A2- [Ulyssea 2018] - Firms Informality and Development:Theory and Evidence from Brazil

 

ANALYSIS OF ARTICLE

The article proposes an Equilibrium Model including intensive margin in the analysis of informality. It sheds light to a different perspective of informality, where intensive margin (informal labor) and extensive margin (informal firms) may lean in different directions.

Literature focuses more on extensive margin, and usually with analysis to reduce entry cost or enforce formalization. To include intensive margin, the Article proposes a taxonomy (Survival, Parasites and De Soto’s) and a framework (switchers, always formal and always informal firms) to assess the impact of policies and winners and losers, in lieu of the Model proposed.

Firm and labor informality do not move in the same direction, because of policy changes. Lower informality can eventually be associated with higher output, TFP or welfare.

This is a seminal article to further analyze Equilibrium Models for informality.

 

 

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

Informal sector on developing economies:

1.      High informality levels imply widespread tax evasion.

2.      Informality may distort firm’s decisions.

3.      Creates large TFP (total factor productivity) losses [Hsieh & Klenow 2009]

4.      Provides flexibility to accelerate growth despite burdensome regulations.

Extensive margin (firms registration) is object of several studies, [Rauch 1991], [Fortin, Marceau and Savard 1997], [Amaral & Quintin 2006], [de Paula & Scheinkman 2010, 2011], [Bosch & Esteban-Pretel 2012].

Intensive margin (firms are formal and hire workers “off the books”) like on [Melitz 2003]. If a firm decides to be formal, it faces fixed entry costs (registration) and ongoing costs (revenue and tax labor). However, it may avoid the latter by hiring informal workers. Formalization policies may impact extensive margin, but not intensive.

The Author proposes a model matching employer-employee data on formal and informal firms, encompassing different views: (1) informal sector as a reservoir of productive entrepreneurs – 9.3%, (2) parasite firms – 41.9% and (3) survival strategy.

With such model, the author assesses that 42% are parasite firms, suggesting that eradicating them through tighter enforcement would in principle produce positive effects on the economy. Testing for the decrease of extensive margin results produces net zero effect on the labor informality (intensive margin). However, testing on enforced reduction of intensive margin results in increase of extensive margin, as the cost of formalization increases for less productive firms.

In its equilibrium model, the article shows that reducing entry costs increases the mass of active firms, contributing to greater competition, output, and wages. Wages increase especially on higher skill workers.

 

 

Section 1 (Informality Facts)

A)     Definitions and Data

·         Informal worker – those w/o booklet (“sem carteira”)

·         Informal firm – not registered with CNPJ

·         ECINF (Pesquisa de Economia Informal Urbana)

·         RAIS

·         PNAD

B)     Firms – Informal firms on average have less educated entrepreneurs, are smaller in terms of employees and revenues, pay lower wages and earn lower profits relative to formal firms. Article show that formal and informal firms coexist in markets

C)      Workers – on average less educated and less skilled than formal. Wage gap between informal and forma workers. Gap disappears within firm.

D)     Intensive and extensive margin of informality – both decrease with firm size (maybe because those are more visible to the Government). Evidence from Mexico that 44% of all informal employees are employed in formal firms.

 

Section 2 (Theory and the Proposed Model)

Original model by [Melitz 2003]. Paper proposes an equilibrium model, with changes in the entry and production structures. In summary, the Model comprehends:

·         Firms are heterogeneous indexed by their individual productivity Ɵ

·         Product and labor markets are competitive

·         Firms profit modelling based on output and cost, for both formal and informal firms. As available in the literature, the two margins of informality introduce a size-dependent distortion in the economy (smaller firms face de facto lower marginal costs. Larger firms are more likely to be formal).

·         Every period there’s a mass of potential entrant firms, with higher entry costs for formal firms.

·         Endogenous entry but exogenous exit (Melitz 2003)

·         Entry and exit are defined by the productivity assigned to the company at entry. After entry occurs, firms draw their actual productivity. Modelling is done by means of a Pareto function.

·         Firm’s actual productivity is modelled with a log-additive form for the post-entry productivity process.

·         Firm value will depend on constant prices and constant productivity

·         Demand is represented by a stationary equilibrium, in which the size of formal and informal sectors remain constant over time (mass of entrants equal to the mass of exits).

