micro and small enterprises from capitalizing the productivity gains that come with scale economies and innovation. If, as discussed above, micro firms undertake a cost-benefit analysis of engaging in formality, extraordinarily high registration costs that are endemic to the region (Janson and Chalmers 2001), or heavy labor taxes may create a poverty trap: due to low productivity firms cannot afford to comply with business and labor regulations, and informality in turn constrains economies of scale and productivity growth..

**_However, the bulk of earnings differentials and thus poverty and income inequality in LAC is not generated by the labor market_** but largely reflects the productivity levels and differences in workers’ endowments. Labor markets do not seem to operate with pervasive segmentation. The residual earnings disparities associated with gender, ethnicity, race, informality (micro-firms and self employed), occupation, sector of employment, and geographic location are of second order and their reduction would have a larger impact on inequality than on poverty, which is symptomatic of overall low labor productivity. Labor reforms to date have indeterminate effects.  As Saavedra (2003) notes, the effects of changes on labor market outcomes in the region have been modest partly because of the simultaneous imposition of reforms with offsetting effects.

**_But the explanations for observed changes in inequality are probably to be found elsewhere, namely through general reforms undertaken._** Behrman, Birdsall and Szekely (2003) found that financial reform, capital account liberalization and tax reform have contributed to increased earnings inequality, while privatization was a force towards equalization.  The reforms worsened inequality in the short-run, but this effect tended to fade away over time.

**_Or skill biased technical change._** As been found elsewhere in the literature, Behrman et. al’s estimates suggest that trade openness had no effects whatsoever on inequality, instead they suggest that skill biased technological progress (SBTC) rather than trade _per se_ has been the mechanism through which the reforms have been operating. Sánchez-Páramo and Schady (2003) reached a similar conclusion using repeated cross-section data for Argentina, Brazil, Chile, Colombia, and Mexico. In particular they suggest that even though the direct effect of trade liberalization on earnings inequality may be small, trade is an important source of technology transmission. However IADB (2004) argue that even when many economic sectors in LA countries have acquired new technologies after the period of trade and financial liberalization, changes in technology are far from being the unique source behind the trend in earnings differentials. In particular, trends in gender earnings gaps and the evolution of earnings for high-tech workers (such as engineers and computer science graduates) are difficult to reconcile with predictions from any version of the SBTC hypothesis. Moreover, some care must be taken in interpreting the results on the rising average returns to higher education and their relationship to relative demand shifts. While these demand shifts are likely to play a key role in rising earnings inequality, the observed upward trends can also reflect partially the upgrading of the unobservable skills of the labor force.

**The unequalizing role of unmeasured workers characteristics** Most of the disparity in wages cannot be generally explained by observed characteristics. Increasing evidence based on quantile regressions indicates the existence of unobserved wage heterogeneity among individuals with the same education, sector of work (formal/informal), gender, age and experience. Factors such as the quality of education, family background, individual ability, and labor market connections are distributed unevenly across workers. These unobserved (by the analyst) characteristics may grant an advantage in access to high paying jobs, affecting both human capital accumulation decisions and its returns in the labor market. In particular, numerous studies for LAC and developed countries point that returns to schooling increase along the earnings distribution so that for example the high return to college is not available to all workers alike.<sup>38</sup> There is also evidence that other earnings gaps

> 38 See Arias and Diaz (2004) for references to these studies.

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