Program In Comparative International Development Department of Sociology Johns Hopkins University Baltimore, MD. 21218 USA Working Paper #5 THE INFORMAL ECONOMY IN LATIN AMERICA: DEFINITION, MEASUREMENT, AND POLICIES by Alejandro Portes and Richard Schauffler December 1992 This project was funded under purchase order number B9K- 21786 from the Bureau of International Labor Affairs, U.S. Department of Labor. Points of view or opinions stated in this document do not necessarily represent the official opinion or policy of the U.S. Department of Labor . Table of Contents I. Introduction . . . . . . . . . . . . . . . . . . . . . . . II. Definition and Origins. . . . . . . . . . . . . . . . . III. Measurement . . . . . . . . . . . . . . . . . . . . . . A. The Dual Economy (PREALC) Approach. . . . . . . . . B. The Unregulated Economic Activity (De Soto) Approach . . . . . . . . . . . . . . . . . . . . . . C. The Unregulated Labor Market (Portes and Castells) Approach . . . . . . . . . . . . . . . . . D. Macroeconomic Estimates . . . . . . . . . . . . . . IV. Articulation of the Formal and Informal Sectors. . . . . . . . . . . . . . . . . . . . . . . . V. Policies toward the Informal Sector . . . . . . . . . . . I. Introduction The aim of this paper is to provide an overview of the informal sector in Latin America. We will review the major efforts to define the informal sector, to explain its origins, to estimate its relative size, and to specify the articulation between formal and informal activities. We will also discuss the role of public policy and its bearing on the growth or contraction of informal enterprise with a particular focus on Mexico, in light of the impending North American Free Trade Agreement. II. Definition and Origins Since the concept of the informal sector made its debut in the early 1970s, debates about its precise definition have centered on several issues. Following Raczynski (1977), it is possible to divide these into questions about its internal structure and its function. The former question refers to whether informality pertains to characteristics of a particular group of individuals or a set of economic enterprises. The second question refers to a more substantive issue, namely the relationship of the informal sector to the modern or formal economy. More specifically, the latter debate centers on whether the informal sector is a set of marginal survival activities of the urban poor and as such a temporary manifestation of underdevelopment, or represents instead a relatively permanent structural feature of modern economies, integrated with its lead sectors. The origins of the concept of informal economy are conventionally traced to an International Labor Office (ILO) study of urban workers in Ghana. In his report to the ILO, economist Keith Hart postulated a dualist model of income opportunities of the urban labor force, based largely on the distinction between wage employment and self-employment. The concept of informality was applied to individuals who engaged in self-employment; indeed, in one sense it was simply a renaming of the urban poor, also referred to at the time as the "marginal" or "traditional" population. Nevertheless, Hart emphasized the notable dynamism of informal activities and their diversity, which went much beyond the conventional portrayal of the urban self-employed as "shoeshine boys and sellers of matches" (Hart 1973: 68). This dynamic characterization of the informal sector was subsequently lost in models elaborated by the ILO World Employment Programme, which essentially renamed the distinction originally advanced by Lewis (1954) between modern and traditional sectors. The ILO defined the informal sector as an urban "way of doing things," whose enterprises are characterized by: a) low entry barriers in terms of skill, capital, and organization; b) family ownership of enterprises; c) small scale of operation; d) labor-intensive production with outdated technology (relative to the formal sector); and e) unregulated and competitive markets (Peattie 1980). Additional characteristics derived from this definition included low levels of productivity and a low capacity for accumulation (Tokman 1982). In publications of the ILO's Regional Employment Programme for Latin America (PREALC), employment in the informal sector is consistently referred to as "underemployment" affecting those workers who fail to gain entry into the modern economy (PREALC 1985; Garc¡a 1991). This characterization of informality as the excluded sector in segmented economies was utilized in numerous subsequent ILO, World Bank, and PREALC case studies of urbanization, poverty, and labor markets in Third World cities (Sethuraman 1981; Mazumdar 1975; Souza and Tokman 1978; Gerry 1978; Tokman 1978). This conception of informality led to a theory of its origins in terms of excess labor supply. The classic statement is the work of Paul Bairoch (1973), who supplied the theoretical terminology in which subsequent causal analyses from this theoretical perspective have been couched. Bairoch used the term "hyper-urbanization" to refer to the consequences of accelerated rural-urban migration that brought huge masses of job-seekers to cities. The inability of modern industry to absorb them led directly to "hyper-tertiarization," as the excluded masses invented their own employment in commercial and service activities of minimal productivity (Moser 1978). This supply/demand model was subsequently refined by PREALC analysts who emphasized the causal role of insufficient capitalist investment in Latin America. Tokman (1982), in particular, noted that it is more difficult for contemporary Latin America to create formal employment than it was for the developed countries, such as the United States, in their periods of industrial expansion. The principal reason for the difference is the use of capital-intensive technologies during the late industrialization of Latin America, which created fewer jobs than earlier technologies had done at comparable stages in the evolution of now developed capitalist countries. In addition, the high costs of modern capital- intensive technologies discouraged their diffusion and eliminated access to them for small enterprises. This trend further limited job creation in the formal sector and exacerbated productivity differentials between large modern sector firms and small informal enterprises (Garc¡a 1982). Yet, PREALC analysts also noted that, despite these obstacles, urban formal employment in Latin America grew at a respectable annual clip of 4.1 percent between 1950 and 1980. The problem was that the urban labor force grew equally fast so that, by 1980 and according to PREALC's estimates, the informal sector still represented 23.8 percent of the urban economically active population (EAP) (Garc¡a 1991: 2-3). Despite the simultaneous growth of urban formal and informal employment during the long period of Latin American economic