Informality, Welfare and Productivity Carmen Pagés Inter-American Development Bank Labor Markets Unit (LMK)

How does informality affect workers’ welfare? I will argue that informality affects welfare not in the way we (I?) thought… That is…not by condemning informal workers to “bad” jobs… (at least not to all) But rather, lowering aggregate productivity and with it, the earnings of most workers (formal and informal, as well as firm’ owners) And by.. making labor and social policy extremely difficult and ineffective

This presentation: 1.How does informality affect individuals´ welfare? –Are formal workers better off? Which ones? 2.What is the effect of informality on aggregate productivity? 3.How does informality affect labor and social protection policies? 4.Policies to increase formality Credit and formality

The one-slide presentation 1.Informal workers are not necessarily worse off (particularly the self- employed with low education attainment) 2.Yet Informality creates important aggregate problems: It kills the efficacy of labor and social protecction policies as we know them; It reduces aggregate productivity. 3.A more proactive approach needed: Re-designing labor and social policies to be informality-proof Or tackling informality: reducing cost of formality, and Increasing its benefits. More access to credit helps.

Part I: Informality and Individual welfare: Based on “ Is Informality a good Measure of Job Quality?: Evidence from Job Satisfaction Data” Lucia Madrigal, IADB Carmen Pagés, IADB

Informality: Choice or/and exclusion? Wage differentials –positive but affected by selection bias. –If corrected using semi-parametric methods or panel data  much smaller differentials. –Wages do not necessarily reflect welfare Mobility studies– if workers value formality they should voluntarily move to formality and involuntarily away from formality. –“revealed preferences” –Problem. In most cases we do not observe if movements are voluntary or not.

In our work Use job satisfaction data to assess whether informal jobs are less valued than formal jobs If workers in formal jobs enjoy rents they should report higher levels of job satisfaction than informal workers.

Job satisfaction: the literature In similar approaches, subjective job satisfaction measures have been used to understand the –Determinants of job quality (Clark, 2004; Sousa Poza and Sousa Poza, 2000) –Determinants of utility of unemployed workers (is unemployment voluntary?) –Whether self-employment enjoy rents. To data these studies conducted mostly in developed countries.

Rather than adhering to any particular definition of informality, we distinguish between: Self-employed; Employed in firms of more than 10 employees with benefits; Employed in firms of more than 10 employees without benefits Employed in firms with less than 10 employees without benefits;

We examine the determinants of Job satisfaction as a function of: X 1 : Observable worker characteristics (gender, age, educ, health status, civil status) Z 1 : Job category cum benefit variables: Self-employed; Employed in a small firm Employed in a large firm without benefits Employed in a large firm with benefits Z 2 : Objective job characteristics (earnings, industry, occupation, hours ) Z 3 : Subjective job characteristics (well remunerated, opportunities for promotion, job is stressful, job is dangerous, monotonous, good work schedule, job is insecure, )

Methodological issues (I) Omitted variable bias: Correlation between job satisfaction and subjective variables may be driven by innate unobservable individual traits (i.e optimism). –We control for different degree of optimism as in van Praag (08) We make use of individuals’ valuations (Vi) about other aspects (health policy, education policy, transportation)/ –Regress different Vi on Xi; –Obtain principal components of residuals. –Add the first principal component (Ki) in (1). Sample selection issues, particularly for women, may be important –need to control for it.

Methodological issues (II) Further omitted variable bias issues: Even after controlling for optimism one could argue that the relationship between type of job and job satisfaction is driven by unobservable variables. –For example, less able individuals choose informality and at the same time have lower expectatives and therefore higher JS. Need panel data to properly account for that, however data contains information on whether workers prefer working as self-employed or salaried.

Data (I) Data for three low income countries (Guatemala, Honduras, El Salvador) Collected by Statistical National Offices in 2007 Nationally representative samples (18-64 years old) –Honduras: 8288 individuals. –El Salvador: 1082 individuals –Guatemala: 1400 individuals One individual randomly selected within the household answers a longer questionnaire In practice some over-representation of women Re-weighting

Data (II) Data contains info on: –Individual (including health status) and objective work characteristics –Job satisfaction and subjective appreciations of job characteristics Whether workers would prefer being salaried or self-employed –Job satisfaction defined as “are you satisfied with the job you do?”

