“Is the Informal Sector a locus of important developmental activity that needs official recognition and support, or is it merely

an indicator of economic distortion and bureaucratic obstruction? Discuss with reference to either Colombia or Mexico.”

Given that estimates for the size of the informal sector can reach up to 90% of the rural labour force and 69% of the urban labour force in Colombia (Bernal, 2009), key consideration must be given to the origins and the role of this substantial sector in developing countries. This essay will first consider varying definitions of the informal sector, finding that the both its origin and role differs markedly depending on which definition is adopted. Secondly, the issue of the informal sector as an indicator of economic distortion and bureaucratic obstruction is discussed and while it is found to be true to an extent, a model of the informal sector characterised by voluntary entry is considered. Finally, attention will be given to both the positive and negative impact that the informal sector has on the development of the Colombian economy, with particular focus on the linkages between sectors and the recent rural conflict as a result of the illicit drugs trade. There is substantial disagreement about how the informal sector should be defined, both theoretically and empirically. One school of thought subscribes to the notion that the informal sector is simply a ‘reserve pool’ of labour, as suggested by the Harris-Todaro model; the urban informal sector compromises of recent migrants of rural origin who were unable to secure formal employment. Capp et al. (2005) subscribe to this view, and
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considers the informal sector as wholly separate from the formal sector, undermining it by being a source of cheap and exploitable labour. Portes (1983), however, rallies against such a dualistic notion, arguing that the informal sector actually predates the formal sector; consequentially, there are strong bilateral links between the two sectors, examined later, that suggests the informal sector plays a greater developmental role than a store of cheap labour. Flórez (2002) provides a comprehensive framework into which the bulk of the literature falls by identifying two schools of thought, each with two definitions. The first is the dualistic notion under which there is a pure ‘dualism’ definition with the informal sector as the disadvantaged sector in the economy, and the ‘excessive regulated’ approach where the informal sector arises as a response to excessive regulation and strict legislation; workers are pushed into a sector with low productivity and poor remuneration. The second school of thought is of the informal and formal sectors as being highly integrated, as Portes (1983) suggests. The two approaches Flórez (2002) lists here are the ‘Structural Articulation Approach’ and the ‘Entrepreneurial Approach’, although the latter is a subset of the former (and restricts the possible size of an informal sector firm). The structural articulation approach highlights the heterogeneity of the informal sector by considering three sub-sectors: direct subsistence (similar to dualistic notions, with the informal sector as a survival mechanism), subcontracted labour (used to reduce formal sector costs) and an autonomous
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entrepreneurial sector, raising the possibility that each sub-sector may play a different developmental role. Under all definitions considered, the informal sector is beyond the control of Government; however the structural articulation approach specifically considers informal sector activity as the illicit production of licit goods, excluding the drug trade. In Colombia, this drastically alters the effect of the sector, as discussed later.

Figure 1: Size of the Informal Sector in Ten main Colombian cities. Source: Flórez (2002)

Figure 1 shows not only that the size of the informal sector can vary substantially by theoretical and empirical definition (old-PREALC/newPREALC are dualist estimates), but also that the size of the informal sector, under all definitions, follows a seemingly counter-cyclical pattern, falling during the early 90s boom and rising during the late 90s recession. This supports the dualistic notion that the informal sector is a survival mechanism to a lack of opportunities in the formal sector, whilst Flórez
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also finds that, under the structural articulation approach, the direct subsistence sub-sector dominates (52%-63% of the total between 1984 and 2000). Goldberg and Pavcnik (2003) find that almost all of the informal-formal sector mobility in Colombia occurs within an industry rather than across industries, which suggests that there are forces, in addition to the economic cycle, influencing informal labourers from graduating into formal sector. Perry et al. (2007) conclude that one factor may be Colombia’s high minimum wage; they find that, over the 11 years preceding their study, the minimum wage had risen by 30% in real terms to become the second highest in Latin America, which has implications for the absorptive capacity of the formal sector. Indeed, Maloney et al. (2006) find evidence supporting the argument that labour market rigidities driving structural wage differences between the two sectors leads to a rise in informal sector employment, as figure 2 shows.

