Abstract
Selected Issues
Informality in Colombia1
Colombia made impressive progress in reducing informality over the last decade, with strong policy measures and improvements in education playing an important role. Going forward, further lowering the costs of formality (such as non-wage labor costs and firm registration costs) and building on the expansion in education would help consolidate the positive trend.
A. Introduction
1. Colombia has achieved a significant reduction in labor informality over the past years. The share of workers nationwide who are not contributing to social security dropped from 70 percent in Q1 2007 to 62.3 percent in Q3 2017. The level remains high but relative to other countries in the region the informality rate is broadly in line with Colombia’s GDP per capita.
2. A number of policy measures have contributed to this decline. Among a large number of formalization initiatives, such as the 2006 Entrepreneurship Law and the 2010 Formalization and Job Creation Law, the 2012 Tax Reform stands out as having been particularly important in pushing formalization by cutting payroll taxes by 13.5 percentage points from close to 30 percent for workers earning below 10 minimum wages. Available impact evaluations suggest that the tax reform led to several hundred thousand additional formal jobs being created and reduced labor informality.
3. A decomposition of the fall in informality suggests that an improvement in the skill level of the labor force has also been crucial. As in all countries, informality in Colombia decreases sharply with education levels. Indeed, 85 percent of workers with postgraduate education are formal, but only 9 percent of those without any education are. Over the last 10 years, the formality rate for most education levels has increased modestly (e.g., from 6.7 to 9.3 percent for uneducated workers) but the largest gains are due not to improvements within education groups, but due to an increase in the average level of education. The latter accounts for two-thirds of the fall in labor informality between Q1 2007 and Q2 2017.
4. A simple exercise at the subnational level further highlights the role of education for informality. Using informality and education data for the 23 largest cities, and their corresponding departments we find that a higher score on the higher education index constructed by the Ministry of Education explains between 44–49 percent of the cross-sectional variation in informality far outperforming even GDP per capita in terms of explanatory power. This is compared to 1–5 percent of the variation being explained by regional differences in the World Bank Doing Business index, for example.
5. A continued focus on providing high quality education is key for further gains in productivity and formality of the labor force. Skill mismatches, especially at the technical level, remain large. Further strengthening the coverage and quality of education by building on the expansion of higher education coverage from 37 percent in 2010 to 52 percent of the age cohort in 2017 is crucial. Keeping in mind fiscal constraints, initiatives could include a focus on the supply of higher education as well as programs to support access for students from low income families.
6. A range of structural reforms would also help reduce informality further. First, non-wage labor costs remain high even after the 2012 tax reform. Employers are required to pay a four percent payroll tax to finance so-called Cajas de Compensación Familiar which bundle a wide range of services from housing and education to sports and entertainment. Alternative sources of financing for the Cajas would be preferable and the services they provide could be reviewed to avoid duplication with other government programs. Second, given large regional differences in human capital, labor productivity varies strongly and the national minimum is much more binding in some regions than others, fomenting informality where it is binding. A regionally differentiated minimum wage could be considered. Third, reducing registration fees for the registro mercantil for small firms and cutting red tape through the Ventanilla Unica Empresarial would also improve firm formality.
7. Staff simulations suggest that additional labor market reforms, as well as further cutting firm entry costs, could indeed lead to lower unemployment and informality in the long run. Staff calibrated the SPR STRESS model2 which is based on one of the key tradeoffs of informality for firms—formal firms have access to larger markets (such as exporting and supplying the government), while informal firms avoid labor and product market regulations and taxes which the formal sector needs to adhere to. Simulations show that permanently cutting entry costs in the formal sector, or labor market reforms such as lower formal-sector workers’ bargaining power and reducing payroll taxes leads to a steady state with lower informality and higher GDP, supporting the case for reforms as set out above. Previous related work in the literature suggests that combining reforms in a package and sequencing labor market reforms prior to product market reforms is often more beneficial.
8. The remainder of this chapter proceeds as follows. Section B defines informality and clarifies how we think about informality in Colombia for the purpose of this chapter. Section C presents stylized facts on informality in Colombia and Latin America, while section D elaborates on some of the key structural factors underlying informality in Colombia. Last, section E simulates a number of reform scenarios in the STRESS model.
