metadata: authors: 0: author: Veloso,Fernando Augusto Adeodato
1: author: Zaourak,Gabriel Roberto
count: Brazil
docna: 0: docna: A Literature Review on Productivity and
            Growth in Brazil
docty: Policy Research Working Paper
theme: Inclusive Growth,Human Development and Gender,Economic Policy,Trade Policy,Social Protection,Social Development and Protection,Economic Growth and Planning,Fiscal Policy,Disease Control,Pandemic Response,Trade,Tax policy,Public Expenditure Policy,Social protection delivery systems,Migration, Remittances and Diaspora Engagement
abstracts: cdata!: Productivity growth in Brazil has not
            kept pace with developed and emerging economies, despite
            progress in achieving macroeconomic stability and
            implementing reforms in product and input markets. This
            paper reviews the literature on reforms and growth in Brazil
            to understand the factors that have hindered productivity
            growth. The paper discusses the impact of competitive
            distortions on productivity, the effect of structural change
            on productivity growth, and the evidence on misallocation
            and growth dynamics. Additionally, the paper analyzes the
            direct and indirect effects of several reforms, such as
            trade liberalization and formalization policies. Based on
            the main lessons from this review, the paper proposes a
            potential reform agenda to improve improve productivity in
            Brazil in the coming years and narrow the income gap with
            developed countries.
display_title: A Literature Review on Productivity
            and Growth in Brazil
listing_relative_url: /research/2024/09/34386215/literature-review-productivity-growth-brazil
topicv3: Private Sector Development m1326060 1921,Economic Growth m1326241 471,Macroeconomic and Structural Policies
            m1327380 439,Jobs m1503931 2670
publishtoextweb_dt: 2024-09-04T00:00:00Z
dois: 10.1596/1813-9450-10897
no_of_pages: 46
author_keys: 0: author_key: 2031055
1: author_key: 1594959
model_extractions: Policy Research Working Paper 10897 A Literature Review on Productivity and Growth in Brazil _Fernando Veloso Gabriel Zaourak_ Macroeconomics, Trade and Investment Global Practice September 2024
Policy Research Working Paper 10897

# **Abstract**

Productivity growth in Brazil has not kept pace with developed and emerging economies, despite progress in achieving macroeconomic stability and implementing reforms in product and input markets. This paper reviews the literature on reforms and growth in Brazil to understand the factors that have hindered productivity growth. The paper discusses the impact of competitive distortions on productivity, the effect of structural change on productivity growth, and the evidence on misallocation and growth dynamics. Additionally, the paper analyzes the direct and indirect effects of several reforms, such as trade liberalization and formalization policies. Based on the main lessons from this review, the paper proposes a potential reform agenda to improve improve productivity in Brazil in the coming years and narrow the income gap with developed countries.

This paper is a product of the Macroeconomics, Trade and Investment Global Practice. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://www.worldbank.org/prwp. The authors may be contacted at gzaourak@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
A Literature Review on Productivity and Growth in Brazil Fernando Veloso<sup>*</sup> and Gabriel Zaourak<sup></sup> World Bank

**JEL Classification** : D22, F17, O11, O30, O40, O47.

Keywords: Growth, misallocation, Innovation, Empirical Studies of Economic Growth, Cross-Country Convergence, Trade, Informality.

> *Email: fernando.veloso@fgv.br

> This paper was prepared as a background paper for the report Brazil 2040. The views expressed herein are only my own and should not be attributed to the World Bank, its executive directors, or the countries they represent. All errors are omissions are our own.

