Labor Market Rigidities and Informality in Colombia

Informality has been at the center of the economic debate in Colombia as a result of the high levels prevalent in the country and its substantial increase during the 1990s. The informal sector includes a range of heterogeneous activities, from unpaid labor to a number of unregulated salaried jobs. Informality is thought to have negative implications, mainly through inferior working conditions, lack of formal health, unemployment, and old age insurance, and low productivity levels for firms. Alternative definitions of informality have been proposed in the literature, each implying a different approach to this phenomenon.

The Colombian labor market is characterized by high nonwage costs and a high minimum wage relative to the economy's level of productivity. Nonwage costs are costs faced by the employer and include health and pension contributions, payroll taxes, and transportation (commuting) subsidies.¹ These labor market rigidities imply that the formal sector, where workers and employers comply with regulations, is less able to adjust to the business cycle than the informal sector. Hence, economic policy originally designed to protect workers might actually be worsening employment conditions by increasing informality.

This paper brings new elements to the study of informality in Colombia and suggests directions for future research. We study the evolution of informality between 1984 and 2006—a period that includes both expansions and recessions, structural reforms of the labor market, and significant variation in nonwage costs and the minimum wage. By generating individual or city-level variation, we are able to disentangle the effects of nonwage costs, the minimum wage, and the business cycle on informality. We begin our analysis by considering alternative definitions of informality, two of which we adopt (primarily driven by data availability): the definition used by Colombia's National Administrative Department of Statistics (DANE, for its initials in Spanish), which is based on firm size and occupation, and a definition based on contribution to health insurance (as a proxy for compliance with labor market regulations).

With regard to the empirical analysis, we first estimate the probability of being informal as a function of individual characteristics, the business cycle, and labor market rigidities. Our results suggest that rises in nonwage costs and the minimum wage are highly correlated with informal sector growth. Next, we look at the transitions between sectors. On the one hand, we measure the transition flows between the formal and informal sectors using transition matrices. These describe, for example, the proportion of job destruction in the formal sector that is absorbed by the informal sector. On the other hand, we estimate the effect of labor market rigidities on the likelihood of switching sectors (controlling for idiosyncratic characteristics and macroeconomic conditions), to determine their role in the decision to make the transition. We find that labor market rigidities are important drivers of the transition into informality, particularly for low-skilled workers. However, further research is needed to understand the channels through which labor market rigidities affect the transition into the formal sector, in particular for workers with high educational attainment.

One strand of the literature associates informality with labor market rigidities in Colombia. Núñez finds a positive relation between informality and income taxes on labor revenue for the period 1988–98.² Sánchez, Duque, and Ruíz find that increases in labor market rigidities increase informality, unemployment, and its duration, based on aggregate data.³ Using a firm panel from the industrial sector, Kugler and Kugler find that a 10 percent increase in payroll taxes decreases formal employment between 4 and 5 percent.⁴ Santa María, García, and Mujica use individual data from Colombia's household survey; they find that the subsidized regime, financed through nonwage costs, has increased the incentives to become informal, thus acting as a subsidy to informality.⁵ Our results suggest that an increase of 10 percentage points in nonwage costs is associated with an increase of 5 to 8 percentage points in the size of the informal sector. Some authors characterize informal workers and study informality from a segmentation perspective. Flórez finds...