The Informal Continent

I am very fond of mozzarella cheese so I pulled over, walked up to the improvised stall and immediately recognized the stall-keeper as a former classmate in the Mathematics school in Caracas Central University, many years ago.

In this part of the country and at this time of day—it was almost noon—temperatures of 104° F in the shade are not rare, yet she looked fresh and vivacious. She wore a local kind of large brim straw hat that cast a protecting shadow on her face. Still, I could see that she has aged graciously. Her typical llanero hat made a fashion-conscious contrast with her summer dress. Llanero is Spanish for “cowhand from the plains.”

We soon engaged in a former classmates conversation. It turned out that she and her husband now lived in a small cattle hacienda nearby. But not as retirees. Originally trained as a mathematician, she joined the financial division of the state-owned petroleum company where she met her husband soon after leaving college. They both worked for the company for more than twenty years. Early in 2003 they were sacked in a series of politically motivated layoffs that followed a failed oil strike. Like most of the more than 20,000 employees dismissed at the time, they never received the severance check they were entitled by law in case of an unjustified dismissal.

The region is very close to the Orinoco river banks and quite prone to flooding. A successful acclimatization process of water buffaloes began here some fifty years ago. My friend’s in-laws have lived in the area for generations. They talked the unemployed middle-aged couple into managing a long abandoned small water buffalo hacienda. It took them a short while to get the hang of it. Now they work hard to keep the dairy business afloat amidst continuous threats of compulsory expropriation now raging throughout this politically agitated country.

Whenever she is short of petty cash my friend drives her van to that bend in the minor road where I met her by chance and sell the her delicious mozzarela bocconcini to the tourists. Chatting by the stall, she made a good humored remark: “In our countries you are either a rent-seeker or an informal worker.” It was meant to be a joke but it stirred my thoughts as I drove home.

Informality as a Latin American propensity has always interested me. My very first Econlib column (“‘Informal Entrepreneurs’ and the Telecommunications Monopoly in Caracas”, Aug. 1, 2005) dealt with the perversions often entailed by informality.

A now classic definition, due to Hernando de Soto,1 describes informality as the collection, workers, and activities that operate outside the legal and regulatory frameworks. It involves avoiding the burden of taxation and regulation but, at the same time, not fully enjoying the protection and services that the law and the state can provide. Informality is sometimes the result of economic agents exiting the formal sector as a consequence of cost-benefit considerations; other times, it is the outcome of agents being excluded from formality as this becomes restricted and the economy segmented.

Cost-benefit calculations are usually affected by key characteristics of the economy, such as its productive and demographic structure and the availability of skilled labor. Many studies, conducted over decades, have shown that low levels of education—measured, for example, by secondary schooling—are less important in the decision to go informal than the combination of poor public services and a burdensome regulatory system.

In all cases, informality is a fundamental characteristic of underdevelopment and may be the source of further economic retardation. It is strongly determined by the relationship the state establishes with private agents through regulation, monitoring and the provision of public services. It often implies misallocation of resources and entails losing the advantages of legality, such as judicial protection, access to formal credit institutions, and participation in international markets.

In most Latin American countries, informality is much more widespread than in the United States and Europe. Some of our countries are among the most informal economics in the world. The typical country in Latin America produces about 40% of GDP and employs 70% of the labor force informally.

These are astounding statistics, which indicate that informality is a substantive and pervasive Latin American phenomenon that must be explained and grappled with. Although de Soto’s definition of informality can be precise in its simplicity, the measurement of informality is not so simple. It is a latent and unobserved variable precisely because it works outside a legal and regulatory structure. But this elusive variable can be traced through indicators that reflect its various aspects.

One of these indicators is the Schneider index of the shadow economy. This index combines dynamic methods for the estimation of the share of production that is not declared to tax and regulatory authorities. Another indicator is the Heritage Foundation index. It is based on subjective perceptions of general compliance with law, with emphasis on the role played in Latin America by official corruption.

It is significant that all studies available reveal a positive relationship between the prevalence of informality and the incidence of poverty. It is now clear that in countries where state intervention prevails—as is the case in most Latin American nations—informality appears as a natural, if distorted, response of an excessively regulated economy to the shocks and hindrances it faces.

Informality arises when the costs of belonging to the country’s legal and regulatory framework exceed its benefits and it is more prevalent when that regulatory framework is burdensome, the quality of government services to formal firms is low, and the state’s monitoring and enforcement powers are weak.

Yet to many Latin Americans informality is indeed preferable to a fully formal but faulty economy that is unable to circumvent its regulation-induced rigidities. This highlights an important policy implication: The mechanisms of formalization matter enormously for their consequences on employment, efficiency, and growth. If formalization policies are purely based on enforcement, it will surely lead to unemployment and low growth.

If, on the other hand, it is based on improvements in both the regulatory and the quality and availability of public services, it will surely bring about a more efficient use of resources and higher growth for our countries.