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Tradable and non-tradable sector
To discuss the role of domestic aggregate demand, it is important to understand differences in skill intensity across sectors. Changes in aggregate domestic demand and terms of trade will have different implications for the skill premium depending on which sectors they favor and the skill content of those different sectors. During 2002–13, employment in South America grew faster in the nontradable sector than in the tradable sector (figure 2.17, panel a). In South America, the nontradable sector is more skill-intensive on average than the tradable sector, and this difference became slightly more pronounced throughout the 2000s (figure 2.17, panel b). In fact, the largest segment of the nontradable sector includes mostly high-paying services such as education, electricity, health, real estate, and transportation. However, the sector also includes large shares of employment in construction and wholesale and retail industries, all of which are intensive in unskilled work.

Formal and informal employment
The level of formal or informal employment is not a policy variable but rather an outcome associated not only with labor market policies but also with fiscal and social policies, as well as with the functioning of other markets (such as the market for credit). However, formalization does play a mediating role in the relationship between labor market institutions (for example, the minimum wage and employment protection policies) and inequality levels, and it can be influenced by policies such as stricter enforcement of labor regulations and social security laws. In countries with high informality, an increase in the minimum wage may have smaller effects on wage inequality than it would in countries with relatively low informality.27 At the same time, increased enforcement of regulations may result in higher formality to the extent that wages adjust. On the other hand, if the minimum wage is highly binding, increases in labor law enforcement might backfire, resulting in higher levels of informality.

Informality may dampen or enhance inequality. To the extent that identical workers are paid different wages if they work in formal versus informal sectors, the effects of informality on inequality would be positive. This effect is probably magnified because informal workers tend to be low-skilled, and hence low-earning workers. However, informality can also reduce inequality through the introduction of allocative distortions that compress the skill premium. Levy and López-Calva show that the persistence of distortions that misallocate resources toward less-productive firms—a distortion reflected in the size-distribution of fi rms—limits the dispersion of wages across educational groups because smaller, informal firms are substantially less intensive in educated workers than are more-productive fi rms. This effect becomes even more important when the supply of higher-educated workers is increasing.

More broadly, the contribution of changes in informality to inequality depends on three aspects:


 * 1) the evolution of the wage premium (or penalty) of formal employment relative to informal employment;
 * 2) the changing distribution of this wage premium (or penalty) across skill groups; and
 * 3) changes in formality across skill groups.

Ferreira, Firpo, and Messina find that the reduction of the formal-informal wage gap from 1995 to 2012 in Brazil contributed to a reduction of 1.7 Gini points of the total inequality reduction of 9 Gini points. Amarante, Arim, and Yapor also report a significant impact in Uruguay.

During the Mexican peso crisis of 1994–95 (the “Tequila crisis”) and the Brazilian crisis of 1999, informality increased in those countries while unemployment rose. In contrast, during the boom years of 2002–13, informality decreased significantly (figure 2.18). To a greater or lesser extent, the rate of informality declined during the 2000s in the vast majority of the countries in the region, regardless of how informality is measured.

It is not immediately obvious that increased formalization leads to a reduction in inequality. A first aspect that mediates this relationship is whether there is a wage penalty for informal employment (or, in other words, a premium for formal employment). If equivalent workers (that is, with the same human capital) are paid differently in the formal and informal sectors, reductions in informality will mechanically reduce wage inequality by eliminating within-group differences in wages.