Now it is the time to Foster Labor Formalization in Latin America and the Caribbean

There is an urgent need to reduce labor informality to encourage inclusive growth after the pandemic is over in Latin America and the Caribbean (LAC). Labor formality boosts government revenue and targeting of transfers, increasing productivity and curtailing poverty.

Given that the region has one of the highest labor informality levels in the world, targeting informality is essential. Before the pandemic struck, between 50%-60% of LAC workers (some 150 million people) had informal jobs. Only Sub-Saharan Africa was in a more critical situation (Figure 1). Even in countries with lower levels of informality, such as Chile, Uruguay, or the Bahamas, it was still around 30% (Figure 2), twice as much as in Western and Southern Europe (14.3%).

Figure 1: Informal labor as a percentage of total employment in 2016

The COVID-19 pandemic has exacerbated the problem by bringing about across-the-board job losses, especially considering that most of the recovery of employment  is  expected to be through informal jobs. Therefore, today more than ever it is vital to implement reforms to recover employment by boosting formalization in Latin America and the Caribbean. These reforms should zero in on low-income workers, who are the most vulnerable segment in LAC, labor informality among the lowest income decile accounts for 80% of all workers (Figure 2).

Figure 2: Non-contributing salaried workers and self-employed workers in Latin America by income quintile (% of paid workers), 2018*

Reasons Behind Informality

Although there are diverse factors leading to informality, three main reasons explain why it is so prevalent in LAC. The first one is the low level and deficient quality of human capital in lower-income countries, hindering workers’ entrance into the formal labor market.

The second reason is formal markets’ high non-wage labor costs, which discourage employers from hiring workers legally. In some cases, these high costs are associated with elevated social security contributions and other payroll taxes, representing between 11% and 48% of wages (27.3% on average [1]). Countries that have cut back on these costs have seen positive impacts on formality. For example, Colombia has managed to boost formal labor by 18% [2] after implementing a tax reform in 2012 that reduced payroll taxes by nearly 50%.

The third reason is associated with social welfare programs for workers in the informal sector. These well-intended social programs were developed to bridge an important gap in access to traditional social security, which was only available to formal workers. Many of these transfers were created during the 1990s as non-contributory welfare programs, such as the cash conditioned programs Progresa in México and Bolsa Familia in Brazil.

Although these programs had a positive effect on reducing poverty and inequality, they have an unintended negative impact on job formality – since getting a formal job leads program recipients to forfeit the social transfer, they find little encouragement to join the formal workforce. Therefore, by reducing once and for all the welfare program if the person enters the formal sector formality entails a 100% implicit tax on social benefits.

Several empirical studies corroborate the negative effect of this implicit tax embedded in the loss of the non contributory social program by entering the formal sector. In developed countries, where informality levels are low, social welfare has a negative effect on labor force participation – i.e., on people’s decision whether to work or not. In LAC countries, where informality is pervasive, recent literature has shown that the impact of non-contributory programs on employment was not so much on the choice whether to work or not, but on the choice of formal or informal work [3]. For example, the introduction of the non-contributory program Family Allowances (AFAM, its Spanish acronym) in Uruguay led to an 8 percentage point drop in formal employment, due mostly (about two-thirds) to an increase in informal employment [4].  

Alternatives to Non-contributory Social Programs: Negative Income Tax

Given that the main issue with the welfare programs currently in place in LAC is that they make informal labor more attractive, the big challenge for public and fiscal policy in the region is finding alternative systems with as few side effects and disincentives to formality as possible. At the same time, due to the region’s fiscal fragility, it is important that these alternatives have budgets similar to those already in place, to avoid adding additional fiscal pressure. They should also be capable of reducing poverty as much as existing cash conditioned programs do, so progress in this area is not lost.

To identify these alternative systems, we must keep in mind that any welfare program focused on redistribution will disincentivize employment to some extent. However, not every alternative is equally distortive. Some options, such as the Negative Income Tax (NIT) or the Earned Income Tax Credit (EITC) programs, generate fewer distortions or disincentives than traditional non-contributory welfare programs.

This is why the NIT and EITC systems are the best choice for LAC to rely on formal “workfare” programs that reward formal workers, as opposed to the current social “welfare” systems that encourage them to informality and  punish formalization.

The key to formal workfare programs is that total compensation for formal work (made up of both the worker’s formal wage plus the refundable tax credit) increases with the employee’s formal income.

One of these formal workfare systems is the NIT. In this system, program beneficiaries who are not working or are employed informally receive the minimum  guaranteed compensation (for example the amount of the conditional cash transfer). The main difference between the NIT and traditional social welfare programs is that under the NIT, when a person gets a formal job, the benefit is not stripped completely; rather, it is gradually reduced as the employee’s wage increases. In this arrangement, transfers to a person who gets a formal job would decrease, for example, by only 50%, making their net income higher if formally employed, therefore rewarding formality. As the worker receives a higher wage, the  refundable tax credit is gradually reduced to the point where the employee can start paying income tax.

