Financial Dependence, Formal Credit, and Informal Jobs: New Evidence from Brazilian Household Data

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DISCUSSION PAPER SERIES IZA DP No Financial Dependence, Formal Credit, and Informal Jobs: New Evidence from Brazilian Household Data Luis A. V. Catão Carmen Pagés Maria Fernanda Rosales December
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DISCUSSION PAPER SERIES IZA DP No Financial Dependence, Formal Credit, and Informal Jobs: New Evidence from Brazilian Household Data Luis A. V. Catão Carmen Pagés Maria Fernanda Rosales December 2009 Forschungsinstitut zur Zukunft der Arbeit Institute for the Study of Labor Financial Dependence, Formal Credit, and Informal Jobs: New Evidence from Brazilian Household Data Luis A. V. Catão Inter-American Development Bank and IMF Carmen Pagés Inter-American Development Bank and IZA Maria Fernanda Rosales University of Chicago Discussion Paper No December 2009 IZA P.O. Box Bonn Germany Phone: Fax: Any opinions expressed here are those of the author(s) and not those of IZA. Research published in this series may include views on policy, but the institute itself takes no institutional policy positions. The Institute for the Study of Labor (IZA) in Bonn is a local and virtual international research center and a place of communication between science, politics and business. IZA is an independent nonprofit organization supported by Deutsche Post Foundation. The center is associated with the University of Bonn and offers a stimulating research environment through its international network, workshops and conferences, data service, project support, research visits and doctoral program. IZA engages in (i) original and internationally competitive research in all fields of labor economics, (ii) development of policy concepts, and (iii) dissemination of research results and concepts to the interested public. IZA Discussion Papers often represent preliminary work and are circulated to encourage discussion. Citation of such a paper should account for its provisional character. A revised version may be available directly from the author. IZA Discussion Paper No December 2009 ABSTRACT Financial Dependence, Formal Credit, and Informal Jobs: New Evidence from Brazilian Household Data * This paper examines a much overlooked link between credit markets and formalization: since access to bank credit typically requires compliance with tax and employment legislation, firms are more likely to incur such formalization costs once bank credit is more widely available at lower cost; if so, well-functioning credit markets help foster formal employment at the expense of informal jobs. We gauge the relevance of this credit channel using the Rajan- Zingales measure of financial dependence and a difference-in-differences approach applied to household survey data from Brazil a large emerging market where substantial changes in banking system depth and formalization ratios have taken place and for which consistent data exists. Our results show that formalization rates increase with financial deepening and the more so in sectors where firms are typically more dependent on external finance. We also decompose shifts in aggregate formalization into those within each firm size category and those associated with changes in firm size, and find that financial deepening significantly explains the former but not so much the latter. JEL Classification: E26, G21, O4, O16 Keywords: credit markets, financial dependence, informality, Brazil Corresponding author: Luis A. V. Catão Research Department Inter-American Development Bank 1300 New York Ave. Washington DC USA * The authors are grateful to Eduardo Fernández-Árias as well as seminar participants at the IADB, LACEA, the World Bank, and IZA Institute for Labor for comments on an earlier draft. Lucia Madrigal provided able research assistance. The opinions presented in this paper are the authors alone and do not necessarily represent those of the Inter-American Development Bank, the International Monetary Fund, or their respective Boards of Directors. 1. Introduction Two basic tenets command considerable consensus in the financial and economic development literatures. One is that financial development is good for economic growth (Levine, 1997; Beck, Levine, and Loyaza, 2000). This because well-functioning financial markets make it easier for firms to attract financing for investment needs, and this is particularly crucial in sectors where productivity gains are potentially high but high dependence on external finance is a potential constraint (Rajan and Zingales, 1998). To the extent that the development of formal credit markets is hindered in countries with unsound economic policies, deficient property rights and law enforcement (La Porta et al., 1997; Johnson et al., 2002; Claessens and Laeven, 2003), the expansion of such high productivity sectors and of higher productivity but financially dependent firms therein will then be curbed; hence economic growth will suffer, all else constant. The other basic tenet is that informality of firms and of employment arrangements broadly understood as the lack of compliance with taxes and regulatory provisions is bad for growth. As shown in a host of recent studies, informality tends to undermine allocative efficiency as well as firm-level productivity, leading to under-investment and lower total factor productivity (Farrell 2006; Perry et al 2007; Levy, 2008; La Porta and Shleifer, 2008; Hsieh and Klenow, 2009). Further, to the extent that informality shrinks national tax bases and induces higher compensatory taxes to be levied on formal business, there is a perverse feedback from the prevalence of informality to higher 2 taxation which reinforces the incentives to go informal. 2 Thus, the adverse effects of informality on economy-wide productivity and growth can easily snowball, making it a pressing policy issue in many countries. This can be particularly so in times of financial distress, when formal employment falters, tax collection efforts step up, and incentives to evade and go informal thus thrive. Notwithstanding this substantial body of literature on the links between financial development and economic growth on the one hand, and on informality and productivity growth on the other, there has been to the best of our knowledge a striking dearth of studies on the links between the functioning of formal credit markets and labor formalization. 