expansion after World War II, PREALC's conceptualization of the informal sector continued to view it as countercyclical; being the refuge of those who could not find access to modern employment, the informal sector was expected to contract with rapid growth and to expand in order to absorb the displaced during economic downturns (Marshall 1987). We will examine the empirical evidence on this point for the period of regional economic downturn during the 1980s below. A radically different perspective on the informal sector was popularized in the late 1980s by the Peruvian economist Hernando de Soto in his account of the economic organization of housing, trade, and transport in Lima (De Soto 1989). For De Soto, the informal economy is not a precisely defined sector, but comprises all extralegal economic activities, including both market production and trade as well as direct subsistence production. The origins of the phenomenon are to be found not in the dynamics of the labor market, but rather in the excessive regulation of the state. The "mercantilist" Latin American state survives on the basis of granting the privilege of legal participation in the formal economy to a small elite. Informality is the popular response that successfully breaks down this legal barrier. Popular disregard for legal restrictions on economic activity leads to de facto deregulation of the economy. More than a survival mechanism in response to insufficient modern job creation, informality represents the irruption of real market forces in an economy straitjacketed by mercantilist regulation. From this perspective, the informal entrepreneur is portrayed not as a low-productivity marginal producer, but something of an economic hero who manages to survive and even prosper despite state persecution of his activities. For De Soto, the massive population shift from the countryside to the cities between 1940 and 1980 provided the social base for the informal economy. The dominant urban elites were hostile to the migrants because "each person who migrates to the capital is in some way a potential competitor and it is a natural inclination to try to avoid competition" (1989: 11). Rural migrants to Peru's cities were thus transformed into informals by the legal barriers to their participation in the mainstream economy erected and enforced by the state. Informal economic activity was originally a survival mechanism, the only way to secure housing and money incomes. Gradually, however, these activities expanded in response to the rigidities and limitations of the mercantilist economy. Informal provision of goods and services proved to be cheaper and more efficient, leading, in Lima at least, to the conversion of unregulated enterprise into the real economic core of many industrial and service sectors. This view of the development of informality is reflected in De Soto's elaboration of a series of stages (10 for housing, 13 for trade, and 17 for transport) that mark "the steady advance of informal over formal society and the latter's corresponding retreat" (1989: 75). A third perspective advanced by Castells, Portes, Roberts, and others may be loosely labelled "structuralist" insofar as it focuses on the structure of relationships between activities regulated and unregulated by the state. It shares elements with the other two in viewing the origins of the informal economy as closely linked with excess labor supply (PREALC), but defining it primarily by its relationship to state enforcement (De Soto). Contrary to the ILO/PREALC approach, however, the informal sector is not defined as a set of marginal activities excluded from the modern economy, but as an integral part of the latter. Contrary to De Soto's argument, informality is not viewed as the irruption of "true" market forces, but rather as part of the normal operation of capitalism. Contrary to both previous perspectives, informality is not seen as a phenomenon limited to peripheral economies but one which is also found in advanced countries (Capecchi 1989). For this third approach, the informal sector is not synonymous with poverty; it is defined instead as all income-earning activities that are not regulated by the state in social environments where similar activities are regulated (Castells and Portes 1989: 12). Unregulated activities, in turn, have been defined as "activities that circumvent the costs and are excluded from the benefits and rights incorporated in the laws and administrative rules covering property relationships, commercial licensing, labor contracts, torts, financial credit, and social security systems (Feige 1990: 992). Analysts writing from this perspective begin by noting that activities called "informal" today were the norm during the nineteenth and early twentieth centuries when most industrial and service enterprises were small scale and there was scant regulation of the economy. During the late nineteenth and twentieth centuries, rapid industrialization in a number of countries was accompanied by increasingly elaborate tax and labor codes that attempted to regulate most aspects of the growing modern economy (Mesa-Lago 1978; Portes and Benton 1984). The enactment of a complex legal framework was due to a plurality of causes: growing pressures from labor unions seeking security and protection for their members; the regulatory inclinations of a growing state bureaucracy; and, in the Third World, the desire to imitate practices of the advanced countries and the rise of populist regimes seeking to gain favor with the urban masses. The result was to consolidate a sharp division in both advanced and less developed countries between a modern economy subject to state-enforced controls and those small enterprises and individuals that survived outside their reach (Roberts 1989, 1990; Moser 1978). In Latin America, a permanent condition of excess labor supply and a historical tradition of unrestricted labor utilization produced new reactive dynamics whereby small firms sought to avoid all contact with state agencies and large firms sought to bypass, whenever possible, their controls. This was achieved through the twin mechanisms of casual, off-the-books hiring by both large and small firms and by subcontracting of production and services to small unregulated enterprises. Although these mechanisms are well concealed from public view and hence seldom make their way into official statistics, several analysts contend that they are widespread, representing significant proportions of the local and national economies (Castells and Portes 1989; Bener¡a and Roldan 1987; Birkbeck 1979). Contrary to the characterization of the informal sector as a simple excess labor supply phenomenon, the structuralists regard its existence as due, in large measure, to alternative forms of labor utilization. Many informal entrepreneurs and workers are integral parts of the modern economy, but are not counted in it due to their incorporation