Reforming Labor Markets May Enhance Human Capital Accumulation


Policy discussions in Latin America have long emphasized the importance of education, and with good reasons. Education is key for general societal advancement. The mechanisms are many, but an important one is better labor market outcomes. In this case, ignoring issues of quality, the causality runs from more schooling into more stable jobs, higher wages, and improved access to social insurance. Investments in schooling are thus assumed to have high returns, in addition to many externalities that are hard to measure but are widely assumed to be positive.  Understanding the determinants of schooling investments is central.

In a recently published paper, we take a novel approach to this issue [1]. Our main result is that dysfunctional labor markets are, de facto, anti-education policy, because they depress the returns to schooling and hence the incentives to invest in schooling. In our view, informality is the manifestation of flaws in the design and operation of the institutions regulating the behavior of firms and workers in the labor market. But another more constructive way of stating our main result is to say that improving these institutions is a powerful mechanism to raise the returns to schooling, increase schooling investments, and augment countries’ stock of human capital.

To study the relationship between informality and investments in schooling, we develop a search model of the labor market that captures two empirical regularities that are hard to explain in models where the market is competitive or where there is segmentation, namely, that individual workers transition between formal and informal jobs, and that conditional on the schooling level of the workers, the formal and informal earnings distributions overlap (Figure 1).

In our model, search frictions generate rents: firms know that if workers forego their wage offers, they may not find another job immediately and thus lose labor income; and workers know that if firms fail to hire them, they may not find another worker immediately, thus losing profits. Firms can offer workers formal or informal jobs. Formal jobs provide social insurance benefits paid from a wage-based tax internalized in the contract between workers and firms, with some benefits pooled (giving rise to cross-subsidies within formal workers) and some proportional to workers’ wages (think health and pensions). Following the practice in most LA countries, informal workers also receive social insurance benefits, the same for all. Although these benefits are not equivalent to those received by formal workers, they are free from the workers’ point of view since they are paid from general revenues (think health). Workers can work for themselves, search for jobs with firms, or remain unemployed until a better opportunity arrives. Firms can comply with the law and offer workers formal jobs or break it and offer them informal jobs; this depends on enforcement which, to reflect another feature of the region, depends on the probability of receiving an audit, proportional to firm size (proxied by its productivity), and a penalty if caught hiring illegally. Self-employed workers, however, are not breaking the law if they do not contribute to social insurance since, following the practice in many countries (e.g., Ecuador, Mexico, Peru), they are not required to do so. When workers are in firms, and given firms’ formal or informal offers, wages are determined by bargaining and by the productivity of the match, which in turn depends on the schooling level of the worker; when workers are self-employed, they are informal and their earnings depend on their own productivity, which also depends on their schooling levels.

In this rich and realistic setting, workers decide on their schooling level prior to entry into the labor market, a decision based on the expected returns to schooling, which in turn depends on the equilibrium resulting from all the factors discussed above. A key finding is that informality depresses the returns to schooling. Since workers anticipate this, they will invest less in it, and the proportion of workers acquiring more schooling will fall. The mechanism is as follows: the institutions that generate informality tax high-productivity formal matches and increase the relative profitability of self-employment and of informal lower productivity matches; in turn, these taxes and subsidies differ across schooling levels, hurting more workers with more schooling. Precisely because these workers are more productive, it is harder for firms to offer them informal jobs (since expected penalties are higher). In addition, because some benefits are pooled, when workers with more schooling are formally employed, they subsidize those with less schooling. On the other hand, since free social insurance benefits for informal workers are the same for all regardless of schooling, they are relatively more valuable for workers with less schooling since they earn less. In sum, informality hurts human capital accumulation.

To probe this mechanism further, we estimate our model on data from Mexico, a country where more than half of the labor force is informally employed. We focus on the decision to acquire three more years of education (9 versus 12) for male workers aged 25 to 55. Combining various data sources, we identify the model’s primitive parameters and reproduce key stylized facts about Mexico’s labor market, including workers’ transitions between formal and informal status and overlaps in the formal and informal wage distributions.

Various simulations highlight the sharp and highly undesirable policy trade-offs that informality creates. They key one is this: eliminating informality increases the returns to education and augments investments in schooling but reduces welfare as free benefits for those informally employed as well as cross-subsidies between formal workers with more and less education disappear. We estimate an overall welfare loss of 6% but larger for firms (28%) than for workers (5%). At the same time, the proportion of workers with complete secondary education increases by 10%.

The trade-off between schooling investments and welfare results from the fact that taxes and subsidies between workers with different schooling levels, and therefore incomes, operate through the labor market and are associated with formality status. The lesson is not that, to increase investments in schooling, redistributive taxes and subsidies should be eliminated, but that they should carried outside the labor market. Countries should not have to choose between increasing investments in schooling and welfare. That choice is there today because the specific institutions that have been chosen to provide insurance to workers operate through the labor market; if other institutions were chosen, this trade-off would be muted.

In a companion paper, co-authored also with Mauricio Tejada, we have extended our model to consider the impact of informality on the accumulation of human capital while workers are on the job, given whatever education they acquired before entering the labor force. [2] We show there that on-the-job learning and skills acquisition occurs more rapidly when workers are formally employed, so that informality also reduces human capital after workers have left school. We estimate the relative contribution of human capital to overall productivity to be about 60 percent on average reaching more than 80 percent for workers with the highest level of human capital.

We think that our findings have important policy implications for LA, a region where overall more than half of the labor force is informally employed. An under-appreciated aspect of informality is that it hurts human capital accumulation, both prior to workers entry into the labor market and while they participate in it. In our empirical estimates for Mexico, we find that these effects are large, and we suspect that they could be of similar magnitude in countries that are also characterized by high informality, like Colombia, Ecuador, Peru and many more. In all these countries, governments are making large investments in schooling, in the expectation that this will raise wages and accelerate growth. But governments may not be aware that the institutions regulating their labor markets are depressing the return on these investments. The causality has always been thought as more schooling, better labor market outcomes. Our research shows that in LA there is a parallel causality: better labor markets, more schooling. It may well be that improving the functioning of labor market is a powerful way to increase investments in schooling. This independently of the fact that at present the institutions regulating labor markets in the region are hurting productivity while delivering mediocre social protection to workers. In LA, labor market policy is also educational policy.  


1. “Labor Market Search, Informality and Schooling Investments”, International Economic Review, forthcoming July, 2021. Permalink
2. “Labor Market Search, Informality and On-the-Job Human Capital Accumulation”, Journal of Econometrics, 2021 (223), 433-433. Permalink


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