Informality and the effects of trade in developing countries

The informal sector accounts for a large part of the economy in most developing countries, yet it is understudied in economics. The informal sector captures, broadly speaking, all activities that are invisible to the government: operations of firms that are not registered with tax authorities and/or the employment of workers who are not covered by labour market regulations and do not receive benefits or severance payments when laid off. Recent empirical work that has studied trade liberalisation episodes in developing countries suggests that shifts into and out of informality constitute important margins of labour market adjustment to economic shocks (Goldberg and Pavcnik 2003, 2018, McCaig and Pavcnik 2018, Dix-Carneiro and Kovak 2019, Ponczek and Ulyssea 2020). Notwithstanding this recent body of research, we know little about the overall labour market and welfare effects of trade liberalisation and other economic shocks in settings characterised by extensive labour market regulation, weak enforcement of this regulation, and informality, as in developing economies. 

We address this gap with our recent paper (Dix-Carneiro et al. 2021) by developing a structural equilibrium model of trade and informality. The framework features two broad sectors – tradable and non-tradable – that are connected through input-output linkages. Within each sector, heterogeneous firms choose whether to operate in the formal or informal sectors, subject to labour market frictions and a rich institutional setting. We estimate the model using multiple data sources, including matched employer-employee data from formal and informal firms and workers in Brazil, household surveys, manufacturing and services censuses, and customs data. We use the estimated model to perform counterfactual experiments to understand and quantify the effects of trade openness on informality, unemployment, welfare, productivity, and wage inequality. In this column, we summarise our main findings.

The effects of trade in the presence of informality

Throughout our discussion, we consider four scenarios for Brazil’s level of trade openness: (1) ‘benchmark’, which corresponds to the Brazilian economy in 2003; (2) ‘moderate’, which corresponds to a 20% reduction in existing trade barriers; (3) ‘high’, which corresponds to a 40% reduction in trade barriers; and (4) ‘autarky’, which corresponds to a large increase in trade barriers, making both imports and exports prohibitive.

Figure 1 shows that trade openness leads to a strong reduction in informality in the tradable sector. Moving to a high level of trade openness more than halves the share of employment in the informal tradable sector (from 8.1% to 3.6%).¹ As a result of declining import costs, domestic firms face stiffer foreign competition, which pushes low-productivity formal firms to informality, but also increases exit of low-productivity informal firms. Empirically, the latter effect dominates. 

Figure 1 Trade openness and informality

By contrast, openness leads to increased informality in the non-tradable sector, caused by the increase in total demand for non-tradable goods, both by consumers (due to higher real income) and by an increase in usage of intermediate non-tradable inputs mostly from exporters. Higher demand encourages productive informal firms to expand and formalise, but it also encourages entry of low-productivity informal firms, which is the dominant force. Considering both sectors together, moderate reductions in trade barriers lead to a net increase in the share of informal employment, which almost reverts to the baseline level when we consider a high level of trade openness. This result may explain why informal employment has not declined substantially in developing countries, despite their rapid integration in world markets in the past three decades (World Bank 2019).

A large literature has focused on the effect of openness on wage inequality (Cosar et al. 2014), which we revisit within our framework.² Figure 2 shows that wage inequality (measured by the standard deviation of log-wages) within the formal tradable sector increases by 10% as we move to a high level of trade openness. As in previous work, we find that greater openness leads to a higher exporter wage premium, driving an increase in wage dispersion within the formal tradable sector….