in ways that avoid state regulation and accounting. Contrary to De Soto's perspective, these market dynamics, in opposition to formal rules, does not arise exclusively "from below" as part of some populist rebellion, but as an integral element of a strategy of capital accumulation by modern firms. The latter adapt the organization of production and labor utilization to the peculiarities of national economies where socially advanced but costly regulatory codes coexist with an abundant and easily accessible labor supply (Roberts 1976). According to this third view, the social dynamics of labor utilization in the context of a state-enforced division between protected and unprotected workers helps explain the resilience of Latin American urban informal employment during the prolonged post-World War II period of rapid industrialization preceding the current crisis. It also accounts for the finding of a number of surveys that informal entrepreneurs (owners of small workshops and labor brokers) receive earnings that are, on the average, two or three times higher than those of formal sector workers (Carbonetto et al. 1985; Portes et al. 1986; Fortuna and Prates 1989). This would be unlikely if informal entrepreneurs were exclusively engaged in marginal survival activities, but is perfectly compatible with their role as middlemen, vendors, and subcontractors for firms in the formal economy. A final corollary of the structuralist approach is that informal activities are largely pro-cyclical since they are integrally linked with those in the modern sector as part of a single economy. Hence, in periods of economic expansion (such as that between 1940 and 1980 in Latin America) and assuming constant levels of state regulation, we would expect to see growth in both formal and informal activities, while in periods of contraction both will suffer. When economic downturns are severe, open unemployment will increase since a weaker informal economy is unable to provide gainful employment for the displaced. This prediction runs contrary, of course, to the view of the informal economy as a countercyclical mechanism. III. Measurement Because of its very nature, the phenomenon of informality is difficult to measure since it consists generally of activities unrecorded in official statistics. For this reason, various approximations have been attempted. They all suffer from serious limitations stemming from the gap between the elusive and highly dynamic character of informal activities and the relatively rigid categories used to apprehend it. For example, the division of the economically active population into "formal" and "informal," commonly reported by PREALC and other organizations, does not take into account the fact that the same workers often participate in both types of activities, dividing their time between them or alternating between both types of employment during their life cycles (Roberts 1989). Regardless of the empirical approximation adopted, there is consensus, however, that the informal sector represents a very substantial proportion of most Latin American economies and that it employs a large share of their urban labor forces. Moreover, there is growing agreement that these activities are not declining, but continue to represent a resilient element of these economies. A. The Dual Economy (PREALC) Approach Table 1 presents estimates of informal employment for selected countries and for Latin America as a whole for 1960, 1970, 1980, and 1989. These estimates are drawn from various PREALC publications. Although the empirical definition of what constitutes informal employment has been modified over the years, it continues to reflect PREALC's and ILO's predilection for defining the sector as marginal activities of low productivity. The urban informal sector (or SIU in its Spanish acronym) is said to be composed of the sum of self-employed workers, minus professionals and technicians, unremunerated family workers, and domestic servants. The latter category is excluded from some estimates, although it is included in those presented in Table 1. By this method, PREALC estimates the size of the urban informal sector in Latin America as 30.8 percent of the urban EAP in 1960, 30.2 percent in 1980, and 29.5 percent in 1989. ------------------------------------------ Table 1 about here ------------------------------------------ These estimates have been criticized on several grounds. First, they exclude unprotected wage workers in small firms and disguised workers laboring at home for a piece rate. They also exclude those hired casually or "off the books" by the large firms. Second, as noted above, these estimates classify individuals as either formal or informal, ignoring the fact that it is common for workers to alternate between the two sectors or combine employment in both (Ybarra 1989; Roberts 1989; Escobar 1986). Third, this method of estimation homogenizes the informal sector, counting informal workers and informal entrepreneurs as one and the same. On the basis of this estimating procedure, PREALC reports that the informal sector in Latin America remained almost constant at about 30 percent of the urban EAP between 1950 and 1980, despite the growth of the gross domestic product (GDP) during this period at an annual weighted average rate of 5.7 percent (Wilkie and Perkal 1985; Wilkie and Reich 1978: 238). For 1980-1989, PREALC estimates that urban informal employment grew at just over twice the annual rate of formal sector employment: 6.2 percent in the informal sector compared to 3.0 percent in the formal (PREALC 1987: Table 2). In all nine Latin American countries surveyed, the informal sector increased its proportion of the employed non- agricultural population during the 1980s (PREALC 1987: Table 6). Future projections estimate that informal employment will rise by the end of the 1990s to 35.6 percent of the urban EAP for Latin America as a whole, with individual country estimates ranging from 28 percent to 46 percent (PREALC 1990). PREALC analysts explain this growth by the countercyclical relationship between the informal and formal sectors. Thus, with economic decline throughout the region in the 1980s, the informal economy expanded rapidly to absorb those displaced from regular employment. B. The Unregulated Economic Activity (De Soto) Approach De Soto and his associates measure informality directly through surveys of participants in extralegal economic activities. De Soto defines informality in terms of a single criterion (the illegal pursuit of legal economic ends) and his measurement of informal activity is based on census-taking of informal economic actors in selected areas. In Lima, his study focused on three such areas: housing, transport, and petty commerce. De Soto hence includes a direct subsistence activity (housing) in his estimates of informality plus visible service activities, while excluding manufacturing and the concealed subcontracting