3 One might conjecture that such links can be quite important once informality is viewed as resulting from decisions by optimizing agents on the costs and benefits of going informal as in standard models (see Straub, 2007 and various references therein). This is because the cost of remaining either an unregistered firm or a registered firm in breach of tax obligations is that of having either limited or no access whatsoever to formal credit markets (cf. Fanjzylber et al., 2006; Gatti and Honorati, 2008; IDB, 2009). After all, to be able to borrow from banks or from other regulated financial intermediaries a firm typically needs not only to be formally registered (or in some cases 2 See e.g. Djankov et al. (2002) for cross-country evidence linking high taxes, informality, and productivity growth. It highlights the positive relationship between high taxes on formal business and the size of the informal sector on the one hand, and the negative relationship between the size of the informal sector and per capita income gap relative to the US on the other. One form of compensatory tax which Djankov et al. (2002) do not consider, however, and which was widely practiced in the past is the inflation tax. Insofar as the inflation tax affects both formal and informal business, it does not per se foster tax evasion by formal business. Yet, to the extent that high and chronic inflation curbs financial development, it tends to foster informality via the very credit channel mechanism that we examine in this paper. 3 For instance, in a widely cited Journal of Economic Literature survey on informality by Schneider and Enste (2000), no attention is paid to the financial development and the credit channel mechanism that we discuss in this paper. Instead, as in much of literature on informality, emphasis on is placed on the roles of taxation, employment regulations and a variety of other institutional factors. 3 legally incorporated as a limited liability company), but also comply with considerable information requirements about its balance sheet and income flows so as to allow some of the usual information intensive monitoring of its activities by banks (cf. Fama, 1985). If anything, such requirements for tapping formal credit markets are likely to have become more stringent in recent years, as developments in communications and data gathering technology allow governments to pool and cross information from different enforcement agencies and thus more effectively clamp down on illegal borrowing and lending practices and the attendant tax evasion associated with informality. 4 Moreover, potential incentives for formalization via such a credit channel can also bite through the employee s own optimizing behavior. For the lower the cost of bank credit, the greater the incentives for workers to take on formal jobs or demand legalization of their current employment situation, since having legal proof of steady earnings should allow better terms of access to credit more generally. In short, from the viewpoint of both the demand and the supply of formal jobs, financial development would tend to shrink the relative size of the informal sector. This paper examines whether such opportunity costs may be empirically relevant. Specifically, we test two main hypotheses. First, we examine whether and to which extent such a credit channel can explain aggregate variations in formal vs. informal employment over and above other driving forces of formality, such as overall economic growth and tighter regulatory enforcement. Second, we examine whether this credit 4 In the particular case of developing countries where public banks play an extensive (and sometime almost exclusive) role in providing credit to smaller and medium sized firms, such enforcement is likely to be even stronger. This is because the government (as the majority or only equity owner of such financial intermediaries) has an obvious incentive to cross-check information with regard to tax evasion and arrears with social security and, based on those records, restrict or deny altogether access to formal credit. 4 channel works mainly through its effect within specific size categories and/or by shifting the composition of employment between firm sizes. Scrutinizing these effects is important to understand the main mechanisms through which financial development drives formalization. For instance, better access to credit among smaller firms (which are usually more credit constrained than larger firms) may lead them to grow, shifting into larger size segments of the market and leaving their previous size segment more dominated by smaller informal firms. If so, access to credit may well increase informality in the lower segments of the firm size distribution. But, it may also be the case that greater access to cheaper credit disproportionally benefits smaller firms, giving them greater incentive to formalize. Looking at such size-related effects may allow us to discern these possibilities and relate our findings to a sizeable literature on credit constraints and firm size. This is a matter of great analytical as well as practical interest since the prevalence of small business policies in many countries is predicated on the very basis of such constraints. Our empirical analysis rests on four pillars. One is the definition of informality. We focus on formal employment defined as those jobs in compliance with registration regulations and social security contributions as our key measure of informality. We do so because this is a readily available measure from household surveys, and one which has a fundamental advantage over others: workers do not have obvious incentives to report that they are formal when they are informal, as opposed to firms incentives to answer similar questions (since hefty penalties for non-compliance can be imposed on firms). Moreover, it is also quite a general measure of informality since the share of formal employment in 5 total employment is often highly (negatively) correlated with other economy-wide measures of informality (IDB, 2009). The second pillar of our testing methodology is the use of the classic measure of financial dependence advanced by Rajan and Zingales (1998). The basic idea is the existence of sectors which are structurally more dependent on external finance than others (using the US as the benchmark for building such a cross-sectional ranking). If so, such sectors and firms therein are the ones standing to benefit the most from an expansion of credit supply or financial deepening broadly defined. Hence the incentives to formalize should be higher in those sectors relative. To the best of our knowledge, this is the first time the Rajan-Zingales measure of financial dependence is used in the context of an analysis on the determinants of informality. Third, we focus on bank credit. We do so because banks are by far the most important class of regulated financial intermediaries in emerging markets and developing countries regarding the provision of external credit to firms, and they remain so in many developed countries as well. If the