> Email: gzaourak@worldbank.org
# 1 Introduction

Since the mid-1990s, Brazil has made progress in achieving macroeconomic stability and implemented reforms in product and input markets. However, productivity growth has been disappointing, lagging behind developed and emerging economies. Demographic dividends are nearly exhausted, with Brazil being one of the fastest aging societies in the world. This implies that in the next decades improvements in living standards will crucially depend on an acceleration of productivity growth. At the heart of Brazil's low and stagnant productivity is a business environment that discourages competition and induces misallocation of resources. Alongside important reforms, such as trade liberalization in the 1990s and improvements in credit collateral and bankruptcy procedures in the 2000s, several competitive distortions were created in the last two decades. In particular, credit subsidies, tax exemptions and local content requirements were introduced to benet specic sectors and rms, distorting labor and capital markets rather than fostering competition. As a result, the development model based on state intervention and import-substitution that prevailed from the 1930s until the 1980s is still present to a large extent. Instead of a level playing eld, the business environment favors incumbents and hampers entry. The lack of competition in both domestic and external markets in turn reduces eciency and undermines productivity growth. The objective of this paper is to review the literature on reforms and growth in Brazil in order to understand why there has been so little productivity growth in the last decades. We will discuss reform mechanisms and how their eects depend on other determinants of productivity, such as the schooling level of the labor force. We will also analyze the evidence on the impact of competitive distortions on productivity. The goal is not only to assess their direct eect, but also to analyze how they may have dampened the potential impact of some reforms, such as trade liberalization and formalization policies. Based on the main lessons from this review, we will discuss a potential reform agenda to improve productivity in the coming years. The paper is structured as follows. Section 2 will present the main stylized facts on aggregate and sectoral productivity in Brazil and a discussion of the contribution of structural change in the last decades. Section 3 will discuss the evidence on misallocation and growth dynamics. Section 4 will analyze the eect of several competitive distortions on productivity. Section 5 will review the literature on reforms and productivity growth. Finally, section 6 will discuss a potential reform agenda to improve productivity in Brazil in the next decades and reduce the income gap with developed countries.

2
# 2 Stylized facts on aggregate and sectoral productivity growth

This section documents the main productivity facts in Brazil at the aggregate and sectoral level since the mid-1990s.

## 2.1 Aggregate productivity growth

Economic growth in Brazil since the mid-1990s has been driven largely by factor accumulation, namely an expansion of the employed labor force, human and physical capital, with only a small contribution from improvements in total factor productivity (TFP).<sup>1</sup> An analysis of the decomposition of GDP growth shows that during the 1997-2005 period, factor accumulation had an annual contribution of 3.5 percent to GDP growth, whereas TFP declined 1.1 percent per year (Figure 1).<sup>2</sup> The GDP growth acceleration from 2.4 percent to 4.3 percent per year between 1997-2005 and 2006-2011 was entirely due to TFP, since the contribution of factor accumulation remained around 3.5 percent. Between 2012 and 2019 there was a sharp deceleration of annual GDP growth to 0.3 percent, reecting a decline in the contribution of factor accumulation to 2.5 percent per year and a collapse of TFP (-2.2 percent per year). The reduction of factor accumulation in the recent subperiod reects lower physical capital accumulation and a signicant slowdown in labor force growth. The contribution of human capital has been positive throughout the 1997-2019 period, averaging a little more than 1 percent per year.<sup>3</sup> The negative contribution of TFP during the 2012-2019 period may in part reect the fact that TFP is calculated as a residual, such that the it may appear that the recession of 2014-2016 was caused by a negative contribution of productivity, when in fact it may have been driven by other unobserved factors such as an increase in spare capacity. Nevertheless, the fact that TFP growth was still negative in the 2017-2019 period seems to suggest that its decline in recent years has not only been due to cyclical factors (Figure 2).

International comparisons conrm that Brazil's negative TFP growth stands out in comparison to other emerging and developed economies (Figure 3). Whereas TFP declined at an annual rate of 1 percent per year between 1997 and 2019 in Brazil, it increased around 2 percent per year in China and 2.3 percent in India. Even though there was also a TFP

> 1See Bonelli et al. (2017)for a review and analysis of the productivity evidence in Brazil.

> 2Figures 1to 5 are updated versions of gures presented in Qian et al. (2018)and Dutz (2018).

> 3The data used to perform the growth decomposition exercises was obtained from the Penn World Table 10.0. The human capital index is constructed using the average years of schooling for the population aged 15 and older and rates of return based on cross-country Mincerian wage regressions.

3
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per year (1995-2002 and 2011-2018). On the other hand, the change in the employment rate has been negative during most of the 1995-2018 period, with the exception of the 2003-2010 subperiod.

# 2.2 Sectoral labor productivity growth

In the last decades, agriculture was the only major sector that had signicant and sustained labor productivity growth (Table 1).<sup>4</sup> Whereas the industry sector had negative annual growth (-0.4 percent)<sup>5</sup> in 1996-2020, services ́ productivity was stagnant (0.1 percent per year) throughout the period. Since services account for more than 70 percent of total employment in Brazil, the lack of productivity growth in this sector contributed signicantly to the sluggish aggregate productivity growth. The subperiod 2003-2010 was characterized by substantial productivity growth in several service activities, such as retail and nancial intermediation. However, this turned out to be an exception, since services had negative productivity growth both in 1996-2002 and 2011-2020.

