Reining in Brazil's informal economy

As in many developing nations, the gray market is strangling productivity and growth.

Why are Brazil's economic-growth prospects just 3 to 4 percent a year despite the country's improved monetary and fiscal stability, while fellow emerging giants China and India are increasing their GDPs by 7 to 10 percent? A major but often overlooked reason is Brazil's huge informal economy, which restrains productivity and discourages business investment. This gray market limits the effectiveness of otherwise sound macroeconomic measures and reduces the potential for economic growth. In fact, a study shows that Brazil's economy could grow by an additional 1.5 percent a year if the government emulated the successful efforts of other countries and launched a comprehensive program to fight informality.

The informal economy accounts for about 40 percent of Brazil's gross national income? much bigger share than it claims in China and India (Exhibit 1). It consists of companies that operate partially or wholly outside the law by avoiding taxes, ignoring product-quality and -safety regulations, infringing copyrights, and sometimes even failing to register as legal entities. In this way, these companies gain a cost advantage and thus compete successfully with their law-abiding counterparts, though on average they achieve only 46 percent of the formal sector's productivity. Formal companies in turn lose out on profits and market share and thus lack the means and incentives to invest in productivity-enhancing measures such as expanding capacity, installing new technologies, and improving the organization. Together, such problems handicap the economic-development process.

If, as we believe, reducing the size of the gray market is a prerequisite for accelerating Brazil's economic growth, it is worrisome that the situation is getting worse. The level of informal employment was virtually unchanged at about 55 percent from 1992 to 2002, even though during that time 7 percent of the overall workforce migrated from agriculture, where the level of informality is very high? about 90 percent. Instead of finding formal jobs in other sectors, these migrants substantially increased levels of informality in manufacturing, construction, and transportation (Exhibit 2). According to data on employment in Brazil's largest metropolitan regions, informal jobs accounted for 87 percent of those created from 1992 to 2002.

A gray area

More than half of the labor force is informal in each of 11 sectors that represent upward of 60 percent of total employment: agriculture and livestock, clothing and accessories, construction, domestic services, furniture, gasoline retailing, hotels and restaurants, personal services (such as beauty treatment, hairdressing, and laundry), recreational and cultural activities, retail and wholesale, and textiles. In contrast, only 17 percent of the labor force works in sectors in which the level of informality is comparable to the 20 percent average in developed countries. Most of these workers, however, are employed in nonmarket sectors such as the government, health services, and education. The lion's share of Brazil's market economy is thus subject to the competitive distortions created by informality.

Levels and forms of informality vary according to the value chain of a given sector, the way it is taxed and regulated, and sector-specific schemes for getting past regulatory or tax-enforcement agents. Indeed, informality is so widespread because of its adaptability to the regulatory, technological, and competitive realities of different economic sectors.

Particularly hard-hit are residential construction and other sectors in which small firms serve individuals, thus making the task of auditors and tax collectors more difficult. Informality also pervades labor-intensive sectors, such as food processing, where the gains of evading payroll-related taxes can be huge. In these kinds of sectors, not only very small companies and individuals but also outwardly respectable modern companies operate informally.

Food retailing is a case in point. It isn't surprising that 95 percent of all street vendors operate outside the law, but we estimate that informal retailers operating midsize supermarkets and minimarkets account for an astonishing 60 percent of Brazil's food-retailing market. Compared with Mexico, for example, Brazil has very powerful incentives for informality: evasion of taxes and social charges can more than triple a Brazilian supermarket's income (Exhibit 3). In the food-processing industry, informal jobs are a smaller share? around 40 percent? but the problem is worsening as informal food processors, wholesalers, and retailers integrate, thereby generating a cost advantage of more than 50 percent over the entire value chain. In the meat and dairy segments, informality accounts for nearly 60 percent of employment. In the meat-processing business, we estimate that more than one-third of all output (by weight) comes from informal producers, many of which ignore regulations for handling animal carcasses and thus risk posing serious health consequences for consumers.

In Brazil's audiovisual and software sector, the main source of rapidly increasing informality is the infringement of copyright law. The market share of illegally copied compact discs is booming: from 5 percent in 1997 to 53 percent in 2002. Slack enforcement may be contributing to the problem. From 1999 to 2001, the public attorney's office filed 6,248 copyright-related lawsuits, but only 17 resulted in convictions.

Unlawful producers have also gained share rapidly in the pharmaceuticals industry, where informality is increasing throughout the value chain, and they now hold about one-third of the total market. Among distributors and retailers, schemes that exploit spreads in tax rates between different states have become common. One trick, which can yield price cuts of more than 10 percent, is to simulate the transport of drugs to states with lower tax rates by registering companies and sales in such states but selling in states with high taxes. In addition, more than 30 percent of the labor force in pharmaceutical retailing works for informal employers. The Regional Pharmacy Council of the State of SA¢Go Paulo has pointed to irregularities in more than half of the pharmacies there, with strong indications of tax evasion in many establishments.

