Photo via the Illinois Institute of Technology
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Latin America is in an economic slump, and it has been for the last decade. According to data from the International Monetary Fund, from 2010 to 2023, Latin America’s regional GDP growth rate has consistently fallen short of that of other emerging economies. Countries with developing economies generally have a more significant growth rate due to their untapped resources, such as raw materials and a large labor supply. Although Latin American countries possess such assets, they still struggle to keep up with other developing regions, such as Asia.
This economic stagnation is due in large part to the lacking productivity of Latin American firms. For instance, the average Latin American worker is about one-fifth as productive as the average American worker. Productivity, essentially equating to economic efficiency, is crucial for any economy. Firms that modernize and produce greater output per worker will raise GDP per capita and overall wages. On the other hand, firms that do not raise productivity will not be able to raise wages, thus keeping the poverty level consistent. Due to Latin America’s productivity issues, poverty persists without any realistic hope for relief.
One of the main culprits behind low levels of productivity is Latin America’s massive informal sector. The informal sector, or shadow economy—firms, workers, and any activities that operate outside the legal and regulatory framework or modern economy—makes up 60-65% of the workforce in Latin America. Yet, despite constituting the majority of the workforce, only 30% of economic output is generated by the informal sector, with the remaining output belonging to the more productive formal firms. The vast majority of wealth and investment is soaked up by the regulated formal sector, which in turn leaves the informal sector in the dust when regarding growth potential. This creates a backward, stratified labor market in which the largest portion of workers contribute very little to the economy while a handful do the heavy lifting.
To raise productivity levels in Latin America, and thus economic growth, governments need to begin taking measures to formalize the workforce. The informal sector should not be treated as an unavoidable aspect of third-world economics. It is something that can be addressed through drafting intelligent policies that create rewarding incentives for formalization, reworking counterproductive social protection systems that encourage informal employment, and upgrading human capital (i.e. professional training) so that workers pursue higher value jobs leading to formal sector employment.
The Costs of Informality
From 2000 to 2010, Latin America experienced a burst in economic growth and formal sector employment as a result of commodity prices skyrocketing. Shortly after this decade of prosperity ensued a commodity price bust which led to recession and a mass exodus to informal employment. Labor that could not be taken into the formal sector ended up being absorbed into the informal sector in several Latin American countries. The reasons for this are simple: the informal sector offers more flexibility, jobs are abundant, and there is zero regulation.
However, this is not an ideal reaction to an economic crisis. Of course, informal employment is preferred to unemployment for the individual worker. Yet, if we look at the issue from an economy-wide perspective, there is often little difference between unemployment and informal employment in Latin American economies. The output of activities that make up informal labor is dismal, as most of these jobs exist simply to sustain oneself. Informality, in essence, is just disguised unemployment.
The shadow economy can be damaging on a personal level as well. Since there is no formal contract dictating work arrangements, job security is precarious. Wages are significantly lower than jobs in the formal sector, and opportunities for upward mobility are hard to come by. On-the-job training is exceedingly rare. Safety and health measures are not taken into consideration, as employment is not government-regulated, meaning that there is also no direct access to social security, unemployment insurance, or any benefits doled out by the government for that matter. Working in the shadow economy is risky, but people often have no other choice. The commercial atmosphere offers few incentives to expand business or increase productivity, since wages rarely increase and one never knows when they might lose their job.
At a broader level, a major issue for governments presiding over a large informal economy is their inability to tax it. The work is done completely off the books, so income can’t be taxed. This is problematic for a number of reasons. An immense portion of the population is not paying taxes but using public services, infrastructure, and anything else paid for through taxpayer money. This results in an underfunded government that cannot keep up with repairing and providing public works for the citizenry, often necessitating further taxation. However, this approach creates a financial burden on the formal sector that does pay income taxes. As the larger informal sector uses up public services, the smaller formal sector is footing the bill. This creates an even larger disincentive to transition to formal sector work, as it is characterized by much higher taxes that compensate for the difference.
Overall, the shadow economy is a strain on productivity, a harmful employer that disregards its workers, and a perpetuator of an unfair tax system. Although the informal sector is able to provide employment to a population that cannot compete in the formal sector and needs to make ends meet, it is an economic hassle that ought to be addressed via the formalization of labor. Transitioning the workforce to formal jobs would reduce inequality and significantly increase wages, which are positively correlated with productivity. In Brazil, for example, the beginning of the 21st century saw a major shift to formal employment that coincided with a significant decrease in earnings volatility. Moreover, workers who switched from the informal to the formal sector in Brazil experienced a pronounced increase in earnings. Thus, attention should be diverted to formalization in largely informal economies to reap the benefits of an organized workforce.
