Salvador, Bahia, Brazil. (Shutterstock)
Salvador, Bahia, Brazil. (Shutterstock)

At an interesting conference on growth prospects for Latin America at the IMF last week, there was an interesting exchange on the factors holding back productivity growth. The proximate cause of the weak productivity performance, most would agree, is the large share of the informal sector in the  region.

Informality is associated with poor pay, lower levels of education, reduced unionization and fewer contributors to social security schemes. At the same time, informal firms operate under the tax "radar" so that governments have less revenues to finance public projects. There are, seemingly, several reasons to bring informal firms into the formal sector.

But what is the connection to weak productivity growth?

Consider two firms. The first firm is in the formal sector, paying high wages and subject to taxes. And since workers are paid a higher wage, they make contributions to the social security system.

The second firm is in the informal sector. It has little physical capital, pays very low wages, given the large supply of poorly educated workers and evades the tax collector.

How can the first firm paying higher wages and taxes compete with the second firm? To be profitable, the marginal productivity of labour has to be high. This means that the first firm has to have a larger stock of physical capital and a trained workforce (as a complement to physical capital).

The developmental implications of this are considerable. Workers in firm one not only earn higher wages, but the incomes of those workers are more stable: firms have an incentive to "hoard" labour in downturns (to retain the human capital investments) while workers contributing to social security plans have lower variance of income. More stable earnings, meanwhile, allow workers to borrow to accumulate home equity and invest in education for their children. Moreover, they can consume additional goods and services, supporting growth.

Such factors offer a route out of poverty. But workers in the informal sector are barred from this path to prosperity.

But can these two firms coexist? And why don't market forces unify the labour market? For the situation to remain, there has to be some failure or a wedge driven between the two markets.

Two competing explanations for the size and persistence of the informal market in Latin America were discussed at the IMF conference. The first, argued by Ricardo Haussmann, involves the time spent traveling to formal sector employment from the outlying suburbs that are not served or are poorly served by public transport. This lost or unproductive time entails a huge implicit tax on formal employment.

Consider a commute that requires, say, four hours of traveling time with a fare equivalent to two hours of labour. This is the equivalent of a tax equal to 50% of formal employment earnings. Informal employment in local neighborhoods is sustained by the huge fixed cost of moving into the formal labour market.

The alternative explanation for the persistence of informal markets was offered by Santiago Levy. He argued that the problem is poorly designed policies that implicitly subsidize informal sector jobs and tax formal sector jobs. Social security and labour market reforms that redress this imbalance are needed.

At the same time, there is a basic issue of lack of trust — perhaps employers are reluctant to make investments in training workers, fearing that those workers lack commitment to the firm; perhaps workers are loathe to make payments to social security systems, believing that the promised benefits will prove illusionary. In any event, the needed investments in human capital are not made and the worker voluntarily remains outside the formal economy.

Needless to say, which of these explanations is correct is important for policy. If it is solely a question of transportation costs, a policy of massive infrastructure investment in public transit might be enough to "bootstrap" the economy out of the dual labour markets equilibrium into a world in which the informal economy is marginalized. But if the second explanation is true, infrastructure spending alone is not enough. Labour market reforms are an important and necessary complement. Indeed, without the supporting policy reforms, there is a risk that the country is saddled with a significantly higher debt burden without a corresponding increase in output in the productive economy (and the tax revenues to pay for the infrastructure).

Given the importance that governments in the region attach to infrastructure, getting the right answer should be a critical issue.

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