Abstract
This Selected Issues paper considers the “informal sector” in Mexico. In Mexico and many other countries, the informal sector represents a large share of total employment. The paper reviews the literature on informality, with special focus on findings for Mexico, and develops a theoretical model that highlights the importance of externalities and the distortion associated with the informal sector. The analysis provides insight into the kinds of policy measures that might sustainably reduce the size of the informal sector. The paper analyzes financial saving in Mexico.
II. The Mexican Informal Sector and its Implications1
Abstract
In Mexico and many other countries, the “informal sector” represents a large share of total employment—but what are the causes and consequences of informality? This paper argues that the presence of externalities means that having a large informal sector can entail significant losses to the economy as a whole, even if each firm operates efficiently at the micro firm level. Negative (and positive) externalities from operating informally (formally) arise from the impact on infrastructure and public service, governance, information, the legal system, and so on. Following a survey of the literature on informality, with special focus on Mexico, the paper develops a theoretical model that highlights the importance of externalities and the distortion associated with the informal sector, and provides insight for the kinds of policy changes that might sustainably reduce the size of the informal sector.
A. Introduction
1. Although the informal sector—defined as small-scale, semi-legal enterprises—encompasses more than a third of economic activity in many developing countries, and an even larger share of employment (Schneider and Enste (2002)), the causes of “informality” and particularly the implications for economic development are still not well understood.
2. A traditional view of informality considers it to be a consequence of a distorted, segmented labor market. According to that view, labor market rigidities (including rigidities arising from regulation) lead to a rationing of jobs in the formal sector, forcing some workers into the inferior informal sector while waiting for a job in the formal sector, i.e., a “dualistic” labor market (Harris and Todaro (1970)). The informal sector is thus essentially a residual comprised of disadvantaged workers who have been rationed out of “good jobs.” According to the more modern view of the informal sector, however, most participants in the informal sector have chosen voluntarily to pursue an entrepreneurial informal sector job. In this view, the informal sector can be seen as the unregulated, semilegal developing country analogue of the voluntary entrepreneur small firm sector found in advanced economies (Maloney (2005)).
3. Indeed, Maloney (2005) provides compelling arguments to question the traditional view of a dualistic labor market, and in support of the voluntary entrepreneur view of the informal sector. First, in interviews with informal sector employees in Mexico, more than 60 percent responded that they left their previous job and entered the informal sector voluntarily because of greater independence or higher pay (Maloney (2005)). Second, using data on micro enterprise firms in Mexico, Fajnzylber, Maloney, and Montes (2003) find that labor mobility between the formal and informal sector is high and is similar to the transition patterns observed in the U.S. They argue that this similarity suggests that “informal micro firms in developing countries should be viewed first as standard firms that offer job opportunities relative to the salaried sector that are comparable to those in the industrialized country.” Furthermore, they report that transition into self employment is similar to the one observed in the U.S—workers tend to start their own business after being employed as salaried workers for 4–6 years. Third, Fiess, Fugazza, and Maloney (2002) document substantial periods of expansion of employment in the informal sector during economic upturns, suggesting that at least part of the sector is voluntary. However, they also find episodes when employment in the informal sector expands during recessions, suggesting that some part of informal sector employment, at least during a downturn, does reflect rigidities in the formal sector.
4. Looking beyond the traditional dualistic explanation of informality has led to consideration of a wide range of other factors that may contribute to informality. Indeed, if the problem is not limited to a lack of market-clearing wages in the formal sector, and at least some participation in the informal sector is voluntary, then the natural question is what are the various factors—costs and benefits—that govern an individual’s decision to participate in the informal sector. This is the approach of the more recent literature.
5. Recent theories of informality focus on the costs to the individual firm, arguing that operating informally entails certain costs associated with the firm’s loss of access to productive public goods, infrastructure and legal framework (Azuma and Grossman (2002), Loyaza (1996), and Marcouiller and Young (1995)) and limited access to financial services (Straub 2005). In these models, a firm weighs the gains from becoming formal against the costs to a firm of operating in the formal sector—in particular costs associated with compliance with tax and regulatory requirements. Indeed the empirical literature finds that the size of the informal sector is correlated with the tax burden (Giles and Tedds (2002), Dabla-Norris, Gradstein and Inchauste (2005)), entry costs (Auriol and Walters (2005)), and the quality of the legal system and financial market developments (Leaven and Woodruff (2004)).
