This paper explores the macroeconomic impact of labor and product market deregulation using a small-open-economy model with formal and informal markets. We examine both the long-term effects and the transition toward post-reform equilibrium, as well as the impact of reform packages and sequencing. Our model suggests that the size of the unofficial sector is an important determinant of the impact of reforms. South Africa, an emerging market economy, is used as a case study. In the long run, both labor and product market reforms boost the economy, though there are short-term costs. A package of reforms, especially with product market deregulation, could help mitigate some of these short-term costs, though it is usually better to start with labor market reforms to speed adjustment toward the new equilibrium.
Lackluster growth in the aftermath of the global financial crisis, coupled with limited scope for further macroeconomic stimulus, has revived interest in the impact of growth-enhancing structural reforms. For example, European Central Bank President Mario Draghi recently noted that, in addition to monetary policy, “structural reforms are key” to achieving prosperity.
Moreover, there has been a lot of focus recently on the impact of widespread tax evasion. The last of the three T’s discussed at the Group of Eight summit in 2013 was fighting tax evasion. G20 leaders in November 2015 also endorsed measures to crack down on failure to pay taxes.
Tax evasion, together with avoidance of compliance with regulations (Williamson 1975), is a key challenge for economies with a large informal sector (Schneider, Buehn, and Montenegro 2010). However, we are aware of only one paper, Charlot, Malherbet, and Terra 2015, that looks at the macroeconomic effect of structural reforms in the presence of informality. Moreover, to the best of our knowledge, there are no papers that analyze the interaction between informality and trade openness.
The informal sector is, by definition, beyond government reach and will therefore not be directly affected by deregulation, or indeed by any other public policies, such as taxation. Thus, the larger the informal sector, the smaller the share of the economy directly affected by government actions.
In the absence of any linkages between the formal and informal sectors, the overall macroeconomic effects of government policies would therefore increase with the relative size of the formal sector. However, there are potentially important linkages between the two sectors, and product and labor market reforms in the formal sector are therefore likely to have significant spillover effects for the entire economy. Deregulation may discourage firms and workers from operating in the informal sector and lead to an increase in the relative size of the formal sector. There is also a productivity differential between the two sectors, (Farrell 2004; Bailey, Farrell, and Remes 2005; La Porta and Shleifer 2008), which can magnify the impact of structural reforms. On the other hand, the informal economy may act as a shock absorber in the economy—for example, by reducing the impact of adverse shocks on unemployment (Boeri and Garibaldi 2007). Also, firms in the formal sector are more likely than those in the informal sector to engage in trade with the rest of the world. Structural reforms that increase the relative size of the formal sector could therefore promote technology and skills transfer, thereby leading to higher productivity.
Although it is difficult to estimate precisely, what evidence there is suggests that the informal sector in many countries is sizable, especially in emerging market and low-income economies. For instance, Schneider (2005) estimates that 16 percent of GDP of countries that are members of the Organisation for Economic Co-operation and Development and 41 percent of African countries’ GDP is generated in the informal sector. The share of informal employment is likely higher because firms operating in the informal sector are typically concentrated in relatively labor-intensive industries (Schneider 2012). Understanding the characteristics of the informal economy is therefore important for an overall assessment of the impact of structural reforms.
The structural reforms we consider are permanent and unexpected reductions in the level of product and labor market regulations enforced in the formal sector. We assess the impact of a decrease in the cost of hiring, a reduction in the bargaining power of workers, and a decline in firms’ cost of entering product markets. Other papers (Cacciatore and others 2016; Lusinyan and Muir 2013) have analyzed the impact of similar structural reforms, though not in the presence of informality. We believe that the large size of the informal sector in many countries, and potential interlinkages with the rest of the economy, makes it important to differentiate between the informal and formal sectors to gain an overall understanding of the impact of structural reforms.
To illustrate our findings, we calibrate and Bayesian estimate STRESS, a small-open-economy dynamic general equilibrium (DGE) model for South Africa (Figure 1) whose informal economy is relatively small, but where structural reforms are at the forefront of the policy debate. STRESS stands for Structural Reforms and Shadow Sector, and it reflects the need for (stress of) structural reforms that most countries face today, especially in the presence of a (large) shadow economy. The framework was developed by Rahul Anand, Purva Khera, Zsuzsa Munkacsi, and Magnus Saxegaard and was also published in Anand and Khera 2016. The model includes unemployment due to hiring costs and wage bargaining, following Blanchard and Gali 2010, and endogenous firm entry as in Bilbie, Ghironi, and Melitz 2012. What is unique about this framework is the distinction between the formal and informal sectors in the labor and goods markets.