activities highlighted by the structuralist approach. De Soto (1989) estimates that, in 1982, 42.6 percent of all housing in Lima was informal, providing shelter to 47 percent of the city's population. The replacement cost of this informal provision of shelter was calculated at US$ 8.3 billion. In commerce, the 91,455 street vendors counted in Lima are believed to support 314,000 people and to have generated gross sales of US$ 322.2 million per year. In addition, 39,000 others built 274 street markets with an estimated value of US$ 40.9 million that support 125,000 people. In transport, informal entrepreneurs invaded routes and gained control of 91 percent of the urban public buses and 80 percent of their seats. The 1984 replacement value of this informal fleet was calculated at US$ 620 million. Informal transport workers themselves estimated the value of infrastructure (gas pumps, repair shops, etc.) at US$ 400 million. In addition to these data, De Soto and his associates estimate that 61.2 percent of total work hours in Peru are dedicated to informal pursuits; that 48 percent of the economically active population is engaged in informal activities; and that the latter account for 38.9 percent of GDP, projected to rise to 61.3 percent by the end of the century (De Soto 1989: 12). The use of these indicators has been criticized by two British economists, who argue that the estimates of De Soto and his research team are invalid due to: 1) inappropriate use of monetary measures of transactions counted in the GDP, designed for use in developed economies; 2) poorly specified models; and 3) primitive use of econometric methods (Rossini and Thomas 1987, cited in P‚rez S inz 1991). The estimates generated by this approach also imply occupational homogeneity within the informal sector by failing to make any distinction between workers and entrepreneurs. A further problem is the failure to relate the size of the formal and informal sectors to each other. This deficiency is the result of the dualism posited by De Soto's perspective. The PREALC approach, although also limited by a dualistic definition, is more systematic in its attempt to estimate the relative magnitude of formal and informal activities. De Soto, on the other hand, makes use of surveys conducted by his own organization yielding figures whose validity is difficult to check independently (Bromley 1990). He does not attempt to reconcile these data with the results of other studies, offering figures mainly to demonstrate the magnitude of the informal economy. The category of "informal" itself remains amorphous, encompassing a wide variety of vaguely linked individuals, economic enterprises, and subsistence activities. C. The Unregulated Labor Market (Portes and Castells) Approach The third theoretical perspective defines the informal sector as all income-earning activities not regulated by the state, in contexts where similar activities are regulated. From this starting point, two empirical strategies have been used to estimate the magnitude of the informal sector. The two seek to assess the level of extra-legal or unregulated income-earning in the context of a single, unified economy. The first strategy estimates the size of the informal sector by the proportion of the labor force excluded from job-related legal coverage such as protection from arbitrary dismissals, unemployment compensation, accident insurance, paid leaves, and retirement pensions. The best work on social security protection in Latin America has been done by Carmelo Mesa-Lago (1985, 1991), whose estimates can be used to calculate the size of the informal labor force. Unfortunately, as Mesa-Lago himself notes, the quality of available official data is generally poor and seldom differentiates between types and levels of government protection. An increase in a particular type of program may lead government agencies to declare the majority of the workers "covered" when, in fact, most are still excluded from effective protection. This seems to have happened in Brazil, where the proportion of the EAP declared covered by the social security system leaped from 27 percent in 1970 to 87 percent in 1980. Most estimates of coverage or exclusion are reported for the total, not urban, EAP and do not differentiate between workers and small entrepreneurs. Table 2 presents recent estimates based on Mesa-Lago, supplemented by data from other authors. For comparison, the percentage of the total EAP reported by PREALC as informal is also presented. Despite serious reservations about the quality of social security coverage data, the evident trend in these figures is for higher estimates of the informal sector based on lack of social security protection than on the sum of employment categories used by PREALC. Except for Uruguay in 1960 and 1970 and Brazil in 1980, where particularly egregious instances of official misreporting seem apparent, the uncovered percentage of the EAP exceeds that defined as underemployed by PREALC by significant average margins. The range is from a few percentage points to over 50 percent of the national EAP. ------------------------------------------ Table 2 about here ------------------------------------------- These gaps can be interpreted as an approximation to the proportion of wage workers not covered by social security protection, an employment category implicitly defined by PREALC as formal and by the structuralists as informal. A second trend in the data is toward the reduction of the gap for most countries between 1960 and 1980. For Mexico, for example, the two estimates differ by 46 percent in 1960, but only 19 percent in 1980. Given the already indicated doubts about the quality of social security data, it is not clear whether this trend reflects a genuine expansion of state protection (and hence a reduction of informality, according to the structuralist definition) or is simply a case of inflated reporting for political or other reasons. A second measurement strategy has been to add directly to the PREALC categories of informal labor indicated above a fourth one composed of the proportion of unprotected wage workers. The latter category is empirically estimated as the proportion of the urban EAP working in microenterprises -- defined in different contexts as firms employing either 10 workers or less or 5 workers or less. Such microenterprises are assumed to avoid social security regulations and other state controls. This approach also assumes that employment categories included in the original PREALC estimates are composed primarily of unprotected workers. Table 3 presents selected estimates for various countries and years of the gap produced by this alternative approach. In most cases, the difference between both estimates is substantial. For Latin America as a whole in 1970, this method leads to an increase of 16 percent over PREALC's estimate of the informal EAP. ------------------------------------------ Table 3 about here ------------------------------------------ In recent years, PREALC researchers have come around to adopting the same method by incorporating workers employed in small firms in their estimates, hence eliminating the disparity. Structuralist attempts to measure informality share with PREALC's an inability to differentiate between individual workers and their activities. The ideal labor market measure from the structuralist perspective would be number of hours spent in regulated versus unregulated work. So far, however, no such reliable estimate has been produced. Several studies have been able, however, to distinguish between informal workers and entrepreneurs. For 1970, Portes (1985: 23), using an indirect estimation procedure, calculated that informal entrepreneurs represented approximately 10 percent of the Latin American EAP. A survey of Montevideo working-class areas in 1983-84 arrived at the same figure for the urban EAP (Fortuna and Prates 1989). In Bogot , Lanzetta de Pardo et al. (1989), on the basis of a 1984 survey of households conducted by the National Department of Statistics, estimated informal employers at about 5 percent of the urban EAP. And in Lima, a detailed study of the informal sector put the number of informal entrepreneurs at 39,333 in 1983, representing 8.4 percent of the SIU and 3 percent of the metropolitan EAP (Carbonetto et al. 1988: Table 36). The recent convergence in measurement procedures between PREALC and structuralist analyses is more apparent than real. It is based on the unavailability of better measures and on the belated recognition by PREALC of the need to incorporate small firm workers in their estimates. However, the similarity of estimates conceals enduring conceptual differences. For PREALC, the informal sector continues to be synonymous with activities of low capitalization and minimal productivity. For Castells, Roberts, Sassen, and other structuralists, it also includes modern production and service activities conducted outside the reach of state controls. The latter definition is congruent with the rejection of the dualistic conceptualization apparent in both the PREALC and De Soto perspectives. So far, however, this third school has not been able to produce estimates of informality fully congruent with its own theoretical definition. D. Macroeconomic Estimates A fourth measurement approach does not derive from any of the three theoretical perspectives discussed above, although it shares with the last two an emphasis on the unregulated or illegal character of the informal economy. Based on this definition, several U.S. researchers have attempted to estimate the magnitude of the informal or "irregular" economy as a proportion of national gross national product (GNP) on the basis of several macroeconomic assumptions. The pioneering work was conducted by Gutmann (1977, 1979) whose method was subsequently adopted and modified by Feige (1979) and Tanzi (1980, 1982). All of these "currency ratio" methods (Feige 1990) are based on the assumption that informal transactions are conducted mostly in cash in order to avoid detection by the fiscal authorities. The idea consists of arriving at an estimate of the currency in circulation required by the operation of "legal" activities and subtracting this figure from the actual monetary mass. The difference multiplied by the velocity of money provides an estimate of the magnitude of the informal economy. The ratio of that figure to observed GNP then gives the proportion of the national economy represented by informal or subterranean activities. Each method depends on the identification of a base period in which the informal economy is assumed to be insignificant. The ratio of currency in circulation to the reference figure (demand deposits for Gutmann; GNP for Feige; M2 for Tanzi) is established for this period and then extrapolated to the present. The difference between this estimate and that observed at present provides the basis for calculating the size of the informal economy. A second approach, called the "physical input" method (CEESP 1987), consists of establishing the ratio of some physical input of wide usage to GNP during a base period and then comparing it with later figures. Consumption of electricity has been the most commonly used variable since it is a basic production input and its income-elasticity relative to GNP can be calculated in a straightforward fashion. Assuming a relatively constant ratio of electricity consumption to GNP, it is possible to calculate an expected GNP for each year following the base period. The difference between that estimate and observed GNP is attributed to irregular activities. Using these methods, the Center for Economic Research of the Private Sector (CEESP) in Mexico, estimated the size of the country's "subterranean" economy between 1960 and 1985 (CEESP 1987). Its two estimates for the 1970-1985 period are reproduced in Table 4. The estimate based on currency in circulation follows Tanzi's method and that based on physical production input uses electricity consumption in gigawatts per year. As seen in the table, these methods yield estimates of informality ranging from 20 to 40 percent of GDP in the 1980s. Eliminating the "anomalous" year 1982, marked by the Mexican debt moratorium, the estimates stabilize in a narrower band of 25 to 38 percent. CEESP notes that, regardless of the method employed, the magnitude of the irregular economy appears to have increased steadily since the early 1960s. Figure 1 portrays this growing gap between the "official" and real GDPs, based on the physical input method. ------------------------------------------ Table 4 about here ------------------------------------------ Figure 1 about here ------------------------------------------ The weaknesses of these macroeconomic procedures have been noted by a number of analysts. First, the assumption that informal transactions take place mostly in cash is questionable in settings where checks and other instruments can be used with little fear of detection by authorities. Second, the assumption that informal activities did not exist in some arbitrarily designated period is also subject to challenge. Third, the assumption that the income-elasticity of energy consumption is constant over time is questionable given changes in technological requirements of production, urbanization of the population, and other social and economic transformations. Fourth, and most important, these estimates do not differentiate between criminal and informal activities proper. The latter involve the production of goods and services that are otherwise licit, but whose elaboration or exchange are not regulated (Castells and Portes 1989). Hence, the huge estimates that are often reached through these methods can be influenced, for example, by a large drug underground whose operations are of a nature and magnitude different from those of unregulated