Mexico - Labor Markets : New Views on Integration and Flexibility (Vol. 1 of 2) : The Main Report

FOR OFFICIAL USE ONLY CONFIDENTIAL Report No. 19438-ME Mexican Labor Markets: New Views on Integration and Flexibility Volume One: Main Report (in Two Volumes-Green Cover Draft) December 6, 1999 Poverty Reduction and Economic Management Unit Latin America and Caribbean Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. Document of The World Bank FILE COPY List of Content O v erview.................................................................................................................................... 1. Unions, Efficiency Wages, and Segmentation .....................................................................7 1.1 W hat D o M exican U nions D o?...............................................................................7 1.2 Efficiency Wages and Labor Turnover...................................................................8 1.3 Evidence from Establishment Data.........................................................................9 2. Informal Self-Employment as a Desirable Destination ......................................................13 2.1 Sectoral Wage Comparisons: Unreliable Measures of Dualism...........................13 2.2 The Benefits of Informality for Workers..............................................................14 2.3 Informality Does Not Imply Precariousness- Micro-firm Dynamics and Formality ...................................................................15 2.3.1 Formality as Social Participation...........................................................16 2.3.2 M icro-firm D ynam ics ............................................................................17 2.3.3 Firm Dynamics and Participation: Reconsidering Precariousness ........17 2.3.4 Evidence from Micro-Firm Surveys......................................................18 2.4 Voluntary Decisions to Become Informal: A Life-Cycle View ...........................21 3. M acroeconom ic Im plications..............................................................................................23 3.1 The Central Efficiency Wage Relationship ..........................................................24 3.2 Analytics of Policy and Economic Changes.........................................................26 3.3 Policy Sim ulations for M exico .............................................................................30 3.4 Mexico in International Context; Cross Sectional Evidence................................31 3.4.1 Empirical Determinants of Self-Employment .......................................33 3.4.2 Empirical Determinants of Turnover.....................................................35 3.4.3 Distortion and Rigidity Reconsidered....................................................35 R eferences:...............................................................................................................................38 A ppendix I: D ata Sources........................................................................................................43 This report is a product of the Poverty Reduction and Economic Management Group, Latin America the Caribbean Region, and the Mexico Country Management Unit. William Maloney wrote the report. The report draws on background papers co-written with Eduardo Ribeiro (Unions), Patricio Aroca (Entry decisions into self-employment), Alec Levenson (Formality decisions), and Tom Krebs (Macro analysis of efficiency wages). Much of the work received support from the office of the Chief Economist, Guillermo Perry. Norman Hicks, The Lead Specialist for Poverty, Marcelo Giugale, Lead Economist for Mexico, Wendy Cunningham, Anna Sant'Anna, Gladys Lopez, Jose Antonio Gonzales, and Carmen Pages-Serra provided valuable substantive advice. Tania Gomez and Michael Geller provided valuable support. The team is especially grateful to the staff of the Secretaria de Hacienda y Credito Publico and the Secretaria de Trabajo y Pension Social. Contact: Please send comments by email to wmaloney@worldbank.com. i List of Tables Table 1. Size of Self-Emplbyment and Turnover Rates .........................................2 Table 2. Measures Taken to Confront the Problem of Recently Trained Workers Who Resign ..................................................................9 Table 3. Wage Equations---2SLS .........................................................................11 Table 4. Labor Demand Equations .......................................................................12 Table 5. Participation in Societal Institutions.......................................................19 Table 6. Distribution of Firm Age by Age of the Owner...................................... Table 7. Determinants of Probability of Moving to Self-Employment ................23 Table 8. Determinants of Transition to Self-Employment from Formal Sector.................................................................................25 Table 9. Simulated Policy Effects.........................................................................30 Table 10. Determinants of Self-Employment and Turnover ................................32 Table 11. Self-Employment Shares ......................................................................34 List Figures Figure 1. Median Real Hourly Earnings...............................................................13 Figure 2. Labor Force Composition......................................................................25 Figure 3a. Formal Sector/Productivity Gain.........................................................27 Figure 3b. Rise in Informal Attractiveness...........................................................29 Figure 4. Self-Employment versus Industrial Productivity ..................................33 Figure 5. Distortion and Rigidity? ........................................................................36 Overview This study provides an integrated some evidence, therefore, that formal sector view of the dynamics of the Mexican labor wages are above market clearing. market. It departs fundamentally from more Previous work has established that traditional views that see government or the vastly eroded minimum wage is not union intervention in wage setting as responsible. Attention therefore turns to the creating a dualistic labor market: One group impact of the widespread unionization and of formal sector workers enjoys higher more generally "What do Mexican unions wages and benefits while unprotected and do?" It emerges that, in the manufacturing disproportionately poor "informal" workers sector where roughly 80 percent of firms are are rationed out of better jobs. The image is organized, they seem to engage in an one of a high segmented, rigid and unequal extreme form of "efficient bargaining" labor market. where increasing employment, rather than But the data suggest that this view raising wages is the principal objective. . This makes sense in an environment where inadequately captures the salient features of job g as een so were there the exicn lbor arkt. I paticuar, job growth has been slow, where there are the Mexican labor market. In particular, n nmlyetsft es n hr what segmentation exists appears to emerge coodnation with nes and he naturally from employers decisions to pay above market clearing "efficiency wages" to government through the pacto has been a deter workers from leaving at the central element of stabilization policy. extraordinarily high rates that they do, often Hence, neither minimum wages nor with informal self-employment as a unions are credible sources of the destination. In addition to reformulating the segmentation observed. However, there is role of unions and informality, this view evidence both in interviews with forces a reconsideration of the meaning of entrepreneurs, and in estimated wage and several common measures of distortion and labor demand functions, of strong rigidity, as well as the likely impact of labor "efficiency wage" effects. The evidence reform measures. supports a "turnover" version of efficiency wage theory where firms that have invested Unions, Efficiency Wages, and Segmentation in recruiting and training workers pay above market clearing wages to deter them from There is evidence of segmentation in taking their human capital either to another the Mexican labor market. Workers with firm, or opening his own business. These comparable measured human capital may kinds of efficiency wage considerations may earn greatly different wages: those in firms be a central and heretofore under-examined of over 500 workers earn on average double feature of the labor market. those in firms of 16 to 50 workers.' Further, roughly 30 percent of those operating urban . micro-firms report being in the sector involuntarily and many of these because Informal workers, defined they cannot get a formal sector job. There is throughout this work as those owners of, or 1. Similar results are found in other LDCs. See, for workers in firms of under 16 employees who example, Mizala, A and P. Romaguera (1998), are not covered by social benefits, are often Velenchik (1996), Funkhauser (1998). seen as the disadvantaged sector of a segmented market.2 They are thought to "normal" and healthy small enterprise earn wages below their formal counterparts, sector. Informal micro-firm dynamics engage in precarious activities, and be resemble those of small firms everywhere rationed out of good employment in the and the usual causal inference from formal sector. inforniality to precariousness and inefficiency is probably spurious: However, most of the arguments Mainstream theory offers good reasons for supporting this view can be shown to be why small firms generally have high largely groundless. First, the conventional mortality rates. In Mexico, small firms also comparisons of wages among sectors is tend to be informal. The usual association fundamentally flawed as means of showing of informality with precariousness is the inferiority of informality or arguably spurious. segmentation. This arises from the inability to control for unobserved job related Further, small firm owners characteristics such as the value of benefits demonstrate life cycle behavior where foregone, taxes evaded, independence, risk workers accumulate human and financial carried, informal training received or, for capital in the formal sector before family workers, payments in kind. voluntarily opening their own informal businesses. This adds additional support to the idea that informality is a desirable sector Table 1. Size of Informal Self-Employment and Turnover Rates Mexico LAC OECD Percent of workforce in informal 26.5 31.5 12.9 self-Employment Average tenure (manufactures) 5.8* 7.6 10.5 Percent < 2 years seniority (manufactures) N/A 38.1 24.5 Generated from firm level survey so not strictly comparable to the other figures based on household surveys. Second, the poor design and for many poorly educated workers, and that inefficiency of many formal benefits losing workers with training may be a programs creates incentives for workers to problem for formal sector firms who avoid paying the implicit "taxes" attending therefore pay efficiency wages. them by moving to the formal sector. The presence of both voluntarily and Third, the dynamics of informal self- involuntarily informal self-employed is not . a contradictory if it is remembered that there is a great variance of skills and earning 2. See Harris and Todaro (1970) for an early opportunities in the sector. Even if formal presentation of this view and Ozorio de firms set an above market clearing wage, Almeida(1994) for its application to Mexico. many entrepreneurs will still prefer self- See Fields (1990) for an overview of theory on employment although some less profitably informality. In practice, the definition employed here leads to a formal/informal breakdown that is self-employed would prefer to be formal. similar to the ILO definition as workers in firms with six workers or less. 2 For these reasons, this work prefers 1. What does the large informal sector tell to emphasize the entrepreneurial dimension us about labor market distortion? of self-employment and to treat the issue of "formality" largely as a secondary In Mexico, roughly 25 percent of characteristic. those working are self-employed or owners of small informal firms, 13 percent are Finally, though not a central focus of salaried workers in these firms, and 9 this work, the informal salaried are also not percent work by contract, or on a piecework obviously predominantly disadvantaged. basis, also with no benefits. A rough Their relative youth, frequent familial comparison of self-employment, most of relation to the micro-firm owners, and rapid which is informal in LAC, suggests that not transition into other sectors suggests that this only Mexico, but the region has shares far sector is an entryway into the labor force higher than found in OECD countries (see and source of additional training (See table 1). This might be considered as Maloney 1999). evidence for high level of wage rigidities that force a large segment of the work force Macro and Reform Implications into informality. These. findings that segmentation is But, the theory suggests that drawing likely to be endogenous and that the conclusions about efficiency from sector informal sector is likely to be a desirable size alone is probably incorrect. In destination for many workers have particular, it is essential to adjust for the implications for our understanding of the opportunity cost of self-employment- labor market and for policy. These are formal sector productivity. Poor countries studied in a general equilibrium model of where opening a business is not costly in the Mexican labor market that has as a terms of wages foregone will have a larger central element the "turnover" version of share of their work force in self-employment efficiency wage theory discussed above. By and much of that will be informal. calibrating the theoretical framework with 2. What do high rates of labor turnover tell Mexican labor force survey data, the . magnitude of the impact on turnover, formal employment, and segmentation of policies The second question centers on what or economic innovations that affect formal seto podctviy th.trcivns f recent findings of high turnover, a common sector productivity, the attractiveness of measure of rigidities (see Nickell 1997), informal employment, or the costs of imply about the flexibility of labor markets training and recruiting, is simulated and are in the region.3 It is often asserted that high found to be plausibly quite large. Even in firing costs and excessive benefits in the the absence of externally wage rigidities formal sector prevent the efficient allocation imposed by government or unions, the of workers among jobs.4 However, as table effects of, for instance, labor market reform is plausibly quite large. 