B. Dimensions and Measurement of Informality
9. Informality is a multi-dimensional phenomenon. Broadly, we can think of informality as economic agents operating outside (part of) the framework of norms and regulations defined by the state. More specifically, informality is usually studied from the perspective of either the worker (labor informality), or the firm.3 For both, being informal can either be a choice (e.g., a worker who prefers the flexibility of informal employment, or a firm which maximizes profits by avoiding taxes and regulations), or a forced outcome (e.g., a worker who would prefer employment which offers standard social security protection, but is unable to get such a job).4
10. Labor formality can be measured with relative accuracy in Colombia, but there is no consensus on any one definition. Reliable measurements of informality from the worker’s perspective can be obtained from household survey data going back to the 1990s. The most common conceptual approach is to think of informal employment as workers who do not contribute to social security. Alternative definitions are: workers who do not receive some or all mandated benefits, or workers who have a contract which does not pass some criterion of formality. As a proxy variable, a common definition of informality originally advocated by the International Labor Organization (ILO) is to use a size-based and occupational measure which defines informal workers as those who work in firms with less than 5 or 10 employees, or are self-employed, and have a low education level. Indeed, this is the official definition used by the statistical institute (DANE) in Colombia.5 The Ministry of Labor and the Planning Office (DNP) both use the social security criterion.6
11. Firm informality is significantly more difficult to measure. The dimension one would usually like to capture is whether a firm is officially registered with the relevant public bodies (e.g., tax authority). Given that both administrative data (such as tax authority databases), and most survey data (e.g., manufacturing firms surveys) only capture formal firms this is a hard exercise in practice.7 The evidence available for Colombia is sporadic, and of limited geographic coverage.
12. Labor informality fell by several percentage points over the past few years, and stands at 48–63 percent now. Depending on the exact definition used, labor informality fell by 3.3 to 8.2 percentage points between 2007 and 2017. For the country as a whole, and using the social security criterion, informality stood at 63 percent as of Q3 2017, relative to 70 percent in 2007. Using the size criterion (which is a purely urban concept) informality dropped below 50 percent for the first time in early 2014.
Labor Informality Rate
Citation: IMF Staff Country Reports 2018, 129; 10.5089/9781484357743.002.A002
Source: DANE.Labor Informality Rate
Citation: IMF Staff Country Reports 2018, 129; 10.5089/9781484357743.002.A002
Source: DANE.Labor Informality Rate
Citation: IMF Staff Country Reports 2018, 129; 10.5089/9781484357743.002.A002
Source: DANE.13. Existing estimates suggest that firm informality lies between 45–65 percent (Haman and Mejia, 2011). Cardenas and Rozo (2009) and Santa Maria and Rozo (2009) use regional economic censuses to calculate firm informality rates and show that informal firms make up a large fraction of total firms. Santa Maria and Rozo (2009) also show that firm informality is very closely tied to firm size, with larger firms being significantly more likely to be formal.
Labor Informality and Formality
(DANE Criterion)
Citation: IMF Staff Country Reports 2018, 129; 10.5089/9781484357743.002.A002
Source: DANE.Labor Informality and Formality
(DANE Criterion)
Citation: IMF Staff Country Reports 2018, 129; 10.5089/9781484357743.002.A002
Source: DANE.Labor Informality and Formality
(DANE Criterion)
Citation: IMF Staff Country Reports 2018, 129; 10.5089/9781484357743.002.A002
Source: DANE.14. In terms of GDP, estimates suggest that between 20–40 percent of output is produced by the informal sector. Using various methodologies to approximate an essentially unobserved variable, Medina and Schneider (2018) find that the informal sector accounts for 21–33 percent of GDP in Colombia in recent years. Anif 2017 report an even higher number, putting the shadow economy (informal sector 33.5 percent + illegal sector 6.3 percent) at around 40 percent of GDP.
15. Given that informality can have significant economic costs, reducing it should be a policy priority. Among the most important macroeconomic costs, informality can have consequences for productivity given that informal firms tend to grow substantially less than formal firms, and thus do not have access to economies of scale to the same degree. Additionally, informality imposes a fiscal cost given that it reduces the tax base.
C. Informality in Regional Perspective
16. Figure 1 highlights a number of stylized facts about informality in Latin America and Colombia.8
Labor informality is a highly persistent phenomenon. Average labor formality has increased across the region over the last decade. In fact, in line with the strong GDP growth and favorable labor market dynamics experienced by the whole region, informality has fallen in most countries. But on aggregate this has only somewhat more than reversed losses in formality experienced during the 1990s.9 The gains in labor formality achieved by Colombia over the past decade are marginally higher than the average gains across the region.
Labor informality decreases with the level of development. In the cross-section, the correlation between the level of development as proxied by GDP per capita and labor formality is very strong. This observation also holds more broadly when looking at a worldwide sample of countries. Colombia’s level of formality is broadly in line with the level predicted by its GDP per capita.