postulated links between the depth of the banking system (what we will broadly call financial deepening ) and informality are significant, one should thus expect that for countries and/or periods in which the supply of bank credit is lower or subject to more frictions resulting in high intermediation spreads and lending costs that are highly dependent on the firm s collateral the opportunity cost of informality would be lower, all else constant; hence the share of informal jobs in total employment should be higher. Conversely, as the banking system becomes more efficient and firms 6 have better terms of access to formal credit (including not being rationed out of formal credit markets altogether due to adverse selection or collateral constraints), overall formality should be higher. Finally, we focus on Brazil for three reasons. One is data availability. Among developing countries, Brazil has one of the most thorough household surveys (the Pesquisa Nacional por Amostra de Domicilios, PNAD) with a wealth of employment data which is nationally representative and allows meaningful comparisons over time. In Brazil, there is also evidence of a very high correlation between a firm s registration, its tax compliance status, and its compliance with social security contributions (Carpio and Pagés, 2009). This makes data on social security and labor registration compliance from the PNAD a reasonably accurate indicator of degree of firm-level formalization in the economy at large. Other Brazilian macroeconomic data that we employ as additional controls in our testing methodology are also deemed to be consistently measured vis-avis their respective counterparts in some other developing countries. All this contributes to the reliability of our results. Another important reason to focus on Brazil is the combination of substantial shifts in the formal/informal composition of employment and in the expansion and cost of bank credit over the years, what facilitates the identification of the effects at work. Last but not least, Brazil is an interesting case study from a policy experiment viewpoint. This is because it has combined in recent years financial liberalization with conservative macroeconomic and financial policies which sought to keep inflation low and stable and banks solidly 7 liquid (through high reserve requirements and stringent capital regulations). One of the main visible effects of this combination has been an expansion of credit supply well in excess of GDP growth and declining intermediation spreads only temporarily interrupted by the global financial crisis in late If such rapid financial deepening did contribute to a significant increase in formalization rates, this would be suggestive of a potentially important dividend of policies that combine the efficiency gains of financial liberalization (in terms of the availability and cost of domestic credit) with prudential regulations and conservative macro policies. To preview our results, the paper finds evidence of a credit-formalization channel at work: formalization has been more pronounced in economic activities that are more financially dependent. We also highlight that a main conduit is through shifts in the formality rate within each firm size category, particularly among firms who employ labor other than the owner s own. To a lesser extent, we also find some evidence that financial deepening shifts the composition away from self-employment and towards larger firms. The remainder of the paper is divided into five sections as follows. Section 2 and 3 below describe the data and main stylized facts, including a decomposition of between and within effects behind changes in formalization rates. Section 4 lays out our 5 The positive effect of financial liberalization on bank credit to GDP and financial deepening more broadly is clearly not a unique feature of the Brazilian experience but holds quite generally. See Bekaert, Harvey, and Lundblad (2005, table 2) for evidence spanning 95 countries. Bekaert et al. (2005) also find that while financial liberalization predicts additional financial development, the decision to liberalize does not seem to be influenced by the degree of financial development and can thus be taken as broadly exogenous to it. This lends further support to the exogeneity assumption underpinning our results as discussed below. 8 identification approach and econometric results. Section 5 discusses robustness. Section 6 concludes. 2. Data As discussed in the introduction, this paper adopts an employment-based measure of formality which has the advantage of being less prone to misrepresentation and reliably tracked from household data. In addition, this measure is useful because it is highly correlated with the formality status of a firm: unregistered firms cannot enroll their workers in social security, although there may be some registered firms that do not enroll their workers in social security because they are only in partial compliance with regulations. In this regard, it is possible that some firms take steps toward formalizing their activities but have not fully regularized their labor force. If anything, this implies that our measure may lead us to find lower effects of bank credit on formalization than if we were using firm registration as the measure of formality. We work with two alternative definitions of formal employment. One is to define as formal those workers with a formal employment contract ( carteira assinada ). This arrangement denotes the fact that to register a worker, employers need to make an entry in a pocketsize booklet ( carteira ) that all workers must have. The other defines formal workers as those who report contributing to social security. While there is typically a tight match between the two, this need not be one-to-one. This is because there are workers who are not formal employees of a private firm, government, or other institution and still contribute to social security either because they have their own business (self- 9 employed) or form a cooperative with other workers. In the event, the correlation between these two alternative measures of formalization has been quite tight in Brazil. 6 Data on formal employment is obtained from the Pesquisa Nacional por Amostra de Domicilios (PNAD), the main Brazilian household survey which employs a consistent measurement methodology for the years This survey is nationally representative and contains information of an average of individuals in households each year, covering all sectors of economic activity. The sample used here corresponds to salaried and self employed individuals between years old who work in non-agricultural activities. Employers, domestic workers, military personnel, a
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