Informality and poverty in Ecuador

For the vast majority of households in the developing world, labor income accounts for the main, if not the only, source of income. In 2013, the estimates of the World Development Report from the World Bank (2013) revealed that self-employment and farming represent almost half of the jobs in the developing world. They also revealed that the important decline in poverty rates between 1981 and 2008 was achieved, to a large extent, through jobs. If non-wage employment represents such a large share of total employment in these countries, understanding the links between informal jobs (whether defined on the basis of self-employment, social security coverage or written employment contract) and poverty becomes critical from a policy perspective.

Indeed, labor informality is a common characteristic of developing countries, which are also characterized by high levels of poverty. In this context, it is easy to think that a link between poverty and informal employment exists. In particular, one may think that being poor affects the probability of working informally, but also that having informal employment is a determinant of poverty. The question then becomes whether informality is both a cause and a result of poverty. That is, are informal employment and poverty interrelated? While there is some agreement about this idea in the literature, there is still limited evidence about the interactions between the two phenomena. Most articles on informality or poverty consider this only as a one-way relationship and do not take into account the simultaneous causality that may exist between these two phenomena—thus, estimates may be biased. This article adds to the limited number of empirical studies that address this problem.

The case of Ecuador is of particular interest since little evidence exists for this country even though its poverty and informality rates are among the highest in Latin America. In Ecuador, the share of employees who do not have social security coverage is the highest among the poorest, at 84% versus 65% for the not poor. Also, households headed by informal workers have higher poverty rates (34%) than those headed by formal workers (13%).¹ There is thus a strong association between informality and poverty in the country.

This paper contributes to the literature in several ways. First, it controls for the simultaneity of poverty and informality by using a simultaneous equation model that allows for error correlation across equations. While the methodology is not new in the literature, the article adds to the limited number of studies that address the double causality between the two phenomena. Second, it provides evidence for a country for which no other stu- dies link poverty and informality. Third, it presents the results for both salaried and self-employed workers. These results, so far unavailable in the literature, contri- bute to a better understanding of the heterogeneity of informal sector employment in a developing country.

The structure of the paper is as follows: Section 2 reviews the literature and the main theories of informality. Section 3 describes the data and presents some descriptive statistics. Section 4 presents the empirical specification, Section 5 the results, and Section 6 the robustness checks. This is followed by a discussion and conclusion in Sections 7 and 8.

The relationship between informal employment and po- verty is a very complex one that is not yet well understood. In the theoretical literature on the informal sector, three contrasting views prevail regarding the origins of informal employment—namely the dualistic labor market approach, the alternative or neoliberal approach, and the structural articulation approach.

In the first approach, informal employment is seen as an involuntary solution to unemployment—it is the second-best strategy that substitutes for the lack of formal employment. As such, the informal sector absorbs the surplus labor in the economy. In this view, informal employment is involuntary, requires little capital investment and only provides a subsistence wage. This approach originated with the works of Lewis (1954) and Harris and Todaro (1970), and was later extended by Fields (1975).

The alternative (or neoliberal) approach sees informal employment as a voluntary choice. In this view, informal employment represents a cost-minimizing strategy for entrepreneurs trying to avoid the costs of labor regulations. Basically, the informal sector is viewed as the optimal and coherent response of economic units to government-induced distortions like minimum wages and excessive taxes (Chaudhuri and Mukhopadhyay 2010).

The third theory of informal employment sees the informal sector as heterogeneous and comprising at least two distinct sub-sectors: informal activities with direct subsistence goals and dynamic activities with decreasing labor costs and capital accumulation goals (see Chaudhuri and Mukhopadhyay (2010)). I argue that informal employment in Ecuador exhibits the characteristics of a heterogeneous informal market, where informal work is both a demand-led phenomenon and a voluntary and primarily supply-led form of employment. See Cunningham and Maloney (2001), Paulson and Townsend (2005), Günther and Launov (2012), and Harati (2013) for studies in developing countries that exhibit similar characteristics.

