Informal is normal in Latin America: taxes matter

By Juan Carlos Benítez, Economist at the Latin American and Caribbean Unit, and Angel Melguizo, Head of the Latin American and Caribbean Unit, at the Organisation for Economic Co-operation and Development (OECD)

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Informality equals vulnerability. In emerging economies and particularly in Latin America, informal is normal. On average, 55% of workers in the region did not contribute to pension or healthcare programmes in 2013. Although informality rates vary significantly across countries (Figure 1), a common feature of informality is its large prevalence amongst the poor and low-middle income workers (e.g. Jutting and De Laiglesia, 2009). On average, 85% and 73% of households in the lowest earning quintiles do not have any member contributing to social security schemes. Furthermore, informality is “one of the most striking differences, within the middle sectors, between the vulnerable population and the consolidated middle class” (Lustig and Melguizo, 2015).

Figure 1. Informality rates in Latin American countries,
by quintile of per capita family income, 2013

(percentage of workers not contributing to social security programmes- aged 15-64 years)

figure-1Source: OECD/CIAT/IDB (2016). Taxing Wages in Latin America and the Caribbean.

Why does this matter? Informality is detrimental to reaching social and economic goals. For many workers, informality translates into lack of safety provisions in the workplace, job insecurity and higher risks of income gaps due to unemployment, injury or illness. Furthermore, informal workers will face specific challenges transitioning into old-age as they will not have a source for income replacement. From a public perspective, the lower tax revenue levels that informality entail might hamper investments in providing more and better public goods, including public health plans. Unfair competition could also arise between lawfully compliant formal firms and informal ones.

Informality is also associated with lower levels of skills, productivity, job quality and income-earnings. Although a causal relationship is less clear, it might be circular and mutually reinforcing. In this respect, low skills render lower levels of productivity that ultimately lead to lower job quality and lesser wage-earnings, usually in the economy’s informal sector (OECD, 2016). An additional factor is the greater volatility within labour markets as workers move among different stages from formally employed to unemployment or to informal jobs. Both the social and economic implications pose daunting challenges for policy makers.

Understanding the causes and effects of informality is crucial for inclusive economic growth and development. The region’s high levels of informality stem from diverse causes, calling for a comprehensive approach to the problem. For workers and firms, the decision between formality and informality can be influenced by several factors. These include tax burdens, wage levels, prospects of job security, excessive labour regulations and the value the worker or firm places on the programme or service. What also drives the choice between formal and informal sectors are expectations of receiving future benefits from formalisation, weak labour institutions, enforcement mechanisms and skills mismatches.

Uruguay and Colombia offer good examples of how altering the incentives for workers and employers can enhance formalisation rates. In Uruguay, a 2008 reform extended the health benefits to include dependent children of formal employees. This led to a decrease in informality rates by 1.3 percentage points by providing more value for the contributions made to the healthcare scheme (Bérgolo and Cruces, 2011). In Colombia, reducing payroll contributions paid by employers by 13.5 percentage points as a result of the 2013 tax reform improved firm employment and led to the creation of 213 000 formal jobs in the short-run (Bernal, Eslava and Meléndez, 2015; Medina and Morales, 2016). The tax reform reduced the informality rate between 2.0 and 3.1 percentage points for workers in 13 main metropolitan areas. This translates into a decrease in the informality rate between 1.2 to 2.2 percentage points for the whole country (Fernández and Villar, 2016).

Improving incentives towards formalisation must be accompanied by comprehensive skills and productive development policies (OECD/CAF/ECLAC, 2016). In fact, education and training programmes have been successful in improving formal employment prospects. In the Dominican Republic, for example, the programme “Juventud y Empleo” increased the probability of men attaining a formal job by 17% (Ibarrarán et al., 2015). In Peru, the probability of employment with health insurance and pension coverage increased by 3.8 and 3.3 percentage points, respectively, for those who participated in the “Projoven” programme relative to those who did not (Díaz and Rosas, 2016).

Still, more and better data is needed to understand the costs propelling informality. Taxing Wages in Latin America and the Caribbean is one effort to accurately depict tax burdens on wages for employed workers in 20 countries in Latin America and the Caribbean, disaggregating personal income tax and compulsory social security contributions paid by employees and employers. It provides homogenous data for the region that is comparable to OECD countries, by income level and family composition.

What does this data tell us?

