Keeping Track of Informality

The Brazilian government is expected to propose two different measures in the coming weeks that are symptomatic of the difficulties in doing business in Brazil. The first is legislation to be submitted to congress this week to substitute a previous presidential veto to the so called “Amendment 3”: legislation that would have restricted the authority of the revenue service to determine whether taxes were being evaded by a firm’s recurring use of one person service providers. These single-person firms are often created to circumvent Brazil’s labor taxes and the vetoed legislation would have conditioned tax authority interventions to court decisions. The government’s motivation seems to be to guarantee contribution levels to social security and the expected legislation will likely address this concern.


The second expected measure is a reduction in taxes paid by three labor intensive sectors: textiles and apparel, footwear and furniture. These sectors, as several other labor intensive sectors in Brazil (construction, domestic services) are largely informal, low productivity sectors. Here the government’s motivation seems to be to protect labor intensive sectors from foreign competition, expected to intensify with the appreciation of the national currency with respect to the dollar (an increase in import tariffs to 35% is also being pursued for the first two sectors).


Both the growth in single-person firms and the difficulties of labor intensive sectors can be traced in some measure to how Brazil’s firms’ and workers’ high taxes, bureaucratic burdens and restrictive labor legislation raise the costs of doing business under the existing rules, while inefficient courts and poor law enforcement reduce the incentives of doing so. The World Bank’s Doing Business indicators have called attention to Brazil’s poor performance in various of these issues. Among the 175 countries of the latest report, Brazil is 151st in ease of paying taxes, 139th in dealing with licenses and 120th in enforcing contracts, making its 99th rank in employing workers actually not look too bad.


The importance of calling attention the continuing environment is not to shed a negative light on prevailing conditions, but rather because high informality is likely a consequence. Roughly half of Brazil’s workers do not fully comply with labor legislation and some 10 million small businesses are estimated to operate in violation of some commercial law. To the extent that unfair competition in domestic markets reduces the incentives to invest, informality should have a hampering effect on productivity growth. Not too long ago, in a broadly circulated study, the McKinsey Global Institute attributed to informality responsibility for roughly 40% of the productivity gap between Brazil and the United States ( Since informality is largest in labor intensive industries such as construction, textiles, footwear, furniture and various types of services in which unskilled labor dominates, improved competition and investment in these sectors should raise productivity of relatively poor segments of the population. In other words, reduced informality should not only foster growth, but it is likely to be “pro-poor.”


I would be interested in further discussing the extent to which informality, not just in Brazil, but in Latin America in general, is or not a serious obstacle to productivity growth. Reform towards formalization is not easy, since it requires an agreement around what is fair and feasible and will likely affect the distribution of rewards. Moreover, it requires enforcing rules where they have so far been broken and where transgressions have been seen as legitimate. In Brazil, some recent measures have been taken, such as last December’s Small and Medium Enterprise General Law, that will enter into force later this year. It will be interesting to follow policies, as successes and failures should be revealing of the possibilities and difficulties of reform in Latin America.