Table 1: Sectoral Labor Productivity Growth, Brazil 1996-2020 <u>( percent per year)</u>

|Years|1996-2002|2003-2010|2011-2020|1996-2020|
|---|---|---|---|---|
|Agriculture|5.3|5.7|6.2|5.8|
|Mining|6.3|2.2|2.5|3.5|
|Manufacturing|-3.7|0.3|0.1|-0.9|
|Construction|-2.8|0.6|-1.4|-1.2|
|Utilities|3.7|2.4|3.2|3.1|
|Retail|-2.5|2/1|-0.2|-0.1|
|Transportation|-1.2|0.5|-2.4|-1.1|
|Information Services|-3.1|-1.7|1.7|-0.7|
|Financial Intermediation|0.6|5.0|0.3|1.9|
|Other Services|-1.2|0.4|-1.0|-0.6|
|Real Estate|2.3|-0.5|0.8|0.8|
|Government Services|0.7|-0.2|-1.4|-0.4|
|Agriculture|5.3|5.7|6.2|5.8|
|Industry|-2.6|0.5|0.5|-0.4|
|Services|-0.5|1.1|-0.4|0.1|

Source: Observatório da Produtividade Regis Bonelli at FGV IBRE.

> 4Labor productivity is measure as value added per worker. The mining sector also experienced sustained growth in the last decades but it accounts for a much smaller proportion of value added and employment.

> 5The industry sector includes mining, manufacturing, utilities and construction. Manufacturing had negative productivity growth during 1996-2020 (-0.9 percent per year).

7
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<!-- Start of picture text --> 0.15<br>3 0.10 1996<br>2<br>F; 2005<br>a]<br>= 2011<br>§ 0.05<br>=<br>oO<br>-40 -30 -20 -10 0<br>Distribution of log (real TFP)<br><!-- End of picture text -->
ing sector is relatively high. The rm's capital wedge in the 90th percentile of the productivity distribution is 4 (U.S. Industry Share) or 3 (Brazilian Firm-Specic Share) times greater than the capital wedge for rms in the 10th percentile. The rm's labor wedge is considerably smaller, varying between 2 (U.S. Industry Share) and 2.75 (Brazilian Firm- Specic Share). De Vries (2014) analyzes the existence of resource misallocation in the Brazilian formal retail sector. The author uses rm-level data from the National Retail Survey (Pesquisa Anual de Comércio, PAC) constructed by Instituto Brasileiro de Geograa e Estatística (IBGE). The author applies the Hsieh and Klenow (2009) methodology to study changes in resource allocation in Brazil's retail sector during the period from 1996 to 2006. The ndings suggest there are large potential output gains from the reallocation of resources to the most ecient retailers. Improvements in resource reallocation may increase TFP levels by a factor of two. However, he does not nd any allocative eciency improvements for the retail sector between 1996 and 2006. Brazil opened up its retail sector in the World Trade Organization's 1995 General Agreement on Trade in Services, and also within MERCOSUR. Furthermore, the participation of foreign capital in Brazilian retail rms was freed from restrictions in the Sixth Constitutional Amendment of 1995. It could thus be expected that these reforms would result in a productive reallocation through the expansion of modern retail chains and the growth of small successful retail businesses. According to De Vries (2008), however, the Brazilian experience suggests a dierent pattern. Retail chains did not replace mom-andpop stores during the period following reforms. The author argues that this may be partly explained by business regulations, such as zoning laws, and diculties in setting up national distribution systems because of the low quantity and quality of rail and road networks. The limited role of reallocation in Brazil's retail sector may explain its low productivity growth.

# 3.2 Informality and productivity

The previous analysis provided evidence of signicant misallocation of factors of production among Brazilian formal rms. However, in order to have a broader picture of misallocation in Brazil, we have to consider the large informal sector.<sup>11</sup> Meghir et al. (2015a) use data from the Monthly Employment Survey (Pesquisa Mensal de Emprego, PME), which provides a rotating panel of individuals sampled from the six main metropolitan regions of Brazil.<sup>12</sup> They show that the lowest part of the productivity distribution is populated only by informal rms. However, over a large segment of the support of the productivity distribution, formal and informal rms coexist. The increased probability of detection for larger informal rms

> 11See Ulyssea (2020b) for a recent review of the literature.

