FIGHTING INFORMALITY IN SEGMENTED LABOR MARKETS A general equilibrium analysis applied to Uruguay *

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1 Vol. 48, No. 1 (May, 2011), 1-37 FIGHTING INFORMALITY IN SEGMENTED LABOR MARKETS A general equlbrum analyss appled to Uruguay * Carmen Estrades ** María Inés Terra ** As n other Latn Amercan countres, labor nformalty n Uruguay manly affects less educated workers, who are also more vulnerable to poverty. We analyze the mpact of some polces aganst nformalty n Uruguay, applyng a general equlbrum model wth a segmented labor market specfcaton. We smulate two sets of polces: payroll tax cuts and ncreased enforcement n the nformal sector. Both sets of polces are effectve n reducng nformalty, but the effect on poverty s not straghtforward. Poverty falls as nformalty s reduced; however, as enforcement polces ncrease hrng costs for nformal frms, wages of low-sklled workers declne and poverty ncreases. JEL clasfcaton: D58, I32, J08, J42 Keywords: Informalty, labor market, general equlbrum model, polces, poverty 1. Introducton Labor nformalty n Latn Amerca, although not hgher than n other regons, s stll a source of concern for polcymakers, snce t s usually assocated wth less favorable workng condtons, lower productvty and weak enforcement of the rule of law (Perry et al., 2007). Informalty rates ncreased n most countres of the regon durng the 1990s and contnued to be hgh durng the 2000s. In ths sense, Uruguay s not an excepton. The fnancal and trade openng of the Uruguayan economy, together wth the creaton of MERCOSUR n 1991 and the mplementaton of stablzaton polces durng the 1990s, deeply affected the country s economy. The labor market was also transformed: the sectoral dstrbuton of employment changed, unemployment and nformalty rose, the female labor supply ncreased and relatve factor remuneratons changed. Unemployment and nformalty rose durng the second half of the decade, and ncreased even more wth the recesson of the economy that began n * The authors thank the useful comments from anonymous referees. All remanng errors are ours. ** Department of Economcs, Unversdad de la Repúblca, Uruguay. Address: Consttuyente 1502, Pso 6, Montevdeo 11200, Uruguay. E-mal addresses: carmen@decon.edu.uy; terra@decon.edu.uy

2 LATIN AMERICAN JOURNAL OF ECONOMICS Vol. 48, No. 1 (May, 2011), 1 37 By 2005, nformal workers represented 45% of total prvate workers n Uruguay (Amarante and Espno, 2007). Although nformalty s a complex phenomenon that affects workers wth very dfferent characterstcs n Latn Amerca, nformal workers tend, on average, to be less educated and younger, whle certan sectors such as constructon, agrculture, retal and transport show hgher nformalty rates (Perry et al., 2007). In Uruguay, nformalty affects manly low-sklled workers: n 2004, 55% of workers wth fewer than eght years of schoolng were employed n the nformal sector, whle 20% of sklled workers wth 12 or more years of schoolng were nformal workers. 1 Informal workers also earn on average less than formal workers, and ths wage gap ncreased n the regon between 1990 and 2002 (Cmol et al., 2006). Several authors (Amarante and Arm, 2005; Amarante and Espno, 2007; Casson, 2001; Terra et al., 2006) estmate wage gaps between formal and nformal workers n Uruguay, and even when they dffer n terms of the tme frame of the analyss and the methodology appled, they fnd evdence of an earnngs gap between formal and nformal workers wth dentcal characterstcs. Furthermore, nformaton from the Contnuous Household Survey shows that the most vulnerable workers n terms of poverty are at the greatest dsadvantage n the labor market. For ths reason, mplementng polces aganst unemployment and nformalty may ndrectly contrbute to the reducton of poverty. Although nformalty n Uruguay s labor market has been wdely analyzed, there are no studes that evaluate specfc polcy optons to reduce t. Wth ths n mnd, n ths paper we dscuss specfc polcy optons to reduce nformalty n labor markets n Uruguay, we provde polcy scenaros and we analyze ther mpact on the labor market and the economy. Even though ths research focuses on the Uruguayan case, the dscusson and evaluaton of dfferent polcy optons may be relevant for other countres as well, snce nformalty s usually assocated wth common causes, partcularly wthn the regon. Specfcally, we smulate two dfferent polcy optons reducton n labor tax rates and enforcement polces usng a sngle-country computable general equlbrum (CGE) model whch ncludes a detaled specfcaton of the labor market. Our results suggest that even when both types of 1. The percentage of nformal jobs for medum-sklled workers was 40% n the same year, accordng to data from the Contnuous Household Survey 2004.

3 C. Estrades and M.I. Terra INFORMALITY IN SEGMENTED LABOR MARKETS polces are effectve n reducng nformalty, they may also produce other unwanted effects on wages and poverty. Specfcally, enforcng polces on nformal frms ncreases ther hrng costs, causng wages to fall wth the consequent negatve effect on poverty. In the next secton we present the operatonal defnton of nformalty appled n ths paper and a revew of lterature on the causes of nformalty and polces desgned to reduce t. Secton 3 presents the methodology appled n the paper, whle Secton 4 presents our results and Secton 5 our conclusons. 2. Informalty: orgn and polces to reduce t Informalty s a complex concept for whch there are numerous theoretcal explanatons and operatonal defntons. The tradtonal ILO-PREALC concepton of nformalty s that of dual labor markets. It suggests that n an economy there s a sector whch encompasses all actvtes that are margnal to the man economc actvtes and presents lower productvty levels (Hart, 1973; ILO, 1972; Sethuraman, 1976; Tokman, 1978). On the other hand, accordng to the structuralst approach developed by Moser (1978) and Portes et al. (1989), among others the nformal sector s consdered part of the structure of the economy. Accordng to ths approach, the nformal sector conssts of all remunerated actvtes that are not regulated by the State, and whch coexst wth other smlar actvtes n the formal sector. Followng ths approach, the nformal sector s measured by the percentage of jobs that do not comply wth exstng regulatons, such as provdng socal securty or healthcare benefts. In Uruguay, ths means that nformal workers are defned as those who do not contrbute to the socal securty system, regardless of the sze of the frm n whch they are employed. Ths defnton of nformalty stresses the fact that the labor condtons of a job are more mportant than the type of frm that provdes the job. 2 We apply ths last defnton of nformalty, but we also consder some aspects of the dual labor market theory. Ths theory states that two sectors coexst n the labor market: the prmary sector, or formal sector, pays hgher wages and offers better labor condtons, 2. A thrd theoretcal approach, known as legalst, consders that nformalty s a consequence of excessve State regulaton. The presentaton of theoretcal approaches on nformalty follows Portes and Shauffler (1992).

