The labor market: challenges and policies

A well-functioning labor market is indispensable for an efficient allocation of labor across occupations, sectors and firms. As pointed out by RED (Álvarez et al., 2018), matching processes between workers and firms, as well as wage-setting mechanisms, are crucial for productivity¹.

In general, if wages reflect the productivity of the job, they will serve as a guide to workers in the search and matching process that characterizes the labor market.

The proper functioning of wage-setting mechanisms is key for higher productivity firms to attract the best qualified workers. However, taxes, regulations and other institutional aspects such as employer social security contributions, minimum wage laws and collective bargaining can distort this process².

An aspect of profound relevance for LAC is the distribution of workers between the formal and informal sectors. As figure 2.8 shows, 52 % of jobs in the region are informal, well above the 13 % in high-income countries or 7 % in the European Union³. Informality in the region is high, even compared to other countries with similar per capita incomes (Álvarez et al., 2020). This implies a loss of productivity due to the multiple inefficiencies associated with the informal sector.

On the one hand, informal companies generally operate on a smaller scale to avoid detection and the costs of formality, such as taxes and parafiscal contributions, compliance with laws and regulations, and the social protection of their employees. This prevents them from achieving economies of scale, adopting better technologies or accessing credit markets. As a result, labor and capital are not used in the most efficient way.

As a result, workers in the informal sector tend to have limited access to resources and training opportunities⁴. RED (Álvarez et al., 2018) shows evidence that in LAC informal employment is associated with lower skill acquisition and, therefore, growth within their field of action⁵.

Moreover, in economies with a substantial informal sector, people may not invest enough in their own education or in acquiring job skills. As a result, informal workers face low wages and lack of social protection, which affects human capital development and perpetuates poverty and inequality.

It is not surprising that schooling levels are considerably lower among informal workers. For example, in LAC, the percentage of workers with at least secondary education is about 30 percentage points lower in the informal sector than in the formal sector (OECD, 2024a).

Similarly, informality affects the quality of worker-job matches. According to OECD data OCDE (2024a), about 16 % of informal workers in LAC, on average, have a lower educational level than that required by their job, which contrasts with the 9 % observed in the formal sector⁶.

And, to complete this bleak picture, the low quality of labor matches in the informal sector results in greater mobility between jobs. RED (Álvarez et al., 2018) estimates that the seniority of informal wage earners is 16 % lower than that of formal employees with similar characteristics and jobs⁷.

In short, the high rates of informality in the region have profound negative consequences for aggregate productivity and perpetuate a cycle of low efficiency and precariousness that limits development.

Informality also has other consequences, beyond its effects on productivity. The literature highlights that it worsens the fiscal capacity of governments, which is an obstacle to growth in developing economies such as those of LAC⁸.

As informality is a complex phenomenon, it is ultimately determined by decisions made by companies and workers. From the perspective of firms, the high costs associated with registration, regulatory compliance and tax payments may deter formalization. The perception of few or no benefits of formality, in terms of limited access to credit or legal protection, also reduces incentives to operate within the regulatory framework. In addition, if institutions to enforce laws and regulations are weak, informal operations will proliferate due to the low risk of sanctions.

On the workers’ side, social welfare policies that do not differentiate between formal and informal employment, coupled with labor market rigidities, can push people into informality.

Likewise, limited educational opportunities restrict access to formal employment. If the perceived returns of formal employment, in terms of wages, job security and skills development, are low compared to the informal sector, the individual’s decision will be biased towards the latter.

We cannot speak of social inclusion when half of the workers in the region do not have access to social security. And the second major problem is that, in a context of high informality, the performance of companies and workers is affected in multiple dimensions that depress productivity. And these are two ideas that must be seen as a simultaneous result of the same phenomenon of dysfunctional institutions, high informality and lack of social protection and low productivity.

Based on an interview with Santiago Levy

Policies for formality

Addressing the multiple causal factors of informality involves a combination of policies that must be adapted to the specific context of each economy. A first set of policies are those aimed at reducing the costs of formalization. These are based on the idea that firms that opt for informality are motivated by high regulatory costs and start-up costs, such as business registration. However, empirical evidence suggests that these policies are not effective in reducing informality, as entry costs are not the main obstacle.

In contrast, policies that aim to reduce the recurrent costs of operating in the formal sector, or that increase its benefits, tend to be more effective, since for many firms, the costs of formality outweigh the benefits. However, such measures may not have much impact and may not be cost-effective (Ulyssea, 2020).