> 12PME has been discontinued in 2016. It was replaced by PNAD Contínua, which also has a rotating panel but is representative at the national level.

12
together with the regulatory costs means that informal rms are much more prevalent in lower levels of productivity and are much smaller. Ulyssea (2018) develops and estimates an equilibrium model of informality using data from the Survey of the Urban Informal Sector (Pesquisa de Economia Informal Urbana, ECINF), a survey of informal rms conducted by IBGE in 2003. He considers two margins of informality. First, the decision of rms to not register their business (extensive margin). Second, the choice to hire workers o the books (intensive margin). The model integrates the three leading views of informal rms La Porta and Shleifer (2014) in a unied setting. The rst view argues that the informal sector is a reservoir of potentially productive entrepreneurs who are kept out of formality by high regulatory costs. The second sees informal rms as parasite rms that are productive enough to survive in the formal sector but choose to remain informal due to the cost advantages of not complying with taxes and regulations. The third argues that informality is a survival strategy for low-skill entrepreneurs who are too unproductive to ever become formal. The results show that the largest proportion of informal rms in Brazil (48.8 percent) correspond to the view that informal rms correspond to low-skill entrepreneurs who are too unproductive to ever become formal. The view that informal rms are to a large extent parasite rms also corresponds to a signicant fraction of informal rms (41.9 percent). On the other hand, the view that informal rms are potentially productive rms hindered by high regulatory costs corresponds to only 9.3 percent of informal rms in Brazil. This evidence on heterogeneity of rm productivity in the Brazilian informal sector suggests that the potential eects of formalization policies focused on the reduction of formal sector entry costs are probably limited. On the other hand, human capital policies that increase the skill of informal entrepreneurs may have signicant eects. We will return to these issues when we discuss the evidence on formalization policies in section 5.

# 3.3 Productivity dynamics

Using data from the World Bank Enterprise Survey, Barbosa Filho and Correa (2017) show that the average size of Brazilian rms is small in comparison to other emerging economies.<sup>13</sup> The average number of workers per rm in Brazil is similar to the one found in Russia, but considerably smaller than the average size in Chile, Colombia and China. The authors also note that older rms are not much larger than young rms in Brazil. Moreover, productivity does not increase with age. This suggests that the competitive selection mechanism is weak in Brazil. As a result, more productive rms do not grow and low-productivity rms stay 13This evidence was obtained from the same dataset that Barbosa Filho and Correa (2017) used to compare the distribution of labor productivity in Brazil to other emerging economies.

13
in the market, contributing to the sluggish growth of aggregate productivity. Cavalcanti et al. (2021) present further evidence on rm dynamics using data from Relação Annual de Informações Sociais (RAIS), a matched employer-employee administrative dataset covering all formal rms in Brazil that follow rms and workers over time. They nd that rm size in Brazil is increasing but concave in age over the rst 15 years of rm life, on average rising 50 percent relative to its entry size. This growth is signicantly less than the lifecycle growth for manufacturing plants reported by Hsieh and Klenow (2014) for the U.S., which show 8-fold average growth over 30 years, but greater than the roughly 1.25-fold increase reported for India. Ulyssea (2020a) analyzes both formal and informal rm dynamics in Brazil, combining rm-level data with a structural model. The paper documents that in, both sectors, rms display an increasing and concave age-size prole. However, the growth in size is signicantly higher for formal rms. The results show that after 10 years there is a 50 percent growth in the sample that includes only formal rms and their formal workers in contrast with the 20 percent average growth that one obtains when using both formal and informal rms. The author shows that the age-size prole using only formal rms and workers in Brazil is very similar to the one documented for Mexico by Hsieh and Klenow (2014). However, once he incorporates informal rms, the age-size prole of Brazilian rms becomes much closer to that of Indian rms, which is remarkably atter. These facts show that dynamic selection takes place in both sectors but is substantially weaker in the informal sector. They also suggest that the lack of dynamism found in the Indian data might also be present in other highinformality countries. Failing to incorporate informal rm dynamics may therefore lead to a substantial underestimation of the lack of dynamism among developing countries' rms.<sup>14</sup>

# 4 Competitive distortions and productivity

There are signicant barriers to competition in Brazil, many of them policy-induced. This section will discuss the evidence on the eect of several competitive distortions on productivity in Brazil.