Literature relating poverty and informal employment is scarce, mostly based on studying a one-way relationship, and usually being descriptive. For instan- ce, Gasparini and Tornarolli (2009) study the trends of labor informality in the Latin America region during the period 1989–2005. While the cross-section evidence seems to be consistent with the idea of voluntary self- employment, the authors found that, on average, being informal implies lower wages, even when controlling for observable factors. Informally employed male wor- kers without a secondary education earn, on average, 30% less than their formally employed counterparts. Accordingly, in all countries the difference in the po- verty headcount ratio between informal and formal workers is sizeable. Loayza et al. (2009) study, among other things, the connection between poverty and in- formality in Latin America and the Caribbean (LAC). Using country-level data, the authors use the share of informal employment as one of the determinants of poverty and use instrumental variables to control for the endogeneity of informality on poverty. The results suggest that the share of the informal sector has a significant positive impact on the incidence of poverty across LAC countries. Maurizio (2012) studies to what extent the income segmentation associated with informality is a relevant factor in the poverty situation of households in Argentina, Brazil, Chile, and Peru. She finds a positive relationship between informality and poverty. However, she also finds that the elimination of informality does not eliminate poverty. A more recent study (Webster et al. 2016) looks at the relationship between informality, property rights, and poverty in three Chinese cities. Among the various definitions of informality used by the authors, the results show a strong association between labor contract types and poverty. While these results are fundamental for the understanding of informal employment and poverty, either no casual relationship between the two phenomena was established, or only a one-way relationship was considered in the analysis, usually with informality as a determinant of poverty.

To the best of this author’s knowledge, only three stu- dies have used a simultaneous equations framework to study the relationship between poverty and informa- lity: Amuedo-Dorantes (2004), who studies the determinants of poverty and its implications for the informal sector in Chile; Devicienti et al. (2009), who study the same process using panel data for Argentina; and Nazier and Ramadan (2015), who study the inverse causality between informality and poverty in Egypt. Both studies in Latin America found a strong correlation between poverty and informality in the countries. In the absence of panel data, I follow the methodology employed by Amuedo-Dorantes (2004) and study the determinants of poverty and informality in Ecuador. In addition to the results already provided for salaried workers in Chile, I also provide estimations for self-employed workers. These results, to date unavailable in the literature, contribute to a better understanding of the heterogeneity of informal sector employment in a developing country, where usually more than 50% of the working population is categorized as self-employed.

The data used in this paper are drawn from the Ecuadorian National Living Standards Survey (ECV) 2014, conducted by the Ecuadorian National Institute of Statistics (INEC). The ECV is a cross-sectional survey representative of the Ecuadorian population. The survey collects detailed information on household demographics, health, education, occupations and labor force participation, housing and asset ownership, household food, and non-food expenditures and income.

Affiliation to the national social security system is mandatory for all salaried workers. A registered worker has access to health care services and retirement benefits. A salaried worker also has the right to earn at least the minimum wage, be paid for extra hours of work and to receive mandated benefits (teen salaries and profit sharing at the end of the fiscal year) (Canelas 2014). Since the social security card constitutes a sufficient proof of labor dependence, it assures employers’ compliance with all these benefits. On the other hand, it also reduces the chances of employees under-declaring their income as the information is cross-validated between the National Revenue Tax Institute, employers and employees. Hence, the definition of informality used in this paper is based on the lack of social security coverage. Since this definition applies only to salaried workers, I run separate regressions using self-employment status as an alternative definition of informality. These results are interpreted in Section 5.

Studying the relationship between informality and poverty is a difficult task since poverty is measured at the household level while informality and other human capital variables are based on individual status. In order to deal with this problem, I follow the standard practice in the literature (Amuedo-Dorantes 2004; Devicienti et al. 2009), and I base the definition of informality on the formal/informal status of the household head. Thus, I work with a sample of working household heads.

The poverty status of the household is assessed using the index of unsatisfied basic needs (UBN) (Necesidades Basicas Insatisfechas; NBI) proposed by the United Nations Economic Commission for Latin America and the Caribbean (ECLAC) and used as an official measure of poverty in many countries in Latin America, including Ecuador.² Most UBN indices include indicators such as access to clean water, quality of housing, crowding, education level of household head, school attendance, nutrition, and others. In the case of Ecuador, a household is considered poor if one of the following holds:

The use of a composite index to measure poverty is not free of criticisms. The most obvious problem with the UBN is that the greater the number of indicators used to create the index, the greater the likelihood of being categorized as poor—the probability of being categorized as poor would be higher if one uses five indicators instead of three.

