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Second Quarter 2020, 
Vol. 102, No. 2
Posted 2020-05-01

On the Aggregate Implications of Removing Barriers to Formality

by Catalina Granda and Franz Hamann


This article examines the aggregate implications of several policies aimed at removing barriers to formality. To this end, we build a dynamic equilibrium model in which heterogeneous agents choose to work for a wage or operate a technology in the formal or informal sector, based on the costs and benefits associated with these occupational choices. Formality entails compliance with taxes, a minimum wage scheme, and firm operation costs but has a productivity advantage stemming from access to external finance and legal enforcement mechanisms. Informal activities avoid taxes and regulations without detection or punishment. The simulation results suggest that eliminating formal operation fees leads to firm formalization, earnings redistribution, and increases in total factor productivity and welfare. In addition, eliminating the income tax reduces labor informality. These two policies, taken together, generate full formalization and gains in redistribution, efficiency, and welfare that are even greater than when all the barriers to formality are jointly removed. In contrast, eliminating the minimum wage has strong adverse effects on labor formalization and little impact on productivity. Elimi­nating the payroll tax leaves the occupational composition nearly unchanged and productivity and welfare as well.

Catalina Granda is an associate professor of economics at the Universidad de Antioquia. Franz Hamann is director of the department of macroeconomic modeling at Banco de la República. The authors thank one anonymous referee for very detailed suggestions. Catalina Granda gratefully acknowledges financial support from the program "Inclusión productiva y social: programas y políticas para la promoción de una economía formal," code 60185, which conforms to the Alianza EFI – Economía Formal Inclusiva, under the contingent recovery grant No. FP44842-220-2018. All errors and omissions are our own. Amalia Rodríguez provided valuable assistance in microdata processing. 


An extensive phenomenon worldwide, but especially in developing economies, is the existence of large informal sectors. Indeed, Schneider, Buehn, and Montenegro (2010) report average sizes of over 40 percent of gross domestic product (GDP) for Sub-Saharan Africa, Latin America, and the Caribbean, which contrast with about 17 percent in high-income Organisation for Economic Co-operation and Development (OECD) countries. While both firms and workers often operate in the informal sector to avoid cumbersome regulations and taxation, there are costs—such as lack of access to the judicial and legal system and to financial markets (including insurance against retirement income risk and other risks)—that are likely to exert a negative influence on productivity, growth, and welfare.

In view of the potential advantages of overcoming the informal sector, this article develops a framework to quantitatively examine the macroeconomic implications of several policies aimed at removing barriers to formality. To this end, we build a dynamic equilibrium model wherein heterogeneous agents choose whether to operate in the formal sector or the informal sector. These decisions result from analyzing the costs and benefits associated with such occupational choices and take into account a variety of policies. Thus, individuals in the formal sector must comply with taxes, a minimum wage, and firm operation costs but also have a productivity advantage stemming from access to external finance and legal contract enforcement mechanisms. Individuals in the informal sector avoid taxes and regulations without being audited and punished.

In the model, there are financial market imperfections that result in agents' inability to insure against idiosyncratic uncertainty, thus inducing them to save for precautionary reasons. This behavior is consistent with evidence from developing countries suggesting that buffering unexpected events seems to be the main motivation for saving among low- and middle-income individuals. In particular, using data from the Colombian Longitudinal Survey (henceforth ELCA), we find this to be the most important motive irrespective of the occupation and/or sector of operation. Moreover, according to Figure 1, individuals employed in the informal sector save more for precautionary reasons than those employed in the formal sector.

Figure 1
Saving Motives by Sector (percent)

NOTE: See note 2 for the categorization of motives.

SOURCE: Authors' calculations based on the 2013 wave of the ELCA survey. 

The model is calibrated to match important aspects of the Colombian microdata, as this developing country is highly regulated (considering both labor and entry regulations), with extensive informality at the firm level and in the labor market. This procedure allows us to assess the impact of a broad array of highly debated formalization policies on the economy's extent of informality, productivity, and welfare. Specifically, the policies considered involve eliminating labor taxation (i.e., payroll and income), fixed costs of formal operation, and the minimum wage.

