How Large are Earnings Penalties for Self-Employed and Informal Wage Workers?
2.1 Theoretical
In a standard neo-classical model in which labor markets are perfectly competitive, labor is free to move between sectors and workers maximize earnings, identical workers would earn the same amount whether they are self-employed, employees in small firms, or employees in large firms. In a competitive labor market, this will be true even though larger firms may offer facilities that boost worker productivity, such as access to capital, export markets, and the opportunity to specialize. Assuming diminishing marginal returns to labor in wage employment, the free movement of labor will equalize earnings between wage employees in different firms and the self-employed.
What are departures from the competitive labor market model that could lead to an observed earnings penalty or premium for self-employed workers vs. employees, or for employees in different types of firms? Most explanations of persistent earnings differentials between the self-employed and employees are based on barriers to movement in response to a systematic earnings difference between sectors. A traditional view of labor markets in developing economies is that they are segmented or dualistic, where formal sector jobs are restricted by minimum wage, tax laws, and labor market regulations that limit employment in the formal sector. Key to this view is that either government regulations, especially those on labor market, or efficiency wages limit the availability of formal sector employment and make it difficult for non-formal sector workers to compete for formal sector jobs. That is, some workers are “excluded” from the formal sector by labor market regulations or efficiency wages. This view argues that workers unable to find adequate employment opportunities in the formal sector are forced to take employment as self-employed workers or employees in the low paid, marginal informal sector firms. In this view, both self-employed workers and informal employees are “excluded” from the formal sector. Limiting competition from these “excluded” workers keeps the wages of formal sector workers above the market-clearing wage, resulting in wage penalties for the excluded workers. The dualistic labor market view subscribes to the notion that informality stems from an imbalance between high population growth and the slow growth of “good” formal jobs (Harris and Todaro 1970; Fields 2005, 2009; Tokman 1978; De Mel et al. 2010).
One distinguishing feature of labor market segmentation is earnings differentials; earnings gaps between informal sector workers (both self-employed and employees) and equally-qualified formal wage and salaried employees has often been interpreted as a measure of the degree of labor market segmentation (Lewis 1954; Mincer 1962; Fields 2009). In this view, self-employment and informal wage employment are prevalent in low income economies because the formal economy is incapable of providing enough good, high-wage jobs. As countries develop, the proportion of workers who are self-employed and informal employees should fall, and the wage differential between the self-employed and informal employees vs. formal employees should eventually disappear.
An alternative explanation for why there might be a self-employment or informal employee earnings penalty that does not rely on segmented labor markets is that workers maximize utility rather than earnings, leading to systematic compensating wage differentials. For example, if self-employment is more desirable than wage employment for reasons unrelated to earnings, such as greater autonomy and flexibility, we would expect to see a self-employment earnings penalty. Unlike the labor market segmentation explanation for self-employment and informal sector earnings penalties, the compensating differential explanation suggests that the earnings penalty will be particularly large in more developed countries and among better educated workers, where the opportunity cost of time is higher and therefore the flexibility of self-employment will be valued more.
A third possibility is that the standard neo-classical labor market model is correct, but that empirically the compensation of self-employed workers, informal employees, or formal employees is not measured properly. Absolute estimates of wage gaps are inherently imprecise due to the difficulty of measuring self-reported profits and of valuing non-wage benefits. For example, self-employed workers might systematically under-report earnings, which could lead to an observed self-employed penalty even when none exists (Hurst et al. 2010). On the other hand, the self-reported earnings of employees include only returns to labor, while the self-reported earnings of the self-employed may also include returns to capital, as well as returns to the risk of entrepreneurship. Failing to account for this may overestimate the self-employment earnings premium. Furthermore, formal sector wage employees often do not include in their reported earnings the value of non-wage benefits such as firms’ contributions to pensions, sick pay, severance pay, and health care, while self-employed workers and informal sector workers, who do not receive these non-wage benefits, may receive higher paid wages as compensating differentials. In the competitive labor market described above, self-employed and informal sector employees would include compensation for these foregone non-wage benefits (Meghir et al. 2015), which would lead to overestimation of self-employment and informal sector earnings (and may even lead to a measured premium for self-employment and informality).
