![Sample our Global Development journals, sign in here to start your access, latest two full volumes FREE to you for 14 days]({"type":"image" , "src" : "/sda/5929/TOC-Subject-Sample-2021-Global-Development.jpg"})
Abstract
This article analyzes the interaction between changes in tariff protection, informality, inequality and aggregate income. First, we describe some new empirical evidence on informality, the formal/informal wage gap and trade openness in Latin American countries. Then we present a simple model characterized by three (empirically based) assumptions: (1) agents consume both formal and informal goods; (2) the government uses tariff revenues to purchase formal goods; (3) informality is a voluntary phenomenon. The model predicts that tariff reduction increases informality and wage inequality and that the maximization of income requires a positive level of tariff protection. The model's results are shown to be consistent with the empirical evidence concerning Latin American countries.
Acknowledgments
We would like to thank Davide Castellani, Luca De Benedictis, Chiara Toglia and two anonymous Referees for very useful comments. All remaining errors are obviously ours.
Notes
1. There are different definitions of informality. Following ECLAC (2008), we define informality as the percentage of urban population employed in micro-enterprises (less than five employees) or low-skilled self employed. The concept of informality and its different definitions are discussed in section 2.
2. In its original meaning, informality included ‘illicit or illegal activities by individuals operating outside the formal sphere for the purpose of evading taxation or regulatory burden’ (ILO 1972). In more recent analysis, the informal sector is usually defined as the sector of the economy that does not comply with labour market regulation such as minimum wage laws, hiring/firing regulations, or minimum age laws. In other cases, it is defined as the group of ‘very small enterprises that use low-technology models and do not refer to legal status’ (Webster and Fidler 1996; ECLAC 2008). A broader definition of the informal sector may also include temporary workers in formal establishments. For a discussion of the different interpretations of the concept of informality see Portes and Schauffler (1993).
3. Boch et al. (2007) draw a similar conclusion considering the Brazilian case. Opposite evidence on this point based on Colombian data is instead reported in Goldberg and Pavicnik (2003).
4. There are, obviously, other important factors that influence the level of informality in a country (see for instance Loyaza, 1996). In particular, early empirical studies focused on the relation between the tax rate (and the level of government intervention in the economy) and informality founding a positive correlation between the two. More recent and detailed studies show that this relation is far from robust (Goldberg and Pavicnik 2004).
5. For instance, Ghosh and Paul (2008) find robust empirical evidence trade liberalization or openness significantly increases the informal share of GDP in 18 Central Eastern European and Former Soviet Union countries. As Maloney (2004) remarks: ‘Arguing that workers are voluntarily informal does not, of course, imply that they are not living in poverty, only that they would not obviously be better off in the formal jobs for which they are qualified.’
6. Marjit and Acharyya (2003) show that with immobile capital the opening of the formal sector induces workers move to the informal sector and the informal wage decreases. Marjit (2003) considers a situation in which even with immobile capital between sectors, trade opening increases the informal wage and informality since the trade-induced contraction in the formal sector causes a capital flows to the labour-intensive sub-segment of the informal sector.
7. Note that restricting our analysis only to Latin American countries somehow minimizes the problems which affect the cross-country analysis of informality as discussed in the previous section.
8. The ECLAC's definition of informality is an extended version of Maloney's (2004) one since also domestic services are included into the informal sector. Since this definition of informality is not subjected to the discrepancies caused by the regulatory frameworks of each country, it can be safely used for comparison across countries.
9. There are four countries in our sample for which the trade/GDP ratio is larger than 1 for at least one year in the period considered. These countries are: Costa Rica, Honduras, Panama and Paraguay.
10. We use three year time dummies to allow for a sufficiently large number of observations in each group.
11. Bacchetta et al. (2009) argue that the size of the informal sector may be a factor determining the country's success in international trade. This reverse effect would bias estimated coefficients.
12. As emphasized by Bacchetta et al. (2009), the size of the informal sector is a possible factor determining the level of trade integration of a country. The reverse effect running from informality to the level of trade integration may bias the estimated of the coefficient in our main regression.