A numerical example is particularly useful to depict this scheme. Suppose an NIT program offers a guaranteed income of $2,000 for unemployed people. If this program’s benefits are cut to 50% of a person’s wage, anybody with a salary under $4,000 in the formal labor market would receive an NIT between $1 and $2,000 [5]. If the worker earns $1,000 for their formal job, the benefit they would obtain through the NIT would be $1,500 ($2,000 – 50%*$1,000), adding up to a net income of $2,500. If this same person decided to work less and only earn $500, for example, the NIT would contribute $1,750 ($2,000 – 50%*$500). Although this amount is higher, the worker’s net income would only add up to $2,250, making the employee’s net income lower if they choose to work less.

Earned Income Tax Credit Program

The initial proposal of negative income tax inspired the successful Earned Income Tax Credit program, introduced in the United States in 1975. Although the general principle of the EITC is the same as that of the NIT, the difference lies in that in the case of low-income wages, the transfers that the employee receives from the government increase proportionally to their salary. Once the level of income is high enough, these transfers stop growing and eventually decrease, progressing to zero.

EITC has become the fastest-growing pro-employment and antipoverty policy in the US. It has also reached the largest number of beneficiaries, reaching some 28 million workers. Despite the program’s relatively large scope, it has a low cost. The budget allocated to EITC reached US$64.9 billion in 2018 or 0.32% of the country’s GDP.

There is an overwhelming consensus in the literature that EITC has many positive effects. Among them, the program increases labor force participation, especially for single mothers, the group that was previously mostly discouraged from working [6]. Positive effects have also been reported regarding poverty reduction because the program rewards employment and subsidizes the income of lower-paid workers.

Studies have found that in 2018, EITC pulled 5.6 million people out of poverty, including 3 million children. Another important effect, very relevant to LAC, is that a 10% increase in EITC led to a decline of men’s participation in the informal sector of between 5.8 and 7.3 percentage points, despite increased formality not being one of the EITC’s goals in the United States and other developed countries [7].

EITC is ideally suited for Latin America since 80% of the poorest work informally. It offers a significant subsidy to the poorest workers, with refundable tax credits as long as they are formally employed. This program could also be easily complemented, at least initially, with demand-side subsidies to firms, acting as incentives to generate increased demand for formal employment. This supplementation with demand-side subsidies could be meaningful, given that the demand for low-skilled — and therefore, low-income — workerstends to be low.

Aside from these clear advantages in increasing formal employment, programs such as the EITC and the NIT have other benefits worth mentioning. On the one hand, they reduce dependency and stigmatization as compared to traditional welfare programs. This is because they offer benefits within the income tax system. Therefore, these programs are managed by tax agencies, which also significantly cuts administrative costs. For example, in the United States, the administrative cost of EITC is 0.5% of the benefit, while the administrative costs of traditional welfare programs usually reach up to 16% of the benefits [8].

Another advantage shared by EITC and NIT is that they make the income tax progressive by integrating lower-income deciles to those affected by the tax, who receive negative tax rates (equivalent to wage subsidies). Another advantage is that these programs’ benefits are automatic and leave little room for eligibility manipulation by politicians, making them less vulnerable to corruption by clientelism, which might take place with conditional cash transfers.

Analyzing the potential benefits of the NIT in Latin America and the Caribbean: Women, the Main Beneficiaries

As a consequence of all the previously mentioned advantages, many countries have implemented refundable tax credit programs on earned income. Among the at least 18 developed countries that have implemented these programs are Canada, New Zealand, the United Kingdom, Sweden, and Korea, with budgets ranging from 0.3% to 2.1% of their GDP. These programs display interesting differences among countries, such as being based on individual, not family income, with a higher or lower incidence of the number of children on the benefit received; and more or less working hours required. This flexibility, a product of each country’s experience, provides alternatives and lessons learned that can be adapted to the various realities of Latin American and The Caribbean countries.

Other alternative and popular systems such as a Universal Basic Income (UBI) that gives a unique transfer for all individuals independent of their income, would be prohibitively expensive for the region, unless they are paired with deep cuts in other social security programs and public expenditures, making the  NIT and EITC more attractive choices. In LAC (population: 650 million), a UBI of US$3.2 per day (covering the poverty line of low middle income countries)  or US$96 per month would cost around US$748 billion yearly, or about 60% of total federal public spending, or 24% of GDP. Instead of granting everybody US$96 per month, an NIT program with a 50% tax rate would provide the same transfer to the extreme poor and also to people whose monthly earnings were under US$192, at only a fraction of the UBI cost.

To explore the possible impacts of introducing an NIT in LAC countries, we conducted simulations using data from income and spending surveys in Argentina, Colombia, Uruguay, Brazil, and Mexico. The scenarios considered implementing a 50%-rate NIT, maintaining a guaranteed minimum income for the first quintile similar to that offered by each country’s cash transfer program. The NIT was applied to the second quintile, allowing informal workers who were receiving non-contributory cash transfers to access a larger benefit, as long as they entered the formal labor market. To reach results that could be compared among countries, it is assumed that they each allocate a moderate budget equivalent to 0.5% of their GDP.

