• 22 Feb 21
  • Posted by Samaniego de la Parra, Brenda

Informal employment in formal firms: prevalence and policy responses

Work arrangements that happen beyond the scope of fiscal and regulatory authorities are widespread in developing countries. Such informal contracts may have greater flexibility and lower costs, but their impact on firms’ performance and workers’ outcomes is hotly debated. This column examines the prevalence of informal jobs even within the formal private sector, and the effects of measures to enforce greater compliance with labor market regulations.

Informality is a complex term used to refer to a wide range of work arrangements that, to various degrees, occur beyond the scope of authorities. According to the International Labour Organization (ILO), the informal sector is defined by the production unit in which an economic activity takes place. The informal sector encompasses activities performed by ‘unincorporated enterprises’ that are ‘not registered under specific forms of national legislation.’ Meanwhile, the term ‘informal jobs’ refers to employment arrangements in which workers are not protected by labor legislation.

There is informality in all countries, but it is particularly pervasive in emerging and developing economies where seven out of every ten workers are informally employed. The ILO’s distinction between the informal sector and informal jobs acknowledges that informality can exist even within firms that are registered with the government and otherwise abiding with other fiscal and corporate regulation (‘formal firms’). The magnitude of within-firm informality in the formal sector remains an open question.

In the case of Mexico, on average, there is one informal worker for every three formal workers at formal firms. At firms with two to five workers, 73% of employees are informal while only 8% of those employed at firms with more than 100 workers have informal jobs. The pattern is similar in Brazil and other Latin American countries. Informal and formal jobs co-exist within narrowly defined occupations, and even with the same firm.

By hiring informal workers, employers and workers avoid certain costs and gain flexibility by avoiding labor regulation. Unlike their formal co-workers, informal employees are excluded from social benefits and lack the protection of various regulatory safeguards, including minimum wage and hours restrictions, safety standards, and severance payments.

While some workers may arguably prefer to trade off these benefits for flexibility and lower or no tax withholdings, combating informality is a pressing issue due to its potential negative consequences for aggregate growth and output volatility, wage inequality, health outcomes, and future employment opportunities.

‘Carrot’ versus ‘stick’ policies

Broadly speaking, policy-makers’ attempts to address informality are grouped into two main approaches: increasing the costs of non-compliance; and raising the attractiveness of compliance.

The former approach includes increasing fines and monitoring. The second approach encompasses policies that reduce registration costs and payroll taxes, or offer compliant establishments access to government contracts, benefits, or subsidies.

Decreases in payroll taxes have ambiguous effects on formal employment. The impact varies across countries and industries. A comprehensive review of the research evidence concludes that the potential for lower payroll taxes to increase formalization is highest when minimum wages are binding and the quality of the social benefits financed through social security contributions is low. Elsewhere, payroll taxes are likely to lead to wage changes without a significant effect on formal employment.

Previous research finds that increasing inspections can have unintended consequences, and that the overall effect depends on specific characteristics of the economy, including the value that workers assign to a formal job and the magnitude of reallocation that can occur between formal and informal jobs. Increases in monitoring can lead to higher unemployment through a decline in job creation, but this effect is mitigated if jobs are reallocated to the formal sector where the job separation rate is lower.

Evidence from Brazil indicates that enforcement reduces firm size and increases unemployment. Monitoring may also lower wages in the formal sector and induce low-skilled informal workers to make the transition to formal jobs paid the minimum wage.

In Mexico, there is evidence that random inspections increase firms’ costs of hiring (and keeping) informal workers. After an inspection:

  • Informal employees experience an immediate increase in the probability of being ‘promoted’ to a formal job.
  • These formalizations occur without a decrease in wages.
  • Smaller firms are more likely to formalize their current informal workers.
  • At larger firms, inspections lead to a decrease in formal job creation and an increase in formal job destruction.
  • Formal employment growth decreases after an inspection and remains two percentage points below its pre-inspection levels for as long as 18 months.

Formality makes workers more attractive to future employers

The effects of an inspection can be long-lasting for workers. Monitoring not only increases the likelihood of formalization at the inspected firm. Once a worker leaves the inspected employer, their chances of landing a formal job with the next employer improve.

We interpret this finding as consistent with employers using workers’ previous labor market trajectory as a signal of their otherwise unobservable skills. When hiring a new worker, employers may rely on the workers’ labor market trajectory to determine their ability.

Thus, two workers with similar trajectories have a similar probability of getting an offer and initial wage with a new employer. As the new employer learns more about the worker, their wages start to diverge. Prior formality status is an important component of a worker’s trajectory: it indicates to new employers that the worker is suitable for a formal job.

Our finding of higher formal job finding probabilities with a different employer after an inspection also implies that payroll taxes and registration costs are not the only costs associated with formalization. Employers must also weigh the cost of increasing the workers’ outside options.

This can explain why transitions from informal jobs to formal jobs are often accompanied with wage increases. Employers must increase newly formalized workers’ wages to prevent losing them to other firms that are now better informed about their abilities.

Concluding remarks

Policies aimed at increasing formal employment and compliance with labor regulation can have unintended consequences. If the perceived value of mandated benefits is low, the evidence indicates that reducing payroll taxes has smaller effects on formalization. If the value is high, stronger enforcement can lead to lower wages and an increase in minimum wage, and formal jobs.

A widespread program of random inspections can increase formal employment at inspected firms and have spillovers on the firms with which inspected firms compete for workers.

 

Author:

Brenda Samaniego de la Parra is an Assistant Professor in the Department of Economics at the University of California at Santa Cruz.  She is a labor economist. She is interested in worker and firm dynamics, as well as development topics.