## 4.1 Credit subsidies, nancial frictions and lack of competition in credit markets

In the presence of nancial market imperfections, the process of ecient allocation of resources can break up. Financial frictions can reduce aggregate productivity via two chan-

> 14See Akcigit et al. (2021) for an analysis of the dierences in the competitive selection mechanism between India and the United States and their aggregate implications.

14
nels. First, they may distort entry and technology adoption decisions and thus reduce the productivity of individual rms. Second, nancial frictions may generate dierences in the returns to capital across individual rms, thus generating eciency losses through misallocation (Banerjee and Duo (2005); Restuccia and Rogerson (2008); Hsieh and Klenow (2009)).

One potential source of nancial frictions are policy-induced interventions. During several decades the Brazilian government intervened heavily in credit markets. As will be discussed later, several credit reforms contributed to a substantial increase in private credit in the 2000s. However, after the 2008-2009 nancial crisis there was a signicant increase in the expansion of subsidized credit provided by public banks. The main source of long-term nancing to rms in Brazil is the Brazilian Development Bank (Banco Nacional de Desenvolvimento Econômico e Social, BNDES), a government-owned development bank.

Several papers do not nd positive eects of BNDES nancing on productivity, especially for large rms.<sup>15</sup> Even when there is evidence of a positive impact on productivity, they do not seem to be strong enough to be cost-eective when the sizable subsidy costs are considered. We will next briey discuss a few papers that illustrate the main issues.

Bonomo et al. (2015) use a large repository of loan contracts between banks and rms to investigate the eect of the expansion of BNDES credit expansion between 2004 and 2012. Their results show that larger, older and less risky rms beneted most from the government sponsored credit expansion. Additionally, the eect on investment appears to be insignicant for publicly traded rms. These results are consistent with the hypothesis that those established public rms in part substituted more expensive credit with subsidized loans.

Calice et al. (2018) study the impact of BNDES credit on resource misallocation in Brazil, using manufacturing rm-level data from 2003 until 2014. The paper rst estimates measures of resource misallocation based on Hsieh and Klenow (2009), documenting high variation in rms' capital and output distortions. It then estimates the eect of access to BNDES loans on distortions and their dispersions. The analysis nds some preliminary evidence that the use of BNDES credit is not associated with a more ecient allocation of resources. The lower cost of BNDES loans reduces the marginal cost of capital and induces rms to reallocate inputs from labor to capital. This eect is amplied for more nancially dependent rms. The authors point out that their results only reect the eectiveness of a particular credit line, FINAME, which nances the acquisition of machines and equipment in the domestic

> 15Bank (2017b) reviews the costs and benets of business support policies in Brazil, including subsidized credit policies by public banks. Bank (2017a) provides a detailed evaluation of the impact on productivity of subsidized credit programs and other business support policies in Brazil. Calice et al. (2018) provide a review of the literature on the eects of BNDES credit on several performance indicators and analyzes its eects on misallocation.

15
market. They suggest that though relatively large rms are the main recipients of BNDES nancing, the impact of BNDES on smaller rms may be dierent.

In fact, Cavalcanti and Vaz (2017) use a variation in access to a targeted loan program from BNDES to assess the causal eect of better credit conditions on investment and productivity of Brazilian manufacturing rms. The estimated causal eects point to positive eects on investment and productivity for small and medium rms. The authors argue that their results support the hypothesis that nancial constraints for long-term investment matter for small and medium rm's productivity and investment decisions. In addition to signicant government intervention in credit markets, Brazil also has very large private lending spreads (the dierence between lending rates and the deposit rate). According to the International Financial Statistics, the average interest rate spread is approximately 0.7 percent in Japan, 3 percent in the United States, 10 percent in Uruguay and 40 percent in Brazil.<sup>16</sup> High spreads may arise due to several reasons, such as poor collateral, credit taxes, regulatory costs and lack of competition. The banking sector is very concentrated in many countries, but concentration in Brazil seems to be particularly high and increasing over time. Between the mid-1990s and 2016, the share of assets held by the 5-largest banks in Brazil increased from 50 percent to more than 85 percent.<sup>17</sup> Joaquim and Van Doornik (2019) use heterogeneous exposure to large bank mergers to estimate the eect of bank competition on both nancial and real variables in local Brazilian markets. Specically, they use merger and acquisitions episodes of large Brazilian banks between 2005 and 2015 as a source of exogenous variation of competition in local banking markets to identify the causal eect of bank competition. The authors nd that a reduction in bank competition results in a signicant increase in lending spreads and a decrease in loan volume. They also show that bank competition has real eects. A 1 percent increase in spreads leads to a 0.2 percent decline in employment. Moreover, they show that if Brazilian spreads fell to world levels, output would increase by approximately 5 percent.