The 2012 tax reform in Colombia is a good example. With it, employers’ social security contributions were reduced from 29.5 % to 16 %, replacing them with a tax on profits. This is associated with a drop in the informality rate of almost five percentage points, mainly due to an increase in the creation of formal employment within micro and small enterprises⁹. This suggests that reducing the costs of formality may incentivize smaller employers to integrate their workers into the formal sector.

Other policies that impose costs on formal employment are minimum wage and employment protection policies, which are widely used in the region. As for the former, high minimum wages in some countries push many employers into informality.

Indeed, RED (Álvarez et al., 2018) shows the results of an empirical exercise that indicates that, in sectors where minimum wages are higher versus the average wage, any change in the legal minimum wage has a larger impact on informality. However, the magnitude of the impact appears to be small, which is consistent with the findings of the literature, which suggest that the minimum wage has no or very small effects on informality. These studies, however, generally refer to moderate minimum wages, which is not the case for some countries in the region. 

Regarding employment protection, there is evidence that higher levels of protection, such as regulation of firing and hiring, are associated with higher informality, especially when compliance is more strictly monitored¹⁰.

As can be seen in panel A of figure 2.9, although the region has average levels of employment protection compared to other regions, there is great heterogeneity within the region. On the one hand, Bolivia, St. Lucia, Mexico, Venezuela and Panama have levels of protection similar to those observed in Europe, the region with the strictest legislation in this area. On the other hand, Costa Rica and Brazil exhibit low levels.

Panel B also shows that there is a positive association between employment protection levels and the informality rate. This, of course, does not indicate a causal relationship, but it is suggestive in light of the above evidence.

In this context, minimum wage and employment protection policies must be carefully calibrated so as not to discourage the creation of formal employment.

Another set of measures that can have a positive impact are those that increase the benefits of formality, such as social protection programs tied to formal employment. Empirical evidence points in this direction. For example, in Brazil, formal workers are willing to pay for more generous benefits in the form of a lower wage relative to informal (Almeida y Carneiro, 2012). This implies that increasing social benefits in formal employment could attract informal workers. In Uruguay, a social security reform in 2008, which extended health benefits for formal workers, had a positive effect on formalization (Bergolo y Cruces, 2014). 

A corollary that emerges from this evidence is that non-contributory social programs or in which beneficiary status is linked to informal employment should be used with caution; otherwise, perverse incentives may be generated that not only increase informality, but also reduce labor participation (Álvarez et al., 2018; Álvarez et al., 2020).

In LAC, several experiences demonstrate this. In Brazil, the Family Health Program (PSF), introduced in 1994 with the aim of advancing universal coverage of the health system, led to an increase in informality, particularly among workers with low levels of education, estimated at 8-10 %. In Mexico, the Seguro Popular program, which extended health coverage to informal workers, also caused a decline in formal employment. In Colombia, the Subsidized Health Regime, the mechanism by which the poorest population has access to medical services through a state-subsidized benefit plan, caused a reallocation from formal to informal jobs. In Uruguay, the conditional cash transfer program aimed at vulnerable households led to a 13 % drop in formal employment of beneficiaries, which also meant an increase in labor inactivity. Finally, in Argentina, the introduction of the Asignación Universal por Hijo (AUH), a program that provides a monetary subsidy per minor child to unemployed and informal workers, which was previously limited to formal workers, reduced the probability of formalization of beneficiaries by 40 %¹¹.

The main problem of social protection in Latin America is that it is segmented, fragmented. We have contributory systems for workers who are in a relationship with the companies, and the companies comply with the law. And for everyone else we have another system, a patchwork of health programs, non-contributory pension programs and other types of social protection programs that are an imperfect substitute, but which segment the population. Basically, how this works is that if you have a job in a formal company, you have access to this type of protection, and if you have a job in other conditions, you have access to this other type of protection.

Based on an interview with Santiago Levy

Another set of formalization policies are those aimed at increasing the cost of informality through increased taxation. There are two types of measures: those aimed at formalizing companies (extensive margin) and those aimed at formalizing informal workers employed in the formal sector (intensive margin).

Regarding the first type, the scarce evidence on the impact of a greater enforcement effort suggests a positive effect (De Andrade et al., 2016). Studies find that increased enforcement is associated with productivity gains at the aggregate level. These gains are, in part, a product of the exit of low-productivity informal firms and the reallocation of resources to more productive formal firms. Now, while these effects lead to higher productivity, they can also result in higher unemployment. However, a recent study finds that stricter taxation has no effect on unemployment because formal firms absorb workers displaced from the informal sector (Dix-Carneiro et al., 2021). 