In order to measure the robustness of the estimates, I also present the results using a consumption poverty line. This measure is one of the official poverty lines used by the Ecuadorian government.³

Table 1 presents the percentage of poor households for different sub-samples and two measures of poverty. As mentioned before, working individuals are divided into salaried and self-employed workers. Salaried workers represent, on average, 40% of all working individuals, while the other 60% are self-employed. The first row of Table 1 gives the percentage of poor households with respect to each sub-sample, while the second row presents the same results with respect to the entire sample of workers. For instance, using the UBN indicator, around 45% of self-employed workers and 28% of salaried workers are poor (row 1, columns 2 and 3). With respect to the whole sample, poor self-employed workers represent 27% of the sample and poor salaried workers represent 11% (row 2, columns 2 and 3). Together, poor self-employed and salaried workers comprise 38% of the sample. Columns 4 and 5 decompose the results of salaried workers into formal and informal workers. The interpretation of the results is similar to columns 2 and 3.⁴ Finally, the interpretation for row 3 (4), is similar to row 1 (2).

Figure 1 illustrates kernel density estimates of monthly earnings for salaried and self-employed workers (Table 2 reports the corresponding sample means along other descriptive statistics). Job income disparities between salaried and self-employed workers are clearly visible, as the earnings distribution for salaried workers is shifted to the right. Also, within salaried workers, household heads employed in the formal sector earn significantly more than their counterparts in the informal sector, as depicted in the right graph of Fig. 1.

In Fig. 2, I plot the kernel distributions of household revenues for salaried and self-employed workers. The distributions are similar to those of monthly earnings. Since household heads’ earnings account, on average, for 69% of household incomes, it is not surprising to find higher poverty rates among informal workers.

The aim of this article is to analyse the relationship between poverty and informal employment in Ecuador. In particular, it aims to address the following questions: Does being poor affect the probability of having informal employment? Is being an informal worker a determinant of poverty? That is, are informality and poverty interrelated? In this framework, informality and poverty are assumed to affect each other in both directions. On the one hand, informal employment affects the poverty status of the household mainly through low earnings. On the other hand, household poverty may be the main reason for a household head to accept informal employment, since they cannot afford to be unemployed.

Modeling this inverse relationship is usually challenging. First, the analysis needs to account for the potential endogeneity of household poverty and household head’s informal employment status, as well as for unobserved factors that may affect these two phenomena simultaneously. Second, focusing the analysis only on working individuals raises the problem of sample selection. Third, poverty is measured at the household level, while informality and other human capital variables are based on individual status. While the latter problem is handled by focusing the analysis on a sample of household heads (see Section 3), a simultaneous equations probit model with sample selection is well suited to tackling the first two issues. The model is specified as follows: where y_1i is a dummy variable indicating the ith household head’s employment status, i.e. formal/informal, y_2i is a dummy variable indicating the ith household’s poverty status, and X_ji is a vector of sociodemographic and work-related characteristics of the ith household head, with j = 1,2. Equation 3 is the selection equation, thus y_3i is a dummy variable equal to 1 if the household head works and 0 otherwise. z_i is a vector of sociodemographic characteristics similar to X_ji, but not equal.⁵ The estimation of this model is thoroughly discussed by Mallar (1977).⁶ The model is estimated as a simultaneous equations maximum likelihood probit model with sample selection. Corrected standard errors are obtained by bootstrapping (1200 repetitions).

These results show, first, the relevance of poverty for both informal salaried work and self-employment in Ecuador. In particular, household poverty, as measured both by the IBN index and household consumption, increases the likelihood of engaging in informal salaried work and self-employment by around 5 and 10%, respectively.¹⁰ This finding, along with the concentration of informal workers in low-productivity and low-income sectors, supports the view of informal work as a second-best strategy that substitutes for the lack of formal employment and to which individuals turn when they face difficulties meeting their basic needs. Indeed, in the absence of unemployment benefits, workers have no choice but to work, even if they have to do it informally—in particular, when the fraction of non-labor income is small, as it is in Ecuador.

