Estimating the effects of informal economic activity: evidence from Los Angeles County.

Author:Marcelli, Enrico A.

Economists have traditionally associated informal economic activity with developing countries [De Soto 1989; Fields 1975; Marshall 1987; Sethuraman 1981] and have emphasized its negative tax implications [Reed 1985]. Less research has been done on the extent, role, and impact of such activities in industrialized countries. This is partly because many analysts have assumed that informality or informal economic activity (IEA) is a temporary alternative to unemployment and poverty and thus tends to disappear as the economy develops a larger urban industrial base that is capable of absorbing surplus labor. 1

Recently, sociologists using the so-called structuralist approach have begun to gather case-study evidence on IEA in large U.S. cities such as Los Angeles, New York, and Miami [Dangler 1994; Fernandez-Kelly and Garcia 1989; Leonard 1994; Lopez-Garza forthcoming; Lozano 1989; Pessar 1994; Portes, Castells, and Benton 1989; Portes and Sassen-Koob 1987; Sassen 1988, 1989]. While earlier approaches defined "the informal sector" according to arbitrary characteristics, such as the type of economic activity, firm size, workers' social status, or the amount of capital investment, this more recent research distinguishes IEA by its production and exchange processes. Thus, IEA is not a single industry sector and is defined instead as "ali income earning activities that are not effectively regulated by the state in social environments where similar activities are regulated" [Portes, Castells, and Benton 1989, 12]. For instance, selling of oranges in a grocery store is a formal economic activity. Selling them on a highway exit ramp in Los Angeles County to passing motorists is not. Likewise, producing T-shirts in a factory where labor and health standards are not enforced is an IEA. Alternatively, prostitution is an illegal economic activity regardless of where an exchange takes place, but it is not an IEA. In short, Ilia involves legal goods and services in which the production or exchange is not effectively covered by state regulations. Informal workers are those who participate in such activities.(2)

Using this definition, the structuralist sociological approach finds that IEA is not necessarily associated with underdevelopment in the "Third World," and it may persist in conjunction with "modern" and even post-modern or post-industrial sectors of the economy. Indeed, various scholars working within this framework have connected Ilia to processes of globalization and restructuring that have been occurring since the late 1970s [Portes, Castells, and Benton 1989; Sassen 1988, 1989]. Specifically, rising global or regional movement of capital, goods, and labor has forced some firms to adopt more flexible and less costly production methods [Larson and Ong 1994], which has resulted in a larger supply of international migrant labor willing to work informally [Joassart 1999]. This contrasts with the notion that IEA results primarily from stricter state regulations on economic activity. Still, understanding the exact impact of IEA has been problematic; after all, it is difficult to obtain reliable estimates of economic activity that consciously seeks to evade measurement.

This paper supplements previous case-study work on informality with a novel approach to estimating IEA using Census and other data. Specifically, we develop a proxy for IEA based on a unique sample of foreign-born Mexicans collected in Los Angeles County and employed in earlier research on the economic effects of unauthorized immigration [Marcelli 1999; Marcelli and Heer 1998, 1997]. We then apply this proxy to the Public Use Microdata Sample to generate a cross-section econometric estimate of wage determination in different labor market segments (categorized by high, intermediate, and low degrees of informality) in the Los Angeles County labor market. We also examine the impact of informality on the position and performance of other workers in Los Angeles County.

For several reasons, Los Angeles County provides an ideal setting for the study of IEA. First, the effects of globalization and economic restructuring, usually associated with IEA, have been especially acute [Marcelli 1999; Soja and Scott 1996]. Since the 1970s, the industrial base of Los Angeles has shifted from heavy manufacturing (e.g., automobiles, rubber, steel, and machinery) to a bifurcated economy characterized by high-technology and communication services on one hand, and lower-skilled, labor-intensive manufacturing (e.g., textile, furniture, jewelry, printing) and services (e.g., cleaning, child care, gardening) on the other.(3) The latter occupations traditionally have been associated with IEA. Second, this labor market polarization was accompanied by a rise in legal and illegal immigration from Asia and Latin America, providing a large supply of potential informal workers. Since the 1970s, unemployment and poverty rates in Los Angeles County have generally been higher than state and national averages, possibly contributing to the growth of IEA as an income-earning alternative.