Introducing an NIT with the aforementioned characteristics could lead to a potential formalization rate of 57% among informal workers in the second quintile alone [9]. In other words, 6.3 million workers could move from the informal sector to the formal labor market in these five countries [10] (Figure 3). Additionally, since women are one of the groups most affected by the pandemic, this system is especially beneficial to them, due to the fact that in every country considered for the simulation, the potential formalization rate for women is higher than that of men. The formalization rate of 57%,  was indeed  71% for women and only 47% for men.

Figure 3. Potential formalization rate with a 50%-rate NIT and a budget equal to 0.5% of GDP

As previously mentioned, the implementation of programs like the NIT should, at least initially, be accompanied by measures to support labor demand, so the latter can adapt to a rise in supply. Examples of such formal labor demand support measures include reducing non-wage labor costs and payroll taxes charged to companies for hiring low-income workers, which would stimulate the creation of formal jobs [11].   

Unique Opportunity to Foster Formalization and Productivity

The results of the Negative Income Tax (NIT) and the Earned Income Tax Credit (EITC) programs reveal that there are policies that can be put in place in Latin America and the Caribbean to increase labor formalization and break the vicious cycle of inefficiency and inequity in public spending and tax evasion. This loop is keeping the region’s productivity at low levels, hindering growth rates, and favoring inequality.

Implementing these programs will require a transition from the current system to an EITC, NIT, or a combination of the two. This process will depend on each country’s characteristics and its social and tax policies. The first step is to define which programs will be substituted, the speed of replacement, and the eventual need to provisionally maintain some non-contributory programs.

In the medium term, due to the positive effect on behavior, a higher formalization rate could lead to the program financing by itself, and even using less budget for a given reduction in poverty. It can take years to adapt these labor income tax credit systems to the realities of LAC. Nonetheless, they are some of the best tools to achieve labor formalization and should be considered in the region’s structural reform agenda to promote recovery after the pandemic.

 

Notes:

This blog entry is based on the report “Fiscal Policy and Management to Increase Formalization,” Pessino, C. E. Pineda. A. Rasteletti & V. Alarcón, to be published shortly by the IDB.

[1] Alaimo, V., Bosch, M., Gualavisí, M., & Villa, J. (2017). Medición de costos de trabajo asalariado en América Latina y el Caribe.  Inter-American Development Bank.

[2] Fernández, C., and L. Villar. 2017 “The impact of lowering the payroll tax on informality in Colombia.”      Economía 18, No. 1.

[3] Levy, 2008; Gasparini, Haimovich & Olivieri, 2009; Camacho, Conover & Hoyos, 2009; Bosch & Campos-Vázquez, 2010; Amarante, Manacorda, Vigorito & Zerpa, 2011; Bosch & Manacorda, 2012; Antón, Hernández & Levy, 2012; Garganta & Gasparini, 2015; Bérgolo & Cruces, 2020.

[4] Bérgolo, M. and G. Cruces, 2021 “The anatomy of behavioral responses to social assistance when informal employment is high,” Journal of Public Economics, Volume 193.

[5] The traditional proposal is a 50%-rate NIT. This means that the program guarantees an income level (called C) for those who are unemployed or hold informal jobs, which is cut to 50% of a person’s wage once they obtain a formal job. This way, the collected NIT is NIT= C – 50% * Y.  If the result of the equation is negative, the NIT is 0. The employee’s net income will be Yn= NIT + Y.

[6] Increasing EITC by US$1,000 leads to an estimated 7.3 percentage point growth on employment, and a 9.4 percentage point drop on families under the poverty line. Hoynes, H. and Patel, A., 2018. Effective policy for reducing poverty and inequality? The Earned Income Tax Credit and the distribution of income. Journal of Human Resources.

[7] Gunter, S., 2013. State earned income tax credits and participation in regular and informal work. National Tax Journal, 66(1).

[8] Eissa, N. and H. Hoynes, 2011.  “Redistribution and tax expenditures: the earned income tax credit.” National Tax Journal 64, No. 2.

[9] This is a potential formalization rate, taking into account all those in the second quintile whose benefits from entering the formal labor market with an NIT are greater than those of remaining in the informal sector. As such, this represents the lower limit, given that it disregards the behavioral effects of workers in the first or higher quintiles, who may also find formalization favorable.

[10] Including the self-employed, the number of potentially formalized workers reaches nearly ten million.

[11] Chile, Peru, and Uruguay developed temporary wage subsidies to recover formal employment during the pandemic as well as for future hires. Chile also developed a permanent incentive to formal employment, offering 2/3 of the subsidy to the employee and the remaining 1/3 to the firm.