Labor informality is counter-cyclical. Informality moves with the cycle, a point also made by Bosch and Maloney (2008), Bosch and Esteban-Pretel (2012), Loayza and Rigolini (2006) and Bernal (2009), among others, largely because formal-sector hiring falls more sharply than informal-sector hiring during downturns (Perry, 2007). In a simple fixed effects regression for Latin American countries we estimate that a one percentage point increase in real GDP per capita growth is associated with an increase in labor formality by 0.3 percentage points after 2 years.10
Labor Informality in Latin America—Stylized Facts
Citation: IMF Staff Country Reports 2018, 129; 10.5089/9781484357743.002.A002
Sources: IDB SIMS Database; WDI; and Fund staff calculations.Labor Informality in Latin America—Stylized Facts
Citation: IMF Staff Country Reports 2018, 129; 10.5089/9781484357743.002.A002
Sources: IDB SIMS Database; WDI; and Fund staff calculations.Labor Informality in Latin America—Stylized Facts
Citation: IMF Staff Country Reports 2018, 129; 10.5089/9781484357743.002.A002
Sources: IDB SIMS Database; WDI; and Fund staff calculations.17. Firm informality in Colombia is high in a regional comparison. According to the latest World Bank Enterprise Survey for Colombia (which dates from 2010), 70.9 percent of firms report competing against informal firms and 55 percent identify practices of competitors in the informal sector as major constraints, highlighting the large challenge posed by firm informality. Both these numbers are substantially above the average for Latin America.
Percent of firms competing against unregistered or informal firms
Citation: IMF Staff Country Reports 2018, 129; 10.5089/9781484357743.002.A002
Source: World Bank.Percent of firms competing against unregistered or informal firms
Citation: IMF Staff Country Reports 2018, 129; 10.5089/9781484357743.002.A002
Source: World Bank.Percent of firms competing against unregistered or informal firms
Citation: IMF Staff Country Reports 2018, 129; 10.5089/9781484357743.002.A002
Source: World Bank.18. Labor informality in Colombia is driven, to a large extent, by informal self-employment. To try to understand what aspects of informality make up the headline number for Colombia we split out formality among salaried workers and self-employed ones. While Colombia does relatively well in terms of labor formality among salaried workers, it does poorly among the self-employed—according to IDB SIMS data, in 2016 67.3 percent of all salaried workers but only 12.7 percent of independent workers were formal. Additionally, the rate of self-employment is very high in Colombia. This is of particular concern since Perry et al. (2007) show that a large share of Colombian self-employed workers seems to be excluded from the formal labor market—in a number of Latin American countries self-employed workers report choosing to be self-employed when asked in a survey, but in Colombia many of the self-employed would prefer a salaried employment, and cannot find one.
Self-Employment in Latin America
Citation: IMF Staff Country Reports 2018, 129; 10.5089/9781484357743.002.A002
Source: IDB SIMS.Self-Employment in Latin America
Citation: IMF Staff Country Reports 2018, 129; 10.5089/9781484357743.002.A002
Source: IDB SIMS.Self-Employment in Latin America
Citation: IMF Staff Country Reports 2018, 129; 10.5089/9781484357743.002.A002
Source: IDB SIMS.19. Education and skills are crucial to understand informality. In all countries in the region, the probability of being informal decreases dramatically with the level of education of a worker. In Colombia, a worker with a postgraduate degree is nine times as likely to be formal than a worker without any education, and twice as likely as a worker with a high school degree, but no tertiary education. While higher income reduces informality via a demand effect, La Porta and Shleifer (2014) argue that the supply channel (a lack of human capital, and specifically a lack of educated entrepreneurs) might be the most important factor for informality.
Formality Rate by Education Level
Citation: IMF Staff Country Reports 2018, 129; 10.5089/9781484357743.002.A002
Source: Gran Encuesta Integrada de Hogares.Formality Rate by Education Level
Citation: IMF Staff Country Reports 2018, 129; 10.5089/9781484357743.002.A002
Source: Gran Encuesta Integrada de Hogares.Formality Rate by Education Level
Citation: IMF Staff Country Reports 2018, 129; 10.5089/9781484357743.002.A002
Source: Gran Encuesta Integrada de Hogares.20. Additionally, policy choices related to taxes and regulations can contribute significantly to informality. A broad range of labor market, product market or other factors can create a wedge between the cost of operating in the formal and informal sectors, making it more beneficial for certain firms and workers to remain informal if the costs outweigh the benefits associated with the formal sector (access to finance, larger markets, social security benefits, etc.). Reforms should thus aim to reduce the relative costs of formality.11
21. Colombia implemented several structural reforms over the past years which are having a positive impact. The government enacted three major reforms over the past decade which attempt to tackle some of the structural constraints. The 2006 Entrepreneurship Law was followed by the Formalization and Job Creation Law of 2010 which introduced a package of measures aimed at reducing the fixed cost of being in the formal sector (simplified bureaucratic procedures), reducing payroll taxes and social security contributions for small firms and providing better labor market support.12 The tax reform of 2012 significantly cut the labor tax wedge, reducing mandatory contributions from 29.5 percent to 16 percent of gross wage earnings for workers earning less than 10 minimum wages.13 Kugler et al. (2017) show that the 2012 tax reform reduced informality, especially for workers in smaller firms, and those close to the minimum wage.14
22. Nevertheless, several structural impediments remain in Colombia. Besides skill mismatches and human capital constraints, complex bureaucratic steps and firm entry costs, a minimum wage which is highly binding in certain areas, and relatively high non-wage labor costs, even after the 2012 reform, stand out as potential factors. In the following section we look at these constraints in more detail.