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Figure 2: Formal Sector Earnings and Formal Sector Employment. Source: Maloney et al. (2006)

There is a striking symmetry in the movement of formal sector earnings and formal sector employment, with a notable movement due to the neoliberal labour market reforms of the mid 1990s, which Flórez (2002) notes raised the cost of a new employee from 12.5% of their wage to 25.5% due to higher health care and pension contributions. Regarding ‘bureaucratic obstruction’, Bromley (1978) provides anecdotal evidence of high levels of corruption harassment of street vendors in Cali; he estimates that approximately 80% of street vendors do not have the required licenses for operating, and that the police operate protection rackets which entrench the informal sector activities and reduce the incentive to formalise as long as the protection money is less than the cost of formalising. More comprehensively, Johnson et al. (1998) use
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1996/7 data to show that Colombia not only has a relatively high tax burden on formal sector firms and a high level of corruption, but that both these metrics are associated with a higher level of informal activity, as figures 3 and 4 show (Colombia has been highlighted with a red dot).

Figure 3: Tax Burden and the Informal Sector. Source: Johnson et al. (1998)

Figure 4: Corruption and the Informal Sector. Source: Johnson et al. (1998)

While the above provides compelling evidence for the informal sector arising as a survival mechanism to cyclical factors, distortions and

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bureaucracy, there is also evidence that a significant portion of the informal sector enter it by choice. Flórez (2002) constructs a ‘life-cycle’ model of informal-formal-informal sector migration. The model postulates that migrants with little skill enter the direct subsistence or subcontracted labour sub-sectors, gain human capital and experience and then graduate to the formal sector. After spending time accumulating financial capital and resources in the formal sector, workers migrate back to the informal sector as self-employed entrepreneurs. There is abundant evidence supporting such a model; Flórez (2002) finds that workers without previous experience are overrepresented in the direct subsistence subsector (over 40% of domestic servants compared with a sectoral average between 32.6%-37% during 1984-2000) while those in the subcontracted sub-sector (informal salaried workers) are more transient than those self-employed entrepreneurs, as figure 5 shows.

Figure 5: Time in Employment by Sector. Source: Flórez (2002)

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Further support is given by Peattie (1981), with anecdotal evidence of shoe-makers in Colombia; she finds a common grievance of medium-sized firms is that employees they have exerted effort and money on training leave to start their own firms. Bernal (2009) uses a 2006 household survey to discover that when formal sector employees were asked why they hadn’t started their own business and the most popular choice (35.1% of respondents) was that they lacked the resources to do so; when the question was asked to informal sector employees, the most popular choice (45.3%) was that it was the only job they could secure. Such answers are congruous with Flórez’s model and highlight the

heterogeneity of informal sector activities; the different effects they have upon the development of the economy shall now be considered. The heterogeneity of the formal sector means that it serves a number of different roles. First, Bromley (1978) finds that street vending is such a profitable enterprise during peak periods that formal sector workers (such as teachers) enter it temporarily, able to do so due to the low barriers to entry that characterise many informal activities. Evidence is provided in figure 6, where there is a swell in informal activity in a central zone of Cali during Cali’s annual bull fights in December.

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Figure 6: Number of Street Traders in City Central Zone in Cali. Source: Bromley (1978)

