## Labor Market Dynamics and Informality over the Business Cycle in LAC

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**Canonical URL:** [Labor Market Dynamics and Informality over the Business Cycle in LAC](https://www.imf.org/-/media/files/publications/reo/whd/2019/october/english/labormarketpresentation.pdf)

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### Motivation
- LAC’s strong economic performance during the commodity super-cycle led to significant improvements in real incomes, employment, and formalization.
- Weak economic activity in recent years has slowed, and in some cases reversed, progress in key labor market outcomes.
- The chapter studies the cyclical response of labor markets in LAC, emphasizing the role of informality and its determinants in explaining the behavior of key labor market outcomes.

### Key messages
- The slow recovery in LAC may endanger improvements in real income, employment and formalization achieved during commodities boom.
- Informality and labor participation are important margins of adjustment that buffer the impact of output shocks on unemployment.
- Informality declines with increases in income and education, but institutional aspects of labor markets are also important determinants of informality.
- Although informality buffers the impact of negative GDP shocks, it also lowers the speed of adjustment to a new equilibrium, thus hampering growth.
- Employment protection and minimum wages in particular are behind the low speed of adjustment to shocks: since they also foster equity and protect workers, their reform involves difficult trade offs.

### Labor market trends and cyclical patterns
- Unemployment in LAC has been falling since the turn of the century, but has picked up again after the commodity price bust.
- Informality fell in the 2000s, but in some countries the decline has stalled in recent years.
- Unemployment exhibits smaller fluctuations, while informality and participation show larger changes.
  - Chile: Slower formal job creation in recent years has been compensated by lower labor force participation and a slowdown in formalization.
  - Colombia: Formal job creation has been met with a strong increase in the formality rate, keeping unemployment relatively stable.
- Participation rates are pro-cyclical across income groups; average female participation in LAC is acyclical overall, but female participation is counter-cyclical during recessions in LAC.

### Estimation approaches
- The chapter uses the Common Correlated Estimator (CCE) proposed by Pesaran (2006):
  - ∆Z_iit = α_i + β_i ∆y_iit + θ_i ∆y_iit−1 + γ_i ∆y_iit−2 + ϖ_i,it
  - ϖ_i,it = μ_i + Σ_{m=1}^p λ_im f_mit + ε_i,it
  - Where ∆Z_iit is the change in the labor market outcome (participation rates, unemployment, informality) and ∆y_iit is GDP growth.
  - The CCE estimator captures cross-country heterogeneity and common factors.
- Two approaches to study labor market adjustments to economic shocks:
  1. Aggregate error correction model adapting equation (1):
     - ∆e_iit = α_i + β_i ∆y_iit + λ_i (e_iit − θ_i y_iit−1) + ϖ_i,it
  2. Sector-level approach following Caballero, Cowan, Engel and Micco (2013):
     - ∆e_ijiit = α + λ_i (e_ijiit−1* − e_ijiit−1) + ε_i,it
     - Speed of adjustment parameter λ_i is modeled as a function of country characteristics such as labor market regulations.

### Cyclical responsiveness and informality
- Unemployment is countercyclical; however, its responsiveness to growth (Okun’s coefficient) is smaller (in absolute values) in EMs and LAC compared to AEs.
- Informality acts countercyclically—declining during expansions and increasing during recessions.
- Total labor force participation is procyclical; female participation displays nuanced behavior, being counter-cyclical during downturns in LAC.

### Informality, regulations, and microeconomic flexibility
- Higher informality levels are associated with a lower speed of adjustment coefficient.
- Informality is positively correlated with higher minimum wages (minimum wage ratio) and with higher redundancy costs (severance measured in weeks of salary).
- LAC countries tend to have more stringent regulations compared to AEs:
  - LAC countries have, on average, higher minimum wages and severance pay than AEs.
  - Indicators reported include: Unemployment protection scheme (2015; share of countries), Severance pay (2010; scale 0–1), Collective bargaining coverage (2016 or latest; percent), Ratio of minimum wage to value added (2018) (Average per country group).

### Speed of adjustment, informality, and growth (reported estimates)
- Reported table entries (as presented):
  - Estimated Speed of Adjustment Average 0.50 12.00-
  - LAC 0.48 12.91 1-
  - Low 0.51 11.79
  - High 0.47 13.26 0.17pp
  - Low, High government effectiveness 0.54 10.56
  - High, High government effectiveness 0.43 14.61 0.47pp
  - Low, Low government effectiveness 0.52 11.39
  - High, Low government effectiveness 0.49 12.32 0.11pp
  - Low, High government effectiveness 0.55 10.56
  - High, High government effectiveness 0.39 16.85 0.74pp
  - Low, Low government effectiveness 0.51 11.72
  - High, Low government effectiveness 0.49 12.48 0.09pp
  - Informality
  - Job security
  - Minimum wage/Labor productivity
- Conclusion drawn: In fact, stringent de facto labor regulations are associated with less microeconomic flexibility and slower growth.

### Empirical results (summary of additional slides)
- Cross-sectional and panel regressions indicate:
  - Job security measures and minimum wage relative to productivity are positively associated with informality in some specifications; government effectiveness interacts with these relationships.
  - CCE error-correction model of employment (average coefficients):
    - Lagged log employment: −0.205*** (No lags), −0.208*** (1 lag), −0.216*** (2 lags)
    - Lagged log GDP: 0.078***, 0.085***, 0.089***
    - GDP growth: 0.122***, 0.112***, 0.121***
    - Implied long-run elasticity: 0.3818***, 0.4064***, 0.4138***
    - Observations: 3320, 3201, 3081; Number of countries: 129
  - Microeconomic flexibility regressions show employment gap is a strong predictor of employment growth; interactions with informality, job security, minimum wage/labor productivity, and government effectiveness are significant in multiple specifications.
  - Sectoral regressions on labor productivity growth show sector's share in country's total value added, t-1 is consistently negative and significant (e.g., −0.156*** to −0.176*** across specifications); interactions indicate country-level job security and relative minimum wage affect sectoral productivity growth when interacting with sectoral labor or capital shares.

### Mexico case study (Alvarez and Ruane, 2019)
- Value Added per Worker Premium in Formal Firms: regression coefficients on formal sector dummy reported; all coefficients are significant at the 95 percent significance level (percent premiums illustrated across specifications: No controls; Sector controls; Sector and location controls; Firm size, sector, and location controls).
- Gains from Reducing Informality Distortions (percent) illustrated across scenarios:
  - Baseline
  - No contributory programs
  - No salaried contract costs
  - Reduced formalization costs
- Findings illustrate substantial productivity gains and shifts in informal shares of firms, employment, and output under reform scenarios.

### Conclusions and Policy Takeaways
- Gauging the cyclical position of Latin American labor markets requires tracking not only unemployment but also the informality rate.
- Informality poses difficult macro/micro trade-offs:
  - Dampens immediate effects of negative shocks and insulates individuals from the costs of unemployment absent unemployment insurance.
  - Can make the effects of shocks protracted and can hamper growth.
  - From a micro-perspective, informal employment exhibits lower wages/productivity and can exclude workers from social benefits.
- Reducing entry costs to formality appears to work better than punishing informality.
- Policies aimed at reducing informality are more effective when combined with a strong productivity agenda.

*Source: labormarketpresentation — https://www.imf.org/-/media/files/publications/reo/whd/2019/october/english/labormarketpresentation.pdf*

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_Source: https://www.imf.org/-/media/files/publications/reo/whd/2019/october/english/labormarketpresentation.pdf_