Volume 43 | Number 2 Spring 2008
Making Trade Liberalization Work for the Poor: Trade Law and the Informal Economy in Colombia
Response: Comments on Kevin Fandl’s Article: Making Trade Liberalization Work for the Poor: Trade Law and the Informal Economy in Colombia by Juan Pablo Calderón Meza
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II. The Informal Economy
The informal economy consists of workers who operate outside the constraints and benefits of legally sanctioned work. This includes those workers who are unable—either due to lack of employment opportunities, lack of appropriate job skills, or geographic location away from formal employment—to secure work that provides stable income, state benefits, and some predictability for future work. “The basic distinction between formal and informal activities relies entirely on the character of production and distribution processes, namely degree of compliance with the terms of the laws.”4 These workers generally do not pay taxes; however, they also do not benefit from job-related social services such as unemployment, social security, and pensions.5 Most importantly, these workers are often working with short-term “contracts” that can be terminated at-will by the employer, eliminating the possibility of financial planning for the worker.6
Informal work expands substantially during periods of economic adjustment, such as those that accompany political or legal reforms related to the economy.7 As workers lose opportunities in the formal sector due to increasing competition or technological advances that reduce the need for labor, they tend to move into informal employment to find the means to survive. These informal workers tend to be poorer and earn less income than their equivalents in the formal economy.8
The informal economy is made up of people who—constituting as much as 80% of the developing world—live or work without meeting formal licensing requirements or maintaining any formal right to their property.9 Hernando de Soto has been the key author in analyzing this sector to identify pathways to economic growth. De Soto first explored this concept in Peru in his book, The Other Path: The Economic Answer to Terrorism, which looked at various economic reforms that would potentially reduce the possibility of violence by the Shining Path (Sendero Luminoso) in Peru in the 1980s and 1990s.10
Informal markets consist primarily of specialized activities, such as street vending, carried out by those who cannot meet their business needs through the formal legal system.11 The majority of vendors, according to De Soto, are women.12 In fact, this was confirmed by a recent case study carried out by the Colombian newspaper El Tiempo on the cellular phone minute vendor market in Colombia.13 The economic contribution of informal vendors is substantial in economic terms as they occupy a substantial portion of the national economy.14 Operating in the extralegal sector, informal market vendors meet a critical need in developing countries: providing goods such as foodstuffs, crafts, textiles, and services such as phone calls and transportation.15 Because of their status (or lack thereof), they do not enjoy the benefits of formal businesses. Moreover, without operating licenses and access to credit, their prospects for exporting goods and services are limited, and they are unable to contribute in a meaningful way to the global economy.
De Soto goes on to argue that property rights are the missing component in effective development strategies.16 Without the right to use, transfer, or sell it, property is a limited-value asset. Yet the informal sector maintains informal ownership over substantial property in many developing countries. Labeling this valueless property “hidden capital,” De Soto finds that the informal sector significantly impairs many developing countries’ ability to grow. He pushes for property reform through a semi-redistributive scheme (for example, titling unused property to the benefit of those that would use it most productively). To achieve this, De Soto turns his attention to legal reform.
De Soto argues that the legal and regulatory barriers to becoming formal in many developing countries result in costs that are indicative of bad law for economic development.17 While De Soto uses Peru in 1986 as an example of the difficulties in this process, more recent and applicable data is available from the World Bank, which shows that it takes roughly forty-four days to start a business in Colombia and costs 19.8% of annual income (estimated to be $2290 in GNI per capita).18 Beyond this initial registration, businesses in developing countries are further burdened with regulatory compliance, including recordkeeping, report filing, and federal compliance, which De Soto estimated to consume roughly 40% of employee time.19 In this sense, companies are judged by how well they comply with the law rather than on their business acumen.20 Accordingly, entrepreneurial activity is severely restricted in both the formal and informal sectors, albeit for different reasons.
De Soto continued his research of informal economic development in his more famous book, The Mystery of Capital. Utilizing his team of researchers as guinea pigs operating informal businesses in Peru, De Soto pursued the reasons for informality and how to move toward formality in developing countries. He found that informal business operators do indeed avoid some formal costs, such as taxation and compliance with the law, but are “taxed” in other ways through a lack of property rights and the resulting need to constantly hide their business from authorities.21 “What determines whether you remain outside [the formal sector] is the relative cost of being legal.”22
Continuing his earlier argument, De Soto contends that it is the law that gives property its value.23 Formalizing property is necessary for economic growth.24 De Soto concludes that without a “formal property system, a modern market economy is inconceivable.”25 He contends that economies become informal primarily because of the legal system, or more precisely, the system of contract enforcement in developing countries.26 He sees this system as the primary motivation to move from the legal to the extralegal sector.27 Yet most informal communities have already developed their own systems of extralegal contract enforcement, providing an efficient means of temporary or interim contract management.28 Thus, De Soto argues that a bridge must be built between the formal and the informal systems of contract enforcement.29 In this regard, this Article is primarily concerned with the divide between formal and informal systems as they pertain to labor contracts.