Informality in the gasoline-retailing sector, where at least 20 percent of the workforce is informal, has been increasing rapidly, especially among unaffiliated gas stations, which have raised their market share from 6 percent in 1999 to 27 percent in 2002. Informal players use several methods to evade high gasoline taxes, which amount to almost half of the pump price. At least 10 percent of the volume sold is adulterated (mixed with untaxed industrial solvents, for example), according to a survey by the National Petroleum Agency. A recent congressional investigation, however, found that the practice may be even more widespread. Half of the volume of alcohol fuel sold in Brazil? around 12 percent of the fuel used by the country's passenger cars? is not reported to the tax authorities. Overall tax evasion in the fuel-retailing sector may surpass 3.3 billion reais ($1.2 billion)? an amount greater than all the petroleum royalties that oil producers pay to Brazil's states and municipalities.

The root causes

Although it is important to identify the ways in which informality is practiced, policy makers must also understand the underlying causes to apply an effective remedy. Around the world, informality is driven by three main factors: certain social and demographic trends, the high cost of being formal, and weak law enforcement. Brazil provides a textbook example of each.

Some social and demographic trends, such as the rapid migration to urban centers that is commonplace in developing countries, can generate an excess of unskilled labor, which is drawn to informal employment when the formal economy can't meet the flow. But such trends don't necessarily generate informality unless the cost of adhering to state-imposed legal obligations is high and enforcement is weak. Rigid and complex labor regulations, as well as overregulated capital, product, and land markets, create incentives for companies to operate outside or at the margins of legality. Similar incentives arise from excessive tax burdens. Ultimately, however, companies operate informally when the benefits outweigh the probability and cost of being caught? an equation that looks all the more attractive if legal obligations are not strongly enforced.

Most developing countries have onerous labor regulations, and many also impose excessively rigorous safety and product standards, so only the public sector and big private companies comply with them. A large part of the workforce is thus shifted toward the informal market, which can pay workers more at a lower cost to employers. Comparative studies by the World Bank consistently place Brazil among the countries with the most burdensome regulatory requirements and bureaucracies? for example, opening a business there takes 152 days, three times the global average? and note that Brazil's labor laws rank among the most inflexible in the world.

Another barrier in developing countries is the fiscal regime, meaning both the level of taxes (income, excise, value-added, labor, and social security) and the administrative cost of complying with them. Excessive taxation encourages tax evasion, particularly if an enterprise can thereby cut the final price of a product by 20 to 30 percent. In general, developing countries levy taxes equivalent to 25 percent of GDP, and formal companies pay about 80 percent of all taxes. In comparison, developed countries levy taxes of about 30 percent of GDP, but formal companies pay only half. Like a developed country, Brazil has a high overall tax level, yet its tax system, which is targeted at companies, resembles that of a developing country. The result is one of the world's heaviest corporate tax burdens. According to the International Institute for Management Development (IMD), the overall tax burden in Brazil increased from 26 percent of GDP in 1992 to 36 percent in 2002, and formal companies incurred two-thirds of these taxes.

While the barriers can vary by sector (and either taxes or regulations may predominate), our work shows that informality appears only if institutions and judicial systems are weak, inefficient, or corrupt. Brazil seems to be vulnerable in this respect: it has no specialized commercial courts, few tax collection agents, and relatively lenient penalties for evasion. The problem is compounded by poor transparency and accountability in the different parts of the legal and law-enforcement system? failings that lead to high levels of corruption. A study by Armando Castelar Pinheiro, an economist with Brazil's Institute of Applied Economics Research (IPEA), estimated that a radical improvement in the performance of the Brazilian judiciary would generate a 10.4 percent increase in investment.

By contrast, Asian countries that have joined the ranks of the wealthy nations or dramatically narrowed the gap with them have never had a serious informality problem. Japan, Singapore, South Korea, and Taiwan all benefited from relatively small tax and regulatory burdens as well as from strong legal and law-enforcement systems. So did Western countries in the early stages of their development: the corporate tax burden was only 4 percent of GDP in the United States in 1913, for example, when it had reached Brazil's current stage of economic development. Brazil's corporate tax burden is now nearly 25 percent of GDP.

In Brazil, the drivers of informality are clearly present. This insight is the starting point for action to reduce it and the resulting distortions that impede economic development.

Taking a coordinated approach

Tackling the informal economy can bring significant advances? both in the short term, through sectoral reform, and, when coordinated with structural reform, in the longer term. Now that Brazil's government has restored a degree of macroeconomic stability, efforts to reduce informality should intensify; indeed, given its many underlying causes, powerful vested interests, and creative practitioners, the government must make efforts to tackle it a priority. Such prominent efforts will also help mobilize the business community, policy makers, and society at large. A good model might be Portugal, whose government has identified informality as the most important single cause of the country's productivity gap with leading European nations and launched an economic-development program? Portugal 2010? that gives pride of place to a package of measures for reducing it.