Nonetheless, as noted by Cortés Aguilar et al. (2013), at least in Latin American countries, the cate- gories of informality and self-employment are too broad to be conclusive. Indeed, when looking at the determinants of self-employment one notices that high-skilled workers, proxied by educational level, are 12% more likely to be self-employed than those without formal education. Further, when the sample is divided into low- and high-skilled workers, the results show that poverty increases the likelihood of informal work among low-skilled workers by around 10%, and that it has no significant effect on informal work among high-skilled workers. These findings support the view of informal work as a voluntary choice for this group of workers.

While, on average, informal employment is associated with lower earnings than formal employment, as shown in Table 2, the evidence also shows that this is not the case for all groups of workers. As shown in Fig. 1, there is an overlap between the earnings distribution of formal and informal workers.

Additionally, non-monetary incentives are likely to play a role. The study of Cortés Aguilar et al. (2013) on job satisfaction among different Latin American countries shows, among other things, that self-employed professionals and business owners are more satisfied than salaried workers with their incomes, while self-employed farmers and fisherman are less satisfied with their jobs and incomes. Along this line, a report from the World Bank (2012) found that being their “own boss” and having “flexible time schedules” are the main motivations for informality across small-firm owners and entrepreneurs in Ecuador. The study also reports that only around 30% of this group cite the inability to find wage employment as a reason for informality. This evidence, coupled with the results of this study, reinforce the idea of a heterogeneous labor market in which some workers are better-off as self-employed while others are worse-off.

Second, the results also show that both informal salaried work and self-employment increase the likelihood of household poverty by 3 and 2%, respectively. While the effects of informality on poverty are lower than the effects of poverty on informality, the results raise concerns about the implications of informal work (salaried or self-employment) for poverty. In particular, informal work, here defined as the lack of social security coverage, concerns more than 60% of the population under study. With a high percentage of low-skilled workers and with poverty rates being the highest among this group of workers, future implications of the lack of retirement benefits are worrisome.

These results suggest several broader implications and avenues for future research. For one, consistent with the literature on heterogeneous labor markets, these results show the relevance of diversity among informal workers in the country and speak to the need for public policies targeting different groups of workers. The findings further offer additional evidence on the relevance of education for decreasing poverty and its effect on informality. In particular, they show the need of incentives appealing to various levels of skills. In terms of future analysis, the findings highlight the need for studies looking at small-firm survival in Ecuador, as well as the role of remittances in alleviating liquidity constraints faced by entrepreneurs in the country.

This study uses microeconomic data from the Ecuadorian Family Expenditure survey of 2014 to study the determinants of poverty and informality in the country, taking into account the possible two-way relationship that exists between these two phenomena. The estimations confirm previous results in the literature that, despite controlling for many relevant variables, informality and poverty are correlated and so this double causality should be taken into account when studying these factors.

In Ecuador, as in many Latin American countries, a high proportion of informal employment is of poor quality. In general, informally employed workers are found to have a relatively low education level and low wages, which supports the idea that these workers have no choice but to work informally. However, the complexity of the informal sector supports the view of a heterogeneous informal market in which work in the informal sector is both a demand-led phenomenon and a voluntary and primarily supply-led form of employment. Informal work is both a last-resort option for low-skilled workers and a voluntary choice for better-educated and entrepreneurial workers.

From a policy perspective, since poverty and informality are interrelated, the results suggest that no public policy could effectively eliminate either of the two phenomena if nothing is also done to alleviate the other. It is clear, for instance, that poverty reduction could only be sustainable if more and better employment opportunities are created. For the vast majority of households in Ecuador, labor income is the main (if not the only) source of income. Thus, quality job creation through enterprise development, as well as investment in education and training, is of great importance.

Last but not least, policies aiming to increase fiscal revenues from the higher-paid segment of the informal sector (salary jobs or self-employment) should be designed in such a way that they also provide incentives for these workers to become formal workers. Since more than 50% of informal workers are concentrated in small firms, measures to increase the incentives of small enterprises to become formal should also be part of these reforms.