How Does Informality Affect Gains from Trade?

Informal activity makes up a large share of the economies in many low- and middle-income countries. Because governments are unable to comprehensively enforce regulations such as minimum wage laws and value-added taxes, many firms flout the law and avoid formal registration. These firms risk fines and closure, and have no access to formal finance and export markets. However, they can operate at lower cost if they successfully evade government notice. Large informal sectors are typically considered undesirable by policymakers – informal firms do not pay taxes, thus limiting governments’ ability to fund things like infrastructure and social safety nets, and are on average less efficient than formal firms. 

International trade is also important in growing economies. It can bring modern products and investment to low- and middle-income countries, and open new markets for these countries’ exports. However, its exact effects depend heavily on domestic conditions. Recent literature has emphasized that features like the rule of law, availability of credit, human capital, and firm-level inefficiencies affect how trade impacts domestic economies. Thus, it seems likely that the presence of an informal sector would shape the impacts of trade liberalization.

Few studies have sought to understand how informality and trade influence each other. To address this gap in the literature, EGC affiliates Pinelopi K. Goldberg and Costas Meghir, along with co-authors Rafael Dix-Carneiro of Duke University and Gabriel Ulyssea of University College London, investigate how a reduction in trade barriers affects economies with significant informal sectors, compared to those without. 

“We started this project asking, what are the effects of trade when you have a big informal sector?” said Goldberg in an EGC interview. “In low- and middle-income countries, the informal sector is a significant part of the economy, and one that, until very recently, had not been investigated by trade economists."

The researchers construct a model to explore the interactions between trade and informality. The model’s assumptions reflect the reality of the economies of most low- and middle-income countries today: firms vary in size and productivity, and some firms comply with the government’s taxes and labor regulations while others do not. Large firms tend to be more productive and more likely to comply with regulations – as firms grow, it becomes difficult to evade government notice. Informal firms tend to be smaller and less productive. Consequently, large productive firms are more likely to be subject to regulation, which causes them to produce less than they would without regulation. Conversely, less productive firms tend to be unregulated and over-produce compared to a completely undistorted economy.

In this model, a reduction in trade barriers can affect firms in several ways. First, it lowers the price of intermediate manufacturing goods – for example, a car factory can purchase tires more cheaply. Second, formal firms can expand the exports of their products overseas, which means they can sell to more consumers. In the presence of informality, this second effect can also change the distribution of resources between the formal and informal firms. Liberalized trade directly affects only formal firms – informal firms cannot export because they are not legally registered with the government. When the formal sector becomes more profitable after trade liberalization, more workers and resources will want to move into that sector. Workers who used to work in the informal sector may move to formal firms that can offer them higher wages, and informal firms themselves may decide to comply with regulations for the opportunity to trade.

Goldberg, Meghir, and their co-authors use their model to study the effects of trade liberalization in Brazil under various hypothetical scenarios. By adjusting the size of the informal sector and the magnitude of the trade shock, they investigate several questions: How does globalization affect the allocation of resources between sectors? How does informality affect the welfare gains from trade? How does informality affect wage inequality and welfare during economic downturns?

Using data from Brazil, the researchers simulate trade policy changes of different sizes. They find that a 33% reduction in trade costs – a large change – increases consumers’ real income by 24%. Part of this gain comes from the fact that products become cheaper and consumers can afford to buy more. But the greatest contributor is a “reallocation effect,” the boost to the entire economy’s productivity gained from workers and capital moving from the informal sector to the formal sector. When trade barriers are reduced, formal firms benefit the most: all firms gain access to cheaper intermediate products, but only formal firms can now export their products more cheaply. As a result, formal firms attract labor and other resources from the informal sector. Because formal firms tend to be more productive, this shift allows resources to be used more efficiently and raises the economy’s productivity and real income.

Next, the researchers investigate how economic downturns and informality interact. They confirm previous findings that informality acts as a buffer for unemployment but does not shield the economy from real income losses. When workers lose their jobs at formal firms, they switch to working at informal firms if possible. If there is already a large informal sector, these workers can be absorbed more easily, which mitigates the effect of an economic downturn on the unemployment rate. 

However, the aggregate real income loss in the economy is larger when informality is present. This is because negative shocks cause resources to be reallocated towards the less-productive informal sector, slowing productivity for the entire economy. 

“One of our most interesting results is that economies with large informal sectors have additional flexibility,” Goldberg said. “If you have a negative demand shock, workers can move to the informal sector instead of becoming unemployed. But economic activity gets reallocated to a less productive sector, and that depresses real income."

This paper is an important step in studying the impacts of trade in low- and middle-income countries, where significant informal economic activity is common. The researchers find that trade liberalization has especially large positive impacts in the presence of informality, suggesting that many countries could benefit even more than previously thought by lowering trade barriers. The researchers also provide a model for incorporating informality into future studies: their quantitative framework is highly adaptable and could be used to study a variety of phenomena in economies with widespread informality, such as tax policies and labor market regulations. 

The findings have important policy implications. Policymakers generally agree that large informal sectors are undesirable: governments rely on tax revenue to fund infrastructure and social programs, and informal firms do not pay taxes. However, simply shutting down the informal sector through enforcement would have enormous social costs. Goldberg, Meghir, and their coauthors’ findings suggest that trade liberalization may be a less costly way to improve the allocation of resources and increase productivity without facing the high social cost of strictly enforcing regulations and shutting down informality. 

 “Our general message is that countries could improve the allocation of their resources  by embracing open trade,” said Goldberg. “Needless to say, this message falls on deaf ears today, with the backlash against trade openness coming from richer countries. But trade liberalization has benefited low-income countries in many ways - the efficiency gain through reallocation towards the formal sector our paper highlights is one of the mechanisms."