6. Although potentially the loss of output to each individual informal firm from being informal may be significant, several observations suggest that the losses to an individual informal firm in practice are limited. First, Levenson and Maloney (1998) find that being informal usually does not imply loss of access to all formal services, but rather that firms, to some extent, can choose the level of formality according to their size and development. That is, many informal firms can still enjoy some form of formality that fits their activity. If a firm chooses not to register and enjoy legal protection, it is often because the benefits from legal protection to this firm are small. Indeed, using data set from Mexico (the 1992 National Micro Enterprises Survey) they document that many informal firms do participate also in various formal activity. Second, McKenzie and Woodruff (2005) find, using a similar data source for Mexico, that informal firms require low start-up costs and that access to capital does not appear to determine the ultimate size of an informal enterprise.
7. This chapter develops a theoretical framework that captures the existence and importance of positive (negative) externalities arising from firms’ decision to operate in the formal (informal) sector. In this model, the equilibrium size of an economy’s formal and informal sector is determined according to the benefits from having better access to formal goods and services compared with the various costs associated with being formal, as well as the transition costs of exiting the informal sector and becoming formal. The existence of externalities implies that regardless of the sources of the informal sector (the dualistic view or the “voluntary decision” view) and the extent of losses to the individual firm from informality, the impact of informality on the economy as a whole can be significant because of externalities.
8. Positive externalities from producing in the formal sector could arise through several channels. The most obvious one is through the beneficial impact of having more firms on the level of public goods, such as infrastructure, or the average tax rate, assuming that the distortion associated with taxes is nonlinear. However, other channels could be just as important. Having a larger formal sector could improve the information set of both the private sector and policy makers and thus raise the amount and quality of financing and investment, the process of matching between firms and suppliers, customers, and workers and improve policymaking. Likewise, a larger formal sector could act to enhance the legal system, property rights and governance as a whole, either by exerting larger political pressure in support of these or by enhancing transparency. Indeed, Kaufman, Mehrez and Gurgur (2002) argue, in the context of public sector management, that transparency, corruption and public service delivery are determined simultaneously. Using governance micro-survey data of public officials in Bolivia, they find that raising transparency would decrease bribery and improve service quality. Likewise, Laeven and Woodruff (2004) argue that one needs to use instrumental variables for the quality of legal system when estimating its impact on firm size, since “there may also be a direct connection between the presence of larger firms and the development of a more effective judicial system, in that larger firms may demand a better judicial system.” Finally, if firms operating in the formal sector tend to use more capital and advanced technology, they may create more learning by doing and innovation, factors emphasized by endogenous growth models.
9. Looked at from the other side, negative externalities from operating informally may arise because informality weakens the public sector, dilutes the information set, reduces transparency, and hampers governance and the legal system. These linkages between the informal sector and public finances are well recognized. For example, Schneider and Enste (2000) claim that “An increase in the shadow economy leads to a decreased state revenue, which in turn reduces the quality and quantity of publicly provided goods and services. Ultimately, this can lead to increased tax rates in the official sector, often combined with deterioration in the quality of public goods (such as public infrastructure) and of the administration, with the consequences of even stronger incentives to participate in the shadow economy.” (See also OECD Employment Outlook 2004, Box 5.2).
10. This chapter offers several contributions to the theoretical analyses of the informal sector. First, it highlights the potentially significant adverse effect on economic development of having a large informal sector. Second, it emphasizes the importance of externalities and the resulting market failure. Finally, it suggests that econometric analysis should estimate the size of the informal sector, and the economic fundamentals such as the level of infrastructure, the rule of law and governance simultaneously.
11. The rest of the chapter is structured as follows. The next section provides an overview of the informal sector in developing countries with a particular focus on the case of Mexico. Section 3 develops the theoretical model. Section 4 concludes.
B. Aspects of the Informal Sector in Developing Countries and Mexico
12. The “informal economy” is defined here as the unregulated, semi-legal enterprises that rarely comply with all regulations, tax payments, conditions of employment and operating licenses. This sector tends to be characterized by low entry requirements in terms of capital, qualifications, and procedures, and typically consists of small-scale labor-intensive operations. Informal activity is concentrated mainly in commerce and services, but can also be significant in manufacturing. Interestingly, as mentioned in the introduction, this distribution of small but informal firms in Mexico is broadly similar to the distribution in the U.S. of small (but formal) firms, especially for owner-only firms, although the frequency of firms with 10 or more employees is higher in the U.S.
Microenterprise size (in percent) Mexico and the United States
(2000)
Microenterprise size (in percent) Mexico and the United States
(2000)
| Mexico | United States | |
|---|---|---|
| Owner only | 62.5 | 67.8 |
| 1–4 employees | 31.9 | 12.5 |
| 5–9 | 2.8 | 4.8 |
| 10 more | 2.8 | 15.7 |
Microenterprise size (in percent) Mexico and the United States
(2000)
| Mexico | United States | |
|---|---|---|
| Owner only | 62.5 | 67.8 |
| 1–4 employees | 31.9 | 12.5 |
| 5–9 | 2.8 | 4.8 |
| 10 more | 2.8 | 15.7 |
13. The informal sector is inherently difficult to measure accurately. Various methods to measure the sector include surveys, national accounts (by reconciling income, expenditure and output estimates) the demand for bank notes, and electricity consumption. For example, Schneider (2002), estimates, based on demand for electricity, that the informal sector in Latin America amounts, on average, to about 40 percent of total output.
14. Detailed data for Mexico is available through the Encuesta Nacional de Empleo survey of employees and of small firms. This reveals that most workers in Mexico, whether they are employed at a formal or informal firm, do not participate in (i.e., do not contribute to or receive benefits from) social protection systems. In a population of over 100 million persons, out of about 42 million workers, only about 15 million receive social security and other benefits. Regarding income, those employed in the informal sector overall earn less, have lower education, and are younger than those in the formal sector Verdu (2004). However, Maloney (1999) using data on transition between sectors, shows that those workers who move from formal jobs to become self-employed in the informal sector experience an increase in their earnings and are older than the formal workers.
15. With regard to firm distribution, analysis by Leaven and Woodruff (2004), based on 1998 Mexican census of firms from INEGI, the national statistical institute, implies that most establishments in Mexico have less than 9 employees and those establishments account for close to 40 percent of total employment in Mexico.
Share in Total Number of Employees By Size Category
Share in Total Number of Employees By Size Category
| Size Category | All firms | Manufacturing firms | ||
|---|---|---|---|---|
| Mexico | U.S. | Mexico | U.S. | |
| 0 to 9 employees | 38.5 | 11.4 | 18.5 | 3.5 |
| 10 to 19 employees | 6.4 | 7.4 | 4.5 | 3.8 |
| 20 to 49 employees | 8.9 | 10.4 | 7.4 | 7.8 |
| 50 to 99 employees | 6.9 | 7.5 | 6.5 | 7.3 |
| 100 to 499 employees | 18.4 | 14.9 | 28.2 | 17.3 |
| More than 500 | 20.9 | 48.5 | 34.9 | 60.3 |
Share in Total Number of Employees By Size Category
| Size Category | All firms | Manufacturing firms | ||
|---|---|---|---|---|
| Mexico | U.S. | Mexico | U.S. | |
| 0 to 9 employees | 38.5 | 11.4 | 18.5 | 3.5 |
| 10 to 19 employees | 6.4 | 7.4 | 4.5 | 3.8 |
| 20 to 49 employees | 8.9 | 10.4 | 7.4 | 7.8 |
| 50 to 99 employees | 6.9 | 7.5 | 6.5 | 7.3 |
| 100 to 499 employees | 18.4 | 14.9 | 28.2 | 17.3 |
| More than 500 | 20.9 | 48.5 | 34.9 | 60.3 |
16. Furthermore, Leaven and Woodruff (2004) document that the share of firms with corporate ownership is small in Mexico compared to the U.S. (8.1 percent compared with 21 percent in the U.S.), while the share of proprietorships is large (89 percent compared to 72.6 percent in the U.S.). Looking within Mexico, they find that Mexican states with more effective legal systems have larger firms, and the impact is larger in sectors in which proprietorships dominates.