3. See Maloney (1995) for Mexico, Gonzaga (1996) The predictions of the framework for Brazil, Anderson Shaffner (1997) for can address questions surrounding two Colombia, MArquez and Pag6s (1998) more indicators commonly used to assess labor generally. See Hopenhayn and Rogerson (1993) for a recent theoretical discussion. market distortions and rigidity: 4. See for example Burki and Perry (1997) The Long March. 3 1 suggests, average tenure, a proxy inversely Mexico in International Context related to turnover, is shorter, and a larger fraction of the work force has been Cross country data is used to test the employed in their current position for less predictions of the framework about the size than two years in Latin America than in the of the' informal sector and rates of turnover OECD. By conventional measures, Latin with respect to several key labor market, America appears extremely flexible. productivity, and demographic variables that the analytical framework suggests are Mexico does not tabulate a statistic important. This first, locates Mexico in a exactly comparable to those in table 1 based global context. Then, by looking at Mexico on household surveys, but the available and other countries' deviations from the statistics suggest a similar story. Firm level values expected given underlying data on formal sector firms suggests that characteristics, somewhat more informed average tenure in manufacturing is very low, estimates of the incidence of unmeasurable with a cautious estimate putting the number distortions and rigidities are be ventured. at perhaps half of the OECD. Across a six Though these results are highly speculative, month period, roughly 26 percent of they suggests that Mexico's labor market is unskilled workers and 9 percent of skilled overall, not unusually distorted or inflexible. workers are reported as leaving firms. Of equal importance, roughly 85 percent of Conclusions and Policy Implications these are quits, rather than fires. Household level data tells a compatible story. The Unions implicit tenure of all formal sector workers derived from the rate of turnover between the beginning and the end of a 15 month effect of expanding employment (feather- period is roughly 5.5 years comparable to bedding) rather than raising wages. This roughly 7.6 years in the U.S. using similar behavior may actually expand total data. Further, since this method misses all employment and lead to desirable transition turnover occurring within the period, dynamics during trade liberalization. implicit tenure is probably substantially However, the impact on productivity growth even lower for Mexico. Consistent with the and firm decisions to adopt technology high percentage of quits in manufacturing merits further study. turnover, motivational surveys of those transitioning to self-employment from 2. U o p al cannotee formal sector firms suggest that roughly 70 are voluntary.5 segmentation or the large size of the informal sector. Efforts to moderate union The analytical framework helps power to these ends will probably have little resolve this apparent paradox of extremely impact. high rates of turnover and hence the appearance of flexibility despite the constitutional proscriptions against firing 3. The informal self-employed and very high mandated severance pay. Of sector corresponds more to an central importance is precisely the largely unregulated small business sector than to voluntary nature of the separations. the disadvantaged sector of a dualistic 5. See Maloney (1999). 6. See Devarajan et. al.(1997) 4 market. Both Mexican and cross-country dynamics is probably essential to evidence is more consistent with the view understanding this issue. that the vast majority are informal voluntarily and approach the sector as 7. Firm growth may be hampered entrepreneurs. Anti-poverty and if 'entrepreneurs do not access employment policies should approach them social/public institutions due to sub- as such rather than treating them as optimally high costs of becoming formal. "underemployed." This may imply a closer look at the ease of access to public institutions as well as the 4. Rformof neffciet soial implicit "taxes" that access would imply. security, health, severance pay and other Agai a p a sure o mir-fr beneits ystms my rduce the Again, a panel survey on mnicro-firm benraciveess s ioma ed ete dynamics would be useful to answering attractiveness of informal employment,. hs uetos Payroll taxes above the perceived value of services to the worker will lead to evasion. Labor Regulation, Distortion, and Rigidity. Further, untied services, such as open health facilities that provide an alternative to 8. Segmentation will always be employment based services, implicitly present in all labor markets, even in the subsidize informality. ' absence of unions or minimum wages so 5. Micro-firm dynamics are long as firms seek to retain workers in similar to those in industrialized countries whom they have invested. Firms will pay and may be "normal" However, the above market clearing "efficiency wages" to available data cannot tell us whether most reduce turnover and in the process, create successful firms stay small because of unemployment or segmentation. market imperfections or because of the Government policies toward the labor preferences of the entrepreneur. Mexico may market have impacts on distribution through find investment in a survey that would these channels. This segmentation may cut permit following micro-enterprises across across lines of formality. the course of several years helpful to better understanding the barriers to growth and the 9. The large size of the Mexican unestofnmicnteprrienrs informal sector does not necessarily imply high level of labor market distortion. 6. A re-evaluation of micro-credit Once adjusted for relevant economic and policies is needed. Evidence for life cycle demographic variables, the Mexican labor behavior suggests that there may be an market appears to have a level of distortion argument for providing start up credit for similar to that in the U.S. or Canada. micro-enterprises. However, the 1992 Generally, raw sector size is not a reliable Micro-enterprise survey reveals a very low measure of distortions or inequality. demand for start up credit (Cunningham and Maloney 1997). Further, credit demand for 10. An absence of segmentation expansion is also low, consistent with a view impistin ou th of labor that the long run firms size is, in fact small legisltin. ongrowt or lbor and most entrepreneurs have no desire to poutvt.Rgltosmydsorg eand. Aost epneursve o msirm tinvestment in physical or human capital, yet not create barriers to efficient allocation of workers between the informal and formal sectors. 7 See Ddvila and Guijarro (1999) 5 Further, though labor market reform transferable training although this may be may not be justified on the basis of provided by the private sector. segmentation, Ddvila (1994) has argued that there may be strong arguments from the 15. In the absence of wage point of view of reducing transaction costs- rigidities due to government or union streamlining and rationalizing separation intervention, it is impossible to know processes etc.. what reduction of labor taxes or other l tcosts to firms or workers will have on Finally, the fact that the distortions distribution. This differs from traditional arising from nominal wage rigidities are not dualistic views which generally predict present today does not mean that they may improvements in income distribution. not arise in the future. Thinking about Simulations based on Mexican data suggest desirable labor market reforms should take that segmentation may increase, but Gini this possibility into account. t. coefficients may improve as well. 11. Barriers to firing workers, and social security taxes on firms appear to reduce the size of the formal sector. Anticipation of costly firing may lead to a reluctance to employ new workers while high non-wage benefits raise labor costs. That said empirically, the level of formal sector productivity, real interest rates, and education levels in general have a larger impact on the size of the informal sector than labor market taxes or barriers to firing. 12. Mexico's high turnover rates suggest that the labor market is not especially rigid. Comparisons of raw turnover rates across countries tell us little about true labor market flexibility. Once adjusted for demographic and economic variables, neither Mexico, nor most of Latin America appears particularly rigid. 13. Labor protections against firing in Mexico may have a substantial effect on increasing labor tenure and lowering turnover, with possible efficiency losses. 14. Public education improves income distribution through efficiency wage channels. Reducing the individual firm's transferable investment reduces the premium paid above market clearing. This also implies a public role for financing 6 1. Unions, Efficiency Wages, and Segmentation8 -1. In Mexico, as in most LDCs, workers with equal indicators of human capital may earn radically different wages. Further, roughly 40 percent of the urban labor force works in the "informal" sector, defined here as jobs uncovered by social protections.9 A long tradition views both these as evidence of labor markets made dualistic by either government or union induced wage rigidities. From a. policy point of view, efficiency could be enhanced by reducing or eliminating either source of rigidities and allowing wages to be set competitively by the market. 1.1 What Do Mexican Unions Do? 2. As Bell (1997) has argued, minimum wages are not binding in Mexico and probably cannot be held responsible for segmentation, leaving unions as the obvious remaining source. Mexico has a long tradition of unionization dating back to the Revolution. Estimates of coverage range from about 10 percent to 25 percent of the total work force of roughly 32 million.o The 1992 National Survey of Employment, Salaries, Technology and Training (ENESTYC) shows that among manufacturing firms, 18 percent have no union representation, and the rest have a median unionization rate of 70 percent. The first goal of this section is to establish whether this union power in fact translates into wages above market clearing and segmentation, and more generally to ask "What do Mexican unions do?" 3. The answer to this question is not necessarily straightforward. While much of the literature postulates a union that sets a wage higher than market clearing and allows the firm to choose quantity hired from their demand curve, unions may also display what is termed "efficient bargaining behavior" where they negotiate over the wage and/or total employment. Though an extreme case, it is entirely possible that union power would be directed toward forcing firms to hire more workers than it would at a given wage (featherbedding), rather than raising the wage. In this case, unions could not be held responsible for segmentation, although the adverse impact on productivity growth would merit the attention of policy makers. 4. Several institutional and economic features of Mexican make this an important possibility to investigate since both union objectives and bargaining power may be different from those in industrialized countries. First, as is the case with most of its neighbors, Mexico has no system of unemployment insurance and employment stability may therefore be more highly valued than higher wages. Second, like much of Latin America during the 1980's and early 1990's, job generation has been slow relative to population growth. 5. Third, the massive Labor Congress (CT) which embraces the Confederation of Mexican Workers (CTM, 2-6 million workers), the Revolutionary Federation of Workers and Peasants (CROC, 1-4 million workers), the Federation of Government Workers (FSTSE, 2 million 8. Based on Maloney and Ribeiro (1998), Efficiency Wage and Union Effects in Labor Demand and Wage Structure in Mexico. 9. Another popular definition is workers owning or working in firms of under 6 employees. In practice, the two yield very similar samples of 'informal" workers (See Maloney 1997b). 10. Statistics from Brooks and Cason (1998). 7 workers) and roughly 38 other labor organizations has had a longstanding and close relationship with the governing Revolutionary Institutional Party (PRI). Particularly since 1987 with the inception of the Pacto Social-a joint agreement of labor, business and the government to promote price stability-unions have closely coordinated wage demands with national stabilization objectives. Though in November of 1997, th6 New Union of Workers (UNT, .7-1.5 million workers) split from the CTM largely over what was perceived to be excessive responsiveness to government initiatives, across the period anal zed here, some analysts have seen a decline in union influence both within the PRI and overall. 6. These three factors-no unemployment safety net, slow job growth, and the unique political economy of union power- taken together may lead to an emphasis on employment creation, relative to pushing up wages. 1.2 Efficiency Wages and Labor Turnover 7. A remaining explanation for the segmentation observed may be found in the extensive literature on "efficiency wages" that provides a rationale for firms to voluntarily pay wages above the market clearing level.12 One common variant of these models arises from the difficulty of monitoring individual workers and the lack of any penalty from being caught "shirking"-any activity, or lack thereof, that might be detrimental to the firm. If wages are market clearing, there is no unemployment, and a worker fired for shirking can simply get another job at the same wage. However, if all firms pay higher than market clearing wages, unemployment will be created in the economy that creates a disincentive to being laid off and hence to shirking. 