The simulation results suggest that eliminating both the income tax and the fixed costs of formal operation substantially improves the occupational composition. Indeed, eliminating the fixed costs of formal operation leads to firm formalization, earnings redistribution, and increases in aggregate efficiency and welfare. In turn, reducing the income tax rate to zero is an extremely effective policy for promoting labor formality, but it is inconsequential for earnings concentration and productivity. These two policies, taken together, generate full formalization and gains in redistribution and efficiency that are even greater than when all the barriers to formality are jointly removed.

In contrast, eliminating the payroll tax and the minimum wage is not beneficial for overcoming the informal sector and improving aggregate efficiency. With no payroll tax, both labor and firm informality remain nearly unchanged, as do productivity and welfare. Further, eliminating the minimum wage has strong adverse effects on the formal sector and little impact on efficiency. These results can be rationalized by the insurance role that a nonbinding minimum wage plays in our model, which mitigates financial incompleteness for low-productivity individuals who work in the formal sector.

Some of the policies considered in this article have been widely analyzed at an empirical level. Indeed, a number of studies have shown that high nonwage costs and wage inflexibility associated with the minimum wage discourage formal employment and lead to high informal employment rates (see, for instance, Bell, 1997; Kugler and Kugler, 2009; and Mondragón-Vélez, Peña, and Wills, 2010). Further, the literature on entry regulation and formalization of microenterprises in developing countries suggests that reforms intended to simplify business registration in the past decades have resulted in modest increases in the number of formal firms (see Bruhn and McKenzie, 2014, and the references therein).

Theoretically, this article is related to a strand of the literature that analyzes the aggregate effects of different formalization policies in developing countries. In a recent study, Ulyssea (2018) develops an equilibrium model wherein formal firms face fixed costs of registration and comply with revenue and labor taxes, yet they may avoid the latter by hiring informal workers. Informal firms in turn are able to evade all taxes and regulations, but they face a detection cost. The author uses the model to conduct counterfactual analyses of several policies toward informality, considering two experiments of interest: (i) reducing formal sector entry costs and (ii) a payroll tax cut. These experiments show that firm and labor informality need not move in the same direction as a result of policy changes. In particular, he finds that lowering registration costs is not effective in reducing labor informality and that lowering the payroll tax reduces the number of informal firms only slightly. Overall, his findings suggest that fewer informal firms and workers are not necessarily associated with higher output, total factor productivity (TFP), or welfare.

Furthermore, Ulyssea (2010) examines the role of labor market institutions and entry regulations in the size of the informal sector and in overall labor market performance. To that end, he develops a two-sector matching model that incorporates the main features of developing countries' labor and entry regulations. The simulation results indicate that reducing payroll taxes and increasing unemployment benefits are not effective policies for reducing informality and improving labor market indicators. In contrast, lowering the costs of entry into the formal sector significantly reduces the size of the informal sector and substantially improves employment composition. The author concludes that the best option for decreasing informality and improving labor market performance and welfare would be to reduce the formal sector's entry costs, instead of intensifying punishment and auditing informal activities.

Moreover, this article is related to a number of recent studies that quantitatively examine the impact on economic development of financial market imperfections and costs of creating and operating formal sector firms. D'Erasmo and Moscoso Boedo (2012) propose a general equilibrium model of firm dynamics, finding that countries with low degrees of debt enforcement and high costs of formality are characterized by low allocative efficiency and a large share of output produced by low-productivity informal firms. Somewhat similarly, Antunes and Cavalcanti (2007) construct a model with three occupational choices (worker, formal entrepreneur, or informal entrepreneur) and inequality in wealth and entrepreneurial ideas to assess how much of the cross-country variation in the size of the informal sector and per capita income can be attributed to entry barriers and limited enforcement of financial contracts. These authors find, among other results, that contract enforcement and regulation costs interact in nonlinear ways and cannot account for much of the output differences across countries.

In the same vein, Lopez-Martin (2019) builds a model of entrepreneurship with the same three occupational choices and financial frictions to evaluate the impact of several formalization policies. His findings suggest that eliminating registration costs has modest effects but that improving access to credit is key to reducing the informal sector size and increasing aggregate TFP and output per worker. Lastly, Araujo and Rodrigues (2016) analyze the role of taxation and credit constraints on formalization, aggregate efficiency, and income distribution. These authors find that, taken together, the distortions included in their model are able to generate substantial inefficiency and inequality. Further, while the efficiency implications of removing these distortions largely come from borrowing constraints, they find that tax rates are the main driver behind inequality reductions.

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