entrepreneurs, workers in microenterprises, small artisans, and vendors. Despite these problems, the above macroeconomic methods represent the best approximations so far to the relative weight of unregulated activities in national economies. They provide an important complement to estimates based on labor market surveys. Overcoming the significant imperfections of both sets of methods will require direct studies of the economic activities of firms and individuals, a task that would also allow estimation of the number of hours spent in informal versus formal sector work, as required by the structuralist approach. IV. Articulation of the Formal and Informal Sectors Each of the above theoretical perspectives sees the relationship between formal and informal activities differently. A review of their contrasting positions will provide a suitable background for a discussion of policies toward the informal sector in the final section. In the ILO/PREALC conceptualization, there is really no articulation between the two sectors. One is essentially "in" and the other "out" of the real economy. As seen above, the primary function of the informal sector is to serve as a cushion to absorb workers expelled or unable to gain access to modern employment. This countercyclical hypothesis leads to the expectation of massive increases in the size of informal employment in the wake of severe economic downturns. During the debt-induced economic crisis experienced by Latin America in the 1980s, the informal sector, defined according to PREALC's occupational categories, did rise significantly in many countries. However, the size of the increase was not commensurate with the magnitude of a crisis that saw the Latin American product per capita decline by 9 percent between 1981 and 1984, the worst performance since the Great Depression, and produced figures that reached catastrophic levels in countries like Venezuela (-16 percent) and Bolivia (-25 percent). By contrast, informal employment rose fractionally, according to PREALC's own data, in comparison to its level in the 1970s (see Table 1 and PREALC 1985: 33). A key adjustment variable was the rise of open unemployment. As seen in Table 5, open urban unemployment increased by about 40 percent during the first half of the 1980s for Latin America as a whole, and surpassed 100 percent in several countries. By 1984-85, most nations had experienced double-digit urban unemployment, a trend that represented a significant departure from the experience of preceding decades. The conventional explanation for historically low unemployment rates was that in countries with weak welfare systems, people could not afford to stand idle when out of work and thus had to "invent" some form of employment in the informal sector (Bairoch 1973; Marshall 1987). This argument, closely associated with the countercyclical thesis, was negated by the spectacle of massive increases in enforced idleness throughout the region in the 1980s. ------------------------------------------ Table 5 about here ------------------------------------------ In some countries, exemplified by the case of Colombia, increases in informal employment appeared due less to the shift of people than of firms to the informal sector seeking to weather the crisis through decentralization of production and avoidance of taxation (Lanzetta de Pardo et al. 1989; Cartier 1988). This is illustrated in Table 6 by the substantial rise in informal employment in manufacturing. The figures--based on the traditional PREALC categories plus owners and workers of firms with less than 5 employees--show an increase of 51 percent in industrial informal employment in Bogot  between 1974 and 1983. By the latter year, informal employment in the industrial sector exceeded significantly the percentage that the informal sector represented of the urban EAP as a whole. Additional data indicate that increases in Colombian industrial informal employment were due to an increase in the number of the self-employed and salaried workers in microenterprises, occupational categories associated with the decentralization and informalization of production. ------------------------------------------ Table 6 about here ------------------------------------------ In most Latin American countries, the adjustment took place via a combination of a rapid decline in formal sector wages and massive layoffs. Both trends compromised the viability of informal microenterprises that depend for their markets either on formal sector firms or on their workers (Fiszbein 1992). With these markets in contraction, the informal sector could hardly be expected to absorb the large numbers left jobless by large firms. The result was the rapid rise in open unemployment, as described above. The trend reflects the fundamentally pro-cyclical character of informal activities as integral parts of the same economy. De Soto's perspective implies that the articulation between informal and formal sectors is to be understood as a takeover "from below" of the regulated economy. Since for De Soto (1989: 12) the informal economy is not a precise sector, but "a grey area which has a long frontier with the legal world," he never systematically explores the relationship between the two sectors, arguing instead that the two stand in antagonistic contradiction to one another. Popular entrepreneurs will simply overrun the state-protected enclave and demolish it. Since the relationship between informality and the elite formal sector is fundamentally political, no attempt is made by De Soto to examine the behavior of the two sectors during economic cycles, nor to explicitly discuss how this approach to articulation compares with results of studies by PREALC and the structuralists. For the third perspective, formal and informal activities are simply alternative facets of the same economy and their articulation adopts a "variable geometry" depending on the scope of state regulation, the requirements of capitalist firms, and the size and characteristics of the labor force (Castells and Portes 1989: 32-33). The articulation between both sectors is the core of the structuralist approach and researchers associated with it have documented its manifold forms as well as their essentially pro-cyclical character (Ybarra 1989; Peattie 1982; Birkbeck 1978). Linkages have been studied in sectors as diverse as construction, food retailing, and rural-based footwear assembly plants (Truelove 1989). Two such examples will be briefly mentioned for illustration. Figure 2 diagrams an informal production chain of the type described by Bener¡a and Roldan (1987) in the electrical appliances, garment, and textile industries in Mexico and confirmed, with variants, for different sectors of industrial production in Colombia, Argentina, and Uruguay (Schmukler 1979; Peattie 1982; Prates 1983). Such arrangements are found in firms producing intermediate and finished goods for both domestic and export