More recent research by Sugata Marjit and Dibyendu Maiti at the Center for Studies in Social Science (Calcutta) and the Center for Development Studies, respectively, shows that the informal sector comprises as much as 70–80% of the economy in many developing countries, and as much as 90% if agriculture is taken into consideration.30 The goods and services produced in this sector are vertically linked to goods and services in the formal sector.31 This important finding corrects prior studies of this sector which showed a minimal relationship.32 Markets are either local, national, or export (international), according to Marjit and Maiti.33 Informal workers generally cannot participate beyond the local market unless they utilize middlemen or traders to carry their goods to those broader markets. When they do, the middlemen extract a portion of the profit from the good.34 “If the artisans wish to avail themselves of the external markets, they become tied to master enterprises (the formal producers) and traders.” 35 The authors contend that deregulation is the most effective approach to improve the conditions of informal workers.36 Echoing these sentiments, Anne Trebilcock argues that “while some informal workers provide low-cost inputs to global production systems, the majority are excluded from the opportunities of globalization and confined to restricted markets.”37
Pinelopi Goldberg and Nina Pavcnik wrote a particularly insightful paper discussing the effects of trade liberalization on the informal sector in Latin America. They conclude that while there is no such linkage in Brazil, there was a linkage in Colombia before the completion of major labor market reforms in the 1990s.38 They begin by pointing out the dearth of evidence supporting the relationship between informal employment and trade policy.39 The authors question the traditional hypothesis that as competition increases, firms are more likely to resort to subcontractors and other informal workers to cut costs.40 They contend that if this were true, firms would have done this long before the increase in competition (perhaps stringent labor laws prevented firing such workers).41
The authors focused on Colombia and Brazil due to their recent major labor market reforms and large informal sectors.42 Colombia reduced its trade barriers between 1984 and 1994, with the largest reforms taking place in 1990 and 1991.43 Between 1984 and 1998, the average tariff in Colombia declined from 27% to 10% (an aggregate measure that does not accurately reflect the tariff on goods produced directly or indirectly by the informal sector).44
Prior to 1990, Colombia maintained very strict labor laws that prevented the firing of workers for unjust reasons.45 In 1990, Law 50 was passed, which significantly reduced the costs of firing workers and increased labor market flexibility.46 Via statistical analysis, the authors conclude that a decline in the tariff for a certain industry resulted in a higher probability of informal employment prior to the 1990 reform than after the reform.47 However, despite the loosening of labor restrictions on firing workers, formal employers were also required at this time to provide social services, savings accounts, and vacation time for workers.48 Accordingly, many employers resorted to the use of service contracts to hire workers, thereby avoiding formality and the need to offer these benefits to their workers.
The authors found that informal workers in Colombia tend to be older, less educated males,49 a finding that contradicts many of the reports on this economy. Moreover, their definition of “inequality” as the difference between those with good and bad jobs seems inappropriate in light of existing studies that define inequality in terms of differences in income rather than quality of work. Nonetheless, they find that work in the informal sector is less satisfying, yielding fewer benefits than work in the formal sector.50 The primary industries in which these authors find informal workers employed in Colombia are in the “manufacture of wood and wood products, agriculture, restaurants and hotels, and household services.”51 Goldberg and Pavcnik conclude that labor market institutions are critical when analyzing the effects of trade policy on employment.52 When operating in rigid labor markets, firms are more likely to respond to increased foreign competition by reducing formal employment.
Anne Trebilcock, Deputy Director of Policy Integration at the International Labor Organisation (ILO), provided a comprehensive summary of the 2002 international labor conference in which the issue of informal work arose. The ILO recognized at this session the important contributions that informal work makes to the global provision of goods and services.53 Speaking about the informal workers, the ILO found that “although they are operating within the formal reach of the law, the law is not applied or not enforced; or the law discourages compliance because it is inappropriate, burdensome or imposes excessive costs.”54 Because linkages exist between formal and informal work, the ILO set forth several recommendations for the betterment of the informal economy.
