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Informality, Welfare and Productivity. Carmen Pag és 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…

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Informality welfare and productivity

Informality, Welfare and Productivity

Carmen Pagés

Inter-American Development Bank

Labor Markets Unit (LMK)

How does informality affect workers welfare
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
This presentation:

  • How does informality affect individuals´ welfare?

    • Are formal workers better off? Which ones?

  • What is the effect of informality on aggregate productivity?

  • How does informality affect labor and social protection policies?

  • Policies to increase formality

    • Credit and formality

The one slide presentation
The one-slide presentation

  • Informal workers are not necessarily worse off (particularly the self-employed with low education attainment)

  • Yet Informality creates important aggregate problems:

    • It kills the efficacy of labor and social protecction policies as we know them;

    • It reduces aggregate productivity.

  • A more proactive approachneeded:

    • 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.

Lucia madrigal iadb carmen pag s iadb

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
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
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
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
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
We examine the determinants of Job satisfaction as a function of:

  • X1: Observable worker characteristics (gender, age, educ, health status, civil status)

  • Z1: 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

  • Z2: Objective job characteristics (earnings, industry, occupation, hours )

  • Z3: Subjective job characteristics (well remunerated, opportunities for promotion, job is stressful, job is dangerous, monotonous, good work schedule, job is insecure, )

  • Methodological issues i
    Methodological issues (I) function of:

    • 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
    Methodological issues (II) function of:

    • 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 (I) function of:

    • 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 (II) function of:

    • 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?”

    Informality welfare and productivity

    Ranking does function of:

    not correspond

    with traditional

    distinctions based

    on firm size

    Informality welfare and productivity

    Omitted category self-employed function of:

    Earnings strongly associated with

    Job satisfaction

    Informality welfare and productivity

    Omitted category self-employed function of:

    Job characteristics correlate

    with job satisfaction in an

    Expected manner

    Informality welfare and productivity

    Omitted category self-employed function of:

    Salaried small are worse off than


    Salaried at large firms are

    better off.

    Results are robust to
    Results are robust to: function of:

    • 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 across countries
    Results change across countries function of:

    Strong preference

    For self-employment

    And education
    And education… function of:

    Higher preference for formal

    among skilled workers Lower

    valuation of benefits among


    In sum
    In sum function of:

    • 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
    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?

  • Informality welfare and productivity

    Part II: Informality lowers productivity informality leads to poor outcomes… based on“Informality, Resource Misallocation and Productivity in Brazil” Carpio and Pagés (2009)

    A channel informality leads to resource misallocation
    (A) channel: Informality leads to resource misallocation informality leads to poor outcomes…

    • 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.

    Informality welfare and productivity
    Data informality leads to poor outcomes…

    Use a large and detailed sample of almost 39000 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

    Informality welfare and productivity
    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.

  • Informality welfare and productivity

    Productivity (TFP) is higher in formal firms no matter how we measure itPayroll: 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


    We measure the difference between mpl or mpk as a firm specific wedge
    We measure the difference between MPL or MPK as a firm specific wedge.

    Distortions that affect the price of Y relative to L

    Distortions that affect the price of Y relative to L

    Simple argument
    Simple argument: specific wedge.

    • 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.

    Informality welfare and productivity

    In Brazil, high marginal products more likely among specific wedge.

    formal firms…

    On average, informal firms in Brazil are more constrained in their growth

    than formal firms.

    Bottom line
    Bottom line… specific wedge.

    • 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
    A more proactive approach specific wedge. 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
    Credit can help specific wedge.

    • 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 specific wedge.

    • 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 specific wedge.

    • 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
    Ideas for when reviewing Madrigal Pages: specific wedge.

    • Do fixed effect estimator by level of education

    Ideas for when reviewing carpio pages
    Ideas for when reviewing Carpio Pages: specific wedge.

    • A few informal firms seem to have very high MPK and L.