D. Causes of Informality in Colombia
Education/Skill Mismatches
23. Two separate exercises show the paramount role improving human capital has for lowering informality in Colombia. First, staff decomposed the fall in labor informality over the last decade into the change in informality within education groups and the change in the size of different education groups and found that the latter dominates. Second, staff empirically assessed the factors which explain cross-sectional variation in labor informality between Colombian regions, and found that an index of the quality and quantity of post-secondary education has the highest explanatory power.
Share of Employment by Education Group
Citation: IMF Staff Country Reports 2018, 129; 10.5089/9781484357743.002.A002
Source: IMF Staff calculations based on DAME.Share of Employment by Education Group
Citation: IMF Staff Country Reports 2018, 129; 10.5089/9781484357743.002.A002
Source: IMF Staff calculations based on DAME.Share of Employment by Education Group
Citation: IMF Staff Country Reports 2018, 129; 10.5089/9781484357743.002.A002
Source: IMF Staff calculations based on DAME.
Labor Formality since 2007
Citation: IMF Staff Country Reports 2018, 129; 10.5089/9781484357743.002.A002
Source: IMF Staff calculations based on DANE. Data missing for most of 2010–11.Labor Formality since 2007
Citation: IMF Staff Country Reports 2018, 129; 10.5089/9781484357743.002.A002
Source: IMF Staff calculations based on DANE. Data missing for most of 2010–11.Labor Formality since 2007
Citation: IMF Staff Country Reports 2018, 129; 10.5089/9781484357743.002.A002
Source: IMF Staff calculations based on DANE. Data missing for most of 2010–11.24. Two thirds of the fall in informality between 2007 and 2017 are due to a better educated workforce. Between 2007 and 2017 the formality rate for workers with no more than primary education increased from 12 to 15 percent, for those with some type of secondary education it rose from 37 percent to 40 percent, and for those with tertiary education it rose from 71 to 73 percent, all increases of roughly 3 percentage points. And yet the total formality rate rose by nearly 8 percentage points. The reason is that the share of workers with only primary education or less dropped from half to less than 40 percent, while the share of workers with higher education increased by 7 percentage points to 23 percent.
25. At the subnational level, access to and quality of higher education is highly associated with labor formality. There exists large regional variation in informality in Colombia which can be exploited to gauge the determinants. Simple cross-sectional regressions suggest that education, and, in particular, access to and quality of higher education (which includes technical professional, technological and university education) has by far the largest explanatory power, outweighing even GDP per capita.15 The higher education index explains 44–49 percent of the cross-sectional variation which compares to 1–5 percent of the variation which is explained by regional differences in the World Bank Doing Business index.
| VARIABLES | (1) Labor Informality Rate | (2) Labor Informality Rate | (3) Labor Informality Rate |
|---|---|---|---|
| GDP per Capita | −4.83e-07* (2.48e-07) | −4.56e-07* (2.37e-07) | −3.86e-08 (2.22e-07) |
| World Bank Regional Doing Business Score | −0.824 (0.761) | −0.467 (0.546) | |
| Higher Education Index | −0.693*** (0.166) | ||
| Constant | 61.97*** (3.530) | 117.8** (50.23) | 103.2*** (35.81) |
| Observations | 23 | 23 | 23 |
| R-squared | 0.202 | 0.269 | 0.495 |
| VARIABLES | (1) Labor Informality Rate | (2) Labor Informality Rate | (3) Labor Informality Rate |
|---|---|---|---|
| GDP per Capita | −4.83e-07* (2.48e-07) | −4.56e-07* (2.37e-07) | −3.86e-08 (2.22e-07) |
| World Bank Regional Doing Business Score | −0.824 (0.761) | −0.467 (0.546) | |
| Higher Education Index | −0.693*** (0.166) | ||
| Constant | 61.97*** (3.530) | 117.8** (50.23) | 103.2*** (35.81) |
| Observations | 23 | 23 | 23 |
| R-squared | 0.202 | 0.269 | 0.495 |
26. Several promising policy initiatives aim to improve education outcomes and reduce skill mismatches in Colombia. These include programs to allow low-income students to access high-quality tertiary education as well as expanding the supply of education. The authorities are also working on a long-term strategy to reduce skills mismatches by developing a national framework (marco nacional de cualificaciones) which aims to ensure that the growing number of higher education degrees are pertinent to the needs of the country. Further strengthening the coverage and quality of education by building on the expansion of higher education coverage from 37 percent in 2010 to 52 percent in 2017 will remain important.
