Brazil’s Ministry of Labor does not take labor informality lightly, carrying out inspections and cracking down on the many businesses that hire workers “off the books.” While these inspections are often successful in catching and penalizing firms that avoid the costly regulations involved in hiring formal workers, they also come with surprising, not always positive, side effects for businesses and the economy.
In a recent study, we examined what happened when firms are forced to formalize their workers and punished with hefty fines after being caught breaking the rules. We found that the associated inspections and penalties can have negative effects on both firm growth and innovation, suggesting that reforms may be necessary to reduce the costs for firms associated with having a formal labor force.
Latin America, like many regions of the developing world, has long struggled with the problem of informality, with roughly half of its labor force unregistered with authorities and, as a result, lacking in social protections like health benefits, unemployment insurance, and pensions, while also typically earning lower wages.
The Incentives for Businesses in Informality
For businesses, hiring informal workers means avoiding taxes, severance pay, and other costs, relieving pressure on some firms that are under stress. But informality also exacerbates inequality and makes it harder for governments to collect taxes and target social transfers, aggravating fiscal problems in the process.
Moreover, informality isn’t just a small-business problem. While smaller firms have higher proportions of informal workers, larger firms also hire “off the books.” In Brazil, even firms with over 500 employees employ about 10% of their workers informally. This widespread use of informality, unrelated to worker skill or education levels, is a calculated cost-saving strategy.
Labor inspections are one tool governments use to combat this problem and try to bring both firms and workers into a legal regime where workers are protected and firms comply with their obligations, including the payment of taxes. In Brazil, inspectors visit firms to check compliance with labor laws, forcing firms caught employing informal workers to formalize their entire workforce and pay steep fines. This sounds straightforward, but the ripple effects on businesses tell a deeper story.
What Happens When Firms Are Caught?
While sanctions lead to an immediate increase in formal employees, they tend to inhibit growth. Indeed, for years after an inspection, businesses of all sizes struggle to expand. Inspections also affect how firms operate. Businesses caught breaking the rules are less likely to innovate. They register fewer patents and trademarks, and they simplify their organizational structures, becoming less dynamic.
These tradeoffs to inspections — slower growth and reduced innovation — challenge policymakers to enforce labor laws and reap the benefits for society in doing so, without stifling business growth and creativity. An important element of the problem is the cost of compliance. Formalizing workers is expensive in Brazil, where payroll taxes can range from 68% to 97% of wages. For businesses already struggling, these costs are a major deterrent. Lowering these barriers, such as by reducing payroll taxes or simplifying firing costs, could encourage firms to comply without heavy-handed enforcement.
The Path to Reform
Brazil’s experience offers valuable lessons for other developing countries facing similar predicaments. Labor inspections are a powerful tool, but they’re not a one-size-fits-all solution. To reduce informality sustainably, governments must strike a balance between enforcement and creating an environment where compliance is feasible. Reforms that combine inspections with business-friendly policies could provide a way forward, including by lowering the costs of hiring formal workers. Tackling informality will remain a priority for governments as the global economy evolves. Brazil’s story reminds us that policymakers have to be alert to potential side effects as they pursue the goal of building a fairer and more inclusive labor market in which workers rights are protected.
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