Tuesday, January 3, 2012

What explains prevalence of informal employment in European countries: the role of labor institutions,governance,immigrants and growth

Paid work without legal contract is a phenomenon closely related to such fields of economic and social studies as shadow economy, tax evasion, trust in and efficiency of institutions, labor demand and labor supply, self-employment, worker mobility, labor market flexibility, social exclusion, social security, and many others. Understanding determinants of the size of informal workforce is thus important both for policy making and for design of institutional reforms. Yet research in this field, especially in European context, has been limited due to lack of data.  

This paper employs data from rounds 2-4 of ESS (European Social Survey, 2004-2009)  to analyze institutional and other macro determinants of prevalence of informal dependent  employment, as well as informal self-employment, across 30 European countries. The measures on prevalence of informal employment used in this paper are those from Hazans (2011a); they include 74 observations on 30 countries. Importantly, for most countries, our data cover the early stage of the economic crisis of 2008-2010; thus the impact of macro factors during different stages of economic cycle is accounted for in our analysis. 

The paper aims to contribute to two strands of the literature. Firstly, many scholars have studied determinants of the size of informal economy and informal workforce (e.g., Johnson et al., 1997; Schneider and Enste, 2000; Friedman et al.,  2000; Djankov et al., 2003; Loayza et al., 2005; Schneider, 2005; Perry et al., 2007; Kucera  and  Roncolato, 2008; Bajada and Schneider, 2009; Loayza et al., 2009; OECD, 2009;  Torgler and Schneider, 2009; Dreher et al., 2009; Dreher and Schneider, 2010;  Schneider et al., 2010; Feld and Schneider, 2010; Fialova and O. Schneider, 2011).  Regarding informal employment, an apparent gap (which we are trying to fill) in this literature is lack of multi-country analysis for Europe based on direct survey data on work without legal contract rather than proxy measures of the size of informal dependent workforce.

As a theoretical contribution, we provide arguments for the effects of many factors traditionally viewed as promoting informality to have a potential for a 
reversal.  Accounting for joint determination of informal wage employment, informal selfemployment, and unemployment is another distinctive feature of our analysis. We also  provide empirical support for the positive impact of income inequality and shares of  minorities and population with immigrant background on employment informality in Europe.

Secondly, there is a growing literature, following the seminal contribution by Layard et al. (1991), on the impact of institutions on labor market performance. We refer to Blanchard (2006), Eichhorst et al. (2008), and Lehmann and Muravyev (2009) for extensive surveys of this literature. Some of the recent developments have been related to complementary policies and interaction between institutions (e.g., Belot and van Ours, 2001; Amable et al., 2007; Fiori et al., 2007; Bassanini and Duval, 2009; Lehmann and Muravyev, 2009); extending the empirical base and theoretical analysis of institutional framework to transition and developing countries (Boeri and Terrell, 2002;  Heckman and Pagés, 2004;  Svejnar, 2004;  Eamets and Masso, 2004; Ederveen and Thissen, 2007; Hazans, 2007; Feldmann, 2009; Fialova and O. Schneider, 2009;  Behar, 2009;  Lehmann and Muravyev, 2009; Muravyev, 2010, among others);  identifying differential impact of institutions on various demographic groups (e.g., Amable et al., 2007; Bertola et al., 2007; Hazans, 2007; Say, 2011); assessing labor market impact of product market and/or financial market regulations (Amable et al., 2007; Fiori et al., 2007; Loayza et al.,  2009; Fialova and O. Schneider, 2011, among others); and robustness checks of the results using alternative panel data methods (e.g.,  Baccaro and Rei, 2005; Amable et al., 2007). 

Most contributions in this body of the literature focus on unemployment and/or inactivity and ignore informal employment. To our best knowledge, Fialova and O. Schneider (2011) is the only paper in this literature addressing the informal employment issue (using proxy measures) in a more or less complete institutional framework. With regards to this strand of the literature, our contributions include: amending institutional variables with the shares of minorities and population with immigrant background; identifying a significant interaction between union density and minimum wage level; finding region-specific productmarket-related factors which affect employment informality; and applying mixed-effects and other panel data estimators which have not been used in this field.  

Motivated by different data patterns found in Eastern and Southern Europe vs. Western European and Nordic countries (see Figures 1-3), we have conducted analysis separately for these two country groups, as well as for Europe at large. 

The rest of the paper is organized as follows. Section 1 provides a simple multi-period model in which agents choose (in the random utility maximization framework) between various labor market states (including formal and informal employment), and firms decide on optimal mix of formal and informal workers. Theoretical predictions on the impact of institutional and other macro factors on informal employment are derived and discussed in the context of previous literature. Section 2 outlines econometric methodology. Section  3 (respectively, 4) describe in detail the model specifications and results for Eastern and Southern (respectively, Western and Northern) Europe. Results for Europe at large are presented in Section 5. Section 6 concludes.   

World Bank. Author: Hazans, Mihails. Document Date: 2011/12/01.Document Type:Policy Research Working Paper.Report Number:WPS5917