·         Worker heterogeneity is provided by a CES aggregation of high-skill and low-skill types of workers, with different wages as for the production function.

·         Formal firms have different thresholds to start hiring low and high-skill workers: (1) hire all workers informally, (2) hire all low-skill workers informally and high-skill formally and (3) higher some formal workers of both skill levels.

·         A profit maximization model resulting from the 2 types of workers.

 

Section 3 (Estimation)

The model is estimated with a two-step SMD (Simulated Minimum Distance) estimator. This approach combines direct estimation and calibration with micro and macro data in the first step, with the SMD estimator itself in the second step.

The article details the parametrization assumed, the functional forms of some equations, and the estimation method.

Finally results from the Model are compared to the actual data, and the model does represent it well, with some small deviations such as (1) share of high and low skill workers for firms with 7 employees, (2) overestimates the decline of the extensive margin as firms grow. The Model represents very well the intensive margin.

 

Section 4 (Counterfactual Analysis)

The Author proposes a simple taxonomy to reflect the main literature views on the role of informal firms in the economic development:

1-      Survival view – informal firms that are too unproductive to ever become formal (48.8%)

2-      Parasite view – informal firms that are productive enough to enter the formal sector once entry barriers are removed – avoid taxes and regulations to be able to survive (41.9%)

3-      De Soto’s view – potentially productive informal firms kept out of formality by high entry costs – if costs are removed, they would enter the formal sector and grow once they are not limited by informality (9.3%)

Type (3) would formalize once entry barriers are taken. Types (1) and (2) may both remain informal, difference being Type (2) does it by choice, and Type (1) cannot survive as formal.

Author uses the model to test four experiments:

a)      Reducing the cost of entry into the formal sector to make it the same as the informal sector

a.      Hurts high productivity formal firms and all informal firms, except for switchers (more firms go formal, more competition)

                                                              i.      Benefits low productivity firms in the always formal group, as they get some cost relief from being formal.

                                                             ii.      Switchers also benefit

b)      A 20p.p. cut in the payroll tax

a.      Hurts low productivity formal incumbents but has positive impact on high productivity firms. Lower taxes, higher demand for labor, hurting low productivity more (labor shifting from low to high productivity)

c)      Increasing the cost of the extensive margin

a.      Always formal benefit from higher enforcement

b.      Low productivity formal firms benefit the most, as they are most directly affected by the competition from informal firms

c.       Some informal firms do formalize. Those that remain informal must reduce their scale to remain invisible to the Government (large negative impact on their value)

d)      Increasing the cost of the intensive margin

a.      Hurts low productivity firms, as they hire mainly informal labor.

b.      Informal firms benefit as a result from the reduction in equilibrium wages due to lower demand on low productivity firms.

Some of the results obtained for Economy wide effects:

-          Reducing entry cost reduces the share of informal firms on 25 p.p. However, intensive margin impact is null as firms formalize and hire informal workers.

-          Reducing payroll taxes reduces informal employment but the share of informal firms does not fall much.

o   Labor tax affects formal firms’ decision to hire formal or informal workers, but formalization of firms is heavily influenced by entry costs.

-          Increasing enforcement on extensive margin reduces informality and has a positive effect on TFP of 8.3% at the cost of eliminating low-productivity firms. Lower entry cost has a negative effect on TFP because more low-productivity firms enter the formal sector (and survive) hurting TFP despite increase in production in the formal sector. Both effects together produce a net positive on output.

-          Welfare analysis show that:

o   Reducing entry costs lead to a welfare gain of 5.5% - more formal firms, more output, wages, taxes.

o   Reducing payroll taxes has a positive welfare effect of 4.4% - positive effect on wages; lower taxes offset by formalization effects.

o   Higher enforcement of the extensive margin leads to a welfare loss of 6.7% - Government enforcing costly and inefficient regulations to all firms. Moreover, there’s a reduction on the equilibrium wage of low-skill workers.

 

 

Section 5 (Final Remarks)

Increasing enforcement is highly effective in reducing informality, however it also reduces welfare in the economy.

Reducing formal sector entry costs is not effective in reducing informality but generates welfare gains leading to greater GDP and wages.