Labor informality: Grabbing the bull by its slippery horns

Tax. If you’re a government you love it. If you’re a business or worker you don’t. 

But tax is a fact of life and it’s hard to see how any society could function without tax dollars flowing into state coffers to pay for the likes of public services.

Leaving aside the thorny issue of how tax revenue is actually levied and redistributed, what is clear in Latin America is that bringing more small businesses and microenterprises – as well as the people who work for them – into the formal sector is essential, since they account for the bulk of jobs in the region after all.

The coronavirus outbreak has driven this message home in Latin America, where the informal economy in most countries is dominant. It has thrown the spotlight on the precarious situation of informal workers and their families and the relative weakness of social safety nets and the fragility of health systems. 

For the region to continue advancing, reduce inequality and improve public services, they have to combat the cash-in-hand culture. Granted, it is a complex and grueling battle, especially in countries where informality seems engrained into the culture and there is a strong disconnect between citizens and authorities. Indeed, it is a vicious circle. A contributor who feels public officials steal or waste their tax contributions is more likely to dodge the taxman.

But break this vicious circle we must. Take Peru and Bolivia for example. These countries have high levels of labor informality and, like most other nations in Latin America and beyond, have plenty of spending pressure in areas including infrastructure, health and education. Imagine the strides that resource-rich nations could make with a larger flow of revenue that was properly administered. 

Being in the formal sector also helps open the doors to the financial system, to products such as working capital loans for businesses and consumer loans for employees.

Income tax paid by the SME and its employees – even if at a low rate – would be one benefit. Plus, employees would become part of the “system”. That means they would start contributing to either a state or private pension scheme, gain greater access to healthcare and likely open some kind of savings or current account, which would also spur financial inclusion. 

It is not a recipe for creating utopias, not a magic bullet, as many countries have associated issues to address, such as high levels of corruption and inefficient bureaucracies. But it would be a step in the right direction.

Chile – which faces higher spending pressure following last year's protests over living costs and inequality, not to mention a bigger debt burden because of crisis-mitigation measures – is sharpening its focus on tax collection. The government’s latest tax reform makes the issuing of digital receipts mandatory. Under the changes, all companies or freelance employees will need to issue digital receipts via a system connected to inland revenue service SII.

Some microenterprises and SMEs, particularly those with very narrow profit margins, will arguably resist becoming part of the system and there is no real way of accurately gauging how much tax revenue the measure will generate. But it is a way to fatten government coffers and help reduce inequality without raising taxes and we may see other nations in the region eventually following suit. The key will be in the implementation, especially now given the fallout from the COVID-19 pandemic. It will have to be a very gradual process, one that, at present, will likely need to be delayed. 

Overall, with lower commodity prices and sluggish growth and investment, Latin American countries must bring labor formalization into focus and boost tax revenue to help create sustainable cash flows for the services that citizens demand. It is a bit of a tightrope walk. Authorities must get the balance right between carrot and stick and have an effective publicity campaign touting the benefits.

Failure to do so will feed mediocrity in a region that can – and must – do better for the good of its citizens.