markets. Large multinational or domestic firms subcontract with a smaller national firm the production of some particular input. The latter subcontracts in turn the more labor-intensive parts to informal shops located frequently in the shantytowns. When demand exceeds their own installed capacity, informal shops turn to homeworkers, who labor for a piece-rate. ------------------------------------------ Figure 2 about here ------------------------------------------ On the basis of their research on one subcontracting chain in the electrical appliances sector, Bener¡a and Roldan (1987: 37) report that work conditions and wages improve monotonically as one moves up the chain: female homeworkers at the bottom are the worst off. Similar results were reported earlier by Prates (1983) for the footwear export industry in Uruguay and by Schmukler (1979) for garment assembly in Argentina. Three types of vertical subcontracting arrangements are distinguished in these studies: a) direct articulation, in which the formal firm contracts directly with informal workers; b) mediated articulation, whereby the link is made indirectly through a jobber; and c) mixed articulation, in which the formal-informal linkage is made inside the small firm itself, which contains both formal (i.e., protected) workers and informal wage workers under one roof (Bener¡a 1989). Figure 3 illustrates an input supply chain of the type first described by Birkbeck (1978, 1979) in Cali, Colombia. He found that garbage pickers, commonly regarded as the most marginal of informal laborers were, in reality, disguised wage workers supplying large amounts of recyclables to formal industrial firms. Figure 3 is based on a replication study conducted by Fortuna and Prates (1989) among garbage collectors in Montevideo, Uruguay. Plastic waste is collected, sorted, washed and dried, processed, and sold either directly or indirectly to large firms. The stratification of economic actors reveals a pattern of informal collectors and their family members at the bottom of the chain and formal sector manufacturers at the top. The boundary between formal and informal activities in this instance can be located at various places in the chain: between formal firm and informal microenterprise; between formal enterprise and informal buyers and washers of plastic; or within a single small enterprise between formal (protected) and casual workers. In every instance, the collectors end up supplying large modern firms with recyclables at a fraction of the cost of imported raw materials. Although they appear to be self-employed, these informal collectors actually function as outworkers for formal enterprises without the latter assuming any responsibility for their social security or welfare. ------------------------------------------ Figure 3 about here ------------------------------------------ The subcontracting chains outlined above illustrate the diversity of work relations within the informal sector. The position of informal entrepreneurs (owners of workshops and labor brokers) is quite distinct from that of informal workers. According to the structuralists, it is this difference in class position that accounts for a fact often obscured in aggregate measures of informal sector incomes: earnings of small entrepreneurs can reach levels as much as three times higher than those of formal sector workers, while the wages of informal laborers are generally far below those in the formal sector (Portes et al. 1986). This is an important part of the explanation why formal workers with some skills commonly return to the informal sector later on in life, as self-employed entrepreneurs in search of higher incomes (Roberts 1989). V. Policies toward the Informal Sector In this final section, we review proposed policies toward the informal economy with a particular focus on the pending North American Free Trade Agreement (NAFTA) and its potential effect on the Mexican labor market. The PREALC policy recommendations are generally congruent with its dualistic image of peripheral economies that it proposes: the informal sector is a lag from a premodern past; its full absorption into the formal economy requires sustained capital investments into productive activities for extended periods of time. Hence, to the extent that NAFTA results in a significant increase in North American investments in Mexico, it should yield rapid formal employment creation and hence contraction of the informal economy. For De Soto, on the other hand, the straitjacket of state regulation would tend to discourage external investments as well as continue to restrict the entrepreneurial energies of informal producers and traders. For the economy to enter what he refers to as a new path of development, the state hand must be effectively removed from the economy so as to give freer rein to the market. This argument is of course closely aligned with the liberalization policies promoted by U.S. and international organizations, such as the Agency for International Development (USAID) and the International Monetary Fund (IMF). The structuralist approach has points in common with both sets of recommendations, but also differs significantly from them. It agrees with PREALC that sustained capital investment in industrial production will lead to employment creation, but notes that much of the latter can take place outside the formal sector if excessively rigid legal codes continue to maintain a sharp break between a relatively privileged, protected labor force and a mass of cheap unprotected workers. In this situation, incentives for firms to bypass legal covenants through decentralization, casual hiring, subcontracting, and other practices can easily diminish formal employment creation. Instead of contracting, the informal sector could well expand to meet a growing demand for flexible and cheaper production arrangements. There are points in common, of course, between this argument and the liberalization policies advocated by De Soto and the international agencies that have sponsored him, but the structuralist approach differs in two key respects. First, complete removal of state controls in a high labor surplus economy is not recommended because it can easily lead to a pattern of worker abuse, minimal wages, and serious disincentives for worker training and technological innovation. Instead of absorption of workers into the formal sector what would take place is the informalization of the entire economy as work conditions in the large factories begin to approach those associated today with informal sector workshops. Second, the structuralists disagree that complete removal of the state from the economy would produce a flourishing of popular enterprise. Instead, it is likely to lead to its further impoverishment because informal enterprises survive precisely by taking advantage of the interstices created by state regulation. Their ability to compete despite low capitalization