Fiscal Policy and Latin America's Socio-Economic Reality: Accounting for Informality

The informal economy is large in Latin America and its existence is intimately related to the fiscal
system. Almost by definition, employers and workers in the informal economy do not pay personal
or corporate income taxes (either because their incomes are too low, or because they are not
registered with tax authorities), nor do their customers generally pay any relevant sales taxes.
Against this, the people left out of the social safety net mean that informality is associated with
lower public-sector expenditures.

Whether informality is defined in terms of those who do not contribute to tax revenues, or those who
are not covered by social security, it is an important indicator of a weak or broken social contract.
Some people in the informal economy are there as the result of a deliberate choice not to engage
with the state, based on a personal cost-benefit calculation – even if they might not see it that way.
Others have been excluded from the formal sector, and for them informal employment is really
disguised under-employment stemming from rigidities in labour-market institutions. A comparison
with Europe is telling. In Europe informality is largely a matter of tax evasion. In Latin America
informality is much more complex, and firms and workers are rarely either entirely formal or informal.
There is evidence in the region of a pick-and-mix approach to taxes and benefits, with individuals
or enterprises accepting some but not all of the engagements the state offers. A survey in Mexico,
for example, found that only half of micro-enterprises questioned were fully informal, while one in
Bolivia found firms twice as likely to comply with their municipal obligations as be registered for
value-added tax.

Fiscal policy makers in Latin America, in addition to taking into account the scale of the informal
sector in their economies, need to respond to the multiple ways the phenomenon expresses itself
and its diverse causes.

Policy must also balance the attractions of special regimes for firms and individuals in the informal
economy against universal tax and benefits for all; each of these policy packages can create unintended
incentives that are counterproductive. Typically, governments (not only in Latin America) craft
special tax regimes to formalise particular parts of the economy. But these regimes can become
barriers to expansion by small firms. And where from a quarter to more than half of workers hold
informal jobs then piecemeal extensions to tax and spending regimes are likely to be inadequate,
particularly as eligibility for the expenditure side (social protection and all the state’s benefits) is
often linked to formal-sector employment. Universal social protection, meanwhile, could encourage
informal employment since it decouples formal work from eligibility. On the other hand it protects
vulnerable workers and may improve national productivity by promoting inter-sectoral and inter-
regional labour mobility.

Innovative policy experiments in Latin America and beyond show that tax compliance can be facilitated
by better aligning the costs of formality for an individual with its benefits, adopting simplified regimes
for all tax payers, and offering formal and informal workers social services on an equal footing.