In particular, the informal economy is characterized by tax evasion and a relatively lower regulatory burden. Firms in the formal sector pay more, in terms of both money and time, to enter the goods markets and incur greater hiring costs than informal firms do. Hiring costs may be associated with training to make up for workers’ educational or experiential deficits, but they could also reflect administrative costs such as the time spent on hiring. Strong labor unions, a more robust legal environment, and more substantial employment protection mean that workers in the formal sector have more bargaining power in wage negotiations and are less likely to be fired than those in the informal sector.
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The formal and informal sectors also differ in areas not directly related to the regulatory environment. Notably, only formal-sector labor income falls under the taxation umbrella, and labor productivity in the informal sector is lower than in the formal sector. In addition, because of administrative regulations and lack of financing in the informal sector, the government may purchase goods only from the formal sector. Moreover, investment goods are produced using intermediary goods from the formal sector only. Finally, only formal goods are traded with the rest of the world, given that entering foreign markets requires meeting certain legal obligations; the fact that trading abroad is limited to formal goods constitutes the main example in our model of the interaction between the shadow economy and openness.
Our results suggest that the relative size of the informal sector has significant bearing on the effectiveness of structural reforms. This is especially true for labor market policies, but the impact of product market deregulation is also affected.
In the long run, both labor and product market reforms have a significant positive impact on South African output. Labor market reforms are somewhat more successful than product market reforms in reducing unemployment. In addition, structural reforms decrease informality by increasing employment in the formal sector, but have little impact on the absolute level of employment in the informal sector.
The short-term costs of these reforms are not trivial. They include lower consumption, exports, and output; reduced wages, and decreased product-market competition. Implementing two reforms at the same time helps mitigate short-term costs, especially if one of those reforms is carried out in the goods markets. Nevertheless, if reforms are implemented sequentially, our model suggests that it is better to start with labor market reforms because this helps the economy reach postreform equilibrium faster.
Possible avenues for future research include the role of monetary or fiscal policies in limiting the short-term costs of structural reforms and in reducing the size of the informal economy.
Anand, Rahul, and Purva Khera. 2016. “Macroeconomic Impact of Product and Labor Market Reforms on Informality and Unemployment in India.” IMF Working Paper 16/47, International Monetary Fund, Washington, DC.
Bilbie, Florin O., Fabio Ghironi, and Marc J. Melitz. 2012. “Endogenous Entry, Product Variety, and Business Cycles.” Journal of Political Economy (April): 304–45.
Blanchard, Olivier, and Jordi Gali. 2010. “Labor Markets and Monetary Policy: A New Keynesian Model with Unemployment.” American Economic Journal: Macroeconomics (April): 1–30.
Boeri, Tito, and Pietro Garibaldi. 2007. “Shadow Sorting” in NBER International Seminar on Macroeconomics 2005, edited by Jeffrey A. Frankel and Christopher Pissarides, 125–63.
Cacciatore, Matteo, Romain Duval, Giuseppe Fiori, and Fabio Ghironi. 2016. “Short-Term Pain for Long-Term Gain: Market Deregulation and Monetary Policy in Small Open Economies.” Journal of International Money and Finance (November): 358–85.
Charlot, Olivier, Franck Malherbet, and Christina Terra. 2015. “Informality in Developing Economies: Regulation and Fiscal Policies.” Journal of Economic Dynamics and Control (February): 1–27.
La Porta, Rafael, and Andrei Shleifer. 2008. “The Unofficial Economy and Economic Development.” Brookings Papers on Economic Activity (Fall): 275–352.
Lusinyan, Lusine, and Dirk Muir. 2013. “Assessing the Macroeconomic Impact of Structural Reforms: The Case of Italy.” IMF Working Paper 13/22, International Monetary Fund, Washington, DC.
Schneider, Friedrich. 2005. “Shadow Economies around the World: What Do We Really Know?” European Journal of Political Economy (September): 598–642.
Schneider, Friedrich. 2012. “The Shadow Economy and Work in the Shadow: What Do We (Not) Know?” IZA Discussion Paper 6423, Institute for the Study of Labor (IZA), Bonn.
Schneider, Friedrich. 2010. “New Estimates for the Shadow Economies All over the World.” International Economic Journal (August): 443–61.