4 LATIN AMERICAN JOURNAL OF ECONOMICS Vol. 48, No. 1 (May, 2011), 1 37 whle the secondary sector, or nformal sector, offers jobs that do not comply wth regulatons. We assume that the dfferental between the wages pad n the formal and the nformal sectors s an effcency wage that frms n the formal sector pay n order to boost worker performance or to mantan employees once tranng costs have been assumed by the frm. The secondary or nformal sector presents lower productvty levels, whch are assocated, among other factors, wth credt and publc servces restrcton (Braun and Loayza, 1994). We also assume that n the nformal sector there are workers and frms that choose to be part of the nformal sector n order to avod the costs and regulatons of the formal sector. Ths hypothess follows Agénor and Azenman (1999) and Fugazza and Jacques (2003), and corresponds to an ntegrated approach to nformalty that combnes the dual economy approach wth the structuralst and legalst approaches. The theoretcal approach adopted and the dagnoss of the causes of an nformal sector n the labor market wll determne the polcy suggestons to reduce t. The most frequently mentoned cause of nformalty n the labor market s the exstence of hgh tax levels borne by the formal sector (Braun and Loayza, 1994; Fugazza and Jacques, 2003; Ihrg and Moe, 2004; Sanches, 2005; Schneder and Klngmar, 2004; among many other authors). The costs of formalzng a busness can be understood as hgh tax rates and onerous socal securty contrbutons (Gërxhan, 2004; Schneder and Enste, 2000). The second most mentoned cause of nformalty s overregulaton n the labor market (Gërxhan, 2004; Schneder and Enste, 2000). Overregulaton can be measured through the exstence of hgh mnmum wage levels (Loayza 1994), hgh entry costs to the formal sector the number of permts requred and the ease wth whch they are obtaned (Braun and Loayza, 1994; Fredman et al., 2000), or labor restrctons on foregners (Schneder and Enste, 2000). How government controls overregulaton s also mportant. Therefore, the way n whch the government controls and enforces complance wth regulatons and penalzes frms whch do not comply s also assocated wth nformalty levels (Ihrg and Moe, 2004). Accordng to Schneder and Enste (2000), the studes tend to show that what matters s how regulatons are enforced, rather than ther quantty or qualty. There may be cases where many regulatons are not followed. Thus, corrupton becomes a factor assocated wth nformalty (Braun and Loazya, 1994; Fredman et al., 2000).

5 C. Estrades and M.I. Terra INFORMALITY IN SEGMENTED LABOR MARKETS Other factors that are mentoned less frequently n the lterature are socal securty plans for unemployed or precarous workers; changes n labor market regulatons, such as a reducton of workng hours and ncentves for early retrement; the deteroraton of publc servces from whch the formal sector benefts (Schneder and Enste, 2000); the presence of powerful unons that frms and workers prefer to avod; and the mpact of nternatonal competton (Gërxhan, 2004). Whch specfc polces can be mplemented to reduce nformalty? Many authors suggest tax reducton polces, and ths goes along wth the opnon that hgh costs n the formal sector lead to a bgger nformal sector. Related to the effcency wage theory, several authors suggest that n order to ncrease formal employment and mprove welfare, government should subsdze wages pad n the prmary (formal) sector (Therfelder and Shells, 1997). Studes that analyze the mpact of fscal polces on nformalty fall nto two groups: those that develop theoretcal models and those that use emprcal data from developed and/or developng countres. In the frst group, Ihrg and Moe (2004) work wth a dynamc model and consder two man causes of nformalty: hgh taxes (postve relatonshp) and regulaton complance (negatve relatonshp). The authors evaluate dfferent polces amed at reducng the sze of the nformal sector: decreasng the tax rate for busnesses operatng n the formal sector and ncreasng enforcement n addton to hgher penaltes. They fnd that reducng the tax rate has a greater mpact on the sze of the nformal sector, although mantanng government revenue requres better enforcement and hgher penalty rates for frms found to be operatng nformally. Albrecht et al. (2006), usng a search and matchng model that consders a large nformal sector, smulate an ncrease n tax rates for both severance taxes and payroll taxes. Ther results show that ncreasng the rates of these two taxes reduces the rate at whch workers fnd formal jobs, but hgher payroll taxes generate a deeper mpact on nformalty; the duraton of tenure n formal jobs falls and unemployment ncreases. Among those n the second group, Sanches (2005) analyzes the effect of a payroll tax cut on nformalty, usng data from the Unted States and Brazl and employng a neoclasscal model wth two sectors. In order to keep the fscal balance unchanged, the decrease n payroll tax rates s compensated for by an ncrease n the value added tax rate. The author draws smlar conclusons for the two countres. In the short term, the lower

6 LATIN AMERICAN JOURNAL OF ECONOMICS Vol. 48, No. 1 (May, 2011), 1 37 overall tax level has a negatve mpact on nformalty n both economes and a postve mpact on GDP. In the long term the conclusons are the opposte: nformalty falls at the begnnng when the ntal level of taxes s hgh, and GDP falls n the long term because of the major declne n captal stock. In spte of that, both n the short and long term, general welfare ncreases as a consequence of substtutng taxes. Fugazza and Jacques (2003) analyze the mpact of fscal polces on nformalty n Italy and Canada usng a dual labor market approach wthn a contnuous matchng model framework, whch consders unemployment for both segments of workers. They smulate a reducton n payroll taxes n the formal sector. They consder dfferent tax rates: payroll taxes mposed on frms and taxes mposed on workers (socal contrbutons). They also consder other parameters related to taxes: nformalty detecton probablty and penalty rates for frms commttng nfractons; and they evaluate how a reducton n both of the tax rates, an ncrease n detecton probablty and a hgher penalty rate affect nformalty n Italy and Canada. They fnd that even when each of the three polces s effectve n reducng nformalty and ncreasng the sze of the formal sector, the ncrease n detecton probablty reduces worker welfare and thus worsens socal welfare. Gven ths result, the tax rate reducton polcy seems to be more effectve n reducng nformalty. Applyng a CGE model wth data from Cameroon, Fortn et al. (1997) smulate dfferent reforms of the tax and regulatory system and analyze the dfferentated effects on model specfcatons wth and wthout an nformal sector. They fnd that n an economy wth an nformal sector and unemployment, a rse n the payroll tax rate, governmentset wage rate or tax rate on profts ncrease the sze of the nformal sector, boost the unemployment rate and have a negatve effect on GDP, more sgnfcant than n a model wthout an nformal sector. Ths happens because as costs ncrease for frms, labor demand and producton fall. If the economy operates wth an nformal sector, frms move to the less effcent nformal sector and the declne n GDP s renforced. Unemployment rates, however, decrease to a lesser extent because the unemployed are absorbed by the nformal sector. In spte of ths, the negatve effect on GDP trggered by expanson of the nformal sector exceeds the postve effect on GDP of a less pronounced ncrease n unemployment. Braun and Loayza (1994) conclude that n order to reduce nformalty, authortes should mpose hgher penalty rates on frms caught

7 C. Estrades and M.I. Terra INFORMALITY IN SEGMENTED LABOR MARKETS operatng nformally. The authors develop a dynamc model wth endogenous growth n whch there s an optmum tax rate for the producton of publc servces. If the tax rate s below the optmum, and at a suffcently low level, the nformal sector mght not exst, because there would be no ncentves to operate nformally and thus avod payng taxes. However, a low tax rate also results n low-qualty publc servces. When the tax rate s ncreased, socal welfare rses, but there s a rsk that nformalty may ncrease. In order to avod that, the authors suggest an ncrease n penalty rates for frms n the nformal sector and greater enforcement n order to prevent those frms from obtanng access to publc servces. Smlarly, Schneder and Enste (2000) agree that governments should pay more attenton to the densty of regulatons and to ways n whch authortes can ncrease regulatory complance n order to tackle nformalty. Some studes for Uruguay fnd that hrng costs are hgh n the Uruguayan labor market, partcularly n some sectors such as domestc servce and the constructon sector (Casson and Ferre, 1997). Therefore, a tax reducton polcy would reduce nformalty n the Uruguayan labor market, although polces focused on specfc sectors may have a greater mpact on the creaton of new formal jobs (Casson, 2005). Informalty n Uruguay s also assocated wth a low enforcement level of current regulatons (Forteza, 1999). Increasng enforcement and penalzng frms caught n the nformal sector may also reduce nformalty. However, ths type of polcy may also ncrease unemployment, as nformalty and unemployment affect the same segment of workers (Boer and Garbald, 2006). 3. Methodology In order to evaluate the mpact on the labor market and the economy of certan polces amed at reducng nformalty, we chose to apply a computable general equlbrum (CGE) analyss. General equlbrum models are a sutable methodologcal tool for evaluatng polcy optons, because they take nto account the drect and ndrect effects of the polces on the economy. They have been more extensvely used to analyze dfferent trade and tax polces than labor polces; however, as Fortn et al. (1997) conclude, general equlbrum models are an mportant tool for evaluatng tax reforms and regulatory polces, especally when they explctly ncorporate an nformal sector. To capture the effect of the smulated polces on poverty and ncome dstrbuton, we also ran mcrosmulatons.

8 LATIN AMERICAN JOURNAL OF ECONOMICS Vol. 48, No. 1 (May, 2011), Theoretcal model We apply a sngle country, statc CGE model for the Uruguayan economy, followng Laens and Terra (2000) and Terra et al. (2006), and ntroduce some changes, mostly n the labor market. In ths subsecton we frst present the general characterstcs of the model and then turn to the labor market. The full model and ts equatons are presented at the Appendx. General characterstcs The model has a conventonal structure n terms of the analyss of trade-related ssues. It assumes perfect competton n good markets, although goods are not homogenous: they dffer accordng to geographcal orgn, n lne wth an Armngton (1969) specfcaton. In nternatonal markets, Uruguay faces a perfectly elastc supply of mports, whle n ts export markets, the country s a prce maker, followng an almost small open economy assumpton (Harrs, 1984). The demand for exports s a functon of the relatve prces and real ncome of Uruguay s trade partners, whch s consdered exogenous. The country has three trade partners: Argentna, Brazl and the Rest of the World. The trade balance s fxed. There are 23 sectors. One of them s the publc sector wth fxed employment (t does not hre or dsmss workers). Another s the nformal sector, whch encompasses all of the nformal actvtes n the economy. The nformal sector produces one good destned for fnal consumpton n the domestc market and operates wth lower levels of productvty, hrng only unsklled and medum-sklled workers. The other 21 sectors are formal sectors, dstrbuted among prmary, manufacturng and servce sectors. Frms produce for the domestc and nternatonal markets, for both ntermedate and fnal consumpton. The producton functon of frms s nested n three levels. At the upper level, frms combne ntermedate nputs and value added followng a Cobb-Douglas functon. Value added s obtaned through a nested CES (constant elastcty of substtuton) functon: at the upper level the frm combnes composte labor and captal, and at the lower level t combnes labor by dfferent sklls, whch means there s mperfect substtuton among dfferent types of labor by sklls. The frm producton functon s shown n Fgure 1. Frms must pay a tax on labor (t fac ) that negatvely affects labor demand. There s also

9 C. Estrades and M.I. Terra INFORMALITY IN SEGMENTED LABOR MARKETS an ncome tax that households pay (t lab ). Ths tax does not affect labor demand. It could affect labor supply, but n our model ths s assumed to be constant. At equlbrum, labor supply equals labor demand. Fgure 1. Frm producton functon Domestc nputs Intermedate nputs (CES) Imported nputs Fnal goods (Cobb-Douglas) Captal Value added (CES) Sklled labor Composte labor Medumsklled labor (CES) Unsklled labor Our model consders three labor categores: unsklled labor (eght or fewer years of schoolng), medum-sklled labor (between nne and eleven years of schoolng) and sklled labor (12 or more years of schoolng), as suggested by some authors for analyss of Latn Amercan labor markets (Wood, 1994). Snce our model s statc, the supply of each type of workers s fxed and workers do not change ther educaton status. Each labor category s perfectly moble between formal sectors, and thus there s one wage per skll category for all sectors (except n the publc sector where employment s fxed). The level of employment n each sector wll depend on the demand for labor n each sector.

10 10 LATIN AMERICAN JOURNAL OF ECONOMICS Vol. 48, No. 1 (May, 2011), 1 37 Fnal goods demand functons are derved from maxmzng the households utlty functon (Cobb-Douglas functon) subject to ther ncome constrants. There are ten types of households n lne wth ncome decles. The government collects taxes, buys goods and servces and makes transfers to households. The nvestment level of the economy s determned by savngs, whch are made up of prvate savngs, publc savngs and external savngs. The equlbrum n the model s reached through smultaneous equlbrum n the good market, n the factor market and n the external sector. In all smulatons the numerary of the model s the consumer prce ndex of the economy. Labor market In order to ntroduce the nformal sector nto the labor market, we consder the dual labor market hypothess, under the assumpton that nformalty affects only unsklled and medum-sklled workers, whereas sklled workers are fully employed n the formal sector. Unsklled and medum-sklled workers are employed n the nformal sector, whch works under perfect competton, or n the formal sector, where they earn an effcency wage, whch s explaned by montorng or tranng costs. If low-sklled workers are dsmssed from the formal sector, they move to the nformal sector, where no effcency wages are pad and equlbrum s reached through wages. Snce wages are hgher n the effcency wage sector, formal workers make greater effort and formal sectors show hgher productvty. Wage dfferentals are endogenously determned n the model. Followng Therfelder and Shells (1997), the wage dfferental s specfed through the equaton below, n whch we see that effcency wages are postvely determned by the labor demand n each sector and negatvely correlated to the quttng rate n the sector. When the economy expands and producton rses, formal labor demand ncreases, and formal frms are wllng to pay a hgher wage dfferental to promote hgher productvty and retan workers. On the other hand, when the economy contracts, formal labor demand falls and nformalty ncreases, and therefore the quttng rate n each sector s reduced (workers are not wllng to jeopardze ther jobs n a formal frm). In ths scenaro, frms have no ncentve to pay hgh wage dfferentals. wd labnc, wd labnc, - 1 k. rd D S LU labnc = ( D -D ) + k( 1+ ) = {1,..,I} 2 1 ( D2-D1) ( LU labnc - lu, ), labnc

11 C. Estrades and M.I. Terra INFORMALITY IN SEGMENTED LABOR MARKETS 11 where k s the utlty of shrkng, rd s the dscount rate, D1 s the probablty of frng workers who were not shrkng, D2 s the probablty of beng caught shrkng and therefore fred and S s the quttng rate n the formal sector. LU labnc refers to labor supply by category of labor (fxed) and lu labnc, represents labor demand by sector for each type of labor labnc. Note that are all the effcency wage sectors, that s all the formal sectors n the economy, not ncludng the publc sector, and labnc ncludes unsklled labor and medum-sklled labor. The wage dfferental at the benchmark s set at 60% for both types of workers, followng estmates by Terra et al. (2006) Data and calbraton Data used n a general equlbrum model s assumed to reflect equlbrum for the economy at the benchmark, and t s represented n a Socal Accountng Matrx (SAM). In ths paper we use the same SAM as n Terra et al. (2006), whch s a modfed verson of the one developed by Barrenechea et al. (2004) for 2000 wth some mnor changes. In our model there are three types of labor correspondng to the skll levels of workers, and thus we needed to ntroduce ths change to the SAM. We dvded unsklled labor nto unsklled and medum-sklled labor, usng data from the Contnuous Household Survey (CHS) for Second, we dvded taxes on labor nto two types: taxes on labor demand, whch are pad by frms, and taxes on worker ncome, pad by households. Although both taxes are consdered n the model, n the orgnal SAM they were lumped nto a sngle payment. In ths paper the dfferentaton of the two taxes n the model and n the SAM s extremely mportant because, snce the model assumes a fxed labor supply, changes n the tax rate appled to labor supply do not affect labor demand and have no mpact on employment. Therefore, a second modfcaton was made to the SAM to dfferentate taxes on factors from taxes on frms. To do ths we used data from the Central Bank of Uruguay (Natonal Accounts, 2005) and the Socal Securty Bank (Banco de Prevsón Socal) Mcrosmulatons General equlbrum models may capture the effects of smulated polces on ncome dstrbuton through changes n the relatve prce of producton factors and changes n relatve household ncome. However,

12 12 LATIN AMERICAN JOURNAL OF ECONOMICS Vol. 48, No. 1 (May, 2011), 1 37 ths s a partal dstrbuton and does not measure the mpact on poverty and ncome dstrbuton at a mcro level. In order to analyze the effect of the smulated polces on poverty and nequalty, the CGE analyss can be complemented wth mcrosmulatons. Several mcrosmulaton technques can be appled as a complement to CGE analyss. One of the most common ones s the so-called top-down approach, whch s appled n a sequental fashon, takng parameters from the CGE model and feedng them nto the mcro module, wthout any further nteracton between the macro and the mcro level. Roughly, ths approach has two varants: a) modelng the ncome generaton process of the households; b) random assgnaton of changes n parameters to households n the survey. In ths paper we apply the latter technque, developed by Ganuza et al. (2002) and appled n Vos et al. (2006) and other studes. Ths approach assumes that occupatonal shfts can be proxed by a random selecton procedure wthn a segmented labor market structure. Ths procedure allows the mposton of counterfactual changes n key labor market parameters (partcpaton rate, unemployment, employment composton by sector, wage structure, and so on) on a gven dstrbuton derved from household survey data, and the estmaton of the mpact of each change on poverty and ncome dstrbuton at the household level. That s to say, random numbers are used to determne whch persons at workng age change ther labor force status; who wll change occupatonal category; whch employed persons obtan a dfferent level of educaton; and how new mean labor ncomes are assgned to ndvduals n the sample. Hence, the assumpton s that, on average, the effect of the random changes correctly reflects the mpact of the actual changes n the labor market. Because of the ntroducton of a process of random assgnaton, the mcrosmulatons are repeated numerous tmes n Monte Carlo fashon. Ths allows for constructon of 95 percent confdence ntervals for the ndces of nequalty and poverty, except n the case of the smulatons of the effect of change n the structure and level of remuneraton, whch do not nvolve random numbers. Gven the characterstcs of our CGE model, n ths paper we take the followng parameters from the CGE results and feed them nto the mcrosmulaton module: share of nformal workers by category of educaton, wages n the formal and nformal sector and by category of educaton, average wage n the economy and share of workers by skll by sector of actvty. We feed changes n these parameters nto the CHS database for 2001 to obtan the average value and confdence ntervals for the relevant ndcators. Specfcally, we obtan the most

13 C. Estrades and M.I. Terra INFORMALITY IN SEGMENTED LABOR MARKETS 13 typcal poverty and nequalty ndcators: the poverty ndex (the percentage of households below the poverty lne), takng as a reference the poverty lne suggested by the Natonal Insttute of Statstcs for the year 2001; the extreme poverty ndex (the percentage of households below the extreme poverty lne); and the Gn coeffcent, calculated wth per capta ncome by household. Comparng the average level of the ndcators wth ther value at the benchmark, we can draw conclusons about the mpact of the smulated polces on poverty and ncome dstrbuton. Mcrosmulatons were run usng STATA software, followng programmng by Ccowez (2006) Smulaton of polcy scenaros We desgn smulatons takng nto account the man objectve of ths paper: to evaluate polcy optons to combat nformalty and to analyze ther mpact on the labor market and the economy. As we have noted, there are two sets of polces mentoned n the lterature. On the one hand, nformalty may be a consequence of hgh tax rates, and therefore a polcy to reduce t would be a tax rate decrease or a subsdy for formal employment; on the other hand, the government can fght nformalty through enforcement polces that ncrease control of the nformal sector and force frms/ndvduals operatng nformally to pay taxes and comply wth regulatons. Frst we smulate fve polcy scenaros nvolvng payroll tax rate reductons. We should remember that n our model ths tax s pad by the frm that demands formal labor, although frms are able to transfer costs to workers through wages. In the fve scenaros the tax reducton smulated s the same, a 20% decrease wth respect to the level at the benchmark. However, the scenaros dffer n two aspects, namely the sectors that beneft from the tax reducton and the type of labor affected. The frst scenaro (TAX1) s the most restrctve n that t smulates a 20% tax cut for unsklled labor and benefts only those sectors ntensve n ths factor. Specfcally, the sectors whch beneft are agrculture, lvestock-rearng, other prmary sectors, rce, ceramcs and the constructon sector. The second scenaro (TAX2) smulates a tax cut for both unsklled and medum-sklled labor, whch benefts sectors ntensve n unsklled labor as well. The TAX3 scenaro smulates a 20% tax cut for unsklled labor, but one whch benefts all effcency wage sectors. Lastly, we smulate a 20% tax cut for unsklled and medumsklled labor n all effcency wage sectors (TAX4). Ths last polcy

14 14 LATIN AMERICAN JOURNAL OF ECONOMICS Vol. 48, No. 1 (May, 2011), 1 37 could have a sgnfcant mpact on government revenue and therefore on publc nvestment, and n the long term on nvestment and human captal accumulaton (Terra et al., 2006). Thus, we smulate a ffth polcy scenaro (TAX5) whch adds a new tax on captal ncome of 0.75% n order to mantan the fscal defct unchanged. The second set of smulatons consders an enforcement polcy n the nformal sector. In ths case, three alternatve scenaros are smulated. The frst consders a less effectve enforcement polcy and the second a more effectve enforcement polcy. Both of them assume that the enforcement polces are appled to both unsklled and medum-sklled workers. In the thrd scenaro only unsklled workers are compelled to pay taxes, on the assumpton that the enforcement polcy s appled only to those sectors that hre unsklled labor. Because the enforcement polces requre nformal sectors to start payng taxes, they become part of the formal sector. Therefore, we smulate an ncrease n taxes specfcally for the nformal sector. If the probablty of detectng frms n the nformal sector ncreases, the tax rate ncreases as well. The theoretcal revenue from labor tax (R ) would be R = tw, that s tax rate (t ) tmes the tax base, whch n ths case s made up of wages pad to workers (W ). In fact, there are two types of wages: those pad n the formal sector and those pad n the nformal sector. In the latter, revenue s zero because we assume no government enforcement at the benchmark: R = tw f + pτ (tw nf ), where p s the probablty of catchng an nfractng frm and forcng t to pay taxes, W f and W nf are wages n the formal and nformal sector respectvely and τ s the penalzaton rate pad by the nfractng frm. At the benchmark p = 0. If government ncreases enforcement n the nformal sector, then p adopts a postve value. In the frst smulaton scenaro (ENF1), p s 50%; that s, enforcement of the nformal sector s 50% effectve, whle the second scenaro consders 85% effectveness (ENF2). Frms n the nformal sector that are caught not only have to pay taxes but also a fne, whch s smulated by ncreasng tax rates by a few percentage ponts that dffer accordng to the type of worker and the scenaro smulated. As a consequence, the payroll tax rate n the nformal sector s now postve, but has a lower value than the tax rate pad n the formal sector,

15 C. Estrades and M.I. Terra INFORMALITY IN SEGMENTED LABOR MARKETS 15 because not all frms and workers are caught nfrngng regulatons. In the frst scenaro (ENF1), the tax rate n the nformal sector s 4.0% for unsklled labor and 4.1% for medum-sklled labor. In the second scenaro (ENF2) the tax rates are 6.8% and 7.0%, respectvely. In the thrd scenaro (ENF3), only the tax rate for unsklled labor rses to 7.2%, whch represents a 90% effectve enforcement polcy. Table 1 presents the eght smulaton scenaros: Table 1. Smulaton scenaros Scenaro Polcy Factors affected Sectors affected Parameter New parameter value TAX1 20% decrease n tax on labor Unsklled labor Unsklled labor-ntensve sectors* tfac Depends on sector TAX2 TAX3 TAX4 TAX5 ENF1 ENF2 ENF3 20% decrease n tax on labor 20% decrease n tax on labor 20% decrease n tax on labor 20% decrease n tax on labor. Increase n captal tax. 50% ncrease n enforcement of nformal frms 85% ncrease n enforcement of nformal frms 90% ncrease n enforcement of nformal frms Medumsklled and unsklled labor Unsklled labor Medumsklled and unsklled labor Medumsklled and unsklled labor. Captal Medumsklled and unsklled labor Medumsklled and unsklled labor Unsklled labor Unsklled labor-ntensve sectors* Effcency wage sectors Effcency wage sectors Effcency wage sectors Informal sector Informal sector Informal sector tfac tfac tfac tfac Depends on sector Depends on sector Depends on sector Depends on sector tcap 0.75% tfac (tncal) tfac (tpcal) tfac (tncal) tfac (tpcal) tfac (tncal) 4.0% 4.1% 6.8% 7.0% 7.2% *Agrculture, lvestock-rearng, other prmary actvtes, dary producton, rce, ceramcs and constructon

16 16 LATIN AMERICAN JOURNAL OF ECONOMICS Vol. 48, No. 1 (May, 2011), Results In ths secton we present the results of the smulatons. Frst we present the results of tax cut polces on the labor market, and then the effect of enforcement polces on the labor market. Next we analyze the effect of the two sets of polces on macroeconomc varables, household ncome and poverty, and ncome dstrbuton. Fnally, we present a senstvty analyss of the value of the elastcty of substtuton among workers by sklls Effects of payroll tax cuts on labor market Table 2 shows the mpact of a reducton n payroll tax rates on nformal and formal employment for unsklled and medum-sklled workers, snce hghly-sklled employment and publc employment s fxed. Frst, we can see that the fve polces smulated are effectve n reducng total nformalty and nformalty among unsklled workers. However, the polces that smulate a tax cut only for unsklled workers (TAX1 and TAX3) cause nformalty among medum-sklled workers to ncrease. Ths s due to a substtuton effect among workers n the sectors that benefted from the tax cuts. Table 2. Effects of tax-cut polces on employment and nformalty (Percentage change) TAX1 TAX2 TAX3 TAX4 TAX5 Informal employment Unsklled nformal employment Medum-sklled nformal employment Unsklled formal employment Medum-sklled formal employment The sectors that beneft from the tax cuts ncrease ther labor demand. In scenaro TAX1, these correspond to the sectors ntensve n unsklled labor, whereas n scenaro TAX3 they correspond to the effcency wage sectors. When the cost of hrng formal workers s reduced, there are two possble effects. Frst, frms may ncrease labor demand, creatng new formal jobs. Nevertheless, a second effect s that frms may also substtute dfferent categores of labor, wthout creatng new jobs. When

17 C. Estrades and M.I. Terra INFORMALITY IN SEGMENTED LABOR MARKETS 17 the frms substtute hgh- and medum-sklled workers for unsklled workers, nformalty among ths last group of workers s reduced, but t ncreases for medum-sklled workers. Therefore, reducng payroll tax rates on one type of labor generates substtuton among dfferent types of workers and has an unwanted effect on medum-sklled nformalty. Even though the polcy reduces total nformalty, t harms medum-sklled workers. The magntude of the substtuton depends on the possblty of the frm to make the substtuton, whch n our model s represented by the value of the elastcty of substtuton n the frm producton functon. In the last secton of ths paper we analyze the senstvty of the results to modfcaton of the value of ths parameter. On the other hand, a reducton n tax rates on unsklled and medumsklled labor that benefts unsklled labor-ntensve sectors (TAX2) generates a decrease n nformalty among all types of workers. Obvously, the declne n nformalty among unsklled workers s less pronounced because there s less substtuton among dfferent types of workers. In ths scenaro, nformalty falls because labor demand ncreases for both categores of workers. The most effectve polcy aganst nformalty s that whch reduces payroll taxes n all effcency wage sectors and for both types of workers (TAX4). In ths scenaro, nformalty decreases for both types of workers, leadng to an overall nformalty reducton of 0.5%. However, snce ths polcy may have a sgnfcant negatve mpact on the fscal defct, we smulate t combned wth an ncrease n taxes on captal ncome n order to keep the fscal defct constant (TAX5). In ths scenaro, nformalty falls even more: 0.7%. Ths outcome s assocated wth the behavor of the constructon sector, whch s hghly dependent on the nvestment level of the economy 3. As we wll show below and n Table 6, the fscal defct ncreases n the four prevous scenaros analyzed, but not n scenaro TAX5. When the fscal defct ncreases, publc nvestment falls, resultng n lower total nvestment as well, and ths has a negatve effect on the constructon sector, whch s ntensve n unsklled labor. In fact, n the TAX4 scenaro, n whch nvestment experences the greatest ncrease, formal employment n the constructon sector declnes 1.07% for unsklled workers and 1.34% for medum-sklled workers, even as the sector benefts from the tax reducton. Formal employment n the other sectors stll rses when 3. Construton accounts for almost 60% of nvestment at the benchmark.

18 18 LATIN AMERICAN JOURNAL OF ECONOMICS Vol. 48, No. 1 (May, 2011), 1 37 labor demand from the constructon sector falls, but ths result reveals that those polces that negatvely affect the fscal defct may have a negatve effect on nformalty. In contrast, n the TAX5 scenaro publc nvestment does not fall and labor demand n the constructon sector ncreases. Thus, the declne n nformalty s greater. Table 3 shows the effect of tax polces on wages. In the model, the consumer prce ndex s fxed as the numerary, so wage varaton s expressed n real terms. When frms see ther hrng costs for unsklled workers fall, they ncrease ther demand for ths type of worker. Ths n turn drves up wages because the labor supply s fxed. Ths happens n the fve tax cut scenaros. Table 3. Effect of tax cuts on wages (Percentage change) TAX1 TAX2 TAX3 TAX4 TAX5 Unsklled wage n the nformal sector Medum-sklled wage n the nformal sector Unsklled wage dfferental Medum-sklled wage dfferental Unsklled wage n the formal sector Medum-sklled wage n the formal sector Sklled wage Publc wage Average wage Sklled wage varaton depends on the possblty of frms substtutng workers wth dfferent sklls. Because sklled employment s fxed, when frms substtute sklled workers nformalty cannot ncrease, as s the case of medum-sklled workers n scenaros TAX1 and TAX3, but wages are negatvely affected. As Table 4 shows, n the scenaros that smulate tax cuts for all the effcency wage sectors (TAX3 and TAX4), wages of hghly sklled workers ncrease slghtly because as labor costs for effcency wage sectors are reduced, producton ncreases and all types of workers beneft. Wth the value of the elastcty of substtuton assumed n the model, the postve producton effect on wages of hghly sklled workers prevals over the negatve effect derved

19 C. Estrades and M.I. Terra INFORMALITY IN SEGMENTED LABOR MARKETS 19 from the substtuton effect. As substtuton among workers becomes more mperfect, wages of hghly sklled workers ncrease more. On the other hand, wages of hghly sklled workers fall slghtly n the TAX1 and TAX2 scenaros. In these cases, the substtuton effect prevals. It s mportant to remember that n these scenaros only unsklled ntensve sectors beneft, and some of these do not employ hghly sklled workers at all. Thus, an ncrease n ther producton does not beneft hghly sklled workers. The wage gap between hghly sklled and medum-sklled and unsklled workers falls n all fve tax reducton scenaros. Even when the wages of hghly sklled workers ncrease n some scenaros, medum-sklled and unsklled wages ncrease more. Ths may lead to more equtable ncome dstrbuton. However, the wage gap between formal and nformal workers ncreases. The wage dfferental pad n the formal sector depends negatvely n the dfference between labor supply and labor demand n the formal sector. Therefore, when nformalty declnes, wage dfferentals ncrease. When the nformal sector s reduced, the probablty of beng dsmssed n the formal sector falls, and workers shrk more. Thus, frms n the formal sector are wllng to pay a hgher wage dfferental to promote effort among employees. Ths explans the ncrease n the wage dfferental pad to unsklled workers n the fve scenaros consdered. Wages for lower-sklled workers present the hghest ncrease n scenaro TAX4, where wages for unsklled workers ncrease 0.8%, wages for medum-sklled workers ncrease 0.9% and wage dfferentals ncrease for both types of workers. It s mportant to bear n mnd that effcency wages mean an effcency loss for the economy, whch ncreases when wage dfferentals are hgher. If wage dfferentals were exogenous and dd not depend on employment, the effcency loss would be lower and formal labor demand would ncrease more (Therfelder and Shells, 1997). The average wage ncreases n all fve polcy scenaros, leadng to mproved general welfare Effects of enforcement polces on the labor market Enforcement polces appled to nformal frms are even more effectve n reducng nformalty because they are desgned to attack the problem drectly nformal sectors must pay taxes once they are

20 20 LATIN AMERICAN JOURNAL OF ECONOMICS Vol. 48, No. 1 (May, 2011), 1 37 found to be n volaton of the law and not ndrectly as tax cuts do. Also, nformalty decreases because tax cuts promote an ncrease n labor demand. Table 4 shows the effect of enforcement polces on nformalty and formal employment for unsklled and medum-sklled workers. We can see that a 50% effectve enforcement polcy reduces total nformalty by 2.2%. A more effcent enforcement polcy has an even greater mpact: total nformalty falls 3.6% under the ENF2 scenaro. Promotng enforcement only among unsklled workers also has a bg mpact on total nformalty, and generates a very sgnfcant declne n nformalty among unsklled workers: 3.9%. In the frst two scenaros, the decrease n nformalty occurs along wth a rse n formal employment for both unsklled and medum-sklled workers. However, as can be seen n Table 5, enforcement polces negatvely affect wages, especally for unsklled workers. In the three scenaros, wages for unsklled workers n the nformal sector fall sharply and wage dfferentals ncrease sgnfcantly. In spte of ths, wages for unsklled and medum-sklled workers n the formal sector also decrease, although less. Wages for sklled workers and publc sector workers fall even less, and there s a declne n average wages n the economy. When frms n the nformal sector are caught evadng and are forced to pay taxes, ther costs ncrease substantally. Because the model does not consder unemployment, frms cannot dsmss workers and an adjustment s made n wages. If there were unemployment, we mght expect that enforcement polces would lead to an ncrease n unemployment among lower-sklled workers (Boer and Garbald, 2006) Effect of smulated polces on macroeconomc varables and welfare Takng account only the effect of the smulated polces on the labor market, the polces that beneft unsklled workers most are those that smulate a tax reducton, because they lead to a declne n nformalty and an ncrease n wages at the same tme. However, these polces have a sgnfcant mpact on publc fnances and publc nvestment, as s shown n Table 6. Tax cut polces actually ncrease the fscal defct and reduce government ncome, whereas enforcement polces ncrease government ncome as a consequence of hgher tax collecton 4. Under the 4. The decrease n the fscal defct caused by the enforcement polces s overestmated because we are not smulatng the cost of mplementng these polces, whch ncreases government expendture.

