This article is part of the Online Forum: Rethinking Reforms

Latin America’s income gap with respect to the United States has widened over the past five decades. Analyzing 18 countries of the Region from 1960 to 2007, Fernández-Arias and Daude (2008) found that the income gap increased in 14 of them. This poor performance was largely due to lagging productivity rather than lack of valuable resources such as labor and capital.

Indeed, when compared to Emerging Asian countries, a more natural benchmark for the Region than the United States, the problem of low productivity levels becomes even more striking. While in 2008 Asia’s productivity levels relative to those of the United States were 20 percent higher than in 1960, Latin America’s fell by 30 percent over the same period. The implications of these numbers are clear: in order to realize sustainable gains in income per capita, productivity in the Region must be enhanced.

How can policies promote stronger productivity growth? This is one of the questions addressed by the IDB’s recently published Latin American and Caribbean Macroeconomic Report, Rethinking Reforms (IDB 2013). Since barriers to efficient factor reallocation will result in lower productivity levels, policies conducive to an economic environment in which firms and agents could efficiently reallocate factors represent a promising area for reform.

Figure 1 presents the potential gains of such a reallocation for a subset of countries in the Region, and they range from 50 to 100 percent. While those gains are measured only for the manufacturing sector, it is likely that the economy-wide effect of such policies would be even higher when other sectors with higher degrees of misallocation, such as the service sector, are taken into account.

Since a more efficient allocation of resources has great potential to improve growth, how to increase efficiency becomes a crucial policy issue. Many structural features may prove relevant in this regard, including fiscal policies, policies to improve access to credit markets, and interventions aimed at reforming monopolies and oligopolies in production markets. Given the specific characteristics of LAC economies, another area where reforms may lead to great gains in allocation efficiency is labor market reform. In fact, the Report argues that this area has lagged behind others in the Region’s reform agenda, leaving considerable room for growth-enhancing reforms.

A feature of particular concern is that labor markets in Latin America and the Caribbean display high levels of informality—both symptom and cause of frictions and inefficiencies. Figure 2 reports the proportion of workers employed informally in 18 countries in the Region. Even if there are large differences between countries, on average an extraordinary 56% of workers employed in the Region are informal.

A labor market characterized by high informality leads to inefficient allocation and lower productivity for three main reasons. First, informal firms are usually small, which frequently implies low labor training, limited adoption of new technologies or innovation, and, in general, unexploited economies of scale or scope. Second, informal workers experience higher turnover rates, and they are frequently self-employed in low-skilled jobs. As a result human capital accumulation is discouraged. Third, both informal firms and informal workers are at higher risk of engaging in illegal activities than formal firms and workers. Such relatively high degrees of illegal activity, combined with small firm size, imply that small firms’ access to credit markets is limited. Measuring the impact of informality on efficient allocation is extremely difficult, however, due to the many channels at work and the presence of numerous feedback effects. In an attempt to overcome these difficulties, the Report presents estimates on a panel of data from 12 countries in the Region; the estimates indicate that a 1 percentage point increase in the informality rate is correlated with an approximately 0.5 percentage point increase in the gap between Total Factor Productivity (TFP) in the Region and that of the United States. These and similar empirical results suggest that labor market reforms hold the potential for positive impacts across the Region.

This great potential notwithstanding, labor market reforms are difficult to achieve and consequently have taken place in only a handful of countries. When action has been taken, it has usually involved only one relevant area of reform, lacking the more integrated approach necessary to bring about effective change. We believe, however, that past inaction should not discourage future reforms. If countries wish to follow this route, the following policy recommendations flow from our analysis:

• Institutional features, distortions, and misallocations in labor markets vary greatly across countries; reforms should therefore be tailored to particular country characteristics and should take into account implementation capacities.

• In countries where informality rates are high, reducing informality may be among the key reform objectives, as a reduction in informality may significantly increase productivity and, hence, long-term growth.

• Labor market reforms to tackle informality are necessarily complex and may also require the reform of social protection programs, which may then require alternative forms of financing.

• As a result, reform design needs to take into account the following:

• a diagnosis identifying which institutional features are creating the most distortionary incentives;
• a design balancing both economic and social objectives; and
• a set of incentives inducing both workers and firms to operate in the formal economy.

References

Busso, M., Fazio, M., & Levy, S. (2012). (In)Formal and (Un)Productive: The Productivity Costs of Excessive Informality in Mexico. IDB Working Paper 341.

Fernandez-Arias, E., & Daude, C. (2010). Productivity and Factor Accumulation in Latin America and the Caribbean: A Database. Inter-American Development Bank.

Inter-American Development Bank. (2010). The Age of Productivity: Transforming economies from the bottom up. Washington, DC

Inter-American Development Bank. (2013). Rethinking Reforms. Washington, DC.

Levy, S., & Schady, N. (2013). Latin America's Next Challenge: Social Policy Reform. Working Paper. Forthcoming