Skills Mismatches
Citation: IMF Staff Country Reports 2018, 129; 10.5089/9781484357743.002.A002
Source: Lora (2015)Skills Mismatches
Citation: IMF Staff Country Reports 2018, 129; 10.5089/9781484357743.002.A002
Source: Lora (2015)Skills Mismatches
Citation: IMF Staff Country Reports 2018, 129; 10.5089/9781484357743.002.A002
Source: Lora (2015)Taxes and Regulation
27. The administrative burden for the formal sector is high. Colombia scored 123th out of 137 countries in the latest World Economic Forum burden of government regulation index, indicating that complex bureaucratic steps are a significant barrier for formal firms. Part of the complexity arises due to the regional variation in regulations and complicated procedures for paying departmental and local taxes (see OECD, 2016; World Bank, 2017). To improve processes, the government is putting in place the ventanilla unica empresarial which will streamline and bundle necessary steps. Regional governments could also usefully harmonize practices to some degree, in line with the best performing regions.
Burden of Government Regulations
(2017–18 Report)
Citation: IMF Staff Country Reports 2018, 129; 10.5089/9781484357743.002.A002
Source: World Economic Forum.Burden of Government Regulations
(2017–18 Report)
Citation: IMF Staff Country Reports 2018, 129; 10.5089/9781484357743.002.A002
Source: World Economic Forum.Burden of Government Regulations
(2017–18 Report)
Citation: IMF Staff Country Reports 2018, 129; 10.5089/9781484357743.002.A002
Source: World Economic Forum.28. Firm entry costs are substantial, especially for small and micro firms. Firms are required to register with the Chambers of Commerce through the registro mercantil, and renew this registration annually by paying a fee. The costs of doing so are higher than in peer countries and the current system is particularly costly for smaller firms and disincentives formality (Salazar et al., 2017; CPC, 2017). Different and less regressive contribution systems could be considered in line with some of the suggestions made by Salazar et al (2017) while preserving the positive role the registro plays for the economy.16
29. For small and micro firms, the tax burden can be a key impediment to formalization. Gomez and Steiner (2015) calculate effective tax rates for firms of different sizes in Colombia. They find that on average the total effective tax rate is around 50 percent of profits and for small firms it can be as high as 100 percent, leading to very significant costs of formalization from the perspective of the firms.
30. Minimum wages are highly binding in regions where labor productivity is lower. According to OECD data, at close to 90 percent of the median wage in 2015, Colombia had the highest ratio of minimum wage to median wage of full-time employees in the OECD sample and the wage distribution is compressed just above the minimum wage. 17 It is particularly binding in regions with lower labor productivity, with negative impacts on the labor market outcomes in those regions (Arango and Florez, 2017). Reform suggestions include making the minimum wage vary by groups of regions (Arango and Florez, 2017).
Minimum to Median Wage
Citation: IMF Staff Country Reports 2018, 129; 10.5089/9781484357743.002.A002
Source: OECD.Minimum to Median Wage
Citation: IMF Staff Country Reports 2018, 129; 10.5089/9781484357743.002.A002
Source: OECD.Minimum to Median Wage
Citation: IMF Staff Country Reports 2018, 129; 10.5089/9781484357743.002.A002
Source: OECD.31. Non-wage labor costs remain relatively high, even after the 2012 reform. According to detailed calculations by Anif (2015), total non-wage labor costs, including pensions, health, holidays, parafiscales, and others, add up to 39–52 percent of the wage of a worker. While many of these costs have direct benefits for the worker, and are a desirable element of a formal work relationship, 4 percentage points of the 16 percentage points payroll tax are used to pay for so called Cajas de Compensacion Familiar which provide a wide range of bundled benefits. Recent reform suggestions propose finding alternative sources of financing for the funds to further lower payroll taxes in the spirit of the 2012 tax reform (CPC, 2017).18
Other Factors
32. Distortions related to social security programs might be incentivizing informality. Among other distortions, a part of formal workers’ health care contributions is used to finance the subsidized system, and thus acts as a tax. Moreover, the subsidized system offers nearly the same services as the contributory one. A clearer link between contributions and benefits could make formality more attractive.
33. Stronger enforcement would help protect vulnerable groups of workers and increase the costs of informality. Enforcement has been a concern in the past, but the authorities have taken steps to increase available resources (OECD, 2016). The Ministry of Labor is working on streamlining IT systems and interactions with other agencies to guarantee improved enforcement of labor laws.
34. Trust in public institutions is ultimately very important to formalize the economy in a permanent way. This requires communicating the benefits of formality (and thus the benefits of interacting with the state) to all economic agents, and delivering public services of high quality. The Ministry of Labor is reaching out to rural areas through the ‘Red Nacional de Formalizacion Laboral’ to inform workers and small business owners about social security systems. Additionally, in 2017 formalization fairs were started to move beyond pure communication, allowing workers and small business owners to take immediate steps towards formalization.
E. Modeling Reform Options: The STRESS Model
35. Staff simulated the impact of some of the reforms discussed above. Staff calibrated a small open-economy dynamic general equilibrium model, with unemployment due to hiring costs and wage bargaining, and endogenous firm entry, developed by Anand and Khera (2016) and Munkacsi and Saxegaard (2017).19 The incorporates a distinction between formal and informal sectors in the labor and goods markets when exploring the macroeconomic impact of structural reforms.20 Firms in the formal sector face higher entry costs and hiring costs than in the informal sector, they pay taxes and workers in the formal sector have higher bargaining power than those in the informal sector. But formal sector firms have access to a larger market, since informal firms are not able to export or provide goods to the government.
36. The steady state of the model calibrated to Colombia highlights the differences between the two sectors. TFP and the capital share in the Cobb-Douglas production function are exogenously fixed and assumed to be the same in both sectors. Nevertheless, in steady state the endogenous values for output, the capital stock and labor productivity are higher in the formal sector as a consequence of the incentives and constraints embedded in the model as set out in the following. The formal sector retailers’21 exit rate is calculated based on exit rates from the ‘registro unico empresarial y social’ for 2013–16, and the informal retailers exit rate is exogenously assumed to be higher, in line with empirical evidence (Ulyssea, forthcoming for Brazil). The exogenous firing probability is higher in the informal sector, with the parameter value for the formal sector calculated based on labor flow data. Last, taxes in the informal sector are zero, while payroll taxes are 16 percent in the formal sector to match Colombia’s statutory rate, and the effective rate of employee taxes is calibrated based on the observed ratio of personal income tax to GDP. Retailer entry costs in the formal sector are calibrated based on data on entry costs relative to output taken from the World Bank Doing Business report. Last, bargaining power in the formal sector is exogenously set higher than in the informal sector to match the long-run value of unemployment.
Formal vs. Informal Sector in Steady State
Formal vs. Informal Sector in Steady State
| Formal Sector | Informal Sector | |
|---|---|---|
| Output | 3.8 | 1.5 |
| TFP | 1 | 1 |
| Capital Share | 0.34 | 0.34 |
| Capital Stock | 24.99 | 12.04 |
| Employment | 0.32 | 0.55 |
| Capital per employee | 78.09 | 21.89 |
| Labor productivity | 11.88 | 2.73 |
| Retailers Exit Rate | 0.125 | 0.35 |
| Probability of Hiring | 0.05 | 0.7 |
| Probability of Firing | 0.09 | 0.7 |
| Tax rate on employees | 0.04 | 0 |
| Tax rate on employers | 0.16 | 0 |
| Worker bargaining power | 0.78 | 0.2 |
| Retailer Entry Costs | 2.89 | 0.06 |
Formal vs. Informal Sector in Steady State
| Formal Sector | Informal Sector | |
|---|---|---|
| Output | 3.8 | 1.5 |
| TFP | 1 | 1 |
| Capital Share | 0.34 | 0.34 |
| Capital Stock | 24.99 | 12.04 |
| Employment | 0.32 | 0.55 |
| Capital per employee | 78.09 | 21.89 |
| Labor productivity | 11.88 | 2.73 |
| Retailers Exit Rate | 0.125 | 0.35 |
| Probability of Hiring | 0.05 | 0.7 |
| Probability of Firing | 0.09 | 0.7 |
| Tax rate on employees | 0.04 | 0 |
| Tax rate on employers | 0.16 | 0 |
| Worker bargaining power | 0.78 | 0.2 |
| Retailer Entry Costs | 2.89 | 0.06 |
37. The calibrated model matches the long-term properties of the observed data for Colombia well. The calibration aims to match the average of quarterly data for a set of macroeconomic and labor market variables over the period 2000–2016. As the below table shows, the model does well in this respect.
Model Steady State vs Observed Values
Model Steady State vs Observed Values
| Variable Description | Model | Data |
|---|---|---|
| Private Investment as share of GDP | 0.24 | 0.23 |
| Openness as share of GDP | 0.40 | 0.39 |
| Unemployment rate | 13.30 | 13.12 |
| Shadow economy as share of GDP | 0.30 | 0.21 to 0.4 |
| Informal employment as share of total employment | 0.63 | 0.66 |
| Ratio of formal to informal sector wages | 2.87 | 2.78 |
Model Steady State vs Observed Values
| Variable Description | Model | Data |
|---|---|---|
| Private Investment as share of GDP | 0.24 | 0.23 |
| Openness as share of GDP | 0.40 | 0.39 |
| Unemployment rate | 13.30 | 13.12 |
| Shadow economy as share of GDP | 0.30 | 0.21 to 0.4 |
| Informal employment as share of total employment | 0.63 | 0.66 |
| Ratio of formal to informal sector wages | 2.87 | 2.78 |
38. Simulation results suggest that labor market reforms, as well as cutting firm entry costs, could indeed lead to lower informality in the long-run. Results show that permanently cutting entry costs in the formal sector, or labor reforms such as lower formal-sector worker bargaining power and reducing payroll taxes leads to a steady state with lower informality driven by higher formal sector employment. Previous related work (Munkacsi and Saxegaard, 2017) suggests that combining reforms in a package and sequencing labor market reforms prior to product market reforms is often favorable.
Steady-State Impact of Reforms
Steady-State Impact of Reforms
| Labor Informality (percentage points change) | Formal Employment (percentage points change) | |
|---|---|---|
| Reduction in Firm Entry Costs by 10 percent | −0.2 | 0.4 |
| Reducation in Payroll tax from 16 to 14 percentage points | −0.3 | 0.1 |
| Reducation in Formal/Informal Worker Bargaining Power Wedge by 10 percent | −1.2 | 3.5 |
Steady-State Impact of Reforms
| Labor Informality (percentage points change) | Formal Employment (percentage points change) | |
|---|---|---|
| Reduction in Firm Entry Costs by 10 percent | −0.2 | 0.4 |
| Reducation in Payroll tax from 16 to 14 percentage points | −0.3 | 0.1 |
| Reducation in Formal/Informal Worker Bargaining Power Wedge by 10 percent | −1.2 | 3.5 |
Annex I. A Sketch of the STRESS Model
1. STRESS (Structural Reforms and Shadow Sector) is a small open-economy dynamic general equilibrium model with unemployment due to hiring costs and wage bargaining following Blanchard and Gali (2010), and endogenous firm entry like Bilbie et al. (2012). The main novelty is the distinction between formal and informal sectors in the labor and goods markets. On the one hand, it means tax evasion in the underground economy, on the other hand, in line with Williamson (1975), the level of regulation is lower in the informal sector. Also, openness is only a consideration in the formal sector.
2. The household sector is standard; there is a representative infinitively living household that maximizes the expected discounted lifetime utility of consumption. However, consumption is an aggregate of home and foreign produced goods, while home produced goods are an aggregate of goods produced in the formal and informal sectors. Then, as regards the budget constraint, labor income originates from both the official and unofficial economies; while the former is taxed. Also, the household owns all the firms, and so finances new firms’ entry cost, in both sectors, which is equal to the expected discounted future profit-stream of firms.
3. Both formal and informal wholesale good producers produce an intermediate good by a Cobb-Douglas production function. Both pay not only the cost of labor and capital as usual, but additionally a hiring cost of newly hired workers, while labor follows a law of motion similarly to that of capital. Next, as regards retailers, due to endogenous entry, their number is not normalized to one, but is related to the law of motion of the number of firms. Additionally, the number of firms, in both the official and unofficial sectors, endogenously affect price markups.
4. Rigidities related to hiring, bargaining and entry are lower in the shadow sector. On the one hand, formal-sector firms incur greater hiring costs than do firms in the informal sector. These costs can be associated with training to make up for educational or experiential deficits on the worker’s part, but they might reflect as well administrative costs such as the time spent on hiring. Then too, the bargaining power of workers in wage setting is higher in the formal than in the informal sector. The strength of unions in the formal sector might be at play here, but this relative bargaining clout can also be related to the sector’s legal environment, which provides more rights for workers than firms in setting wages. Employment protection might also be reflected in the fact that the probability of firing is relatively lower in the formal sector. Furthermore, registering a new company is costly, in terms of both money and time; formal entry costs are larger than informal ones. Finally, price mark-up is higher and firm exit rate, similarly to the dismissal rate of workers, is lower in the formal sector than in the underground economy.
