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Does your social benefit system encourage informal employment?

14/07/2022

Senior social policy specialist, Chad Anderson, talks about his experiences of the impacts social policy choices have on the informal sector.

In my final year of secondary school in the early 2000s, I had a summer job in a flower greenhouse. I saved enough for a flight to visit my older brother – a super cool musician in western Canada. It was good for me, but I wondered how so many of my colleagues, many of whom were young women, were raising families on our low wage, only partially offset by payments in cash, meaning we did not pay income tax. We were part of the ‘underground economy’, or informal sector.

That summer I witnessed first-hand how the government’s poverty targeted Family Benefit Allowance – a lifeline that most of my colleagues received – fuelled an underground economy. The logic behind poverty targeted benefits was clear: you must be classified as poor to get them.  And so, my colleagues were actually incentivised to hide their earnings and join the underground economy to avoid losing the benefits they needed to raise their families, which even the lowest paying formal job with a contract would have jeopardised. Ironically, this nudge to join the informal sector and retain poverty targeted benefits also locked my colleagues out of better and more comprehensive contributory social security.

Years later, working as a social policy specialist in low- and middle-income countries, I have witnessed this problem across different contexts and on a much larger scale. The vast majority of the labour force in low- and middle-income countries work in the underground economy. That’s over 80 per cent of the labour force in Africa and an estimated 59 per cent in Asia and the Pacific. This underground economic activity reduces tax revenues as the individuals and businesses that comprise it often do not pay any direct tax at all. This reduced tax revenue holds back public investment in the social services that our societies and economies need to thrive, particularly in times like these when inflation is skyrocketing.

Within this context, it is important for governments to consider how the design of social security benefits influences labour market participation choices, such as whether those who receive them will choose to work, and if they do, whether they will seek work in the formal or informal economy. Three clear examples of different designs and their impact include:

Poverty targeted schemes that discourage work: In Georgia, women who receive the Targeted Social Assistance benefit, that attempts to reach the poorest 15 per cent of households, are 9 to 11 percentage points less likely to work when compared with women of similar economic standing in households that do not receive the benefit.

Inclusive schemes that encourage work: In South Africa, households that receive the universal Child Support Grant are 15 per cent more likely to work and 18 per cent more likely to seek it.

Targeted schemes that discourage movement from the informal to formal sector: Argentina’s targeted child benefit targets those in the informal sector and provides higher benefit levels than contributory schemes for formal sector employees. This has meant parents and caregivers are less likely to move to the formal sector, but people without children, outside the scheme, were much more likely to make the move, as shown in Figure 1.

Figure 1: Proportion of informal workers that became formal in Argentina after Asignación Universal por Hijo, or Universal Child Allowance

Source: Garganta, Santiago, Gasparini, Leonardo (2015). The Impact of a Social Program on Labor informality: The Case of AUH in Argentina, Journal of Development Economics

This growing body of international evidence on the impact of poverty targeting on labour market participation choices supports what I witnessed decades ago in Canada. The logic is still clear: when eligibility for benefits is linked to being and remaining poor, women and men of working age, including business owners, will factor these criteria into their own decisions on whether and where to work, and act in their own self-interest. Countries with high administrative capacity usually seek to move out of this ‘benefit trap’ towards more comprehensive contributory social security. In Malta, where a family benefit was disincentivising the take up of work, the government launched a ‘Making Work Pay’ programme in 2014 to promote re-entry into the formal labour market and increase enrolment in social security.

For employees, it is easy to see how poverty targeted benefits create incentives to remain ‘off the record’ and earn additional income in precarious and sometimes dangerous work, without risking the loss of benefits. For business owners, including small and medium sized enterprises in high-income countries, poverty targeted benefits create incentives to inaccurately report income and expenditures to qualify for these benefits. For both employees and businesses these incentives come on top of other structural incentives, including sometimes cumbersome processes required to formalise, which together increase the risk of tax fraud and reduce tax revenues.

Over the years, I have had the privilege to support governments to address this problem head-on through investing in inclusive social protection, following the example of South Africa and others, including many high-income countries where inclusive and universal social security schemes are more common and informal sectors are much smaller.

Inclusive and universal social security benefits offset key risks experienced throughout life, for example during childhood, disability, and old age. Instead of providing benefits based on household income or estimated poverty, universal social protection programmes most often provide benefits based simply on one’s age or assessed level of disability. For example, a child benefit that is fully universal would provide benefits to all children from birth to their 18th birthday. As benefits are not linked to income, those receiving benefits, or their parents and caregivers, are not sanctioned or penalised if they seek work in the formal sector.

As such, inclusive and universal social protection benefits do not hold anyone back from contributing to the economy and paying their share of income tax. They increase the number of people in formal employment, boosting tax revenues. Further, working in the formal sector opens opportunities to contribute to social insurance programmes, including contributory pensions, which can increase financial protection later in life.

The differences are simple and clear. Poverty targeting creates incentives for employees to join the underground economy, and for businesses to engage in tax fraud. Universal benefits remove these incentives. This was clear to me when I was watering plants at the greenhouse, and it is even clearer now that I have had the opportunity to support governments to tackle this problem.


References

DSD, SASSA &UNICEF. (2012). The South African Child Support Grant Impact Assessment: Evidence from a Survey of Children, Adolescents and Their Households. Pretoria: Department of Social Development, South African Social Security Agency, UNICEF.

ESCAP (2021). The Social Protection We Want: Social Outlook for Asia and the Pacific. https://unescap.org/sites/default/d8files/2021-01/RC5_Social_Outlook_Report_Ch_1_1.pdf

Garganta, S., & Gasparini, L., (2015) The Impact of a Social Program on Labor Informality: The Case of AUH in Argentina, Journal of Development Economics (2015), doi: 10.1016/j.jdeveco.2015.02.004

International Social Security Association (2022). Priorities for social security https://ww1.issa.int/sites/default/files/documents/2022-04/2-priorities-report-Europe-WEB.pdf

UNICEF (2018). Universal Child Allowance (AUH): a contribution to the discussion on the role of conditionalities https://www.unicef.org/argentina/media/4186/file/Universal%20Child%20Allowance%20(AUH).pdf

World Bank (2020). Supporting Africa’s urban informal sector: Coordinated policies with social protection at the core. https://blogs.worldbank.org/africacan/supporting-africas-urban-underground-sector-coordinated-policies-social-protection-core