8. Since, in Mexico, as in many Latin American countries, workers can be fired only with difficulty, the "turnover" variant of efficiency wage models is probably more appropriate: firms must invest resources in workers when they are hired, perhaps in training or through the process of recruitment, that will be lost if the worker leaves (Stiglitz 1974). Hence, it is worthwhile for firms to pay higher wages and raise the opportunity cost of leaving. 9. This view seems very relevant to the Mexican case. As noted earlier, turnover rates are very high and the vast majority of separations (85 percent) are quits, rather than fires. Further, in interviews with Mexican entrepreneurs tabulated in the ENESTYC, roughly 30 percent stated that the resignation of recently trained workers was a problem. This is almost certainly an understatement for two reasons. First, "recently" may not capture the relevant period of return on the investment in the worker. Second, if the firm is already paying the optimal efficiency wage to prevent workers from leaving, it will not report excessive turnover as a problem. Of those reporting frequent resignations after training, 58 percent do something to raise the total well-being of the worker after training, 28 percent raise remuneration without promoting the worker, and 40 percent take measures that increase the wage of the worker, including promotions. 11. For discussions of the historical evolution of union power see Collier and Collier (1991), Cook (1995), Brooks and Cason (1998). The imprecision arises from the difference between what each organization claims as its membership , a measure of its bargaining power, and what independent observers estimate. 12. For discussions of the theory of efficiency wages see Stiglitz (1974), Shapiro, C. and J. Stiglitz (1984),. Krueger and Summers (1988), Esfahani and Salehi Isfahani (1989), Weiss (1990). 8 Table 2. Measures Taken to Confront the Problem of Recently Trained Workers Who Resign (percent) Total Large Medium Small Micro Increase wages 23.1 7.1 7.6 9.5 29.2 Increase other remunerations 4.6 17.5 17 14 0.1 Promote those trained 12.7 39.6 32.8 24.3 6.1 Reduce the number of those trained 8.4 0.2 1.3 1.3 11.5 Reduce the training offered 0.2 0.5 0 0 0.3 Give non-monetary recognition 8.5 12.8 9.8 7.3 8.4 None 33.5 15.5 26.1 35 34.7 Don'tknow 1.2 2.3 0.7 5.2 0 Others 7.8 3.9 4.1 3.2 9.7 Source. 1992 ENESTYC 10. The efficiency wage argument is particularly compelling in Mexico and LDCs where firms may absorb a larger share of training costs due to poorly functioning education systems." Thus, firms will be very concerned about preventing workers they train from moving to another firm. In addition, as chapter 2 discusses, in countries where self-employment (formal or informal) is considered a desirable destination, it is possible that workers enter formal salaried work to accumulate skills and financial capital, and then quit to open their own business. 1.3 Evidence from Establishment Data 11. The detailed ENESTYC permits testing for union and efficiency wage effects in the demand for labor and the determination of wages in Mexican manufacturing firms. The survey also contains extensive information on establishment characteristics and their use of factors. 12. Both union power and efficiency wage effects should appear both in wage equations and standard labor demand functions augmented by some critical variables. Efficiency wage theory implies that firms will have to pay wages that make staying with their present firm attractive relative to those offered outside the firm. The wage set will therefore depend both on the expected wage offers workers can get outside the firm, (the outside wage) as well as the probability of being able to get a job at that wage (the hiring rate). This also has implications for labor demand. A firm that raises its wage above the market clearing wage will hire less labor. Therefore, given the wage that the firm pays, increases in either the outside wage or probability of hiring should increase the amount of labor hired. 13. Union power may enter the wage equation only if there is no attempt to directly influence employment. At the other extreme, we may only see an impact on labor demand if there is no attempt to influence the wage. Because both the outside wage and the hiring rate may capture the bargaining power of a given union strength, in addition to capturing efficiency wage effects, 13. As Marquez and Ros (1990), noted, and has been confirmed by later studies for Peru (Shaffner, 1 998)and Guatemala (Funkhauserl998), wages of similar workers rise with firm size, much as they do in industrialized countries. Further, MArquez (1990), and Abuhadba and Romaguera (1993) find evidence consistent with efficiency wage effects in the high correlation of sectoral wage differentials among Brazil, Chile, the United States, and Venezuela. This evidence suggests that the conditional wage dispersion (wages adjusted for human capital) may be emerging endogenously and is not due to either government or union intervention. 9 both relationships were tested on a sub-sample of firms with at least one union affiliated employee and a sub-sample with none which, were it to show the influence of outside wages or hiring rates, would presumably suggest efficiency wage effects rather than union power. 14. The estimations use both standard OLS as well as Quantile Analysis4 to more completely characterize the distributions of wages and labor demanded than can be done using the standard OLS, 2SLS methods. In particular, Quantile Analysis reveals if union and efficiency wage effects may exist for certain classes of workers but not others, or vary in degree. Tables 3 and 4 present the standard OLS, 2SLS estimates with the grey areas capturing the coefficients representing efficiency wage or union effects. 15. Strikingly, the union concentration variable never appears as a statistically significant determinant of the wage, with the exception of the lowest quantile: workers who would earn in the bottom 10 percent of wages given their human capital and the characteristics of the firm do seem to have their wages pushed up slightly toward the median wage. For the most part, unions cannot be held responsible for the wage distribution observed or any segmentation that might exist.'5 16. Union power does, however, appear to have very strong effects on employment decisions leading to a 2.6 percent rise in unskilled workers employed with each additional percentage point of the workforce organized. This "Featherbedding" is a way of transferring firm profits to workers through the creation of unnecessary positions, rather than wages. These bargains are clearly not efficient from a production point of view: more workers are being hired than the firm would hire in the absence of a union. Theoretically, they may lead to more employment overall in the economy despite their possibly adverse dynamic effects on productivity growth.16 17. The extraordinarily large impact of unionization on employment, and the fact that unions appear to decrease(although barely significantly) the number of skilled workers raises an important alternative interpretation for these results. It may be that union organizers seek out firms with relatively large work forces and are perhaps interested disproportionately in recruiting unskilled rather than skilled workers. Unfortunately, it is very difficult to compensate for this selection bias and the results presented are likely some combination of the two effects. 18. Both the outside wage and probability of being hired enter in both union and non-union samples for both wages and employment suggesting strong efficiency wage effects are present. Sectoral dummies do not appear to be significant. However, there are large size effects in the wage equation as in the industrialized countries: large firms of over 500 workers pay roughly double firms of between 16 and 50 workers for work forces with comparable levels of experience and education. As always, unobserved worker characteristics may be responsible for these differentials: large firms may be more careful in their recruiting or attract better workers and pay them their higher marginal product. However, given that union power appears directed primarily toward the generation of employment, rather than toward raising wages, and minimum 14. See Koenker and Bassett (1982). 15. This finding is somewhat at odds with Panagides and Patrinos (1995) who found union impacts on the wage. However, they did not have information on the firm characteristics which might account for wage differentials as they appear to here. 16. See, for example, Layard and Nickell, (1990). 10 wages are not binding, whatever segmentation there is in the market seems to emerge endogenously. Table 3. Wage Equations Non-union Union Skilled Unskilled Skilled Unskilled Product. 0.036 (0.028) 0.097 (0.025) a 0.036 (0.012) a 0.039 (0.012) a Oile 0.384 (0.156) a 38(0.204b 0'300 (0.057) a. 0.433 a(0.06) a Union - - - - -0.865 (0.210) a 0.236 (0.197) Hire -0.002 (0.090) -0.014 (0.010) -0.065 (0.029) a -0.002 (0.004) Sch 0.424 (0.081) a 0.235 (0.103) a 0.571 (0.058) a 0.238 (0.055) a Sch2 -0.016 (0.003) a -0.017 (0.007) a -0.022 (0.002) a -0.014 (0.004) a Exp -0.021 (0.023) 0.000 (0.015) 0.027 (0.007) a 0.018 (0.006) a Exp2 0.001 (0.001) 0.000 (0.001) -0.001 (0.000) a -0.001 (0.000) a R&D 0.121 (0.065) b 0.004 (0.064) 0.010 (0.025) -0.035 (0.026) Tech. 0.030 (0.063) 0.078 (0.061) 0.097 (0.024) a 0.135 (0.026) a Training 0.197 (0.067) a 0.110 (0.065) b 0.024 (0.025) 0.001 (0.026) Corporate -0.038 (0.081) -0.008 (0.079) 0.028 (0.026) 0.067 (0.028) a Foreign 0.327 (0.096) a 0.127 (0.093) 0.179 (0.030) a 0.025 (0.032) Export. -0.123 (0.074) b 0.012 (0.073) -0.108 (0.026) a 0.024 (0.028) Auto 0.001 (0.001) 0.001 (0.001) 0.001 (0.000) b 0.000 (0.001) Competit. -0.013 (0.055) 0.026 (0.054) -0.008 (0.022) -0.003 (0.023) Qual.ctr. 0.083 (0.248) -0.193 (0.242) 0.094 (0.186) 0.238 (9.197) LogKIL 0.001 (0.019) -0.026 (0.018) 0.016 (0.008) b -0.014 (0.008) b Sect_32 006 (010y 0072. (0.10 1) -0.008 (0043) ~ -0.028 (0.042) Sect 33 -0.018 (0.143) 0.094 (0.126) 0.063 (0.068) 0.075 (0.069) Sect_34 0.129 (0.134) 0.200 (0.156) 0.072 (0.056) 0.103 (0.063) Sect_35 0.162 (0.124) 0.059 (0.132) 0.116 (0.044) a 0.061 (0.047) Sect_36 0.142 (0.194) -0.006 (0.183) 0.079 (0.060) 0.078 (0.061) Sect_37 0.226 (0.233) -0.192 (0.227) -0.011 (0.065) -0.068 (0.064) Sect_38 0.035 (0.102) 0.107 (0.110) 0.085 (0.038) a 0.065 (0.042) Sect_38 -0.503 (0.256) b -0.045 (0.250) 0.031 (0.090) 0.117 (0.094) Medium -0.132, (0.077) b -0.085 (0.075) -0.229 (0.025) a -0.091 (0.026) a Small -0.702 (0.083) a -0.349 (0.082) a -0.676 (0.032) a -0.335 (0.033) a Cinst. 2_.912(1.5O) b 3.943 (1.643) a 3.523 (0.680) a 3.082 (0.732) a R2 0.3987 0.1692 0.2895 0.1191 F - test 17.26 a 5.30 49.43 a 16.39 a Note: Sample sizes: Non-union n = 731, Union, n = 3,422. Chow tests for equality of union and non-union coefficient (27d.f.) 86.66 a (skilled), 42.37 a (unskilled). a-significant at the 5 percent level, b-significant at the 10 percent level. 19. The next section deals with one labor market phenomenon that may contribute to exactly these kinds of effects. 11 Table 4. Labor Demand IEquations -2SLS Non-union Union Skilled Unskilled Skilled Unskilled Output 0.441 (0.039) a 0.493 (0.049) a 0.480 (0.018) a 0.405 (0.019) a Wage-s -0.252 (0.038) a -0.082 (0.047) b -0.379 (0.019) a -0.024 (0.020) Wage-u -0.057 (0.036) -0.636 (0.045) a 0.037 (0.016) a -0.591 (0.017) a Outside-s -0.14 _(6174) -f.028 (0.219) a -0091 (0.073) 0.195 (0.019) a Outside-u 0.094 (0.255) 1.423 (0.320) a -0.002 (0.121) -0.244 (0.132) b Union - - -0.417 (0.243) b 2.689 (0.264) a Hire-s 0.237 (0.078) a -0.154 (0.098) 0.081 (0.033) a 0.067 (0.036) b Hire-u -0.008 (0.009) 0.036 (0.011) a 0.008 (0.004) a 0.001 (0.004) Cap. util. -0.001 (0.001) 0.004 (0.002) a -0.001 (0.001) b 0.003 (0.001) a Corporate 0.154 (0.068) a 0.190 (0.086) a 0.080 (0.025) a 0.059 (0.027) a Foreign 0.068 (0.082) 0.124 (0.104) 0.155 (0.029) a 0.010 (0.032) Age 0.002 (0.005) -0.003 (0.006) 0.004 (0.002) a -0.003 (0.002) Age2 0.004 (0.007) 0.003 (0.009) -0.002 (0.002) 0.008 (0.003) a Export 0.056 (0.064) 0.233 (0.081) a 0.068 (0.026) a 0.234 (0.028) a Auto 0.001 (0.001) 0.001 (0.001) 0.000 (0.000) 0.000 (0.000) Qual.ctr. -0.215 (0.209) 0.253 (0.263) -0.060 (0.176) 0.048 (0.192) R & D 0.073 (0.055) -0.001 (0.070) 0.042 (0.024) b -0.039 (0.026) Tech. -0.064 (0.054) -0.020 (0.068) -0.016 (0.023) -0.027 (0.025) Sect_32 0.200 (0.106) b -0.115 (0.134) 0.075 (0.045) b 0.182 (0.049) a Sect_33 0.344 (0.120) a 0.161 (0.151) 0.228 (0.065) a 0.163 (0.071) a Sect_34 0.370 (0.148) a -0.647 (0.186) a 0.292 (0.065) a 0.010 (0.071) Sect_35 0.056 (0.114) -0.456 (0.143) a 0.283 (0.049) a -0.025 (0.053) Sect_36 0.268 (0.164) 0.166 (0.207) 0.370 (0.058) a 0.150 (0.063) a Sect_37 0.368 (0.199) b 0.064 (0.250) 0.253 (0.061) a 0.016 (0.067) Sect_38 0.361 (0.101) a -0.331 (0.128) a 0.371 (0.046) a 0.177 (0.050) a Sect_38 0.057 (0.223) -0.319 (0.280) 0.100 (0.088) 0.003 (0.096) Medium -0.396 (0.076) a -0.528 (0.095) a -0.339 (0.030) a -0.612 (0.033) a Small -0.611 (0.109) a -1.207 (0.136) a -0.524 (0.050) a -1.129 (0.054) a Const. 0.484 (1.538) a 3.789 (1.934) b 1.986 (0.690) a 3.212 (0.752) a R2 0.6518 0.6872 0.6339 0.6918 F -test 46.77 a 59.47 a 210.25a 269.56 a DHW 32.52 a 19.68 a 72.44 a 151.53 a Note: Sample sizes: Non-union n = 731, Union, n = 3,422. Chow tests for equality of union and non-union coefficient (26d.f.) 36.23 b (skilled), 130.89 a (unskilled). a-significant at the 5 percent level, b-significant at the 10 percent level. * Instruments for output: capital stock, its square, sector dummies and its interactions and technology variables. 12 2. Informal Self-Employment as a Desirable Destination 20. Much of the literature on the informal self-employed sector in LDCs beginning with Harris and Todaro (1970) has seen self-employed workers unprotected by labor legislation as those rationed out of protected or "formal" salaried jobs sector jobs by above market clearing remuneration in the protected sector. This view has been bolstered by four principal observations. * By definition, the informal sector lacks the benefits and protection of formal employment. * Often it is found that mean informal salaries are below those in the formal sector as would be expected if informal workers were the disadvantaged sector of a segmented labor market. * Informal work appears precarious compared to formal sector work. Informal firms show high mortality rates and often appear unprofitable. * Informal work for some serves as the safety net for unemployed workers during downturns. 