and human capital lies in their avoidance of tax and labor controls, lowering costs relative to formal firms. This advantage would disappear in the absence of state controls and would not be compensated by increases in capitalization and technological know-how necessary to turn these firms into competitive, flexible microenterprises. De Soto's liberalization message may ultimately be a way of promoting the demise of the same informal establishments whose entrepreneurial abilities it extols. Our own policy recommendations are three-tiered. First we argue for flexibility within, not complete liberalization from, state controls and for the removal of key incentives for large firms to engage in casual hiring and informal subcontracting. Basic state-enforced protections such as minimum wages, workplace safety, health insurance, and retirement benefits should be maintained, but other regulations can be made less stringent. Of these, none is more important than greater flexibility in labor utilization. Field studies consistently indicate that employers object less strenuously to minimum wages and other workplace protections than to the obligation of maintaining a labor force rigidly protected against dismissal, despite economic downturns and other contingencies. Protective regulations against workers' dismissals have been more rigidly applied in countries like Colombia, Ecuador, Peru, and Mexico than in the United States. The result has been a strong disincentive for firms expanding their protected labor force. The second tier of our policy recommendations consists of state-initiated efforts to transform informal enterprises into a new "leg" of economic development rather than promote their disappearance. Even after improving incentives for labor absorption by large firms, there is likely to remain an excess labor supply whose main recourse for employment continues to be the informal sector. In the absence of effective outside support, it is improbable that small unregulated concerns will transform themselves into the "flexible producers" so praised by students of the central Italian and Hong Kong experiences (Sabel 1982; Piore and Sabel 1984; Benton 1990). Instead, informal shops in Latin America would remain as low-technology appendages of the formal sector, dependent for their survival on the exploitation of unprotected workers. To overcome this situation, it is necessary to target technology-transfer, training, and credit programs toward informal entrepreneurs and to help build cooperative links between them. As the experiences of Emilia Romagna and other industrial districts indicate, small producers can be competitive in domestic and world markets, not on the basis of overexploited labor, but by virtue of their greater ability to adapt to fashion changes, explore new market niches, and specialize in custom-made products and small-batch production (Sabel 1982; Piore and Sabel 1984). To do so, however, small enterprises must be brought up to date technologically and their owners trained on both how to run their firms more efficiently and how to seek new market opportunities. Isolated informal entrepreneurs, with limited human and physical capital resources, are unlikely to do so on their own. Every experience of successful transformation of informal economies of survival into communities of flexible producers had depended on outside assistance, commonly provided by local state agencies and private non-profit organizations capitalizing on the entrepreneurial energies and basic know-how of small producers and their social bonds (Portes, Castells, and Benton 1989). Effective assistance programs have integrated training in production techniques and administration, access to credit, and marketing. Their most impressive result has not been individual success stories, but rather communities of viable entrepreneurs. Cooperation among these firms is not cemented in any sort of ideological fervor, but rather on the realization that concrete common interests can be fostered by a measure of solidarity. Hence, the transformation of the informal sector into an engine of development does not depend in getting the state out of the economy, but rather in it, albeit in novel and imaginative ways. NAFTA will require increasing labor market flexibility, as indicated above, to yield the expected benefits in growing labor absorption in the formal sector. However, the same historical agreement offers the possibility of transforming the Mexican informal economy by redirecting popular entrepreneurial energies and the proven ability of small producers to survive difficult market conditions. For this result to come about, it is necessary that the current program of credit support to small firms and other official assistance programs to the informal sector be transformed. The final tier of recommended policy is designed to extend direct benefits to informal workers who may not benefit immediately from the transformation of informal microenterprises. The recent expansion of the informal sector has meant that households are sending more members into the labor market, in particular young boys and women (Oliveira and Roberts 1991). In Mexico, the rate of participation of economically active women grew 6.5 percent annually between 1979 and 1987; these women are mainly adults with children and low levels of education, entering the labor force as "self employed" (i.e., subcontracting homeworkers). These vulnerable workers must be assisted directly through social programs working in tandem with those aimed at improving labor flexibility and technological competence. Such policies include programs to extend health care and education services more directly to low-income households. The pressure to prematurely terminate the education of children in order to turn them into income-earners must be counterbalanced through direct support for children's education for needy families. Provision of health care through mobile clinics and local facilities, funded as a citizenship right for all, will also improve directly the well-being of informal sector families. In recommending policies at these three levels, we intend to draw attention to the heterogeneity of the informal sector. Policies that aim to improve conditions of work and economic possibilities must be based on a recognition that no single policy will equally benefit the various kinds of informal economic actors: self- employed homeworkers, informal entrepreneurs, family labor, domestics, street vendors, workers in microenterprises and in the informal side of medium and large formal enterprises. The characteristics of these actors vary by income, gender, and access to state welfare benefits according to their precise location in the informal sector. Without a recognition of this fact, well-intended policies could result in unintended consequences. Endnotes References Bairoch, Paul. 1973. 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