Latin American Labor Protections Increase Informality, Poverty

By Claudio Loser
Published in the Dialogue's Latin America Advisor., February 28, 2008

Latin American Labor Protections Increase Informality, Poverty

Originally published in Claudio Loser’s monthly “By the Numbers” column for the Dialogue's daily Latin America Advisor.  WASHINGTON, DC—Latin American labor markets are a portrait of contradictions: complex and far-reaching worker protection legislation, significant unemployment, and a high degree of economic informality, not to speak of poverty and inequality. The protective practices were introduced over a long period, following the example of many advanced economies, particularly in Europe. Unfortunately, the good intentions or populist urges—your choice—that motivated government actions did not have the desired results. The evidence suggests that the higher the non-wage labor costs, and the greater the desired workers' stability, the larger the degree of informality. The two charts below illustrate the point. They include indices of labor informality calculated by the World Bank and ILO; per capita income, on a purchasing power basis (PPP) by the IMF; a combined index based on non-wage labor costs; and rigidity estimates derived from the World Bank's "Doing Business 2007" report. The latter reflects information for larger firms, and is considered biased by many critics, but it actually reflects the difficulties encountered by enterprises in the formal sector. The first chart shows, unsurprisingly, a strong negative link between per-capita income and informality. Countries that are better off tend to have smaller informal sectors and vice-versa. However, there are clear deviations from the trend line. The second chart shows the relationship between informality and the weighted index of labor costs and labor market rigidities (rigidity to hire, fire, etc). In this case, there is a clear (although statistically less significant) positive link between rigidities and labor informality. This indicates that, contrary to the intent of policy makers, alleged protective legislation results in higher informality, poverty, and exclusion from decent standards of living. In the end, the "haves" are those in the modern, mostly foreign-owned industries, government, public education, and possibly health, and are well protected by strong labor unions and a populist state. The "have-nots" remain unprotected and openly subject to the uncertainties of the market. While the best solution is to develop a strong strategy for the long run, a first step would be to make labor markets more flexible, as some countries have done, and develop a good protective network for the needy. Such actions may not be popular with some voters, but certainly they will be pro-growth and pro-poor. Claudio Loser is a Senior Fellow at the Inter-American Dialogue and former Head of the Western Hemisphere Department at the International Monetary Fund.