The prevalence of economic informality is an economic malaise that is characteristic of many developing countries. The scarce number of productive jobs in these economies and the limited capacity of the state bureaucracy generate incentives for low-skilled workers and small businesses to conceal their economic activity from the state. This is particularly true in Latin America, where the informal sector encompasses between 35% and 40% of total GDP[i] and where almost 70% of the labor force is employed informally.
This rampant informality leads to: 1) losses in consumption and income tax revenue for governments, 2) limited government services and underfunded pension programs, 3) precarious employment and lower labor standards for informal laborers, 4) and a stratified economy due to the limited access to markets, technology, and productive resources for informal businesses.
Notably, informality creates a harmful equilibrium for small businesses, since they are oftentimes not profitable enough to overcome government-imposed barriers to entry but too small to be noticed by the state. In sum, informality generates a suboptimal equilibrium in relation to economies without excessive regulations and with adequate public service provisions[ii].
Despite the aforementioned repercussions, the informal sector is unmistakably a source for new jobs. Since 1980, 60 out of 100 new jobs have been created in the informal sector[iii]. This clearly denotes a pattern of job creation that adds to national economies despite the fact they don’t add to government revenues. With this in mind, governments must implement policies to formalize rather than crackdown on informal businesses. Yet striking this fine balance is difficult and requires significant policy reforms to improve government efficiency and business practices.
Informal sectors often sell and buy legal goods, their informality mostly stems from the partial compliance with laws, regulations, and taxes[iv]. Therefore, the key for Latin American governments is stimulating compliance by making it easier and economically attractive to businesses and workers.
A first step would be to adapt the formalization requirements for businesses. Oftentimes, costly business permits and the duration of bureaucratic processes act as significant barriers to entry for small businesses. Streamlining regulations and improving bureaucratic agility is crucial. However, at times simply lowering regulations to levels that approximate to the equilibrium of the informal sector may be even more effective.
Another low-hanging fruit is to make it easier for individuals and businesses to pay taxes. Simplifying tax returns and increasing the funding for technology driven approaches to tax recollection can achieve improve tax revenues for government struggling with deficits. Although the initial investment may appear burdensome, endowing government agencies with better tools can augment the capacity of the state to effectively regulate markets without stifling the newest developments.
The structure of the taxing regime can also have significant influence in the choices businesses make. A reduction of the corporate tax and a focus on a progressive income tax can allow for more businesses to develop without depriving the state of revenues.
There are less evident ways to combat informality beyond improvements on permits and taxing. Improving access to credit for small business owners is one way to incentivize formality. Oftentimes, small businesses recur to informal avenues to fund ventures given the high requirements to formal lending. Allowing businesses to formally finance their business without imposing excessive costs to liquidity,[v] can present clear benefits to embracing regulation. Other micro-enterprise incentives can range from imparting knowledge of best practices to improving digital connectivity to level the competitive playing field.
Given the large portion of the labor force that resorts to informality and self-employment, a significant portion of the population does not contribute to national pension systems. While in the United States less than 10% of the labor force does not contribute pensions systems, in Latin America the percentage can range from as low as 40% in Chile to almost 80% in Bolivia[vi]. Reforming pension systems[vii] paired with a business formalization push to include more contributors could go a long way in improving pension fund liquidity and more importantly the compensation workers receive. The implementation of social welfare programs for informal worker can not only alleviate poverty but can also allow for higher labor productivity in small businesses – increasing the likeliness of formalization.
Last but not least, governments must take coordinated steps to stimulate credit transactions and diminish the prevalence of the cash economy. If done correctly, the digitalization of commercial transactions can both improve individual transactions in the marketplace and give government’s better tools for regulation.
Incorporating informal activity into the market economy requires well thought out policies in order to balance formality and new business development. There is a broad range of policies to choose from and they may be best served as a cohesive effort combining a broad array of policies.
Following the 2003 economic recession, the Uruguayan government took aim at decreasing informality and passed a comprehensive economic package including tributary reform, investment promotion, and social welfare expansion. This policy effort is credited with endowing Uruguay[viii] with the much needed labor market dynamicity to recover – seeing a rise in labor participation from 58% in 2003 to 64% in 2012. These improved economic results were paired with a 15% decrease in labor informality.
It is unclear to what extent Uruguay’s experience can be replicated in the rest of the continent. Nonetheless, understanding the similarities among economies in Latin America is a first step what ensues is adapting this knowledge to fit the needs of each individual country. If done correctly, bringing light to the informal sector can be a significant boon for Latin America and the rest of the developing world.