5. Alongside differences in regulation levels, other features serve to distinguish the two sectors. Notably, only formal sector’s labor income falls under the taxation umbrella. Also, by virtue of administrative regulations in the formal sector and lack of financing in the informal sector, the government can only purchase formal goods and investment is also a function of formal goods only. As well, labor productivity in the informal sector is lower than in the formal sector. Finally, formal goods are traded abroad, but informal goods are not, which is likely to be explained by the fact that entering the foreign markets requires meeting certain legal obligations. The fact that only formal goods are traded abroad constitutes the main example in our model of interactions between the shadow economy and openness.
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Prepared by Frederik Toscani (WHD) and Zsuzsa Munkacsi (SPR).
One can also think of spatial or land informality (CPC, 2017) but this will not be a focus of this chapter.
See Perry et al. (2007) for an extensive discussion of frameworks to think about informality.
According to DANE’s exact definition, informal workers: (i) work in firms with 5 or fewer employees; (ii) are business owners of firms with 5 or less employees; (iii) are unpaid family aids and housekeepers; or (iv) are self-employed, with an educational level less than University or Technical education. Note also that DANE’s preferred definition of informality is a purely urban concept, measured either for the major 13 cities of the country and surrounding metropolitan areas or 23 cities with metropolitan areas. The firm size criterion was changed from 10 to 5 employees starting in 2010.
Bernal (2009) calculates 23 potential informality measures for Colombia and concludes that “After analyzing all the available definitions, the author concludes that making Health and Pension benefits is the more suitable for the case of Colombia. Because it adheres more to the concept of informality, identifies vulnerable workers, is highly correlated with other measures of informality, is a good indicator that the individual has the entire package of benefits associated with formal employment.” Also see Galvis (2012).
Mexico is the only country in Latin America which regularly (every two years) collects data which allows following developments in firm informality in a reliable way.
Cross country labor formality data comes from the Inter-American Development Bank’s (IDB) SIMS database (Labor Market and Social Security Information System). The definition of informality follows the IDB’s official definition which uses pension contributions as the criterion for formality. Data are harmonized across countries and so is age coverage; the working age population is defined to be the population between ages 15–64.
Since data is not available for all countries in all years the composition of countries underlying the yearly average varies somewhat, introducing volatility into the series.
Mondragon-Velez et al. (2010) argue that in the case of Colombia the business cycle is of second-order importance and labor market rigidities are the key factor for informality.
See Perry et al (2007), Dabla-Norris and Inchauste (2007), OECD/CIAT/IDB (2016) and Ulyssea (forthcoming) among a large literature on policy choices and informality outcomes.
Specifically, the support programs included micro-credit programs for individuals under 28 years old, technical training programs, and financial support programs.
The reform aimed to be revenue neutral by adjusting the VAT system and making personal income taxes more progressive.
Morales and Medina (2016) also find a positive impact of the reform on formal-sector job creation.
The higher education index (‘Indice de Progreso de la Educacion Superior (IPES)) is compiled annually by the Ministry of Education and based on a methodology developed for Mexico by the education institute in Monterrey. It combines information on the share of 17–21-year-old enrolled in higher education, the share of students with high scores in standardized exams and the share of students who graduate from their course within 14 semesters.
See also Cardenas and Rozo, (2009) who suggest easing access to the registro mercantil, and expanding training programs for owners to reduce firm informality.
Trade union density is very low in Colombia as is the coverage of collective bargaining. The minimum wage negotiations thus gain an outsized importance by being one of the few instances in which worker bargaining power is high. Any minimum wage reform would thus have to be accompanied by adequate offsets.
Cuesta and Olivera (2014) caution against how big an impact a reform of the parafiscales would have given the multiple distortions in the labor markert.
The original applications of the so-called STRESS (Structural Reforms and Shadow Sector) model were to India and South Africa. It was subsequently applied to Argentina (2017 Argentina SIP) and Peru (2017 Peru staff report), with the version used in this chapter following the one for Peru.
See Suescun and Steiner (2017) for a literature review of Colombian macro models, a number of which distinguish between the formal and informal sector and include a minimum wage which is binding in the formal sector, generating unemployment in equilibrium.
Retailers sell differentiated varieties of the intermediate goods produced by wholesale goods producers.