21. In this section, it will be shown that the first is not obviously or always a disadvantage, the second is largely untrue and almost certainty irrelevant, that the truth of the third testifies only that the dynamics of small firms in Mexico are similar to those in the industrialized countries, and that the fourth is not consistent with the available data. 2.1 Sectoral Wage Comparisons: Unreliable Measures ofDualism 22. A substantial literature finds that mean Figure 1: Median Real Houriy Earnings informal salaried wages are 14 below those in the formal 13 .. ---- .- ..-..-. -. - sector and that this suggests 12 .... - - that the informal are the " disadvantage sector of a segmented labor market. 0 Neither proposition is on obviously true in Mexico. 0 Previous research on - Mexico (Maloney 1997, 04 -i iii Marcouiller et al. 1997) 9 198 99 1o 9 92 193 suggests that it is not S EmplDyent . Inf l Salaned Fonal Salaned . Contract generally true that informal workers earn less than their formal sector counterparts. Figure 1 shows that the median wages of informal self-employed and contract workers (those doing piecework or on fixed contract) generally lie above those of the formal salaried. These differentials also hold for those moving between sectors. In 1992, a period of relative prosperity the self-employed and contract workers earned roughly 25 percent more upon leaving formal employment. It is also true that, consistent with the graph above, 13 informal salaried workers gained roughly 15 percent entering formal employment. The fact that this would be the case even in a time when unemployment was the lowest in 15 years suggests that this differential cannot be taken necessarily as evidence of segmentation. 23. In fact, such conditional wage comparisons are Misleading and should not be used to establish segmentation. The specific characteristics of work that pertain to or even define the formal and informal sectors affect the earnings paid in each sector and make it unclear what the magnitude or sign of the differential should be even in an unsegmented market. Informal earnings should rise above formal wages to compensate for the expected value of benefits foregone, but should fall below by the amount of taxation that is often evaded. Earnings in self- employment may reflect a premium for risk, a more independent lifestyle, and the implicit costs of capital invested, and the value of unpaid work by family members that the 1992 micro- enterprise survey suggests comprise 34 percent of micro-firm employees. 24. This also applies to the informal salaried who appear to earn less than formal salaried workers. These are among the youngest workers and the micro-enterprise survey reports that roughly 30 percent are related to their employer. Their reported earnings may therefore incorporate training or unobserved payments in-kind that would explain the differential in earnings without implying anything about segmentation. In sum, without having reliable measures of all of these factors, earnings comparisons are unreliable measures of segmentation.'7 2.2 The Benefits of Informality for Workers 25. Recent work suggests that there is little reason to suppose that the expanding literature on self-employment in the industrialized world that views self-employment as a desirable and more flexible alternative to wage work may not also be relevant in LDCs. The sociologists Baldn, Browning, and Jelin (1973) et al. in their longitudinal interviews with workers in Monterrey find that being one's own boss was well-regarded and that movements into self-employment from salaried positions often represented an improvement in job status. Of those moves from formal into self-employment they studied, 57 percent were upward moves in job quality, 30 percent horizontal (which the authors argue is considered welfare improving because of the greater independence), and 11 percent downward (which also could also be welfare improving e.g., a supervisor who buys a grocery store may still consider himself better off). This is supported by findings using the 1992 National Survey of Micro-enterprises (ENAMIN) that roughly 70 percent of those entering informal self employment from formal salaried work reported doing so either to increase their pay or because they wanted more flexibility (Maloney 1997a). In sum, though a substantial share of the sector, perhaps 30 percent, corresponds to the more traditional view, the sector is a desirable destination for many workers. 26. In addition, the benefits of labor protections may, for many workers, have been overstated, even for the informal salaried worker. In a market with downwardly flexible wages, the costs of providing workers benefits comes at the cost of lower wages: workers pay for the benefits received. If workers value the benefits less that the implicit "tax," they have every 17. See MacIsaac and Rama (1997) and Maloney (1995, 1997a.) 18. See Maloney (1997b). Carmen Pages-Serra at the IDB has identified pro-cyclical movement in Chilean Self- employment. Paes de Barros finds no cyclical movement in Brazil. Saavedra in Peru finds a broadly countercyclical movement. 14 reason to work where they can avoid paying for them. Three examples suggest that this is not obviously a minor issue. 26a. Since the medical benefits program in Mexico, as elsewhere, covers a worker's entire family, the marginal value of benefits to the second formal sector worker in a family is zero. This would seem particularly important for informally employed workers in households whose principal bread winner may be formally employed: There is no reason to pay again the implicit tax for benefits already received. 26b. Administrative overhead costs are high and the benefits may be of low value given their cost. In his interviews with Guadalajaran workers, Roberts (1989, p. 50) found that "many informants cited the deduction made for welfare as a disadvantage of formal employment, particularly since the services they received were poor." 26c. Third, rapid rates of turnover mean that leaving does not necessarily imply the loss of nominally very generous separation benefits and pensions since as Baldn et. al (1973, p. 212) found "many change enterprises quite often and thus they cannot benefit from the seniority accumulated in each of them." 27. In each case, the value to workers of formal sector benefits is below their value on paper, and in a market with reasonably flexible wages, workers implicitly pay. And when explicit income taxes are added in, working in the informal sector may appear a compelling alternative. 2.3 Informality Does Not Imply Precariousness"-Micro-firm Dynamics and Formality 28. Informal work appears precarious compared to formal sector work: informal firms show high mortality rates and often appear unprofitable. However, if two assumptions are made, it can be shown that there is no necessary causal link from informality to these characteristics and further, all are consistent with a healthy and dynamic small firm sector. * Formality, defined as firm's participation in the numerous institutions of civil society: federal and local treasuries, governmental programs such as social security (including pensions and health care), the legal system, the banking system, health inspection, firm censuses, trade organizations, civic' organizations, etc, is a normal input into small firm production. That is, as firms grow, they will desire more formality. * Micro-firm dynamics are similar to those of small firms in industrialized countries. 29. While these working hypotheses may seem extreme, together they generate most of the characteristics of the sector without any connotation of inferiority or disadvantage. There is no existing data for Mexico or other countries that would lead us to reject this vision in favor of the more traditional. 19. Based on Levenson and Maloney (1997) The Informal Sector, Firm Dynamics and Institutional Participation. 15 2.3.1 FORMALITY AS SOCIAL PARTICIPATION 30. A minimal degree of participation in some institutions is a necessary input to growth for many firms, and participation increases with the success of the business. That is, formality can be viewed as a normal input to production. The benefits of formality, while often overlooked, are numerous. They include, but are not limited to: 30a. Enforceable/impersonal contracts and credible signaling. All entrepreneurs have access to social relationships to enforce implicit contracts among their friends and family who form a large share of their potential customers and employees. Participation in the legal system is needlessly expensive for transactions with these individuals. Similarly, old age and health insurance may be easily handled by insuring through their mutual extended network of friends and family. Property rights secured by personal ties may be sufficient if investment is minimal. But this mode of operation is constrained by the ability of the entrepreneur to maintain personal relations with all involved parties, a task increasingly unmanageable as firms expand. Legally recognized, enforceable contracts lend credibility to arrangements, permit entry into long term commitments, diminish risk, and can reduce monitoring costs. For example, in a world of imperfect information, certification that the firm complies with government health and safety codes may be necessary for firms to attract the largest customer base possible. Larger investments require that property rights be secured through the legal system. 30b. Access to capital. Informal capital markets may be sufficient to fulfill the firm's external financing needs at low levels of production. However, the small scale and undiversified nature of informal capital markets makes them unsuitable for satisfying the firm's financing needs at larger scales of operation. Growing firms will turn to formal financial intermediaries such as banks. 30c. Access to public risk-pooling mechanisms. In order to attract good quality workers the firm may have to offer fringe benefits such as workers compensation, health/un-employment/disability insurance, and pensions. However, uncertainty over the expected costs of these benefits is high for risk pools with limited numbers of participants, i.e. small firms. Hence, even in the absence of mandatory enrollment laws, a firm may want to enroll in government programs that pool risks over a larger population than its own employees. 31. In exchange for this participation, society imposes "taxes" such as reporting requirements,20 fiscal obligations, or social insurance payments. These may include initial fixed cost that may include information or initial registration costs, and per period costs such as taxation.21 Though a somewhat extreme vision, this approach highlights an important effect that 20. This is particularly relevant for bank financing. The firm may have to become registered when it seeks such financing: the government may require the bank to report the identity of all its loan recipients for tax or other purposes. 21. We initially assume that the market for formality is voluntary (society levies no costs on firms that choose not to participate in an institution) and that non-payers are perfectly excluded (no free riders). While extreme, these assumptions are consistent with voluntary health or social security programs, and business associations. For example, Chile's self-employed are offered the choice of whether to participate in the state social security 16 is not considered by the standard approach in the literatures on tax evasion and regulatory compliance. These assume that enforcement is the only determinant of compliance because no private benefit is derived from participation: the institution is treated as a strict public good. However, there may be private benefits that make compliance in many public institutions voluntary. In the mandatory workers' compensation system example cited above, the private benefit of participation outweighed the private cost for many, if not all, firms. De Soto claimed that Peruvian sidewalk vendors sought, not to avoid but, to pay taxes as a way to establish property rights over their precarious business locations. In reality, though the direct private benefit from paying taxes may be zero, there may be ancillary benefits that make compliance worthwhile.22 2.3.2 MICRO-FIRM DYNAMICS 32. This very stylized concept of formality or participation can now be embedded in a model of firm dynamics that has become popular in the mainstream industrial organization literature. Lucas' (1978) argues that the size distribution of firms arises from the distribution of entrepreneurial ability in the population: those with a sufficiently high level of proficiency become entrepreneurs, while the rest become wage workers. Among the entrepreneurs, those who are more proficient have firms that are larger and/or more successful. However, the model is static: firms do not grow or fail, nor are they born; no one transitions between wage work and self-employment in equilibrium. 33. Jovanovic (1982) addressed these limitations by further assuming that entrepreneurs are uncertain about their true costs of production: their precise entrepreneurial ability or business situation (ie location) initially is unknown and can only be learned gradually over time by actually operating a business. They make their best guess of their particular costs and go into business with no certainty that that they will prosper or even survive. Many do not. Others will earn unexpectedly high profits, revise downward their estimations of their particular cost structure and expand. Obviously, those firms who survive several years get a more precise idea of their costs and are less likely to go bankrupt. This view is widely accepted precisely because it explains the very high levels of mortality among young firms, and declining mortality rates with firm size and age observed in the United States. 2.3.3 FIRM DYNAMICS AND PARTICIPATION: RECONSIDERING PRECARIOUSNESS 34. The combination of these two assumptions results in several predictions: program. This framework is broadly consistent with that of Loayza (1996). 22. Even in cases where the private benefit of participation does not exceed the private cost, the net private cost may differ substantially, leading to different probabilities of compliance conditional on a given level of enforcement resources. For example, it may be quite difficult for a firm to undo the effects of a binding minimum wage if the compensation package does not include fringe benefits that can be reduced when the wage is raised. In contrast, it may be easier for the firm to comply with mandated health, pension or other benefits programs by adjusting the wage without significantly altering labor input. Our general point is that the probability of compliance is a positive function of the relative private benefit of participation (net of private costs). 17 34a. There is heterogeneity in the degree of formality. The benefits and costs of participation undoubtedly vary across societal institutions, and vary for firms of different size and expected lifetime. A large number of firms will choose to participate in only a subset of institutions at any point in time. 34bl. Small firms are disproportionately informal. They benefit least from participation because of the small scope of their dealings with the public and hired employees (relative to the total volume of transactions undertaken by the firm). This has the corollary that: 34b2. "Inefficient" firms are disproportionately informal. This implication is in line with many characterizations of the informal sector (Thomas, 1992; Portes, 1994). However, in contrast to other formulations, in this case the causality is not necessarily from informality to inefficiency. High cost firms choose less formality because they are small and formality benefits them less than more efficient firms that produce at higher volumes for longer lengths of time. 34b3. Young firms are disproportionately informal. This is partly because young firms are more likely to be small. Adjusting for size, the population of young firms contains a disproportionate number that have not received enough signals to figure out whether paying the costs of formality are worthwhile; many eventually will go out of business. 34cl. Underlying patterns offirm dynamics should be comparable in both developing and industrialized countries. If the distribution of entrepreneurial ability and the learning process are similar across countries, then so should be'the patterns of firm entry and exit. This also implies similar firm age distributions and overall firm dynamics (assuming comparable environments). 34c2. Informal sector firms have relatively high mortality rates. The high turnover rate of informal firms that might appear as evidence of the inferiority of informal employment reflects the high mortality among small firms observed everywhere. The high turnover rate of such firms and jobs is not necessarily related to being informal per se. Although many informal firms will be small mature firms with high costs (but not so high that they eventually go out of business), many will be the "false starters" with imprecise estimates of their profitability that eventually fail. 34d. Firms participate in an increasing number of societal institutions as they grow. As firms with a low costs grow to their equilibrium size, the depth of participation-measured by the fraction of all institutions in which the firm participates or by the degree of participation with each individual institution- increases as well. 2.3.4 EVIDENCE FROM MICRO-FIRM SURVEYS 35. The National Survey of Micro-Enterprises (ENAMIN) offers limited evidence from Mexico that is consistent with this story. However, the ENAMIN is cross sectional and, though it does ask questions about time in business and how the firm was started, it does not allow firms to be followed over time to see how their patterns of birth, death and formality correspond to those of the view outlined above. Nonetheless, several stylized facts do emerge. 18 Heterogeneity ofParticipation 36. Though the data set is bounded above at five workers (fifteen in manufacturing), even within this narrow firm size range informality is clearly not an all or nothing proposition. The data suggest that there are high participation rates ii societal institutions for even these small firms: 41.7 percent are registered with the federal treasury, 25.2 percent are registered with the local treasury (including Mexico City), 34.6 percent pay some taxes to one or both treasuries, 34.6 percent of firms with paid workers have them registered with IMSS (Mexico's social security administration), 22.5 percent are members of a business guild or association, 15.6 percent pay dues to a business organization, and 33.1 percent of firms that existed in 1989 were enumerated in the Census of that year. 37. Clearly, participation is a question of degree and spans many dimensions. This suggests that previous research that lumped together all small firms as representing the informal sector (e.g. Rauch, 1991) obscured important differences among them. In the interest of avoiding some of the conceptual confusion that surrounds the topic, it may therefore be preferable that future analysis employ the term "informal" to exclusively refer to the issues of participation discussed here. This would leave considerations of firm size, wages/productivity, labor market segmentation, etc. to be addressed under labels that correspond more precisely to the phenomena being studied. Distribution ofFormality Across Firm Characteristics 38. Points 34bl-34b3 above argue that participation decreases with the individual entrepreneurial cost, and increases with the probability of long run success. Although we cannot observe either, the framework shows that they are closely related, respectively, to firm revenue/size and to firm age (conditional on size). Table 5 reports the results from fitting probit regressions for seven different types of institutions. In each case the coefficients on both firm size and age are positive and significant at better than the 1 percent level of confidence. Table 5. Participation in societal institutions Log Years in Pseudo Nobs Dependent variable revenue business R 2 Registered with federal treasury .661 .006 0.200 8870 (37.7) (3.95) Registered with local treasury .371 .006 0.083 8870 (26.9) (3.57) Pays any taxes .556 .008 0.158 8870 (35.6) (5.35) Any paid workers registered with IMSS .634 .010 0.161 1697 (17.2) (2.95) Enumerated in 1989 census .538 .013 0.154 5121 (26.5) (6.26) Registered with business guild/organization .383 .006 0.090 8870 (26.8) (3.87) Pays any dues .312 .007 0.066 8870 (21.6) (4.02) Note: Probit regressions. Absolute values of z statistics in parentheses. The standard errors have been corrected for arbitrary forms of heteroskedasticity 19 Firm dynamics 39. The observed patterns of firm entry and exit are consistent with those observed in the U.S. and in other developing countries. Numerous studies have documented high entry and failure rates among startups that decline with size and agb of the firm.23 Evans and Leighton's (1989) study of self-employment dynamics in the United States provides the most comparable benchmark for our analysis. They find that inflows into self-employment over the previous year account for about 20 percent of self-employment for men over 35, with an even greater proportion for younger men. This is consistent with a constant rate of entry and older men running more established firms that are less likely to fail. Evans and Leighton also document a sharply decreasing exit rate from self-employment for the United States, with the probability of failure ranging from 15 percent for the oldest of the self-employed to over 50 percent for the youngest of the self-employed. 40. The overall patterns of firm age by age of the owner for Mexico in Table 6 are comparable. The last two sets of columns show the fraction and number of firms at each age range that are no more than one year and two years old, respectively. Consistent with Evans and Leighton's estimates, the number of entries is relatively flat throughout the life cycle. Yet the fraction of the self-employed comprised of new entrants declines steadily, commensurate with a sharp increase in average firm age. Together, these patterns suggest that declining exit rates are 24 probably partially responsible for the sharp increase in average firm age in these data. These broad similarities in self-employment dynamics between Mexico and the United States suggest that common determinants of self-employment may be as important as differing institutional factors in explaining the observed patterns of participation. 41. In sum, most of the characteristics used to show that informality is inferior can be shown to emerge from mainstream models of rational firm behavior and do not imply that the informal micro-firm sector is any way disadvantaged. This is not to imply that some fraction of the sector is rationed out of formal employment, finds itself unproductive and would close if there were alternative employment. Previous work with motivational questions from ENAMIN suggests up to 30 percent of the sector is in the sector involuntarily (Cunningham and Maloney 1998). But the critical point is that the patterns we see are consistent with all micro-entrepreneurs voluntarily joining the sector, and trying their luck running their own business, some successfully, some less so. 23. Mansfield (1962) shows that smaller firms have higher and more variable growth rates. Dunne, et al. (1989) demonstrate that U.S. manufacturing plant failure rates decline steadily with the age of the plant. Davis, et aL. (1994) find that net job creation in small U.S. manufacturing firms is not high relative to large businesses, despite inordinately high rates of gross job creation, because of their disproportionately high rates of job destruction. Roberts and Tybout (forthcoming) find that in Colombia, Mexico, and Morocco business births and failures are even more frequent and numerous in those countries than in the United States, accounting for much larger shares of total employment adjustment. New plants are much smaller and less productive than the industry average and the failure rate is highest at young ages. 24. Evans and Leighton do not report average firm age by age of the owner, making direct comparison with the numbers in Table 6 difficult. However, if we assume that the exit probabilities in their data apply disproportionately to the very young firms within each age cohort, a likely phenomenon given the learning process, then average firm age must rise with age of the owner, as in Table 6. 20 Table 6: Distribution of Firm Age by Age of the Owner Years in Years in business: Years in business: business (one year or less) (two years or less) Age of Owner Mean Mean Frequency Mean Frequency 19 or less 2.61 .524 99 .693 131 20 to 24 2.86 .366 191 .573 299 25 to 29 3.96 .277 253 .462 421 30 to 34 4.96 .233 268 .380 437 35 to 39 6.41 .193 250 .325 420 40 to 44 7.90 .168 196 .283 329 45 to 49 9.53 .138 138 .251 251 50 to 54 11.5 .128 117 .191 174 55 to 59 12.8 .116 75 .199 129 60 to 69 15.8 .107 91 .180 153 70 or older 17.8 .086 33 .153 59 2.4 Voluntary Decisions to Become Informal: A Life-Cycle View2- 42. Another test of the voluntariness of self-employment arises from studying patterns of entry into the sector from formal work. As the previous section documented, Mexican entrepreneurs also show similarities in this respect as well to their industrialized country counterparts. In both cases, however, these patterns seem theoretically counter-intuitive. Johnson (1978), Jovanovic (1979) and Miller (1984) argue that younger individuals are better able to bear the risk involved and hence should be heavily represented among entrants into self- employment. However, as Evans and Jovanovic note, this is inconsistent with Evans and Leighton's (1989) finding that the probability of moving into self-employment is constant in age, a pattern also found in and in the previous chapter Mexico and in Balan's et al' work. This they attribute to liquidity constraints that dictate that workers require time to build up the capital needed to start a business. That this phenomenon may be exacerbated in the developing world where credit markets are poorly developed emerges strongly in Balan et al's interviews. First, the man must accumulate capital. This is no easy matter when he has a manual job and must provide for a large family, so it generally takes years to accumulate enough capital. There must be sufficient funds not only to set up the business, but also to keep it going during the months or years while it runs at a deficit. . .these kinds of capital requirements are modest enough, but the capital is not easy to come by for the working classes of Monterrey or elsewhere in Mexico. p. 217. 43. It is worthwhile to put a theoretical structure behind these ideas so as to generate hypotheses that can be tested more rigorously with larger data sets than the sociological literature has had access to. The problem is similar to that of workers who, perhaps with the idea of opening a business upon their return, migrate to a country that offers the possibility of accumulating wealth more quickly, and return home only when they reach a "target" level of savings (See Piore 1979, Berninghaus and Seifert-Vogt (1993)). Solving a very difficult 25. Based on Aroca and Maloney(1998), Logit Analysis in a Rotating Panel Context and an Application to Self- employment Decisions. 21 dynamic programming problem gives the optimal "switching" time, in the present case, the transition from formal to informal self-employment. Under moderately restrictive conditions the target level of savings. * Falls with a rise in the expected profitability of self-employment. * Rises with the opportunity cost of savings that would be employed in the business, the interest rate. * Rises with a higher wage in the salaried sector. It raises the comparable stream of income from self-employment to be an attractive alternative to formal employment, and hence the start up capital required. 44. The first two factors have a predictable effect on when the worker changes sectors. In the last case, however, the overall impact of current income on the switch time is ambiguous since higher incomes both increase the level of target savings as well as increase the possible rate of savings accumulation. Given two workers with identical savings, the one with higher income may find himself below the target rate of income and stay one more period to earn another period wage.26 45. It is worth comparing these predictions to those from the standard dualistic view where an above market clearing formal sector remuneration, rations workers into the informal sector where the returns fall to absorb those in the queue. A fall in relative returns of self-employment for salaried work occurs in the context of economic downturns where the informal return must fall to absorb displaced workers. Similarly, to the degree that increased interest rates are associated with recession and the loss of salaried jobs, again, we may expect more movement of the displaced into the informal sector: movement into self-employment would be counter- cyclical. In both cases, the predicted signs would be the opposite of those postulated by the model above.27 46. The National Urban Employment Survey (ENEU) conducts extensive quarterly household interviews in the major metropolitan areas and is available from 1987 to 1993. It is structured as a rotating panel where in each quarter, a fifth of the sample is dropped and replaced by individuals who will be interviewed for each of the next five quarters. In 24 overlapping panels spanning 1987-1993, individual workers can be followed as the move among sectors of work. Individuals are matched by position in an identified household, sex, level of education, and age to ensure against generating spurious transitions. The analysis restricts itself to men aged 16-65 with a high school education or less. It also focuses on formal salaried workers and the "informal" self-employed, including owners of firms under 16 employees who do not have social security or medical benefits and are therefore not protected.28 Only those who begin in formal salaried employment and move exactly once over five quarters into self-employment are 26. By the same token, a worker who suddenly loses his job, y goes to 0, will suddenly see the target level of saving decline and is more likely to move. In this way, the common vision of the informal sector as the reserve army of the unemployed can be seen in somewhat different light. 27. See Maloney (1997) for a discussion of the relative merits of formal vs informal work and the procyclicality of the latter in Mexico. 28. It is often the case that the informal sector is defined as firms with five or less workers. As we are focusing on informality defined as being unprotected by social security or other legislation, we loosen the size limit to the next category tabulated. In practice, the vast majority of firms are under 3 workers. 22 retained, yielding a sample of 1087 workers. In essence, we are attempting to explain the timing of the decision to move, rather than the decision to move itself. 47. In the estimations, we employ predicted earnings in each sector as a measure of the "own" and "alternate" earnings, given the standard human capital variables, experience, experience squared, education, education squared. The return to accumulated capital (the opportunity cost of using savings to open a business) is the real 30-60 day deposit rate as calculated from the International Financial Statistics of the IMF deflated by growth of the consumer price index. 48. The paper develops a heretofore unavailable methodology for analyzing logits in a panel context. Table 7 presents the results of the estimation of the model. The results are supportive of the model. Self-employed earnings appear very strongly and of the predicted sign reflecting that as opportunities improve in the informal sector, workers are more likely to open their own businesses. The current wage in the formal sector still enters ambiguously, again, as predicted, and is not significant. This is to be expected given that a rise both increases the attractiveness of formal sector employment, and raises the savings rate making a move into self-employment possible. Finally, the interest rate is strongly significant and of the predicted sign suggesting that a rise in the opportunity cost of the capital used for start up discourages opening up a business. In all cases, the sign is the opposite of that predicted by conventional dualistic views of informal self-employment. Table 7. Determinants of Probability of Moving To Self-Employment Coefficient Standard Error Wage (salaried) -.357 .128 Earnings (self) 4.03 .235 Interest rate -2.71 e-3 1.92 e-5 Interest rate(-1) -3.83 e-3 1.65 e-5 Note: Rotating Panel Logit Regression Nobs = 1078, Sample includes 24 complete panels of 5 quarters each spanning 1987-1993. All coefficients significant at 5 percent level. 3. Macroeconomic Implications 49. To recapitulate, there appear to be several new stylized facts about the Mexican labor market that need to be integrated into any framework developed to analyze the sector. Informality 49al. The informal sector is extremely heterogeneous containing both voluntary and involuntary members. Many of the factors generally assumed to mark informality as inferior can be shown to be more a function of normal firm dynamics than any intrinsic drawbacks of the sector. There is ample evidence suggesting that self- employment is a desirable destination for many workers who voluntarily leave formal employment in a life cycle pattern. 23 49a2. There is no strong evidence of government or union induced distortions of the wage structure. 49a3. Despite this, there is still evidence of "segmentation" both measured as differentials in wages given human capital and in workers who claim to be unable to find salaried jobs. Turnover 49a4. Labor turnover appears surprisingly high for a market that is thought to be very rigid Most turnover is due to quits, rather than fires and is voluntary. Firms report the loss of recently trained workers to be a problem. 49a5. There is evidence that, as a result, firms pay wages above market clearing- efficiency wages. Entrepreneurs report that they do, and efficiency wage effects appear in the determination of wages and in labor demand. 50. This section a offers a consistent macroeconomic framework that integrates these stylized facts. The analysis is based on a complete general equilibrium framework (Krebs and Maloney, 1998) that models formal sector production, investment, hiring and wage setting decisions, as well as worker sectoral choice decisions, in a growth context. Though the intertemporal nature of both problems makes the model complicated, the intuition is easily represented graphically and the impact of various policy interventions and economic innovations can be studied and then simulated using Mexican data. 51. The central role of efficiency wage considerations in wage determination makes the framework especially well-suited to studying turnover and rigidity issues. The reliance on these effects to generate segmentation, rather than any wage rigidities exogenously induced by government or unions means that the predictions of the model provide an important "base case" against which more distorted economies can be compared. To this end, Mexico is located in an international context using cross country data and some conclusions drawn about the relative degree of distortion and rigidity in the labor market. 52. As is the case with any modeling exercise, it is necessary to simplify a very complicated economy and the results tautologically depend on initial assumptions made. Nonetheless, such exercises offer if not the "best guess" then at least a "better guess" than we could make in the absence of such a structure. 3.1 The Central Efficiency Wage Relationship29 53. As section 1 suggests, a large fraction of workers may treat the informal sector as a very desirable destination either to attempt to run a business, or as a place to search for a better formal sector job. As section 2c suggests, the decision to enter self-employment will partly be made by comparing the expected "wage" from self-employment to the wage that would be earned by staying in the formal sector. But as 2b suggests, most start up firms will fail or not do well and the entrepreneur may well be concerned with how easy it will be to find another formal sector 29. Based on Krebs and Maloney (1998), Quitting and Labor Turnover: Microeconomic Evidence and Macroeconomic Consequences. 24 job if his firm does less well than expected. The higher the probability that a worker can find a new job in the formal sector, the greater the likelihood of quitting his current formal sector job and trying his luck as an entrepreneur. 54. This relationship is supported by the 1987-93 ENEU panels. As Table 8 shows, the probability of a worker moving from formal salaried to informal self-employment increases with informal income and the probability of being hired in the formal sector and decreases with the formal sector wage. These findings suggest broadly pro-cyclical transitions into self- employment that is borne out in the aggregate data. Table 8. Determinants of Transition to Self-Employment from Formal Sector (Panel Probit) Coefficient Stardard Error Formal wage -1.3153 .3895 Informal wage .8879 .1965 Hiring probability .3122 .05647 School -.08249 0.01231 School Sq .004241 0.000968 Experience .03200 .002887 Experience Sq -.000535 .0000556 Constant -1.6167 .3860 Nobs 100978 Significance 02(6)-440.8 p-0.00 Note: All coefficients significant at 5 percent level. 55. Figure 2 shows the evolution of both formal and informal self-employment sectors as a fraction of the economically active population. As is clear, as the economy moved from recession in 1987 into a moderate boom in 1990-92, self-employment expanded while formal salaried employment contracted. This is exactly the opposite of what would be expected from the view that informality is purely comprised of workers rationed out of the formal sector. Figure 2: Labor Force Composition 39 23.5 - 38 22.5 - 1 37 21.5 1 1 36 20. -- 35 20.5 3 -4* .- . .- - . 19.5 -- . ' ,' "'.. ^ --33 18.5 I l : : :1 1 32 . Self-Employed - Formal Salaried 25 56. Should a worker leave a formal job his firm will lose any investments made in recruitment or training. His employer will therefore raise the wage relative to earnings in the informal sector to increase the incentive to stay. What is also important is that the greater the probability that the worker could easily find another job should self-employment prove unprofitable, the more likely the worker is to move and th'erefore, the higher the efficiency wage that firms must pay. This implies a positive relationship between the probability of being hired, and the formal sector wage relative to the informal. 57. This relationship is a central one in the general equilibrium model. Despite the complexity of its structure, the intuition can be distilled to two equations, captured graphically in Figure 3a. On the X axis is the probability of being hired in the formal sector-the number those who find jobs in the formal sector divided by those searching. On the Y axis are formal wages relative to the average "wage" in the self-employed sector. The positively sloped incentive curve II captures the essence of the efficiency wage story. As the labor market tightens and the probability of being hired rises, employers must pay a higher wage relative to the informal wage to prevent workers from leaving. Though the II curve is not a traditional labor supply curve, it incorporates the usual depressing effects on labor supply to the formal sector of increased attractiveness of the informal sector, or a rise in taxation of formal sector wages. 58. The second curve DD is similar to the traditional labor demand curve. It can be argued that as wages rise, formal firms hire fewer workers and the probability of being hired falls. 59. Though relatively simple, these two relations capture most of the five stylized facts above. In particular, though much of the informal self-employed sector is attractive, it is also clear that some fraction is trapped there involuntarily-that is the expected byproduct of efficiency wages. In an inversion of the commonly held view that higher than market clearing wages create informality, it may be that the attractiveness of self-employment is one reason that firms pay above market clearing wages. This, in fact, does create a subset of the informal sector that is involuntarily self-employed and who are unable to easily move back into the formal sector.30 60. The efficiency wage effects described, and the procyclical patterns of quits are likely to apply equally well to transitions between formal sector jobs. Firms may lose recently trained workers to competitor firms and, again, pay wages above market clearing to prevent it. However, because the ENEU does not permit following transitions within work classes (i.e. formal to formal), this can not be directly tested. 3.2 Analytics ofPolicy and Economic Changes 61. The two curves in Figure 3a allow analysis of the determinants of the size of the informal sector, rates of turnover, as well as formallinformal wage differentials. In particular, it is 30. Some fraction of the informal sector serves the role of unemployment benefits in industrialized countries. This raises the possibility of an analogy between the size of the sector and the natural rate of unemployment (NAIRU). The large movements in formal/informal remuneration in LDCs can generating insights on the elasticity of the NAIRU to unemployment benefits in the industrialized countries where the lack of variation in wages/unemployment benefits have prohibited rigorous testing. (Katz and Blanchard 1997). 26 possible to study the impact of three broad classes of policy interventions or economic innovations: * Increases in labor productivity or firm profitability * A rise in the benefit to being self-employed * Changes in hiring or recruiting costs Figure 3a: Fonnal Sector Productivity Gain (Z) \D' Formal/ Inform. D Wage \ W ' ........ ...... .. W ND' I D P P' Probability of Being Hired 62. The impacts of these factors are first graphically analyzed below. Section 3.3 then simulates the magnitudes of their impacts on the Mexican economy. Finally, section 3.4 locates Mexico in an international context and tests for the import of these interventions and innovations on informality and turnover using cross-country data. Somewhat speculatively, it then uses the residuals of these regressions to gauge the true degree of distortion and flexibility in the Mexican labor market. Increases in Labor Productivity or Firm Profitability (Z) 63. This category includes technological progress, and of particular interest, a fall in labor taxes, or a reduction in any regulation that adversely affects productivity. Any of these changes has the effect of shifting the DD curve to the right along the II curve (Figure 2). As productivity increases, firms are willing to hire more workers, and this increases the probability of being hired. The movement along the incentive curve implies that a higher wage relative to that in the informal sector must be paid to retain workers. But this also necessarily implies that a larger fraction of informal workers is involuntary and would be better off finding a job in the formal sector, if possible. For each of the shocks discussed below, the rise in formal sector employment and wage therefore may have negative distributional effects. 64. The impact on turnover is ambiguous. Both wages and the probability of being hired rise over time with opposing effects on turnover and it is not clear, ex ante, what the net effect should be. Though the implied shifts of curves are the same for the following cases, it is worth highlighting certain aspects. 27 64a. Technological progress: A secular rise in formal sector productivity due to technological progress has the effect of raising both the level of employment in the formal sector, and the wage paid there. In effect, the resulting higher formal sector wage has raises the opportunity cost of being self-employed. The model has the prediction, then, that as countries' grow, a larger and larger fraction of those self-employed are involuntary and segmentation increases among the sectors. For very poor countries, salaried versus self-employment maybe very close substitutes, but in richer countries, perhaps Argentina, self-employment is, on average less desirable. 64b. This dynamic may offer some insight into the elusive Kuznets relation of worsening and then improving distribution with development. A poor country has a very large self-employed sector. As productivity rises, segmentation between the formal and informal sector increases and increases the wage differential between formal and informal sector workers, worsening distribution. However, eventually, the self-employed sector shrinks to so small a size that, though the differentials are great, the number of workers affected is small, leading to a relative improvement of the Gini. Using estimates of the important elasticities, simple simulations suggest this is a plausible story. The indeterminacy of turnover suggests that it is not obvious that LDC's should have higher or lower rates of turnover.. 64c. Regulations and Taxes: Any regulation that can be reinterpreted as a tax on firms-non-wage benefits, firing costs- or any economy wide regulation that leads to lowering the marginal product of labor reduces the size of the formal sector and lowers the formal sector wage. It is important, however, to bear in mind that this effect is most compelling if workers do not value these benefits. To the degree that they do, this is simply payment in a different form. 65. This even applies in some measure to restrictions on firings which can be seen as a tax equal to the option value of the ability to divest of an underperforming asset. To the degree that the worker sees these costs as an insurance premium against termination, they are passed along to workers as lower wages with no impact. However, it is easy to generate scenarios where this might not be the case, and the net result is to reduce employment, and turnover.3' 66. It is important to highlight that the distributional impacts of a reduction in labor taxes are the opposite of those generally postulated in the traditional view with a minimum wage or union induced wage rigidities. There, a reduction in taxes reduces total remuneration to the formal sector relative to the informal, and at the same time increases the size of the formal sector, with likely positive distributional effects. Here the result is less clear. Rise in the Benefit to Being Self-employed, or a Reduction in Worker Taxes (t) 67. Anything that raises the benefit to being self-employed relative to being formally employed increases the rate of turnover and causes a shift in both the incentive curve and the demand curve (Figure 3b). In the former, for any probability of being hired, the formal wage must rise to offset the increased desirability of the informal sector. In the latter, the increased 31. See Bentolila and Bertola(1990) for a discussion of the impact of firing costs and labor demand. 28 cost of retaining workers also shifts the labor demand curve left. What is clear is that employment in the formal sector falls. 68. This coincides with existing literature on unemployment in the OECD countries that increasingly focuses on the level and duration of 'benefits as the key determinant of unemployment. Nickell finds the duration to be the key determinant of long-run unemployment levels while Blanchard and Jimeno(1995) attribute the relatively high Spanish unemployment to the fact that Spaniards get access to benefits of indefinite duration if employed only 6 months of the last 4 years while Portuguese workers must have been working 1.5 of the last two years. Benefits of indefinite duration are similar in principal to self-employment as an alternative to formal work. The absence of unemployment benefits in Mexico, as well as most LDCs has the effect of collapsing both the self-employed and the "unemployed" into one sector. Figure 3b: Rise in Informal Attractiveness (c) Formal /Inform. D Wage D I.> D D' P' P Probability of Being Hired 69. The impact on relative wages, however, is ambiguous since both curves shift left, hence it is difficult to say anything definite about distribution. This indeterminacy also prevents any ex ante statement about turnover despite the increased difficulty of finding a formal job. Income or other taxes: Any tax that finances a public good or whose benefits are perceived as below its cost in terms of taxation renders the informal sector more attractive. Internal mobility restrictions: Where internal reallocation in the formal firm is highly regulated, talented workers may choose to work on their own. Changes in Hiring Costs 70. Any policy that serves to lower the fixed costs of hiring (recruitment, training, and so forth) reduces the loss involved with a quit and hence the magnitude of efficiency wage effects. Showing the effect graphically is difficult since it involves both shifting and changing the slopes of both curves. However, what is clear, is that in the limit where training costs fall to zero, there is no longer any need to pay efficiency wages, no segmentation, and there is an increase in 29 formal sector employment. The impact on turnover is positive since there is no reason for firms to prevent identical workers from leaving and replacing them with new ones. 70a. Public education: Public education has long been justified on the grounds that it addresses the externality implicit in the efficiency wage story: the private sector will under-invest since the basic skills they pay to impart can be easily transferred elsewhere. To the degree that poor LDC education systems force both training and socialization costs on individual firms, the wage gap between self-employed and formal salaried workers will be larger, segmentation greater and distribution worse, and a larger fraction of the self- employed involuntarily employed. This offers another channel through which improving education may equalize the distribution of income in the economy. 70b. Reduced Interest Rates: Reduced interest rates lower the cost of investment in human capital and thus lower hiring costs. 70c. Better job matching and signaling: If the recruitment and selection process constitutes a sizeable fixed cost, any improvement in mechanisms to promote good matching, or that reliably signals workers' skills, such as the education certification schemes in Mexico, cause all the same desirable outcomes. 70d. Trade Reforms: To the degree to which other reforms, such as that of the current account, increase the demand for skilled labor and raise implicit training costs, segmentation and wage dispersion may increase. This may offer one explanation for the increasing wage dispersion observed with trade liberalization in Mexico and Chile. 3.3 Policy Simulations for Mexico 71. The results from the estimation of the quit function in Table 8 can be used to calibrate the general equilibrium model and then simulate the impacts of various innovations on three key labor market variables: the share of the work force in informal employment, the rate of turnover and the relative formal/informal sector wage differential. The two experiments correspond to the first two graphical exercises described below (Table 9). The third case, a fall in hiring costs that results in a 1 percent increase in costs per worker, has the same effect as the change in formal sector labor productivity and is not analyzed separately. Table 9: Simulated Policy Effects 1 percent decrease in 1 percent increase in formal informal attractiveness MPL Change in nT A Z Informal employment -0.9% -.9% Turnover rate -2.6% -2.29% Relative wage 0.7% 1.6% 72. The results suggest that in an economy with the structure described here, both a reduction in taxes on workers, or a rise in marginal productivity of labor to the firms can have substantial effects on relative wages, turnover, and the size of the informal sector. 30 73. The steady process of economic growth has the impact of reducing the size of the informal sector about 1 percent for each point of growth. Further, though the graphical analysis was ambiguous, in the Mexican case it also appears that growth reduces turnover. These findings immediately offer an explanation for the disparities between Mexico and the OECD laid out in table 1. All things held the same, poor countries will hive higher rates of turnover and larger informal sectors. 74. The large impact on both the size of the informal sector and the wage differential between formal and informal sectors generates strong distributional impacts as well. A simulation of the growth process using the coefficients above shows the Gini rising from OECD levels to Mexican levels and then falling again to OECD levels in just under a century. 75. Reforms that either decrease the burden of taxation on enterprises or reduce the implicit tax on workers can also have important one-off effects. Again, for each percentage point reduction in either, formal employment grows roughly equivalently and turnover falls substantially. The distributional implications are ambiguous-the impact on the gini depends on where the country is on the Kuznet's trajectory. 76. It must be reiterated that the model underlying the simulations abstracts from many elements of the Mexican reality that might affect them. However, these are likely to be the best guess of the impact of such measures and they suggest that the labor force dynamics emerging from a pure efficiency wage story are of important magnitudes. Even in the absence of the usual minimum wage and union distortions, very large changes in labor force composition, turnover and distribution, may result from labor market reform or even moderate rates of growth. 3.4 Mexico in International Context; Cross Sectional Evidence32 77. Both the graphical results and the simulations suggest that both the size of the informal sector and rate of turnover may be strongly affected by demographic and economic factors including the normal process of growth. The question then arises, how distorted or inflexible is Mexico once we adjust for these factors? 78. Table 10 presents some suggestive tests using cross-country data for determinants of the share of the workforce in self-employment and the mean tenure in the manufacturing sector. Mean tenure bears an inverse proportional relationship to turnover and was more consistently reported in the data so it is used to proxy for turnover.33 The results must be interpreted with caution. First, data on at most 40 countries are available. This in some cases can make the results sensitive to the countries included. Second, the data are not uniform. Most of the OECD variables were gleaned from presumably consistent publications of that organization while the Latin American variables were individually extracted from not necessarily consistent survey data. A Latin American dummy that might have picked up these data discrepancies was never significant. Despite these potential pit-falls, the regressions prove surprisingly robust and 32. Based on Maloney(1998) Self-Employment and Labor Turnover in LDCs: Cross Country Evidence. The data sources and more detailed descriptions are listed therein. 33. If half of all workers leave their jobs in a year, then the mean tenure is two years. 31 consistent with most of the predictions of the graphical analysis. The explanatory Table 10. Determinants of Self-employment and Turnover variables corresponding to the Self-employment Mean tenure graphical exercises and simulations Sample Complete Reduced Complete Reduced are the following: C 0.36 0.50 74.35 43.30 (2.46) (3.29) (4.23) (6.03) Indust. V.A. -0.03 -0.05 -16.21 -3.19 1. Formal Sector Labor (2.24) (3.19) (3.99) (4.88) Productivity/Profitability () I.V.A. sq 0.92 (3.99) Industrial Value Added (Indust. SS Worker 8.68 V.A.): The log of industrial value (3.62) added per industrial worker SS Emp 0.16 0.15 6.23 11.65 (2.81) (1.63) (1.79) (5.86) proxies for formal sector labor Protection 4.OOE 0.09 productivity specifically and more (2.93) (2.99) generally for level of development. Real Interest 0.23 0.21 -7.10 (4.71) (3.21) (1.89) Social Security Tax-Employers Secondary -1.00E 0.04 (SSEmp): Social security (broadly (2.37) (2.23) secuity 'y Yuth4.14 defined) taxes as a share of the (2.8) wage by worker. The model NOBS 40 20 26 17 suggests that there may be R2 0.90 0.90 0.68 0.81 different effects. Note: t-statistics below coefficients Employment Protection(Protection): An index of employment protection constructed by Gustavo Marquez (1 998bl that captures both the difficulty of laying off workers and the cost in terms of severance pay. Unfortunately, this leads to roughly a halving of the available observations and hence a separate set of regressions are run using this reduced sample. 