By Ángel Melguizo (OECD Development Centre) and Nora Lustig (Tulane University)
26 January 2016
On labour informality and its causes
One of the most important achievements of the recent period of economic expansion in Latin America has been the substantial reduction of poverty and the surge of an emerging middle class. According to World Bank estimates (Ferreira et al, 2013), in 2009 the Latin American population with a daily income of between 4 and 50 dollars a day (in parity of purchasing power) represents 68% in the region today, compared with 29% who still are moderate poverty. These 'middle sectors' are composed of 38% belonging to a vulnerable population, which has between 4 and 10 dollars a day, and 30% middle class, between 10 and 50 dollars.
This advance does not, however, hide the fact that the situation of 'middle sectors' citizens in Latin America is still very fragile. Although this group is not in a situation of poverty and they represent a growing source of consumers, they are not satisfied nor have access to much in the way of public services, and they remain vulnerable to loss of employment, health problems, or to income falls after retirement (OECD, 2010).
One of the most notable vulnerabilities of this emerging middle class is its high labour informality. Far from being a problem only for low-income workers, informality impacts these middle sectors significantly. This fact distances them from the definition of a stable middle class with formal employment (Banerjee and Duflo, 2008; Tuesta, 2014). Up to now, to our knowledge, there have only been suppositions and on this issue, not allowing for direct comparison with previous socio-economic groups. Thus, on the basis of income deciles (whose level varies between countries), in Latin America, 5 in 10 of middle-sector workers, i.e., between the third and the eighth decile of per capita income, contribute to the social insurance system, only slightly above the national average (Bosch, Melguizo and Pages, 2013). These figures are robust compared to other definitions of informality, such as contributions to health plans, existence of a written contract, or occupation and sector.
In response, and as within the initiative of the Commitment to Equity project (CEQ), the Development Centre of the OECD, the Labor Markets and Social Security Unit of the IDB, the Policy Center and Inter-American Research (CIPR) and the Department of Economics at Tulane University and the Inter-American Dialogue, are all analyzing the characteristics of working households in Latin America according to the aforementioned World Bank socio-economic classification (the disadvantaged, vulnerable, middle-classes and affluent). In addition, analysis will be made on the impact of taxes and public expenditure, including public services and monetary transfers, on income and economic mobility, within the focus of Commitment to Equity (Lustig and Higgins, 2013).1
The analysis distinguishes three groups of countries according to level of informality in a wide sample of Latin American countries. The highest levels of informality are observed in Bolivia, El Salvador and Guatemala, where more than 80% of households respectively do not have any member contributing to social security schemes.2 A second group, with a level of informality between 60% and 70%, includes Peru, Colombia and Mexico (73%, 68% and 62%, respectively). Lastly, Uruguay, Costa Rica and Brazil, reflect the lowest rate of informality of all analyzed countries, with 40% and 50% of households not contributing (39%, 47% and 55%, respectively).
More importantly, emphasis must be made that informality is one of the most striking differences, within the middle sectors, between the vulnerable population and the middle class. The previous classification of countries remains the same when analyzing only middle-income households, but the most interesting result is the noticeable difference in the degree of formality between households classified as middle class, compared to the vulnerable population. The rate of average informality among the vulnerable class is 70% (with a range between 45% in Uruguay and 82% in Bolivia), much higher than middle class households at 47% (with a range between 35% in Uruguay and 65% in Guatemala). On the other hand, except in El Salvador and Peru, a degree of similar informality is observed among middle class and relatively affluent households (whose informality reaches 48% of households).
The effects of the informal economy, and particularly those affecting the middle sectors, differ between countries, therefore the solution must be addressed case by case. Among possible explanatory factors, some countries, such as Colombia or Peru, show high non-wage costs of formal employment, especially when interacting with high minimum wage (compared to the average wage). In addition, the region has implemented a series of subsidized pension and health schemes while extending non-contributory benefits for citizens without formal savings, as is the case in Mexico; all with best intentions but have introduced disincentives to formality (Levy, 2008). Altogether, this adds to the low valuation of social security systems, low financial knowledge and myopia, as well as a low enforcement. This undoubtedly makes for a relevant and challenging agenda for policy makers in Latin America.
In this reform agenda, the increase of middle sectors formality, especially for vulnerable populations, would not only contribute to increasing productivity and potential growth, but would also help in the fight against inequality in Latin America.
1. This Project is being coordinated by Nora Lustig along with the following country working groups. Bolivia – V. Paz Arauco, G. Gray-Molina, W. Jiménez and E. Yáñez; Brazil – S. Higgins and C. Pereira; Colombia – N.Lustig and M. Meléndez; Costa Rica – P. Sauma and J.D. Trejos; El Salvador - M. Beneke and J. A. Oliva; Guatemala – M. Cabrera, N. Lustig and H. E. Moran; Mexico – J. Scott; Peru – M. Jaramillo; Uruguay – M. Bucheli, N. Lustig, M. Rossi and F. Amabile. We would like to thank Jose Ramon Perea (OECD Development Center) for his excellent technical support.
2. Depending on the availability of data in the survey of households in each country, a household is defined as informal when none of its members contribute to the pension system in the case of Bolivia, Brazil, Colombia, Costa Rica and Uruguay, to the health system in El Salvador and Mexico, and the pension and health systems in Peru. In the case of Guatemala, a household is formal when it counts an affiliate to the pension system.
Bosch, M., A. Melguizo and C. Pages (2013), Better Pensions, Bejjer Jobs. Toward Universal Coverage in Latin America and the Caribbean. IDB, Washington.
Banerjee, A.V. and E. Duflo (2008), "What Is Middle Class about the Middle Classes around the World?" Journal of Economic Perspectives, 22(2): 3-28.
Ferreira, F.H.G., J. Messina, J. Rigolini, L.-F. Lopez-Calva, M.A. Lugo and R. Vakis (2013), Economic Mobility and the Rise of the Middle Latin American Middle Class, The World Bank, Washington DC.
Levy, S. (2008), Good Intentions, Bad Outcomes. Social Policy, informality and Economic Growth in Mexico. Brookings Institution Press, Washington, DC.
Lustig, N. and S. Higgins (2013), “Estimating the Incidence of Social Spending, Subsidies and Taxes” Handbook, Commitment to Equity Assessment (CEQ), Tulane University Department of Economics Working Paper 1219.
OECD(2010), Latin American Economic Outlook 2011: How Middle Class in Latin America? OECD Development Center, Paris.
Tuesta, D. (2014), “The Informal Economy and the Constraints that it Imposes on Pensions Contributions in Latin America”, BBVA Research Working Papers 14/19.
This article first appeared in Vox.LACEA on May 20, 2015, and was ranked first among the top 10 most liked/read blog articles of 2015 to appear on the site. Read it anew here: http://vox.lacea.org/?q=blog/middle-class-households-latam
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