International Conference on How to make formal work attractive? Vilnius, 17 September 2014 the undeclared economy and informal employment: challenges and policy responses Mark Keese Head of the Employment Analysis and Policy Division Directorate for Employment, Labour and Social Affairs (mark.keese@oecd.org)

Why tackle informality? Informal firms are less efficient and rarely able to generate sustained economic growth The informal sector is often a trap for the most disadvantaged workers A large shadow economy places a heavy burden on public finances

The shadow economy is large… Size of the shadow economy % of GDP The shadow economy comprises a sizeable share of GDP in many European and OECD economies (and an even larger one throughout the developing world), but there is considerable variation across countries. The size of the shadow economy has generally fallen over the past decade (despite a recent slow-down in the process due to the crisis). TECHNICAL NOTE: The estimates reported are obtained using an ‘indirect’ method for calculating the size of the shadow economy, based on comparisons of macroeconomic aggregates. Such methods are often deemed to over-estimate the size of the shadow economy. Caution, therefore, should be taken, but the figures should be informative for cross-country comparisons and to assess the change in informality over time. Source: Schneider (2013). Size and Development of the Shadow Economies of Portugal and 35 other OECD Countries from 2003 to 2013: Some New Facts

… and it employs a significant share of the labour force Share of labour force in informal employment, 2008-2009 Percentages TECHNICAL NOTE: Figures obtained using survey data. Contrary to the previous slide, these figures tend to under-estimate the size of the informal sector. Nonetheless, cross-country comparisons should be informative. It is interesting to see that macro estimates of the shadow economy (on the previous slide) show a much larger informal sector in Eastern European countries than these survey-based estimates. This could be due to different factors. One plausible explanation is that under-reporting of earnings (as opposed to workers operating ‘entirely’ in the informal sector) is more common in Eastern Europe. That would explain why informality is low as a share of total employment, despite a large shadow economy estimated on the basis of national aggregates. *Data from 2006; ** Data from 2007 Source: Hazans, Mihails. 2011. Informal Workers across Europe : Evidence from 30 European Countries. World Bank; Calculations based on European Social Survey (ESS) Data

Informal firms are typically smaller and less skill-intensive Incidence of informal employment in European countries, 2008-2009 % of all employees - TECHNICAL NOTE: Calculations based on European Social Survey (ESS) Data Source: Hazans, Mihails. 2011. Informal Workers across Europe : Evidence from 30 European Countries. World Bank; Calculations based on European Social Survey (ESS) Data

Informality is highest among the young, the old and the less educated Incidence of informal employment in European countries, 2008-2009 % of all employees The fact that younger and less-educated workers are more likely to be in the informal sector raises the concern that informality may be a trap for the most disadvantaged worker categories. TECHNICAL NOTE: Calculations based on European Social Survey (ESS) Data. Source: Hazans, Mihails. 2011. Informal Workers across Europe : Evidence from 30 European Countries. World Bank; Calculations based on European Social Survey (ESS) Data

Informal firms are generally less productive and they rarely grow into formal ones Using data from World Bank firm level surveys, La Porta and Shleifer (2008) find that informal enterprises are small and significantly less productive than their formal counterparts. Formal enterprises are run by better educated managers. As a consequence, they use more capital, cater for wider markets and have better access to finance. They also find that hardly any of the formal firms analyzed had ever operated informally. TECHINCAL NOTE: Calculations based on European Social Survey (ESS) Data

OECD’s policy agenda to encourage formalization Increasing benefits Improve quality of public services Increase public awareness of the benefits of formalization Strengthen the link between contributions and benefits Reducing costs Improving enforcement Streamline formalization process Simplify Tax Systems Increase flexibility in the use of formal contracts Keep regulation simple and transparent Employ trained inspectors and increase awareness of the risks of non-compliance Improve coordination between enforcement agencies Taking a comprehensive approach

Reducing the costs of formal employment Complex tax systems increase compliance costs and encourage under-declaration Overly strict EPL increases incentives for informal employment in countries with limited enforcement capacity Strong restrictions on the use of fixed-term contracts and high costs of dismissal discourage formality of new hires (especially among young inexperienced workers) High wage floors and high non-wage labour costs induce informality and under-declaration of earnings Preferential taxation of earnings from self-employment may induce under-declaration of wages and encourage work as ‘false self-employed’

Increasing the benefits of formalisation Improved public service delivery and increased awareness of existing benefits (e.g. social protection) encourage formality A stronger link between contributions and benefits is fundamental The design of the pension system plays a crucial role Unemployment benefits can act as an incentive to formalisation Certain groups may need special attention. For instance, young workers are likely to discount the benefits of contributing to a pension scheme more heavily, as they accrue further into the future. Special attention should be paid to healthcare provision, where it may not be advisable to strictly link benefits to contributions, since that may amount to excluding the most vulnerable. The experience of individual accounts linking contributions to benefits is a useful example (e.g. Mexico).

Improving enforcement (1) Well-designed regulation and transparent administration make it easier for firms and individuals to comply Well-trained inspectors or auditors should be allocated to enforcement activities Inspections should be concentrated on small firms in industries with highest risk of informality Publicizing planned auditing activities and results may influence taxpayers 'perceptions of the probability of being audited

Improving enforcement (2) Sanctions should be large enough to act as a deterrent and the risk of receiving a fine should be non-negligible Coordination between enforcement agencies (e.g. tax and social security collection authorities) can help contain costs and improve effectiveness Cooperation with social partners may help increasing awareness of the benefits of formalization However… In countries where informality is a survival strategy, it is important to make sure that the livelihoods of vulnerable workers are not put at risk by overly vigorous enforcement activities

But… not all firms will respond to these incentives Many informal firms are fundamentally different from formal ones (lower skills, worse management practices, lower productivity) And they may be simply unable to compete in the formal sector Hard to expect those firms to ‘formalize’ Best to promote ‘formality from the start’

Growth and human capital accumulation are the best cure for informality In the long run, informality tends to fall with economic development (La Porta and Shleifer 2014) As human capital accumulates, productivity increases and informal firms become sufficiently competitive to operate in the formal sector Promoting human capital accumulation (and, in particular, the accumulation of managerial skills) should naturally help the process of formalization

Need for better evidence Improving the evidence base Crucial to evaluate formalisation programs rigorously, in order to understand what policies work best Identifying sectors that are most at risk of informality will make policy action better targeted and more effective Understanding the determinants of transitions from informality to formality will help designing better policy interventions

For further information: Contact: mark.keese@oecd.org Read more about our work OECD Directorate for Employment, Labour and Social Affairs: www.oecd.org/els OECD Employment Outlook: www.oecd.org/employment/outlook @OECD_Social