To work in the informal sector, as roughly half of Latin Americans do, is to labor in the shadows. It often means working for firms that neither register with authorities, pay taxes or abide by labor regulations. It is to be deprived of health insurance and contributory pensions. And it generally means limited career advancement, as most firms employing informal workers do little, if any, training of the workforce. For those reasons and more, economists have long thought of labor informality as one of the great scourges of Latin America.
Working in the formal sector pays more
But informality is also tightly associated with another endemic characteristic of Latin American labor markets: high levels of inequality. In a recently published book, Wage Inequality in Latin America, Joana Silva and I examine the phenomenon. We show how declines in informality played into the remarkable drop in inequality that occurred between the early 2000s and 2012, when wage inequality dropped in 16 out of 17 countries we considered.
How does informality contribute to inequality? To start with, workers in the informal sector make considerably less than their peers with similar skill levels (education, labor market experience) in the formal sector, where minimum wage protections and unions carry more weight.
To demonstrate this, we divide workers into skill groups defined by all possible ages (15-65) and 8 education levels (a total of 408 age-education cells) in several Latin American countries, and compare the average wage of each cell in the formal and informal sector. If wages for each group were the same for the two sectors, we would observe the points aligned with a 45-degree line. Figure 1 clearly indicates the existence of a wage boost for being in the formal sector in the vast majority of cells—that is, the data points lie above the 45-degree line. While we can’t rule out that these differences in pay are due to differences in skills beyond education and age, the formal/informal wage gaps are ubiquitous.
Figure 1 also reveals a less known fact. The wage gap between the informal and formal sector is larger among low- than high-skilled workers. A combination of factors may be at work, including the role that minimum wages play in boosting low-skill pay more than high-skill pay in the formal sector. But, whatever the exact reasons, once we take these two facts together we conclude that generalized reductions of informality are expected to limit inequality in two dimensions: across workers with similar skills and across skill levels.
Declines in informality reduced inequality
Between 2002-2012, informality declined because of unprecedented, sustained growth and greater enforcement of labor standards. It fell by more than 10 percentage points in Brazil, Peru, and Uruguay; by 7-8 percentage points in Argentina, Bolivia, and Chile; and by 2 percentage points in Mexico. All other countries also experienced some degree of informality reduction.
In the book we describe three channels through which this decline in informality acted on inequality. The first two have already been mentioned. Less informality meant more equal pay among workers with similar skills and a decline in the pay gap between high- and low-skilled workers. In addition, the combination of rising levels of education and strong demand for low-skilled labor that we document in the book implied that during the 2000s the reduction of informality was highly concentrated among low-skilled workers (Figure 2). As we saw, these workers were more at a disadvantage in terms of pay with respect to formal workers with similar skills. Thus, the increasing formalization of low-skilled workers constituted a third force pushing inequality down. Taking all these factors together, our book’s analysis suggests that declining informality contributed to significant reductions in inequality in Argentina, Brazil and Peru. It played a similar role in Bolivia, Chile, and Uruguay, but to a lesser extent.
Today, with flagging growth in the region, some workers who made their way out of the informal sector could be driven back in. That would be unfortunate, and not just because of the loss of the social security safety net that comes with being employed in the formal sector. Formality also contributes to equality, and equality fosters a sense of social fairness and cohesiveness. Those are values worthy of preserving, and it will be up to policymakers to decide how best to do so.