Ranking does not correspond with traditional distinctions based on firm size

Job characteristics

Omitted category self-employed

Earnings strongly associated with Job satisfaction

Omitted category self-employed Job characteristics correlate with job satisfaction in an Expected manner

Omitted category self-employed Salaried small are worse off than self-employed Salaried at large firms are better off.

Results are robust to: Controlling for selection into employment Results do not seem to be related to unobservable variables correlated to job security and job category. Using a pseudo- fixed effect estimator to control for unobserved heterogeneity

Results change with level of education

Results change across countries Strong preference For self-employment

And education… Higher preference for formal among skilled workers  Lower valuation of benefits among Unskilled?

In sum Data suggests that unskilled workers have lower valuations of benefits. –Lower financial/pension literacy –Cash constraints? They perceive payments as taxes; Labor supply more elastic; taxes will tend to fall on employers; Which may explain why many unskilled workers are hired without SS It may explain why so few workers blame the entrepreneurs for their lack of social security

Even if workers are better off in (some) informal jobs, informality leads to poor outcomes… Large numbers of people possibly not getting protected against poverty in old age. Do informal workers save for retirement? Informality renders labor policy ineffective. How to implement unemployment insurance, or protect workers against accidents or disability?

Part II: Informality lowers productivity based on “Informality, Resource Misallocation and Productivity in Brazil” Carpio and Pagés (2009)

(A) channel: Informality leads to resource misallocation TFP (formal) > TFP (informal) firms. Informal and formal firms produce goods that are substitutes to some degree. Informality is a subsidy on less productive firms, allowing them to sell products to a lower price than they would if they paid taxes and regulations. This increses their market share And reduces aggregate productivity.

Data Use a large and detailed sample of almost small firms in Brazil (less than 5 paid workers). Urban Informal economy 2003 (ECINF) It covers employers with less than 5 employees and self-employed workers, irrespective of the number of non-remunerated employees or partners. Definition of formality: –Formal firms: Pay income tax –Informal firms: Do not pay income tax

We measure TFP and marginal product of capital and labor in each firm following Hsieh and Klenow (2009) Assumes CRS production function with shares computed from cost shares for each sector. If all firms in efficient allocation: MPK(i)=R MPL(i)=w Departures from this indicate allocative problems.

Productivity (TFP) is higher in formal firms no matter how we measure it Payroll: sum of wages for employees and self-employed without unpaid workers, excluding social security payments. We attribute wages to unpaid workers by using a Mincer regression. Capital: the value of capital stock at its market value. Mean difference 55%

We measure the difference between MPL or MPK as a firm specific wedge. Distortions that affect the price of Y relative to L

Simple argument: If formal firms are characterized by high MPL and MPK it indicates that hiring more labor and more K would increase overall output and TFP. –Formal sector too small, Informal sector too large Instead, if MPL and MPK is higher in informal firms, it indicates they face constraints to growth. Productivity would increase if informal firms grew.

On average, informal firms in Brazil are more constrained in their growth than formal firms. In Brazil, high marginal products more likely among formal firms…

Bottom line… A larger number of formal firms should be larger than they are (they are taxed above average) A larger number of informal firms should be smaller than they are (they are relatively subsidized by not paying taxes) Since formal firms are more productive, the fact that they are too small reduces aggregate productivity. Other possible channels at play (less access to K & less innovation of informal firms)

A more proactive approach needed Creating social security and labor systems which are informality-proof (delinking them from the labor market, particularly for unskilled labor). Reducing the costs and increasing benefits of formalization –Credit can help

Credit can help Catao and Pagés (2009). Higher access to credit increases the opportunity cost of informality We explore an episode of increased supply of credit in Brazil. We find that formality rates (SS affiliation) increased faster in sectors that are more credit dependent, and therefore benefit more from credit.

Conclusions Self-employed workers may not be worse off than salaried formal workers. Salaried workers in small firms tend to be less happy about their jobs. Higher preference for self-employment and lower for SS benefits for less skilled workers. Yet, informality even if optimal from an individual point of view is socially suboptimal

Conclusions Informality lowers productivity –How much? Informality renders social and labor policy ineffective State needs to be more proactive to deal with informality –Reducing costs of formality –Increasing benefits of being formal –Designing social security and labor policies which are more informality-proof.

Ideas for when reviewing Madrigal Pages: Do fixed effect estimator by level of education

Ideas for when reviewing Carpio Pages: A few informal firms seem to have very high MPK and L.