Importantly, the ILO recognized that the elimination of the informal economy is not a reasonable or desirable goal. Rather, it suggested removing the negative aspects of the informal economy while ensuring the protection of the opportunities for entrepreneurialism and livelihood that informal work provides.55 This protection specifically includes the right to decent work and social security coverage. While not directly linked with poverty, working informally does indicate income variability and instability.56
According to the report, bad macroeconomic and social policies are often at the root of expanding informal economies.57 These factors include the lack of a good legal and institutional framework, good governance, and the proper implementation of laws and policies. In particular, the report suggests enacting legislation governing employment relationships, enforcement of rights and protections, easy access to legal dispute resolution mechanisms, lower costs of establishing new businesses, and laws that protect property rights and title assets.58 To promote these interests, the ILO suggests the protection of freedom of association, including the proliferation of business associations to protect the rights of informal workers.59
The report finds that labor laws have not kept pace with the changing nature of labor markets. With regard to informality, an interdisciplinary approach, such as the one incorporated in this Article, is the best mechanism to seek adequate solutions.60
A. The Informal Economy in Colombia
Colombia maintains one of the largest informal economies in the developing world, with roughly 60% of its population working outside the bounds of the law.61 This suggests half of the population works without job security, without reasonable livable wages, with little or no public service benefits such as social security or medical coverage, and is likely on the road to worsening poverty. According to some authors, this fact represents one of the greatest challenges to the development of the country.62
The growth of the informal sector in Colombia may be partially linked to the rapid growth of the nation’s urban areas, a result of mass migration and displacement of workers in rural areas by the guerillas.63 Conditions which contribute to increased migration “ha[ve] a large impact on the probability of being employed in the informal sector.”64 Additionally, the informal economy grew due to a decline in the demand for labor during the economic downturn of the 1990s.65
Moreover, according to Francisco Thoumi, the former chief of the International Economics and Infrastructure section of the Inter-American Development Bank, the rise in the informal economy, which he posits began in the 1970s, is one of the main reasons for a weakening rule of law in Colombia.66 Thoumi finds that the expanding informal economy has “made respect for the law more costly and . . . has made engaging in illegal activity more acceptable.”67
While some authors have drawn linkages between informal work and the formal global economy,68 the majority of informal workers are excluded from global opportunities and are “confined to restricted markets.”69 Thoumi argues that the growth of the informal economy has made it more difficult for Colombia to compete internationally in markets where economic growth has the potential to increase income and well-being. His conclusion is largely founded on the substantial drug trade, where many Colombian youths work in place of gaining an education or seeking more skills-intensive industry training.70
International trade reforms can have a substantial, negative impact on the labor market in a developing country. Dani Rodrik finds that global trade favors capital-intensive as opposed to labor-intensive industries, placing most developing countries with their labor-intensive economies at a significant disadvantage.71 Additionally, trade liberalization often has the effect of increasing competition in the domestic marketplace. As demand for labor decreases, informal workers proliferate and the number of workers with unstable and generally lower-paying positions increases:
[G]lobal competition tends to encourage formal firms to shift formal wage workers to informal employment arrangements without minimum wages, assured work, or benefits and to encourage informal units to shift workers from semi-permanent contracts without minimum wages or benefits to piece-rate or casual work arrangements without either assured work, minimum wages, or benefits.72
Informal workers in Colombia primarily occupy service industries, such as hotels and restaurants, as well as the transportation sector—operating buses, taxis, and other public transit. Thus, taking a bus or eating out in Colombia more likely than not means your service provider is underpaid and working without the knowledge that they will have a job the next day. These dynamics result in a highly competitive marketplace in which scarce jobs are fought over by the workers and maintained only at the demand of the employer.
Until recently, labor laws in Colombia made it difficult to relieve formal, salaried employees from their position without good cause.73 To increase their flexibility and control over the employment relationship, employers routinely hired informal workers as day laborers or non-permanent subcontractors without benefits. However, major labor reforms in 1990–1991, in conjunction with the development of a new Constitution, changed these laws to make it easier to release employees.74 Accordingly, the reliance upon informal workers has decreased in some sectors.
Yet despite this change, the informal sector in Colombia is expanding rather than contracting.75 Less work available due to increases in technology and increasing foreign competition, combined with a growing labor force, lead many workers to seek alternative employment opportunities. In Colombia, this is evident in gratuity-oriented positions, such as parking lot attendants guiding your car into and out of spaces for a few coins, entertainers and window washers at every stoplight looking for monedas, and supermarket grocery baggers that will pack your food and walk it to your car (or all the way to your house if you like), all earning nothing more than you are willing to give. These informal workers cost nothing to the owner of the parking lot or grocery store, yet they provide a service that some people find useful and for which they are willing to tip. What is increasingly apparent, however, is that these informal positions are themselves in high demand. Using the supermarket grocery bagger example once again, you will rarely find less than two workers bagging your groceries at the same time, and in some cases as many as four or five. Demand for the change in your pocket is growing.
This problem is not unique to Colombia, but Colombia stands out as an example of a failure to reduce the reliance on informal work despite overall economic growth. Colombia is a middle-income country, an active member of the GATT and WTO, and the fifth-largest recipient of U.S. foreign assistance monies.76 All of this indicates that Colombia should be able to invest in its population in order to prevent more workers from falling into the poverty trap of working in unsustainable positions. Yet as the informal sector grows, it becomes apparent that increased aggregate economic growth is failing to alleviate a substantial economic development problem.