Regarding increased taxation at the intensive margin, the results can be very different. Empirical evidence suggests that, while it may increase formal employment, it may also increase unemployment and labor inactivity (Almeida y Carneiro, 2012; Samaniego de la Parra, 2017). Likewise, increased taxation of formal firms may increase the fraction of informal firms. The reason is that higher taxation increases the costs of formality, especially for less productive firms (Ulyssea, 2018). 

The reduction of informality also requires improvements in the education of the labor force. Education and training policies are essential to increase worker productivity and facilitate their insertion into the formal sector.

Evidence indicates that the fall in informality in Brazil in the early 2000s was largely due to significant improvements in the educational composition of the population (Haanwinckel and Soares, 2021; Soares and Haanwinckel, 2017; Fairris and Jonasson, 2020). This suggests that educational policies may be the most effective tool to address the problem of high informality in the long run, as such changes occur slowly.

There are, however, training and skills formation policies with short-term effects. Several studies find that the Jóvenes en Acción program in Colombia, aimed at encouraging human capital formation of the young population in situations of poverty and vulnerability, has had positive and persistent effects on formal employment (Attanasio et al., 2011, 2017). A similar program in the Dominican Republic, Youth and Employment, also shows a positive and sustained impact over time on formal employment and wages of participants (Ibarrarán et al., 2014, 2015).

Other studies point in the same direction. We speak specifically of the meta-analysis by Escudero et al., 2019, which finds that training programs implemented in LAC have been particularly effective in comparison with other policies. It also concludes that programs that incorporate on-the-job training, such as internships, present a higher probability of having a positive impact on employability. In addition, it is observed that programs with a duration of more than four months and that are developed in collaboration with private institutions, or where providers go through a bidding process, have a greater impact.

Labor policies in the face of major technological changes

Education and training policies are essential to address major present and future technological changes, such as those related to the energy transition, digitalization, automation and artificial intelligence. In this context, it is essential to invest in the development of new skills, retrain workers and adapt education and vocational training systems to the labor market needs of the future¹².

In this sense, the creation of the so-called Skills Councils is a step in the right direction. These are spaces for dialogue where the public and private sectors and workers can identify skills needs and design strategies to meet them. They can also foster collaboration between the education and business sectors, ensuring that training programs are relevant.

Other active employment policies are also needed, as well as compensatory policies to support workers during the transition. On the active policy side, the creation of employment agencies can help the unemployed find vacancies and certify their skills. It is also important that information on job opportunities is accessible to all, including those with a digital divide. The cases of Job Bank in Canada and SkillFuture in Singapore can serve as examples¹³.

As for compensatory policies, an unemployment insurance system can be a crucial tool to mitigate the impact of technological change. However, the coverage of such insurance in LAC is considerably lower than in developed countries. In this sense, strengthening these insurance mechanisms is key to face the possible disruptive effects of technological change.

Finally, subsidies for low-income and less skilled workers are another tool to mitigate the adverse effects of change. These measures, however, should be complemented with job insertion and training strategies such as those described above, so as not to discourage formal employment.

Policies for the inclusion of women in the labor market

The low labor force participation of women is another widespread problem in the region. The average gap with men is almost 22 percentage points, while in OECD countries it is 10 points (figure 2.10). This not only implies a serious problem of social inclusion, as discussed in chapter 4, but also a problem of economic efficiency, as mentioned in chapter 1.

RED (Álvarez et al., 2020) made a detailed analysis of policies to promote women’s labor participation. The report highlighted two sets of measures that go hand in hand with the main determinants of the gender gap: the difficulties women have in reconciling family and work life and the level of formal education (Marchionni et al., 2019).

Addressing the first problem involves implementing maternity and paternity leave policies that contribute to sharing the burden of responsibilities in the home, essentially the care of newborn children. In this regard, one initiative that has been taken in many countries is to grant equal and shared leave. However, as this type of leave is usually offered to formal workers, its effectiveness may be limited where there is high informality.

Likewise, expanding the supply of care services and extending the school day would reduce the opportunity cost associated with motherhood and make it easier for women to enter the labor market.

Regarding the second problem, it is worth highlighting the following figures. For tertiary education levels, the gap in the labor participation rate in the region is 7 percentage points on average, while for lower levels it is around 20, 26 and 28 for secondary, primary and less than primary education levels, respectively¹⁴. In this context, active employment policies and programs to support female entrepreneurship can promote the inclusion of women in the labor market.