C. Factors Affecting Firms’ Choice to be Informal
17. Key to the existence of the informal sector are the obstacles and costs associated with becoming formal. These obstacles include costs to the firm of registration and government regulations, and, of course, taxes. Indeed, across countries there is a negative correlation between the extent of regulations and share of informality in the economy.
18. Obstacles to starting a business vary greatly across countries. For example, World Bank data indicate that starting a business in Australia requires 2 procedures and 2 days, compared with 19 procedures in Chad and 203 days in Haiti. In terms of costs of starting a business, these vary from zero in Denmark to US$1,663 in Sierra Leone. As for Mexico, obstacles to starting a business are somewhat higher than in other OECD countries, but are somewhat lower than the average in Latin America. It requires 8 procedures and 58 days to start a business in Mexico.
Number of Procedures
Citation: IMF Staff Country Reports 2005, 428; 10.5089/9781451825657.002.A002
Source: World Bank, Doing Business in 2005.Number of Procedures
Citation: IMF Staff Country Reports 2005, 428; 10.5089/9781451825657.002.A002
Source: World Bank, Doing Business in 2005.Number of Procedures
Citation: IMF Staff Country Reports 2005, 428; 10.5089/9781451825657.002.A002
Source: World Bank, Doing Business in 2005.19. Likewise, registering a property involves large costs that in Mexico amount to 5.3 percent of the property value, and requires 5 procedures and 74 days.
Cost of Registring Property (percentage of property value)
Citation: IMF Staff Country Reports 2005, 428; 10.5089/9781451825657.002.A002
Source: World Bank, Doing Business in 2005.Cost of Registring Property (percentage of property value)
Citation: IMF Staff Country Reports 2005, 428; 10.5089/9781451825657.002.A002
Source: World Bank, Doing Business in 2005.Cost of Registring Property (percentage of property value)
Citation: IMF Staff Country Reports 2005, 428; 10.5089/9781451825657.002.A002
Source: World Bank, Doing Business in 2005.20. Labor market rigidities do appear to be high in Mexico. According to the World Bank’s “Doing Business” data, the difficulty of hiring and firing is large in Mexico, even compared to other Latin America countries.
Rigidity of Hours Work
Citation: IMF Staff Country Reports 2005, 428; 10.5089/9781451825657.002.A002
Rigidity of Hours Work
Citation: IMF Staff Country Reports 2005, 428; 10.5089/9781451825657.002.A002
Rigidity of Hours Work
Citation: IMF Staff Country Reports 2005, 428; 10.5089/9781451825657.002.A002
Difficulty of Firing Index
Citation: IMF Staff Country Reports 2005, 428; 10.5089/9781451825657.002.A002
Source: World Bank, Doing Business in 2005.Difficulty of Firing Index
Citation: IMF Staff Country Reports 2005, 428; 10.5089/9781451825657.002.A002
Source: World Bank, Doing Business in 2005.Difficulty of Firing Index
Citation: IMF Staff Country Reports 2005, 428; 10.5089/9781451825657.002.A002
Source: World Bank, Doing Business in 2005.21. Labor legislation in Mexico is very detailed and complicated, and appears to be outdated. The main labor regulations date back to 1917 (Article 123 of the Constitution), and to 1970 (the federal labor law). In addition to setting regulations regarding the minimum wage, length of working day, overtime pay and creating large firing costs, Mexico has a law that prohibits nominal wage reduction. It is important to note, however, that because of the relatively high inflation in the past, real wages have been quite flexible. Moreover, nominal wages in Mexico exhibit little downward rigidity when compared to the U.S., Canada, or Australia (Castellanos, 2003, Castellanos, Garcia-Verdu and Kaplan, 2004), although the minimum wage does impact many workers.
22. Likewise, the gains from becoming formal also may vary significantly among countries, depending on the efficiency and effectiveness of public services. For example, enforcing a contract in Mexico requires 37 procedures and 421 days.