When examining earnings premiums, it is useful to distinguish between low-skilled self-employment, entrepreneurial self-employment, and informal wage employment. While many have identified self-employment in developing countries with the informal sector, others identify self-employment with entrepreneurship (Bennett and Estrin 2010; de Soto 1989). Higher skilled, more entrepreneurial self-employed may earn a wage premium compared to formal employment. This could arise if the most motivated and productive workers became entrepreneurs, or if there are compensating earnings differentials for entrepreneurs that compensate for increased risk and volatility, or if wage employees’ compensation is underestimated in the data.
High adjustment or entry costs into entrepreneurship could also contribute to an observed self-employment premium because the future earnings of entrepreneurs would need to compensate for these costs. One such adjustment cost is the initial investment needed to set up a small business, often financed through credit. If credit markets are imperfect and it is difficult to obtain credit, then self-employed entrepreneurs must be paid more than they could get as employees in order to compensate them for the high costs of credit. On the other hand, in low income countries many self-employment opportunities may require little capital, while searching for higher-paid wage employment may involve relocating or other expensive search costs.1 For those facing credit constraints, starting a low-level business as a petty trader or farmer may entail less upfront cost than searching for a wage job. In this case, imperfect credit markets would create a self-employment earnings penalty.
Another adjustment cost of self-employment and entrepreneurship could be associated with complying with regulations and permits needed to start a business. These costs can be substantial in many developing countries (de Soto 1989). If there are regulatory and other costs to becoming self-employed that limit access, then self-employed workers will be paid more to compensate for these additional costs, causing an observed self-employment wage premium. For example, if it is costly and time consuming to obtain all of the necessary permits and permissions to work as self-employed (i.e., a more regulated economy), or if taxes are higher for the self-employed than for employees, then self-employed workers may be paid more than they could get as employees as compensation for the high costs of entry. Note that the self-employed would need to be compensated for these regulatory costs even if they attempt to avoid them because there may be costs to violating these regulations.
A final possible reason why formal sector wage employees may earn more than similar self-employed workers is that formal sector employees may successfully bargain for a portion of the quasi-rents earned by firms. Several studies have identified non-competitive rents as an important determinant of inter-industry wage differentials.2 Most recently, Abowd et al. (2012) find that shared quasi-rents account for a large percentage of inter-industry wage differentials in the United States and France. Based on wage bargaining models that allow for on the job search (i.e. Cahuc et al. (2006)), they posit that the wage formal sector firms pay employees is the sum of the opportunity cost of wage employment plus the workers’ share of quasi-rents. Under the assumption that earnings in self-employment or the informal sector is an approximation of comparable formal sector wage workers’ opportunity cost, the self-employment and informal employment earnings penalties will be determined by the bargaining power of workers and the size of the quasi-rents. That is, the self-employment and informal sector earnings penalty will increase if the relative bargaining power of formal sector employees increases or if firms’ quasi-rents increase.
The bargaining power of formal sector employees, and therefore self-employment and informal sector wage penalties, could be increased by the presence of efficiency wages or labor market institutions such as unions. Van Reenen (1996) focuses on the role of innovation and increased labor productivity in generating quasi-rents, which firms can then “share” with workers as efficiency wages. That study presents strong evidence that workers in British firms that adopt more innovative and productive technologies earn more than identical workers in other firms. It argues that more productive firms allocate part of their “quasi-rents” from innovation to workers in the form of higher wages. To the extent formal sector firms share quasi-rents with workers, this would contribute to a self-employment and informal sector wage penalty. These penalties would be larger in countries where firms are more productive, and therefore have more quasi-rents to share, and/or in countries in which labor market institutions favor workers in the wage bargaining process.
In one traditional dualistic model of economic development, the formal sector in least developed countries is small (and self-employment and informal employment are large) because lack of demand, credit, reliable inputs, and export markets keep scale and productivity low for formal sector products (see Lewis 1954 and La Porta and Schleifer 2014). For this reason, formal sector firms in low income countries will be less productive. Since firms in low income countries tend to be less productive than those in more developed countries, quasi-rents and by extension self-employment penalties would likely be smaller for workers in low income countries. As demand increases for domestic products and credit, input and export markets expand, the scale of production and productivity increase in the formal sector. As countries develop, firms not only earn more quasi-rents, but labor market institutions may also become more effective in increasing workers’ bargaining power. Both of these factors will lead to increased earnings for formal sector employees relative to the self-employed and informal sector workers.