In addition to a high average level, there is a large dispersion in credit spreads to Brazilian rms. Cavalcanti et al. (2021) develop a quantitative dynamic general equilibrium model and calibrate it to the Brazilian data for the period 2005-2016. They use data from the Brazilian credit registry, a condential loan level data set covering all the credit operations in Brazil and containing information on loan characteristics and interest rates. They merge these data with Brazil's linked employer-employee administrative dataset to examine how interest

> 16See Cavalcanti et al. (2021).

> 17See Joaquim and Van Doornik (2019). They report that during this same time span the share of assets held by the 5-largest banks in the U.S. increased from 30 percent to more than 45 percent. Averaging across countries, the share of assets held by the 5 largest banks is 78 percent.

16
rates and loan size vary with rm characteristics. The results show that, even controlling for several loan characteristics, the loan interest rate and the volume of credit vary considerably with rm characteristics, such as rm size and age. In particular, young and small rms pay higher interest rates. The calibrated nancial frictions lower output per capita by 31 percent relative to a frictionless credit benchmark. TFP is 25 percent lower and capital is 26 percent lower relative to the frictionless credit benchmark. Counterfactual simulations reveal that spread variation coming from direct intermediation costs drive the vast majority of impacts. The evidence thus suggests that the high average level and large dispersion of spreads in Brazil has signicant negative eects on output and productivity. There is also some evidence that lack of competition and high intermediation costs may contribute to high spreads. In Section 5 we will examine the potential role of poor collateral in also accounting for these patterns.

# 4.2 Labor market frictions

## 4.2.1 Labor informality

The previous discussion about informality emphasized the decision of rms to not register their business (extensive margin) and their implications for aggregate productivity. Next we will focus on distortions that may aect the rm ́s choice to hire workers o the books (intensive margin).

Meghir et al. (2015b) show that search frictions reduce the competition for workers and make it harder for workers to locate to higher productivity rms. In their model, search frictions increase the prevalence of low-productivity rms and reduces the probability of workers matching with higher productivity rms, thus reducing output.

One of the most important stylized facts of the Brazilian labor market is the decline in labor informality in the 2000s. Between 2003 and 2012 the informality rate among salaried workers fell by 10.5 percentage points and unemployment fell by 7.5 points. This decline in labor informality is particularly puzzling because, during the same period, the minimum wage increased by 61 percent in real terms and changes in other labor regulations were negligible.<sup>18</sup> Haanwinckel and Soares (2020) develop a search model of informal labor markets with worker and rm heterogeneity, intra-rm bargaining with imperfect substitutability across types of workers, and a comprehensive set of labor regulations. They estimate the model using Brazilian data and use it to understand the main determinants of the reduction in labor informality. The model accounts for 57 percent of the decline in informality and 58 18 See Haanwinckel and Soares (2020) . Barbosa Filho and Veloso (2016) provide a detailed discussion of the decline in labor informality in Brazil during the 2000s.

17
percent of the reduction in unemployment observed during the 2003-2012 period.

Subsequently, they assess the contribution of several factors in generating the observed decline in informality. Overall, the composition of the labor force, productivity and demand parameters are, together with the minimum wage, the main determinants of the changes observed in the Brazilian labor market during this period. The change in the composition of the labor force appears as the main driving force behind the reduction in informality. The model predicts that without an increase in the share of skilled workers, informality would have gone up instead of declining.

Moreover, positive productivity and demand shocks contributed to reducing informality. In their model these shocks beneted mainly the formal rms and induced their expansion. This in turn increased the formalization of labor through the intensive margin. In particular, the sizable improvement in terms of trade associated with the commodity boom may have contributed to labor formalization. In Section 5 we will discuss some evidence that the credit expansion of the 2000s may have also played an important role.