One of the most significant ways in which the informal sector has a positive impact upon the economy is through its linkages with the formal sector; Portes (1983) notes that the informal sector provides access to cheap consumption, which reduces living costs and acts against the creation of a formal sector wage-price spiral. However, the informal sector also impacts in a more direct fashion upon formal sector costs by boasting a comparative advantage in cheap labour. Because informal sector activities are unregulated, workers are not subject to Colombia’s burdensome labour market regulation and minimum wage, which makes them attractive temporary workers for large formal sector firms – this is the ‘subcontracted labour’ sub-sector of Flórez’s structural articulation approach. Peattie (1981) and Bromley (1978) provide accounts of how this relationship is borne out in Colombia. Bromley (1978) finds that formal producers use informal labourers as a cheap method by which to distribute their produce; he finds that producers will provide access to
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capital and merchandise (given certain conditions), upon which the informal worker is reliant. An example is that of apple-sellers: one of the larger orchards loans the cart and apples (upon payment of a deposit) which are returned at the end of the day, with a share of the profits. Peattie (19981) observes this relationship in reverse; formal sector shoe distributors rely on informal shoe producers (some, lacking sufficient capital, further subcontract certain processes to other informal sector producers) for their supplies. That the informal sector can act as a complement to the formal sector is also shown by Flórez (2002), who finds that, while the aggregate motion of the informal sector is counter-cyclical, it is only the direct subsistence sub-sector that is countercyclical, as shown in table 1.

Table 1: Correlation Coefficient between Lagged GDP Growth Rate and SubSector Relative Size. Source: Flórez (2002)

A negative coefficient signifies a rise in the growth rate leads to fall of that sub-sector’s relative size. Indeed, the informal subcontracted and entrepreneurial sub-sectors behave in a similar manner to the formal sector due to their close integration with it; the entrepreneurial sub-sector performs a similar role to formal sector firms and is therefore similarly susceptible to the macroeconomic environment. The demand for

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subcontracted labour is also susceptible as it is derived from the demand the formal sector firm faces. In countries with poor social infrastructure, such as education, the informal sector may also play a role as a substitute to formal education. Bromley (1978) notes that only 5% of Cali street vendors had postprimary education and Flórez (2003) notes that rural-urban migrants have an average of 1.4 years less formal education than natives; such a developmental role is consistent with the life-cycle model, where recent migrants must first gain human capital before entering the formal sector. Further, Gërxhani (2004) notes that while the size of the sector falls with development, it does not disappear; the average size, as a percentage of GNP, in the OECD was 12% compared with 39% in Latin America and 44% in Africa. It is possible the fall can be partially attributed to better social infrastructure, and the underlying persistence reinforces the concept that the sector plays an important supporting role to the formal economy. Abstracting from the structural articulation approach to include illicit goods production leads to one of the greatest threats the informal sector poses for a developing economy. The Colombian drugs trade has been identified by Cardenas (2001) as the ultimate cause for faltering total factor productivity growth (from 1.55%-0.66% since 1979-2000), and Rubio (1997) considers the mechanism by which this occurs. He concludes that criminality is associated with the creation of perverse social capital (where social capital is capital that facilitates exchange and reinforces human capital). Using the homicide rate as a proxy for perverse social
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capital, it can be seen that there is a relationship between such capital and TFP growth, as shown in figure 7, where the homicide rate rose with the proliferation of the drugs trade in the early 80s.

Figure 7: Homicide Rate (Pink Line) and TFP (Blue Line). Source: Cardenas (2001)

The drugs trade has also distorted rural-urban migration; Flórez (2003) estimates that 2 million individuals had been displaced by the violence and that, while the percentage of recent migrants of rural origin had fallen from 20.2%-13% from 1984-1992, it had risen again to 19.5% by 2000. Given that Flórez (2003) also finds that even the informal sector has a limited ability to absorb recent migrants, such forced migration has lead to a rise in open unemployment as well as the informal sector, as shown in figure 8.

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Figure 8: Unemployment, Underemployment and Informal Employment in Seven Colombian Cities. Source: Flórez (2003)