The Path to Formalization
The fundamental ingredient of formal work is the employment contract: that which dictates the terms of employment and provides a legal document. Such contracts are endogenously correlated with the benefits of social security, job tenure, professional training, and higher income levels. Latin American governments have the capacity to introduce policy initiatives to encourage formal contracts. It is crucial to improve occupational status, especially as these countries move towards greater social protection that is only covered through the incomes of formal sector workers.
Social insurance, although being contingent on formal occupational status, has come to benefit the informal sector as well despite being paid for by the formal sector exclusively. If a worker does not qualify for a pension or unemployment status, there are loopholes to access financial assistance through non-contributory schemes. In effect, occupational status has been made obsolete in obtaining government assistance in many countries. This has made formal occupations more expensive and less attractive in the labor market. In order to encourage formalization without hurting informal workers, governments should make benefits such as pensions and health insurance universal entitlements that are funded through general revenues other than income tax so as not to place the tax burden on the formal sector. For example, consumption expenditure items should have a larger retail tax in order to compensate for the decreased income tax. That way, the tax burden is placed on everyone regardless of occupational status. Equally distributing the tax burden will remove the excessive income tax on formal work, thus removing a major obstacle to formalization.
Managerial training and education are additional components needed to formalize the workforce. Human capital, as measured in years of education, is a key determinant of resilience in Latin American economies responding to economic shocks. An educated workforce allows a greater capacity for growth in formal employment and is able to weather economic crises without transitioning to informal employment. Furthermore, managerial training in developing economies has been shown to significantly aid formalization efforts. Managers with vocational training are more likely to register their firms (i.e. formalize) than managers without such training. The benefits go beyond formalization, as education helps managers adopt new technology, manage their firms, and identify new opportunities—all of which result in higher productivity. Governments must encourage training programs and direct subsidies to firms that invest in human capital in order to develop the formal workforce and make transitioning easier.
Lastly, governments must improve the quality of public institutions and deregulate spheres of economic activity. The formalization of businesses is often prevented by a weak rule of law that allows bribery and corruption to prevail. These threats create an atmosphere of uncertainty that is counterproductive to investment and the development of private enterprise. Well-established property rights are also necessary to incentivize business development. Strengthening the rule of law and protection of rights through policy targeting corruption, bribery, and extortion is crucial to promoting a free and safe business environment. Furthermore, the government must address the burdensome regulations facing businesses by pursuing policies of deregulation. Regulations such as licensing, minimum wage, and early retirement requirements can contribute to a restrictive business environment that discourages economic activity. Breaking down complex bureaucracy and loosening regulations will jumpstart ailing Latin American economies and promote free enterprise.
Envisioning a Formal Future
In response to poor productivity, a disorganized workforce, and an inefficient tax system, the only path forward for Latin American governments is to pursue policies of formalization. The informal sector warps economies by feigning to be genuine employment, provides poor job prospects, and traps hard-working citizens in a cycle of trying to survive one day at a time. Safety and health precautions are not taken into consideration, and government programs are not fully taken advantage of. Leaders need to address these issues while ensuring tax revenue is equally and fairly distributed among the whole working population; formalization of the workforce is the clearest solution for accomplishing that.
Governments have several options open to them to incentivize a move towards formalization within the labor market. Public officials must enforce labor contracts and make them requisite for select businesses without harming the welfare of well-meaning citizens. The social insurance and tax systems have to be revamped so that the tax burden is no longer placed on the formal sector but spread throughout the population regardless of occupational status. Higher levels of education and managerial training must be pursued to open up opportunities for low-income, informal sector workers to transition to formal employment. Finally, labor laws must be enforced so as to provide a safe and organized business environment along with deregulation that cuts the red tape acting as a barrier to greater economic activity.
Latin America is bursting with potential as a region with rich resources and an immense and growing population. The only thing slowing down economic growth is the shadow economy that plagues the region. Such labor organization disrupts efficiency and prevents improvements in quality of life. Once governments begin to address these issues, the region will be in a far better place to take advantage of its position and reign in a new era of productivity, greater living standards, and overall economic prosperity.