Enforcing Contracts
(Number of Procedures)
Citation: IMF Staff Country Reports 2005, 428; 10.5089/9781451825657.002.A002
Enforcing Contracts
(Number of Procedures)
Citation: IMF Staff Country Reports 2005, 428; 10.5089/9781451825657.002.A002
Enforcing Contracts
(Number of Procedures)
Citation: IMF Staff Country Reports 2005, 428; 10.5089/9781451825657.002.A002
D. Informality and Externalities: A Basic Framework
Having obstacles to becoming formal might cause many firms to operate informally, while at the same time not necessarily implying large losses to the individual firm. Informal firms may often be able to choose the degree of formality that fits their characteristics or to circumvent the lack of credit of public services by using “own funds” (retained earnings) and informal networks (e.g., obtaining funds from family members or other associates). Nevertheless, even if the losses to each firm may be small, it may not follow that the losses to the economy as a whole are small as well. As argued in Section I, the existence of externalities could imply significant losses to the economy as a whole along the channels of externalities. To provide further insight and understanding of the operation of the economy and the role of externalities, and to identify empirical and policy implications, the chapter develops a theoretical framework with formal and informal sector where externalities play a major role. To focus on the externalities and the underlying framework of the model, the chapter presents a simple model, which is then extended in various dimensions to highlight various elements and dynamics.
The Model
23. Consider an economy composed of two sectors, a formal sector with n firms2 and an informal sector.3 Firms in both sectors use labor to produce an identical final good.
However, the production function that each firm faces differs between the two sectors reflecting the benefits (costs) of being formal (informal) associated with access to public goods and infrastructure, credit, legal rights, protection of property rights, and so on, as well as the positive and negative externalities discussed above. Mobility of labor between the two sectors implies equalization of (after-tax) wages.
24. Specifically, let the production function in the formal and informal sectors be given, respectively, by
25. Where f represents the formal sector and I the informal sector, y represents output, θ is a productivity parameter (which is derived endogenously later), I represents the number of workers employed by the firm and LF, (LI) is total employment in the formal (informal) sector.4
26. The production functions differ between the two sectors in two ways, capturing the benefits of being formal and—more importantly—the externalities. First, productivity differs between the two sectors reflecting the higher capital intensity in the formal sector (which is derived endogenously below), the better access to information, public goods and so on. Second, and more importantly, the production functions in the two sectors embody assumed externalities—positive externalities in the formal sector and negative in the informal sector. As discussed above, the positive externality occurs through several channels—higher infrastructure and public goods due to higher taxes and tax base, enhanced information, a positive impact on the quality of governance and legal rights, or learning by doing. On the other hand, the negative externalities in the informal sector reflect the adverse effect of the informal sector on infrastructure and public goods, information, quality of governance, legal rights and so on. To focus the discussion on the role of externalities, the model is kept simple, and the derivation of externalities from micro foundations is left for further research.
27. The solution of the model is defined as the relative size of each sector such that the (after-tax) wage is equal in both sectors and labor demand is equal to labor supply, which for simplicity is assumed constant). Note that each firm, when deciding on its wage and employment, takes the size of each sector as given (i.e., ignores the externality by which its own decision affects others). Thus, firms in the informal sector view their production function as exhibiting constant returns to scale, although the production function of the sector as a whole exhibits decreasing returns to scale, while firms in the formal sector view their production function as having decreasing returns to scale, but the sector exhibits constant returns to scale.
The demand for labor by each firm in the formal sector is given by
Using the fact that all firms in the formal sector are identical and hence l=LF/n, one derives the wage in the formal sector as
Note that because the firm ignores the positive externalities, the wage is below the socially optimal level for the formal sector.
Likewise, the wage in the informal sector is given by
which is above the socially optimal level for the sector, because of the externalities.
Equalization of wages across sectors yields the relative size of the two sectors,
28. That is, the smaller the productivity gap (i.e., smaller gains from formality), the larger is the informal sector; the smaller the positive externality in the formal sector, (1-α), the smaller is the informal sector, and the larger the negative externality in the informal sector, χ, the smaller the informal sector.
29. It is obvious that this equilibrium is inefficient and that the informal sector is too large. For example, in the extreme case when χ=1 the optimal level of the informal sector is zero because the socially marginal productivity of an informal firm is zero. In other words, the existence of externalities causes firms in the formal sector to pay wages below the optimal level for that sector (a fraction α of the socially optimal wage) and likewise, the wage in the informal sector is above the social optimum. Note that the inefficiency of the market equilibrium increases once one considers that taxes are borne mainly by workers in the formal sector.