4 Responses to "Keeping Track of Informality"

  1. Anonymous   May 16, 2007 at 4:43 pm

    US SEC Commissioner Atkins cited in a recent speech the work of De Soto on informality. Atkins stressed the importance of protection of property rights in reducing informality….is this an issue in Brazil as well?   Speech By SEC Commissioner Paul S. Atkins: The Financial Services Roundtable Lawyers Council 2007 Spring Meeting  11/05/07  ” one has to acknowledge that the legal and regulatory environment has affected the course that innovation has taken. Laws, of course, provide the solid framework without which innovation would not be as likely to happen at such a rapid rate. Protection of property rights, enforcement of contracts, impartial application of transparent rules – all the things that we commonly call the rule of law – give people confidence to invest their money with people with whom they do not have a personal relationship.  Peruvian economist Hernando de Soto in his book The Mystery of Capital discusses the importance of a strong system of property ownership.1 We often take it for granted, but the recognition and protection of contract and property rights by the government and courts is a central achievement of economically developed countries. Just think about it: our system of credit, mortgages, securities, derivatives, and all the securitized instruments that have developed during the past twenty years are built on a standardized, transparent system that evidences clear title to property and enforceability of contractual terms. The predictability and transparency allows others to see and assign an arm’s length value to the property. This clarity facilitates trading and allows owners, in Dr. de Soto’s words, to “unlock” the value inherent in their capital.  It is not that less developed countries are necessarily poor. They have plenty of entrepreneurial spirit and in fact a lot of capital. It is just that this capital is “dead,” in Dr. de Soto’s words. It cannot be tapped by the owners to realize the full value of their property. Thus, the owners have to rely on family, friends, and the informal economy to finance their businesses. Without the rule of law and transparency of assets, it is difficult for people to enter into transactions with unfamiliar people or property – to minimize risk, they will deal only with those whom they know and trust. The risk, and thus the cost, to them of doing otherwise may prove to be prohibitive. This protective economy is necessarily more constrained and less liquid than a more open alternative.  Behind every system of property rights, of course, there has to be a system that protects and vindicates those rights. A vigilant, honest, predictable policeman certainly contributes to investor confidence. In a system that is perceived to be relatively honest, transaction costs are lower than they are when extensive due diligence is required before routine financial transactions. The risks of investing are lower too. Alan Greenspan noted the particular importance of regulation in the securities markets: “Lax supervision may suffice in some kinds of markets, but stands little chance of succeeding in financial markets which rely so heavily on confidence and trust and the supporting legal infrastructure.”2

  2. Nouriel   May 16, 2007 at 5:08 pm

    Among the Latin American countries in the “Doing Business” rankings of the World Bank, Chile is ranked 28 among all world countries in terms of the ease of regulations for doing business.  Mexico is ranked 43  Uruguay is 64  Peru is 65  Colombia is 79  Argentina is 101  Paraguay is 112  Brazil is all the way down to 121  Paraguay is 131  No wonder that now Lula and the Brazilians authorities – as suggested by Uriarte – are now proposing reforms to make it easier “doing business” in Brazil. The Doing Business initiative of the World Bank and IFC has been very effective in naming and shaming countries that are ranked poor in its rankings of “Doing Business” ease or difficulty.  It must have been indeed a bit embarrassing for Brazil, a member of the BRICs to be ranked #121 in this list. Not that the other BRICs are any better: China is ranked #93, Russia is #96, India is even worse than Brazil at 134. So, if informality and difficulty in “doing business” are such negative factors for productivity how come that Brazil is growing slowly but China, India and Russia are growing fast? How much does informality matter for productivity and growth?

  3. Alex Uriarte   May 17, 2007 at 3:58 pm

    I do not have the answer to the property rights question off the top of my head, and the situation probably varies a bit depending on what kind of property we are talking about (land, intellectual property, etc.). Brazil does not rank particularly well on the World Bank’s Doing Business index for ease of registering property (124th) so that might be a first indication.  Nouriel, thank you for your comment, I think you make a good point and we could very well end up concluding that informality is not an issue at all for productivity growth in Brazil, or it may prove to be more important for particularly poor segments of the population than for aggregate growth.  Please note, however, that even if a poor business environment does not slow down growth, say, in China, this does not mean it cannot slow down growth in Brazil. Imagine someone having to make a decision based on his/her perceived costs and benefits (including risks): going formal or informal? Investing or not? From this point of view, obstacles in doing business and informality are additional costs, perhaps additional risks. However, this does not mean difficulties will halt formality or that informality will halt investments. The result depends on other costs as well as perceived benefits, and these may be very different in China and Brazil. Informality is just part of the story and it may make all the difference in one situation and none at all in another. Informality could also be concentrated in certain sectors that are not particularly the most dynamic at a particular point in time and have very little influence on aggregate investment. We cannot immediately jump from difficulties in doing business to informality to lower investment, but the fact that it has not been a factor in China does not mean it is not one in Brazil.  On the other hand, the point you make does put the issue into perspective and forces us to consider whether other factors are not more important. The following link to a World Bank note has some more information on informality in Brazil: