The Americas | Bello

Why it’s hard to reduce informality in Latin America’s labour market

Solving a problem that holds back growth and productivity

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HER business occupies a small concrete patch in a distant corner of Lima’s wholesale market. There Dora Iparraguirre sells herbs, spinach, cauliflower and cabbage. Her aim is to go up in the world—to the raised, roofed platforms that house bigger stands where lorries can unload directly. Getting one would help her business expand. The platforms are auctioned periodically by the market authority. But to bid Ms Iparraguirre would need a tax-registration certificate.

She says she will try to get one, but it is “complicated” and she doesn’t have the time. “I need to have all the papers, and I don’t know which ones.” She works on her own and says she would need an accountant, but can’t afford to pay one.

Ms Iparraguirre is one of around 135m Latin Americans—or around half of all workers—who, according to the International Labour Organisation (ILO), toil in what economists call the “informal sector”. Remarkably, in most countries this proportion has fallen only slightly, even as people have become more educated and economies have modernised. Since a large informal sector is associated with slower economic growth and low incomes, this points to a colossal failure of public policy. Yet there is little agreement as to what explains informality.

The term itself is vague. It applies to firms and workers that stand outside a country’s tax and regulatory systems but is not synonymous with illegality. In Peru, for example, it is not obligatory to register in the social-security system. According to the ILO, half of informal workers are self-employed. Others work in businesses that may be formal or informal, or are domestic servants. Many businesses are partly formal and partly not. Workers sometimes drift in and out of informality.

Some economists say that informality is a result of low growth—but it may be cause as well as consequence. Libertarians blame business taxes. They and “institutionalists” point to coils of red tape. Anthropologists note that some workers choose informal self-employment, for its flexibility and because they resent bad treatment by formal firms. For Ms Iparraguirre, it is the only steady work available.

In fact, all these explanations may be true. The biggest problem, says Santiago Levy at the Inter-American Development Bank, is that Latin America has so many very small, not-very-productive family businesses, which tend to be informal. The reason, he says, is the interaction of regulations, taxes and social-protection schemes, which means that businesses have no incentive to grow. The preponderance of low-productivity firms means that the region is not getting the return it should from its big investments in education.

Take Mexico, where 57% of the workforce is informal, according to the statistics institute. Mr Levy notes that the typical Mexican business limits itself to a few members of an extended family who do not receive a contractual wage. If the business does well and starts hiring outside workers, its costs and risks shoot up. Social-security and other labour costs add 40% or more to wages. If trade dips, by law salaried workers cannot be laid off. Official application of regulations can amount to “extortion”, says Luis de la Calle, another Mexican economist.

Piecemeal reforms haven’t worked. In Peru, the share of the workforce in informal jobs fell from 80% in 2002 to a still huge 70% in 2013. The reason for that modest decline was faster economic growth, especially in sectors with labour-intensive businesses, according to research by Juan Chacaltana of the ILO. A new, low tax for small businesses had almost no effect. Such tax reforms, which are popular among politicians, discourage firms from growing. Colombia’s government slashed labour taxes, which seemed to work better. Formal employment rose from 44% of the urban workforce in 2013 to 51% last year.

Latin America is paying a high price for having imported Bismarckian social-security structures to the tropics. Workers and politicians resist labour flexibility in the formal sector because losing a job also once meant losing health care and pensions. But rigid labour rules and high costs keep the formal sector small. Governments, in turn, have launched a patchwork of non-contributory benefits for the mass of informals, undermining the point of enrolling in social security.

What is missing is political ambition. A serious effort to reduce informality requires a shift to universal social protection combined with flexible labour laws and simpler tax and business regulations. That was what the government of Pedro Pablo Kuczynski promised when it came into office in Peru in 2016. It drew up a bold plan. And then it shelved it.

This article appeared in the The Americas section of the print edition under the headline "Bismarck’s tropical misadventures"

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