Tailor reform to sectors

Reforms must be adapted to individual sectors. In banking, steel, and telecommunications, relatively few fairly modern companies are seeking competitive advantages through irregular practices. Since informality is already the exception and not the rule, the focus should be on better controls and tax collection processes. But for predominantly informal sectors, such as retailing and residential construction, more structural changes are required. In contrast to Russia, for example, where modern formats face relatively high taxes, Poland launched a program that combined equal taxation for traditional and modern retailers with the allocation of substantial resources to reducing tax evasion. As a result, the country attracted substantial flows of foreign direct investment into the modern retailing sector, which today makes 60 percent of all retail sales in Poland. In Brazil, several government agencies are taking a sectoral view. The federal tax collection agency, for example, now requires leak-measurement devices in all Brazilian beverage plants? a move that could cut 500 million reais from the sector's estimated annual tax evasion of 720 million reais.

Sectoral strategies can often be implemented relatively quickly, without wide-ranging legislative change. They thus provide an opportunity for quick wins that can help sustain political momentum and ensure that public opinion supports deeper structural reforms.

Tackle structural obstacles

Fundamental long-term changes, which hinge on tackling informality's underlying incentives, should accompany sectoral measures that promote short-term progress.

The government of Peru, for example, concluded that large numbers of the poor were in effect excluded from formal economic activity: a complex and extensive bureaucracy made it hard to open businesses legally or to use personal assets in economically efficient ways. This diagnosis led the country to implement a number of measures in the early 1990s to make its economy more formal. Registering a business now takes just a single day instead of 300 and costs $175 rather than $1,200. As a result, 671,000 companies and 558,000 jobs were formalized in Peru from 1991 to 1997.

Spain too introduced structural reforms in the 1990s by simplifying the taxation system and creating a new agency to fight evasion. As a result, the country increased the amount of taxes collected from small companies by more than 75 percent. It also introduced more flexible labor laws, an important move that reduced the costs and risks an employer incurs when registering employees and thus stimulated the creation of formal jobs. These changes contributed to a 40 percent decrease in unemployment in only six years. Among other things, the Spanish reforms allowed employers and employees to negotiate the terms of employment contracts directly rather than having them dictated solely by labor laws. The rules for temporary work? previously frowned upon by legislators? were liberalized, as were the rules for temporary employment agencies. In addition, a new type of permanent job contract was designed for young people and other groups that had unusual difficulty finding positions. The new contract reduced by 60 percent the sum employers must pay workers they lay off. Many barriers to part-time work were removed. More important, the employers' social-security contribution (a percentage of the worker's wage) was cut by 25 to 45 percent for part-time jobs with undefined terms.

Structural reforms are under way in Brazil, where the government has passed public-pension and tax bills and is considering labor market changes. Brazil's congress recently passed legislation modernizing the country's bankruptcy law and is debating measures that, among other things, would reduce social-security charges on low-income salaries and simplify the process of opening a company.

Tighten up the legal system

Since another requirement for the formalization of an economy is an efficient legal system, law reform has been high on the agenda in many countries. Examples of how to make enforcement more efficient abound in both developed and developing economies. The United States and Italy, for instance, impose heavy fines, indexed to the violator's earnings, for tax evasion, and both countries publicize punishment in the media. In addition, the United States has increased the criminal responsibility of accountants in tax evasion cases, and Italy has established fines for auditors who accept products or services without a receipt. In Chile, if a retailer can't prove the origin of its goods they may be confiscated by the tax authorities, and cashiers who don't issue receipts can also be punished.

International experience suggests a need for structures dedicated specifically to mobilizing and coordinating the battle against informality. Ireland, the Netherlands, Spain, and the United States created special agencies to fight the evasion of taxes and social charges; Poland and Spain set up special courts for tax evasion cases. Brazil is debating the creation of an agency to coordinate the efforts of vital government bodies, among them the Public Attorney's Office, the Federal Tax Secretariat, and the Economic Law Secretariat.

Our estimate of an additional 1.5 percent a year of economic growth for Brazil may seem high, but it becomes intuitively more plausible if we recall the benefits of reducing informality. In a less informal economy, productivity is the main source of competitive advantage, so businesses are encouraged to optimize their processes. Similarly, lower levels of informality reduce distortions in the relative cost of capital and labor, thereby encouraging automation. Reduced informality also promotes consolidation as formal, modern companies? those with greater productivity? gain market share from less productive ones. Finally, a lower level of informality will help increase overall investment, since modern players will understand that they have a fair chance of winning in the competitive fray.