First, for an average worker in Latin America and the Caribbean, the tax wedge, or the difference between the total labour costs and the worker’s take home pay, is 14 percentage points lower than in OECD countries (35.8% compared to 21.7% of total labour costs; Figure 2). This gap is almost exclusively explained by the amount of personal income tax paid in OECD economies. Differences in social security payments between workers in OECD countries and in Latin America and the Caribbean are very small. In fact, for most Latin American and Caribbean countries employer social contributions are even larger than the OECD average.

Figure 2. Income tax plus employee and employer
social security contributions, 2013

(As a % of  labour costs)

figure-2

Source: OECD/CIAT/IDB (2016). Taxing Wages in Latin America and the Caribbean.

Second, the cost of adhering to social security programmes as a percentage of earned income is considerably high in some countries of the region, especially for the lower and middle-income deciles, and strongly correlates to high informality levels (Figure 3). The interaction of lower contributory thresholds (usually minimum wages) and social security program rates might make these programs unaffordable. From the employer’s perspective, high non-labour costs might play a detrimental role in the supply of formal jobs. This adds to the many other non-tax factors that explain individual decisions to become or remain informal.

Figure 3. Theoretical formalisation costs and informality rates by labour income deciles for salaried workers in Latin America, 2013 (ages 15 – 64)

figure-3
Source: OECD/CIAT/IDB (2016) Taxing Wages in Latin America and the Caribbean.

While the huge heterogeneity both in terms of the size of the tax wedge and the percentage of informality within the region must be noted, what is universal is the need for appropriate policy responses.

What could these policies include? To start, implementing a jobs strategy is key. Improving opportunities for formal employment so that workers and companies can fully enjoy not only the benefits of social insurance, but also the capacity for personal growth and added value that comes from formal economies, is critical for Latin America and the Caribbean. What also is critical is reassessing the fiscal and social security system. Appraising how social security contributions are levied is the first step towards changing the incentive structure for workers. Progressive social security cuts and matching contributions pension schemes that increase the returns from becoming formal have the potential to change the incentives for formalisation.

In these ways, taxes matter in promoting job stability that will lay the foundation for longer lasting and productive employment relationships. And these are at the heart of ensuring inclusive growth and consolidating a stronger and more vibrant middle class.


References:

Bérgolo M. and Cruces, G. (2011). “Labor informality and the incentive effects of social security: evidence from a health reform in Uruguay”. CEDLAS.

Bernal, R., M. Eslava and M. Meléndez (2015). “Taxing where you should: formal employment and corporate income vs payroll taxes in the Colombian 2012 Tax Reform”. Mimeo.

Díaz, J.J. and D. Rosas (2016), “Impact evaluation of the Job Youth Training Programme Projoven”, Working Paper Series, No. IDB-WP-693, Inter-American Development Bank, Washington, DC.

Fernández, C. and L. Villar (2016), “A taxonomy of Colombia´s informal labor market”. Working paper No. 73 2016-11. Fedesarrollo. Bogotá, Colombia.

Fernández, C. and L. Villar (2016), “The impact of lowering the payroll tax on informality in Colombia”. Working paper Nº. 72 2016-10. Fedesarrollo. Bogotá, Colombia.

Ibarrarán, P. et al. (2015), “Experimental evidence on the long-term impacts of a youth training programme”, Working Paper Series, No. IDB-WP-657, Inter-American Development Bank, Washington, DC.

Jütting, J. and J. de Laiglesia (2009), Is Informal Normal ?: Towards More and Better Jobs in Developing Countries, OECD Publishing, Paris, http://dx.doi.org/10.1787/9789264059245-en

Lustig, N. and A. Melguizo (2015). How middle class are middle-income households in Latin America?. VoxLACEA.

Medina C. and L. Morales (2016). “Assessing the effect of payroll taxes on formal employment: the case of the 2012 Tax reform in Colombia. Borradores de economía Nº 971/2016.

Melguizo, A. (2015), “Pensions, informality, and the emerging middle class”. IZA World of Labor, pp. 1-10. Institute for the Study of Labor.

OECD (2016), The Productivity-Inclusiveness Nexus: Preliminary version, OECD Publishing, Paris.
Available at:  http://dx.doi.org/10.1787/9789264258303-en

OECD/CAF/ECLAC (2016). Latin American Economic Outlook 2017: Youth, Skills and Entrepreneurship, OECD Publishing, Paris. Available at: DOI: http://dx.doi.org/10.1787/leo-2017-en

OECD/CIAT/IDB (2016). Taxing Wages in Latin America and the Caribbean. OECD Publishing. Paris. Available at:  DOI: 10.1787/9789264262607-en