13. While it would also be possible to model a continuum of informal sectors, the simplified framework here adopted is able to highlight the basic idea of the model and the mechanism behind our results.
14. ECLAC estimates show that the relative informal/formal productivity ranges between 10% and 40% (Cimoli et al. 2006).
15. This implies that the informal good is assumed to be necessary in consumption. There are different ways to motivate this assumption. One is to argue, as in Marcouiller and Young (1995), that the formal and the informal sectors produce different goods. Another is to think about the informal sector as something like agriculture, which would be simply too costly for the government to regulate so that the informal good will never become formal. We thank an anonymous Referee for suggesting us this additional interpretation. Finally, note that modeling the informal sector as a non-traded one necessary for consumption (possibly agriculture) and the fact that the demand for the formal good is independent of the informal one under Cobb–Douglas preferences imply that in analyzing the impact of trade integration on South we would not need to consider the informal sector in North.
16. Government spending is assumed to be financed only through tariff revenues. The presence of a taxation scheme would not modify our results as long as the (net) formal wage is superior to the informal one, condition which is consistent with the evidence discussed in Section 2.
17. A more general formulation of the model would take into consideration that the elasticity of substitution determines how reactive is the formal price index to changes in the tariff level. Ceteris paribus, the higher θ the lower the formal price index for any reduction in the tariff level.
18. If this were not the case, since formal wage is higher than the informal one, all workers would prefer staying in the formal sector. Note that if there were no benefits attached to being informal, the only possible explanation for the existence of an informal sector with a lower wage than the formal one is a segmented labour market due for instance to the existence of efficiency wages (Cimoli et al. 2006) or to the presence of institutional rigidities that do not allow the labour market to clear (Loyaza 1996).
19. According to Maloney (2004): ‘If much of the sector is voluntary, in the sense of workers preferring their present job to one in the formal sector, then the informal job must be at least of equal quality measured along a broader set of relevant job characteristics.’
20. An alternative justification for the workers' preference for not being formal can be given in terms of reallocation costs. For instance, as long as rural agriculture is informal, one may interpret the benefit of informality as the value the individual attaches to her preference for staying in her village instead than moving to the urban area to become a formal worker. In equilibrium, the formal wage net of these costs and the informal wage would be equal. We thank an anonymous Referee for suggesting us this additional interpretation.
21. The system has 9 variables and 9 non-linear equations. We numerically solved the model using an ad-hoc FORTRAN77 program. We have extensively checked the qualitative robustness of the results to all the admissible ranges of the parameters of the model and we only discuss this issue when results are sensitive to the parameter specification. If not otherwise stated, Figures are drawn using the following parameters: g = 0.5, A(z) = 1–0.5z, λ = 0.8, α= 1. The program codes are available upon request from the Authors.
22. Note that this effect depends on the relative change in the import and export quantities and thus on the shape of the A(z) function.
23. This follows from Proposition 1: since labour is the only factor of production, relative goods prices mimic relative factor prices.
24. See the Appendix for the Proof.
25. To anticipate the result, in the presence of government inefficiencies, the relation between the tariff level and informality becomes convex, in accordance with the estimation results reported in .
26. Emran and Stiglitz (2005) show that, in the presence of an informal sector, price-neutral reforms (i.e. reducing trade taxes and increasing consumption tax like VAT) do not necessarily enhance welfare. Other recent contributions comparing tariffs and VAT in the presence of informality are Boadway and Sato (2009), Davies and Paz (2010) and Keen (2008).
27. This results implies that, if the government in inefficient, there is a level of the tariff below which a reduction in the tariff decreases informality. The reason is the following. Starting from the tariff revenue maximizing tariff, reducing the tariff reduces tariff revenues and thus aggregate income. This implies that both formal and informal demand decrease. But since the informal market is only domestic, income reduction mostly affects the demand for the informal good. Instead, the formal market (relatively) increases as an effect of the reduction in the tariff which has enlarged the opportunity for international trade.
28. Detailed regression results are available upon request from the authors.
29. The same proxy is also used in Bacchetta et al. (2009).
30. Detailed results are available from the Authors.