The paper proceeds as follows. In the next section, we review the dominant theoretical approaches used to explain the position and the effect of informal workers in labor markets. The third section explains the data we use and the method by which we estimate the level of IEA, and it provides descriptive statistics. Section four presents the results of regression analyses that test the existence of labor market segmentation by level of informality and the impact of the estimated number of informal workers on the earnings and employment outcomes of other workers. A final section concludes by highlighting some policy implications of our results.

Analytical Approach

The dominant view in neoclassical economics is that IEAs offer a solution to poverty and unemployment. Informal workers are seen as small-scale entrepreneurs (e.g., street vendors, transport operators, craft producers) who skirt the legal and bureaucratic obstacles preventing them from earning a descent standard of living in a market economy. According to Hernando De Soto [1989, 185], one of the most popular defendants of this perspective, "the choice between working formally and informally is not the inevitable result of people's individual traits but, rather, of their rational evaluation of the relative costs and benefits of entering existing legal systems." Informality is therefore exogenous to the labor market - it is believed to be a by-product of extra-economic state regulations. Hence, the expectation is that workers who "chose" to become informally self-employed will fare better than those (with similar human capital) who follow a "legal" path, which imposes institutional constraints.

Sociologists in the structuralist tradition have rejected this view by arguing that most of the participants engaged in IEA are not self-employed, but rather work for private companies under less than favorable conditions. In this framework, informality is endogenous to the labor market - it is a by-product of firms constantly seeking to restructure production and to lower costs. According to this view, IEA intersects with labor markets already segregated along lines of socioeconomic status, race, ethnicity, and gender. And informal workers working in the lowest segments often earn very low wages that are generally not sufficient to lift them out of poverty. Consequently, part of our empirical analysis investigates whether informal workers are best described as successful entrepreneurs or as disadvantaged or exploited laborers.

As for the labor market impact of informal workers on formal workers, economic theory offers hypothetical explanations and expectations.(4) Although an oversimplification, we can distinguish again between the neoclassical and structuralist approaches, with the latter dividing into neo-institutionalist and Marxist frameworks [Elliott 1984, 59-60]. The neoclassical approach has traditionally assumed a homogeneous and single labor market, where ali members of the labor force compete for jobs, and the level of one's human capital determines one's competitiveness [Borjas 1990; Mincer 1974]. Labor market equilibrium is reached through adjustment in wages. Higher-skilled and lower-skilled laborers are, more often than not, assumed to be substitutes for one another in many production processes. Hence, in theory, if more workers offer their labor informally at a lower wage, we may predict that their employment will increase, resulting in downward pressure on the earnings and employment of other workers.

Economists in the first of our structuralist approaches, the neo-institutional tradition, believe that the labor market is segmented into primary and secondary markets by institutional processes [DeFreitas 1991, 1988; Gordon, Edwards, and Reich 1982]. This dual labor market hypothesis suggests that workers in the two occupational segments may complement each other.(5) Although no neo-institutionalist study to our knowledge focuses directly on informal economic activity or systematically connects it with tertiary occupations, theoretically we may conceptualize informal employment as part of the non-primary labor market. In this framework, a rise in the number of informal workers may not have any negative impacts in the primary sector. To the contrary, informal workers may benefit formal workers and firms by performing necessary but less desirable tasks at a lower cost via direct hiring or subcontracting. For example, the existence of a secondary market where informal workers produce electronic coils, computer boards, or parts of antennas at very low piecemeal rates may increase the competitiveness of the high-technology industry and raise profits. In turn, some of this added profit may be distributed to higher-skilled workers.

A second structuralist perspective on labor market activity is rooted in the Marxist theory of class relations. In...

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