Vietnam caused a formalization of microenterprises workers. [Dix-Carneiro et al. 2019]

·         Workers – one aspect is the trade-off between formal (coverage by labor regulations and social security) and informal (greater flexibility on hours worked). Informal jobs may represent a viable alternative for unemployed individuals who cannot get a formal job.

o   Static determinants – literature focused on welfare policy vs formal/informal employment: [Bosch & Campos-Vazquez 2014], [Conti et al. 2018] assess Mexico’s Seguro Popular (SP); cash transfer programs are analyzed by [Banerjee et al 2017], [De Brauw et al 2015], [Bergolo & Cruces 2018], [Garganta & Gaparini 2015]. Unemployment insurance is object of analysis by [Gerard & Gonzaga 2018], [Bosch & Esteban-Pretel 2015], [Fugazza & Jacques 2004], [Boeri & Garibaldi 2005], [Albrecht et al. 2009], [Ulyssea 2010b], [Margolis et al. 2012], [Meghir et al. 2015]

o   Dynamics – life cycle effects such as the design of social security systems, e.g., pension systems that provide some form of government-provided safety net to guarantee a minimum wage for the elderly [Joubert 2015].

Education and informality are strongly and negatively correlated in the data. [Garcia 2015], [Joubert 2015]

Section 4 (Consequences) – starts with the firm level and go to aggregate analysis (both micro and macro effects).

·         Firm-Level effects of formalization – seminal paper [Rauch 1991]. Lower quality firms self-select into informality [Arias et al. 2010]. Static world: formality cause effect on productivity is not well defined; Dynamic, informality can have a negative effect on productivity.

Generally, the literature indicate that formalization has no statistically significant effect on firm performance [Benhassine et al. 2018], [Rocha et al. 2018]. [De Mel et al. 2013] find some positive effect of formalization on profits. [Bruhn & McKenzie 2014] argues that formalization benefits are very low for most small-scale entrepreneurs.

·         Increasing the costs of informality – data shows that extensive and intensive margins of informality decline with firm size. Higher enforcement of informal firms by making cost function steeper could lead to a reduction of informal firms, leading to gains in aggregate productivity: (1) reallocation of resources from informal to formal [Ulyssea 2010b], [Bosch & Esteban-Pretel 2012], [Charlot et al. 2015], [Meghir et al. 2015], [Ulyssea 2018]; (2) reducing availability of low-quality informal jobs [Meghir et al. 2015], (3) higher enforcement leading to greater overall capital accumulation [D’Erasmo & Boedo 2012], [Ordonez 2014]; (4) discourage low-skill workers to self-select informality [Ordonez 2014], [López 2017]; (5) higher investments in human capital [Bobba et al. 2017, 2019].

Tradeoff are analyzed by [Boeri & Garibaldi 2005] pledging it could lead to higher unemployment, as well as [Ulyssea 2010a], [Charlot 2015]. [Meghir et al. 2015], [Haanwinckel & Soares 2016] and [Dix-Carneiro et al. 2019] find no unemployment effect. [D’Erasmo & Boedo 2012], [Ordonez 2014] and [Ulyssea 2018, 2019] show that output increases with higher enforcement.

Focusing on the intensive margin of informality, enforcement results are limited [Almeida & Carneiro 2009], [Ulyssea 2018]. [Almeida & Carneiro, 2012] show that more inspections cause modest reductions of formal workers; [Ponczek & Ulyssea 2019] exploit regulations enforcement vs informality. [de la Parra, 2016] analyze enforcement in Mexico.

·         Reducing the costs or Increasing benefits of formality – several articles show that reducing the costs bring important aggregate effects: [Ulyssea 2010a], [D’Erasmo & Boedo 2012], [Charlot et al. 2015], [Ulyssea 2018]. Some articles go on the opposite way, [Lopez-Martin 2019], [D’Erasmo 2016].

Another dimension is related to tax payments, with some effect but with low elasticity [D’Erasmo & Boedo 2012], [Haanwinckel & Soares 2016], higher impact on internal margin [Ulyssea 2018], and overall positive aggregate effects [Ulyssea 2010a], [D’Erasmo & Boedo 2012], [Haanwinckel & Soares 2016].

Section 5 (Conclusions) – the article provides a review of the literature focused on the causes and consequences of informality, with Micro and Macro approaches, and different approaches and tools used. Main observations:

·         Reducing costs of entering the formal sector is not the most effective way to reduce informality, though it can bring positive effects on the economy.

·         Reducing the ongoing costs of formality (e.g., taxes) has stronger formalization effects though not cost effective.

·         Intensify enforcement as the most effective policy. Positive effects on extensive margin, more unemployment on intensive margin

Finally, the article leaves with a provocative proposal to explore the role of informality in developed economies, on the gig economy jobs (e.g., Uber, Airbnb), which benefit large and high-productivity firms.