Informality as a channel to cope with rigid labor markets

Rigid labor markets prevent formalization, especially when labor costs are high relative to the productivity of the workforce. These rigidities include restricting the types of contracts allowed and high dismissal costs. Although the evidence is out there, many developing countries have not been able to carry out substantive reforms to combat informality. Policy makers need to know that inaction disproportionately affects the least productive workers. And these are usually the most vulnerable to unemployment and informality. Moreover policy makers need to understand that private firms seek to make profits in order to remain in business. They need ways to adjust their labor costs so they can remain profitable.
 
Evidence from around the world, from developed and developing countries, shows that employers have a number of ways they adjust to the costs imposed by onerous labor policies. Some of these channels of adjustment are arguably better for the economy than others. However, the ability to use these channels depends on the rigidity of regulations around contract types, the protection on tenure and costs of dismissal.
 

Firms in developed countries typically use three adjustment channels: first, raising prices on products and cutting non-wage costs; second, implementing changes in the human resources structure, either through a freeze on hiring permanent personnel or by increasing temporary or short-term contracts and making greater use of outsourcing; and third, making greater investments in technology, human capital, and the streamlining of administrative processes.
 
In many less developed countries, businesses tend to rely on just two approaches to adjust to changes in labor costs. One of these is through the third channel just mentioned. The other adjustment channel that happens in developing countries is the use of informal employment. In other words, businesses that cannot pay legally mandate costs may leave the formal sector, either partially or totally. These are only general trends and there are many exceptions in both types of countries. Given that emerging economies are highly dependent on foreign markets and their companies have varying levels of sophistication, all the adjustment channels presented in this blog are viable. Since many of their industries depend on cheap labor and since informal employment is ubiquitous, it is to be expected that that there will be a bias toward using these channels.
 
One of the main lessons that can be learnt, is that adopting measures that reduce rigidity and costs can help mitigate the negative impacts on unemployment and informality. In some cases, especially those in which channels of adjustment foster improved firm productivity, changes in management level and wage policy can also bring positive impacts. For example, when labor costs are aligned with the real economic situation, employers are able to adapt more easily, and even plan investments to make their firms more productive. Conversely, when employers are faced with high (dismissal) costs and face limitations on their hiring practices, they are likely to opt for suboptimal channels of adjustment which allow them to remain in business. 
 
Unfortunately, suboptimal channels of adjustment lead to detrimental outcomes that are difficult to reverse. Thus, when reforming - or choosing not to reform - labor regulations, it is critical that policymakers take into account firm incentives. They need to have a clear understanding of the various distinct ways that firms can take to cope with these changes - or lack of change. All labor reform should be accompanied by measures that help vulnerable workers improve their productivity to remain formally employed. They should also facilitate the upgrading of low-productivity firms so that they can remain in the formal economy, or help them leave it.
 
This blog is based on a study written by Del Carpio and Pabon, entitled: ‘Minimum wage: impacts on employment, with emphasis on labor productivity’. World Bank, 2015.