2. The rise in the benefits to being self employed, or a reduction in worker taxes (*c) Social Security Tax-Workers (SSWorker): Social security (broadly defined) taxes as a share of the wage by worker. 3. Hiring Costs: Share of appropriate age group with secondary education (Education) Real Interest Rate (Real Interest) 4. Other Variables: Share of the working population found between the ages of 16 and 20 (Youth.) * 34. Chief Economist Office of the IDB. 35. The model implicitly assumes homogeneous work forces across countries. This is clearly not true as the share of young workers is much higher in Latin America than in the OECD countries. This variable is most relevant to the turnover regressions where traditionally young workers have higher rates of turnover as they shop around for careers. But it may also have a similar interpretation in the self-employment regressions. 32 3.4.1 EMPIRICAL DETERMINANTS OF SELF-EMPLOYMENT 79. The employers' social security tax, the real interest rate, the level of education, the labor productivity and educational variables and the share of young people, enter significantly and of predicted sign. The first four are all consistent with'both the graphical analysis and the simulations. The fact that in no case was the worker's share of social security remotely significant may well be due to the large measurement error in this variable." 80. Most important in terms of magnitude is formal sector labor productivity. Taking the extreme values of this variable would account for 9.6 points of the variance in the share of self- employment. Figure 4 suggests the same, but important conclusion: a large self-employed sector is not obviously evidence of distortions, but may rather reflect that the opportunity cost of self- employment is lower in poorer countries. 81. Table 11 presents the raw self-employment level for each country and its deviation from that predicted given the country's level of development as measured by formal sector productivity. As might be expected from Figure 4, there is a complete re-ordering. Costa Rica, Honduras and Panama, with among the largest self-employed sectors appear grouped with relatively undistorted economies such as Canada and the United States once level of development is taken into account. Mexico appears roughly at the predicted value given its level of development. Figure 4. Self-employment versus Development Level 1I II .461 Peru E Bol 0 C- EIS EE Col Ven 4_ Hon Gua Par (D Arg Gre Pan Chi meyuk 0CR oBra Kor ita 0 Por .0Spa New Ice 0 Ire A el .0576- Ay Den Nbox II III 6.63332 10.5322 Log of Industrial V.A./ Worker 36. In roughly 25 percent of the cases, the social security law dictates a progressive tax that varies greatly across the range of incomes. We chose the midpoint of this range, but we can have no way of knowing if, in fact, this represents that average tax on labor. 33 82. The relative youth of Latin America's population also explains much of the variance Table 11: Self-Employment Shares with the spread across the sample accounting Percent self- Dev. from for 8.8 percent of the higher share in self- Country employed predicted employment. The education variable, Costa Rica 24.4 -7.6 measuring the degree to which firms must bear Hus 6.6 -6.9 the burden of financing general education, Anara 6.2 -5.1 would account for roughly 7.5 percentage United States 7.3 -4.8 point difference. Real interest rates are also Canada 8.9 -4.6 surprisingly important." The difference France 8.6 -4.1 between 5 percent as in the OECD versus Guatemala 32.3 -4.1 often above 30 percent in Latin America is Denmark 6.9 -3.6 worth over 6 percent in the share of self- Ireland 13.5 -3.3 employment. Once again, the importance of Chile 25.2 -3.2 ensuring macro-economic stability, and Paraguay 31.7 -3.2 reducing risk to bring down interest rates Germany 8.5 -2.8 seems clear. Netherlands 9.6 -2.7 Norway 5.9 -2.7 83. In general, these effects dwarf the Luxembourg 5.8 -2.3 impact of any of the three labor market Sweden 9.3 -1.9 variables. Across the range observed, social Brazil 23.2 -1.8 security taxes on employers explain relatively Finland 9.7 -1.8 little of the size of the sector, roughly 3.2 Australia 12.3 -1.4 percentage points. Bolivia 39.2 -1.2 Portugal 19.5 -0.7 84. The same exercise was repeated with United Kingdom 12.6 -0.7 the smaller sample arising from using the New Zealand 16.2 -0.5 Marquez protection index, in column 2. With El Salvador 35.2 0.2 fewer observations, the apparent collinearity of Mexico 26.5 0.2 the productivity variable and education Turkey 26.0 0.7 variables makes identifying the "correct" Belgium 13.3 0.8 parsimonious form difficult. However, in all Japan 9.9 1.7 cases, the employment protection index has the Spain 18.6 2.4 impact of increasing the size of the self- Switzerland 10.6 2.5 employed sector. But, again, the difference Iceland 15.5 4.0 between the highly protective Mexico, or Korea 23.6 4.3 Bolivia, Honduras, Peru or Spain compared to Argentina 28.5 5.9 the unprotective United States or United Uruguay 32.8 6.8 Kingdom is worth only about 1.35 percentage Greece 27.7 8.4 points in the share of self-employment, a fairly Venezuela 34.4 8.4 small impact. Italy 22.8 9.4 Peru 46.1 18.6 85. In sum, the three labor distortion variables, the tax on salaries, on payroll, and restrictions on hiring and firing have relatively 37. Peru's very high self-employed sector (46 percent) and high real interest rates (67 percent) are clearly dominating the relationship although even dropping this outlier yields a significant coefficient. 34 small impacts compared to those of the productivity, real interest rate, education variables and, in the larger sample, the relative youth measure. Thus, it is hard to argue that these distortions are responsible for the size of the sector. 3.4.2 EMPIRICAL DETERMINANTS OF TURNOVER 86. The turnover results are more difficult to interpret first, because of the small number of observations available, and second because as the previous section shows, it is far less clear theoretically what the signs should be.38 Column 3 presents regressions of average tenure in manufacturing employment on the same set of independent variables. In the complete regressions, labor productivity enters both in levels and with its square suggesting a non-linear relationship. Taken at the mean, labor productivity appears to have a negative impact on tenure (a positive impact on turnover), consistent with theory, and in conflict with the simulation results. This can be reversed with the exclusion of all other variables, but the inclusion of the share of the population with secondary schooling reverses its sign. Thus, it appears that the OECD countries have more stable work forces, it appears that it is the fact that they are educated, rather than rich that drives the result. Both taxes on social security appear to increase tenure and real interest rates decrease it. 87. Including the employment protection variable reduces the sample to 17 observations and leaves only the productivity, social security tax on employers and protection variables significant. The latter enters with predicted sign, suggesting that it does negatively affect turnover and importantly. The difference across the range from the United States (1) to Venezuela (37) accounts for 3.24 years on a mean of about 9. 3.4.3 DISTORTION AND RIGIDITY RECONSIDERED 88. The above findings suggest that many economic and demographic factors not directly related to labor market legislation affect both the size of the self-employed sector and rates of turnover. Only by compensating for these variables can more meaningful measures of distortion and rigidity be constructed. 89. Figure 5 attempts, in a rough fashion, to do this. It plots the residuals from the regressions of the self-employment share and tenure on labor productivity, education, real interest rate, and youth to see if the combination of the two can reveal anything about the functioning of a given labor market. In theory, these residuals capture the impact of all variables not explicitly included in the regression, including other labor market distortions or rigidities." Though speculative, we will interpret these residuals as measuring labor market distortion (self- employment above the predicted value) and rigidity (average tenure above the predicted value). 38. See Mdrquez and Pag6s (1998) for a graphical treatment of these issues. The econometric results here are broadly consistent with their findings. 39. It is absolutely correct to argue that they also include any country specific variables and any error in measuring sector size or turnover, both of which cast doubt on using the residuals for this purpose. However, this critique applies to the use of the raw measures of these variables as well and since they are thought to contain information, then the adjusted values obtained from the residuals are probably more appropriate. 35 90. Despite the crudeness of the technique, the results are broadly plausible. In the North East quadrant of Figure 5, more rigid and distorted economies, we find Greece, Italy, and Spain, all European countries renowned for repressive labor codes. It is, however, interesting to note that the only Latin American country appearing in this quadrant, perhaps unsurprisingly is Argentina. Paraguay, in the South-East quadrant also apliears quite rigid although less distorted than average. Venezuela, in the North-West quadrant, on the other hand, has high rates of turnover but a very high self-employment sector suggesting perhaps substantial rigidity. 91. Among the most flexible and undistorted, the South West quadrant, we find, unsurprisingly, Canada and the United States. But we also find Mexico.40 This is not entirely implausible. Most sources of wage rigidity and segmentation, beyond those efficiency wage effects that are likely to appear in all countries, have been shown to be absent: minimum wages are not binding and unions appear not to affect the wage. In fact, the union emphasis on job creation may lead exactly to finding here that the share of self-employment is below that expected. The turnover number must be treated especially carefully since it was culled from an industrial survey instead of the household surveys like the others. But the finding here may also be plausible. The extreme difficulties of firing a worker for economic reasons is shared with many other countries in the region, including several who also show up as not particularly rigid: Bolivia, Panama, and Venezuela in the Western quadrants and Brazil and Panama just over the line (See Burki and Perry,1997). Figure 5. Distortion and Rigidity? Adjusted Mean Tenure .1 -Ven- C Gre U) 0 E ItaV 0 Arg E Spa 0 LW] Fin Bel U)UK Swit C 0 Qer Lux Par M AusI Bol Mex Aua Neth Jap US Can Pa n Fra U) Ire 0 V ~Bra ( -2.6 0 2.6 Flexible ..................................................... R igid 40. The results are also not entirely consistent with the indexes of distortion calculated in The Long March, a regional reform perspective published by the World Bank, which showed Chile, Colombia, and Peru among the most liberalized and Bolivia, Mexico and perhaps Brazil among the least. This divergence, again, may be due to data problems-Chile may count its self-employed more conscientiously. But it also may be the case that enforcement varies greatly, and that a formally rigid market may, in practice, be quite fluid. 36 92. These results require very strong caveats both on empirical and conceptual grounds. The available data is thin and hence the regressions and their residuals must be treated with caution. It also must be remembered that the level of development (formal sector productivity) is not exogenously given, but may itself be affected by labor legislation.4' Since this variable has great explanatory power in both the self-employment and tiirnover regressions, the measures of distortion above may be understated. Further, many other social programs and labor market institutions also have historically emerged over the course of development that will be correlated with productivity. Since it is not obvious whether these would be more or less distortionary, the direction of bias induced in the residuals cannot be known a priori. 93. 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World Bank. 1995. World Development Report 1995: Workers in an Integrating World. New York: Oxford University Press. World Bank. 1990. World Development Report 1990: Poverty. New York: Oxford University Press. 42 Appendix I: Data Sources 1. Tenure variables of the OECD countries are from the following sources: Table 2: Measures of the Sluggishness of Employment and of Adjustment Costs, Page 11, in Stephen Nickell, "Labour Market Dynamics in OECD Countries", Centre for Economic Performance, Discussion Paper #255, August 1995 Table 5.5: Distribution of Employment by Employer Tenure, 1995, Page 138, Table 5.6: Average Employer Tenure by gender, Age, Industry, Occupation, 1995, Page 139, in "OECD Employment Outlook, July 1997", 2. Self-employment rate of the OECD countries is from "OECD Labour Force Statistics 1976-1996." 3. Self-employment rate and tenure variables of the Latin America and the Caribbean countries are from various CEPAL surveys of the following years: Argentina 1992, Bolivia 1995,Chile 1995, Colombia 1995, Costa Rica 1995, El Salvador 1995, Guatemala 1989, Honduras 1995, Mexicol994, Panama 1995, Paraguay 1995, Peru 1996, Uruguay 1995, Venezuela 1995. 4. Per capita GNP and wages of Industrial workers are from Table 1: Basic Indicators, Page 214,215 and Table 12: Structure of the Economy: Production in "World Development Report 1997" 5. Employment Protection variables provided by Gustavo Marquez, Chief Economist Office, IDB. 6. Social Security variables are from Table3: Contribution rates for social security programs -OECD countries(1997), and Table 5.8: Social security and non-wage labor costs, in "Social Security Programs Throughout the World - 1997". 43 MiCROGRAPFMcS CATALOGU ERS/FULE CONFIDENTIAL CONFIDENTIAL Report No.: 19438 ME Repot No.: 19438 ME Type: SR Type: SR