Dynamics—Movement Across Sectors
30. To investigate the importance of various costs of entering the formal sector and derive the size of each sector endogenously the model is extended to the case in which the movement between sectors is not frictionless. It is likely that a move between the two sectors, particularly from the informal to the formal sector entails transition costs, perhaps substantial costs. A firm will move from the informal sector to the formal sector when the increment in the present value of its profits is greater than the costs of becoming formal. Thus, firms will move to the formal sector until the number of firms in the formal sector, n, is such that the benefits of being a formal firm equal the costs of transfer.
31. Specifically, assume that firms can move between the informal and formal sector every period, but the move from the informal sector to the formal sector entails a onetime, fixed cost, denoted C. In addition, assume that each period every formal firm faces a probability, δ, of getting out of the formal sector because of change in demand, external competition, bad luck, or management mistakes.5
32. Recall that in the model because each firm faces decreasing returns to scale (or rising marginal cost), the wage (which is determined by marginal productivity) is below the average productivity. In other words, the aggregate production function is linear with constant marginal productivity equal to θ, but firms ignore the externalities and pay only αθ, resulting in profits per workers of (1- α)θ. As a result, the profits of every formal firm is equal to
33. Firms then will enter the formal sector as long as the net present value (NPV) of profits (which depend on the number of firms in the sector), is greater than the moving cost C. Specifically, ignoring the discount rate, firms will enter the formal sector until
Or
Finally, to solve for LF, use equation (6)
and the fact that labor in the formal and the informal sector has to sum up to total labor supply LF + LI = L to derive
After substituting LF in equation (9), we get that the number of formal firms is
34. The number of firms depends on the cost of entering the formal sector and the probability of staying in it. The larger the costs, the fewer firms are in the sector and the profits of each firm are higher. Likewise, the larger the probability of getting out of the formal sector, δ, the smaller the number of firms in the formal sector.
35. Note that the fact that the number of firms does not affect the size of each sector is not a general property of the model. For example, if one assumes that the positive externalities in the formal sector depend on total output in the formal sector (or that the positive externalities in the informal sector depend on the output per formal firm) this would mean that having more formal firms would raise the size of the formal sector and output.
E. Policy Implications and Conclusions
36. The analysis above and the theoretical framework yield several important conclusions with potential implications for policy. First, the theoretical framework suggests that the informal sector could have significant implications for economic growth regardless of whether it represents a dualistic labor market or a developing market analogue of small sector enterprise in industrial countries. That is, positive and negative externalities could result in significant market failure, multiplying the impact of any distortion on output of the economy. In this sense, having a large informal sector is detrimental to economic activity and governance, the rule of law and infrastructure.
37. The theoretical model suggests that because the size of each sector is determined in equilibrium, new policy efforts that simply forced some existing informal firms to comply with legal obligations and become formal might have only a temporary effect on the size of the informal sector. Such a policy intervention could raise profitability of the informal sector, inducing resources to flow from the formal to the informal sector, until the earlier equilibrium was restored. Instead, reducing the costs of operating formally—including costs associated with regulations and taxes, and increasing the benefits from becoming formal including improving the quality of infrastructure, rule of law, access to credit, and governance—would increase voluntary participation in the formal economy and could raise activity considerably. This, in turn, would improve governance, transparency, and the rule of law, which would increase the formal sector and economic activity further.
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Prepared by Gil Mehrez (gmehrez@imf.org). The author is indebted to the Mexican authorities at the Bank of Mexico and the Ministry of Finance for valuable suggestions on an earlier draft of this paper.
The number of firms will be derived endogenously later, according to the costs and benefits of entering the formal sector.
The number of firms in the informal sector is not of importance here, because the sector is assumed to exhibit constant returns to scale (that is, from the point of view of an individual firm, overlooking externalities that in fact mean diminishing returns to scale).
The results do not depend on the exact functional form. Only the existence of positive and negative externalities is important.
This assumption introduces some dynamics at the equilibrium (some formal firms disappear and some informal firms become formal and replace them), but is inconsequential to the equilibrium solution of the model.