21 C. Estrades and M.I. Terra INFORMALITY IN SEGMENTED LABOR MARKETS 21 Table 4. Effects of enforcement polces on employment and nformalty (Percentage change) ENF1 ENF2 ENF3 Informal employment Unsklled nformal employment Medum-sklled nformal employment Unsklled formal employment Medum-sklled formal employment Table 5. Effect of enforcement polces on wages (Percentage change) ENF1 ENF2 ENF3 Unsklled wage n the nformal sector Medum-sklled wage n the nformal sector Unsklled wage dfferental Medum-sklled wage dfferental Unsklled wage n the formal sector Medum-sklled wage n the formal sector Sklled wage Publc wage Average wage Table 6. Effect on macroeconomc varables (Percentage change) TAX1 TAX2 TAX3 TAX4 TAX5 ENF1 ENF2 ENF3 Absorpton Prvate consumpton Investment Real GDP Government ncome Fscal defct

22 22 LATIN AMERICAN JOURNAL OF ECONOMICS Vol. 48, No. 1 (May, 2011), 1 37 TAX5 scenaro, government ncome ncreases 0.28% because government collects more payroll taxes as well as taxes on captal ncome. Investment reacts to the fscal defct: when the latter ncreases, the former falls (the frst four tax cut scenaros), and when government ncome ncreases, nvestment rses as well, because publc savngs ncrease, as Table 6 shows. Under the TAX5 scenaro, nvestment falls slghtly, due to lower prvate nvestment, whch reacts negatvely to the ncrease n the captal ncome tax rate. The effect of the smulated polces on real GDP, absorpton and prvate consumpton s less marked. Real GDP ncreases n all the scenaros consdered. In fact, the polces smulated may have two contradctory effects on GDP. On the one hand, they have a postve effect because they ncrease effcency n the economy by rasng employment n formal sectors, whch work wth hgher productvty levels. On the other hand, they produce a negatve effect derved from the effcency loss that s mplct n wage dfferentals. Total absorpton does not change sgnfcantly n the smulated scenaros, whle prvate consumpton falls when enforcement polces are mplemented. Ths s a consequence of the declne n wages prevously analyzed, whch means a decrease of ncome n all types of households. In prncple, we would expect poverty and nequalty to fall as a result of tax cut polces, because these polces generate an ncrease n wages for unsklled and medum-sklled workers and reduce nformalty, whch manly affects unsklled workers. Enforcement polces, on the other hand, may have an ambguous effect on poverty and nequalty: under these scenaros, nformalty falls, but so do wages for unsklled workers. Table 7 shows the mpact of the smulated polces on poverty and ncome dstrbuton. The results were obtaned through mcrosmulatons. We present the changes n three ndcators: the poverty ndex (percentage of populaton below the poverty lne), the extreme poverty ndex (percentage of populaton below the extreme poverty lne) and the Gn coeffcent. We also present the value of the ndcators at the benchmark (year 2000). The fve payroll tax cut polces generate a declne n poverty and extreme poverty. The effect s greater when the tax cut benefts more sectors and workers: under the TAX5 scenaro, poverty falls 1.4% and extreme poverty 1.6%. The same happens wth nequalty: under the same scenaro, the Gn coeffcent falls 0.2%. The decrease

23 C. Estrades and M.I. Terra INFORMALITY IN SEGMENTED LABOR MARKETS 23 Table 7. Effects of polces smulated on poverty and ncome dstrbuton (Percentage change) Benchmark value TAX1 TAX2 TAX3 TAX4 TAX5 ENF1 ENF2 ENF3 Poverty ndex Extreme poverty ndex Gn coeffcent n ncome concentraton n ths case s assocated not only wth the mprovement n ncome of poorer households but also wth lower ncome n wealther households, due to the lower wages pad to sklled workers. Mcrosmulatons only ncorporate changes n the labor market, and therefore the mpact on ncome dstrbuton s underestmated. We mght expect a greater decrease n ncome concentraton as a result of the mposton of a tax on captal ncome. Enforcement polces have dfferent effects on poverty and ncome dstrbuton. A 50% effcent enforcement polcy ncreases poverty, whereas an 85% effcent polcy reduces poverty ndexes. The less effcent polcy leads to a decrease n the ncome of poorer households and does not have a sgnfcant mpact on nformalty, whch does occur n the 85% effcent polcy scenaro. Under ths polcy, the postve effect of a reduced nformalty s greater than the negatve effect of a decrease n wages. The ncrease n the enforcement level for sectors whch are ntensve n unsklled labor produces an ncrease n poverty and extreme poverty. In ths scenaro, the large declne n wages leads to a worsenng of workng condtons, and the effect s not reverted by the reduced nformalty whch the polcy promotes. And although wages pad to sklled workers also fall n ths scenaro, nequalty ncreases Senstvty analyss of the substtuton elastcty among skll categores θ Demand for labor n the CGE model follows a CES functon, through whch frms combne dfferent categores of workers by sklls. Therefore, substtuton between workers of dfferent skll level s mperfect, that s,