However, even within the structural articulation approach, the informal sector can act as a drag on growth. Capp et al. (2005) stresses the unfair advantage of illegally cheap labour undermining formal sector firms, whilst Loayza (1996) notes the informal sector reduces the corporation tax base, forcing the Government to increase the tax rate to compensate. In a study on Belgium, Adam and Ginsburg (1985) find that the existence of an ‘irregular’ (informal) sector dampens the Keynesian multipliers associated with a fiscal stimulus by 5%-40% depending on how the stimulus was initially targeted; there is little reason to suggest this phenomenon wouldn’t carry through to developing countries with substantially larger informal sectors. Finally, the informal sector has low productivity due to credit problems stemming from lack of collateral and property rights, meaning contracts cannot be negotiated. Peattie (1981) notes that informal shoe producers average 2.4 pairs a day compared to the 3.5 of larger firms, with scarce capital and inputs a commonly cited problem. In conclusion, the informal sector is an indicator of bureaucratic obstruction and economic distortion, however it is also a sector
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characterised by voluntary exit. Similarly, the informal sector can act as a drag on growth through creating perverse social capital, undermining formal sector firms, being an inefficient use of resources and diminishing the tax base of the Government. However, it can also play a similar role to the formal sector and reinforce the formal sector through acting as a cheap source of labour and a flexible distributor or supplier, and act as a substitute to inadequate social infrastructure in developing countries. These seemingly contradictory conclusions are made possible due to the heterogeneity of the sector. Government policy must also take this heterogeneity into account and give support to those activities which facilitate development, whilst tackling activities which act as a drag on development, as opposed to promoting crude, sector-wide policies that a dualistic definition would imply as the correct path. BIBLIOGRAPHY: Bernal, R. (2009) ‘The Informal Labour Market in Colombia: Identification and Characterization’, Desarrollo Y Sociedad, vol. 63, pp. 145 – 208 Bromley, R. (1978) ‘Organization, Regulation and Exploitation in the SoCalled ‘Urban Informal Sector’: The Street Traders of Cali, Colombia’, World Development, vol. 6, pp. 1161 – 1171. • Figure 6 reproduced directly from this document.

Capp, J., Elstrodt, H-P., and Jones Jr, W. B. (2005) ‘Reining in Brazil’s Informal Economy’, The McKinsey Quarterly 1. Cardenas, M. (2001) ‘Economic Growth in Colombia: A Reversal of ‘Fortune’?’, CID Working Paper No. 83. • Figure 7 reproduced directly from this document.

Gërxhani, K. (2004) ‘The informal sector in developed and less developed countries: A literature survey’, Public Choice, vol. 120, pp. 267 – 300

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Flórez, C. E. (2002) The Function of the Urban Informal Sector in Employment – Evidence from Colombia 1984-2000, CEDE Document No. 2002-04. Bogotá: Universidad Los Andes. • Figures 1, 2, 5 and Table 1 reproduced directly from this document.

Flórez, C. E. (2003) Migration and the Urban Informal Sector in Colombia. Bogotá: Universidad Los Andes. • Figure 8 reproduced directly from this document.

Goldberg, P. K., and Pavcnik, N. (2003) ‘The Response of the Informal Sector to Trade Liberalisation’, NBER Working Paper 9443. Johnson, S., Kaufmann, D., and Zoido-Labatón, P. (1998) ‘Regulatory Discretion and the Unofficial Economy’, The American Economic Review, vol. 88, pp. 387 – 392. • Figures 3, 4 reproduced directly from this document.

Maloney, W. F., Fugazza, M., and Fiess, N. M. (2006) ‘Informal Labour Markets and Macroeconomic Labour Fluctuations’. Paper presented at the Annual Conference of “Verein für Socialpolitik: Research Committee Development Economics,” Göttingen, June 29–30. Accessed From: http://econpapers.repec.org/RePEc:gla:glaewp:2006_17 Paettie, L. R. (1981) ‘What is to be done with the 'Informal Sector': A case study of shoe manufacturers in Colombia’. In: Safa, H. I., Editor (2002) Towards a political economy of urbanization in third world countries, Delhi: Oxford University Press. Perry, G. E., Maloney, W. F., Arias, O., Fajnzylber, P., Mason, A., and Saavedre-Chanduvi, J. (2007) Informality: Exit and Exclusion in Latin America. Washington, DC: World Bank. Portes, A. (1983) ‘The Informal Sector: Definition, Controversy, and Relation to National Development’, Review (Fernand Braudel Centre), vol. 7, pp. 151 – 174. Rubio, M. (1997) ‘Perverse Social Capital – Some Evidence from Colombia’, Journal of Economic Issues, vol. 31, pp. 805 – 816.

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