In the model, an increase in the relative supply of skilled workers makes their labor market less tight. Since formal rms are more intensive in skill workers, the improvement in the skill composition of the labor force induces an expansion of formal rms. Moreover, due to the complementarity between skilled and unskilled workers, the productivity of unskilled workers increases. Both forces end up reducing informality through both the intensive and extensive margins. There is a reallocation of labor to formal rms and marginal informal rms choose to become formal. show that these model predictions are consistent with the Brazilian evidence.

# 4.2.2 Minimum wage

Between the mid-1990s and the mid-2010s, Brazil has seen a remarkable decline in income inequality.<sup>19</sup> Over the same period, Brazil's real minimum wage more than doubled. This fact has motivated several studies about the eects of the minimum wage and other variables on earnings inequality. However, very few papers addressed the eects of the minimum wage increase on the eciency of labor allocation among rms.

Engbom and Moser (2021) combine rich administrative and survey data with an equilibrium model of the Brazilian labor market and quantify the eects of the increase in the minimum wage in Brazil from 1996 to 2012 on inequality and employment. They show that the rise in the minimum wage accounts for a large part of the decline in earnings inequality in Brazil during this period. The paper focus on the role played by heterogeneous rms

> 19Firpo and Portella (2019) analyze the decline in wage inequality in Brazil since the mid-1990s.

18
in mediating the eects of the minimum wage policy. In their model the increase in the minimum wage aects mostly low-productivity rms, for which the minimum wage is more binding. The results show that these rms cut employment creation as the increase in the minimum wage squeezes their prot margins. The easier recruiting environment in turn induces higher-productivity rms to increase hiring. As a result, in their model the minimum wage primarily reallocates employment from lower- to higher-productivity rms rather than to unemployment. The magnitudes of their estimated eects of the minimum wage on inequality are driven by how binding the minimum wage is together with the extent of rm productivity dispersion in Brazil. The authors argue that they nd muted negative eects of the minimum wage on employment and aggregate output due to the heterogeneous eects of the minimum wage across the rm productivity distribution. However, Haanwinckel and Soares (2020) obtain dierent results. Specically, they nd that the decline in unemployment between 2003 and 2012 would have been greater in the absence of a minimum wage rise in the magnitude observed in the data. They also show that the decline in informality in Brazil would have been considerably larger if the minimum wage had not increased. To the extent that higher informality is associated with lower productivity, their results suggest that the increase in the minimum wage might have been detrimental to productivity growth. It thus remains an open issue how the rise in the minimum wage aected informality and productivity in Brazil during the 2000s. In any case, it should be noted that in Brazil, an increase in the minimum wage has signicant scal eects since many social benets, including pension payments and unemployment insurance, are indexed to the minimum wage. Hence, possible positive eects of an increase in the minimum wage have to be compared to the associated scal costs and their implications for investment and innovation decisions.

# 4.2.3 Misallocation of labor between the public and private sectors

There is a large body of evidence showing that for many countries the structure of wages and pensions and the labor law legislation are dierent for public and private employees. Such dierences aect the occupational choice of agents and might generate some type of misallocation. This is particularly relevant for Brazil, a country with a high public sector premium.<sup>20</sup> Cavalcanti and Santos (2021) develop a life-cycle model with endogenous occupational choice and heterogeneous agents to study the implications of an overpaid public sector in Brazil. The paper investigates whether dierences in labor compensation and labor legislation between private and public workers aect individuals' occupational choice, investment and

> 20See Bank (2017c).

19
aggregate productivity.

The authors analyze the eects of both static and dynamic types of misallocation. First, the existence of a public earnings premium inuences the occupational decision of agents. The main idea is that such premium might attract high-productivity entrepreneurs who would not apply for a job in the public sector in the absence of such a public wage premium. Moreover, there may be negative long-run consequences, since investment decisions depend on the agents ́ occupational choices. The results show that an overpaid public sector has sizable productivity losses. They show that a decrease in the public wage premium from 19 percent to 15 percent can produce a signicant positive eect on long-run aggregate output (7 percent increase) without any substantial decrease in public infrastructure. They also show that the reallocation of factors of production accounts for about 19 percent of the aggregate change in output. The rest is due to changes in factor accumulation. The authors also argue that pension reforms can have similar aggregate eects, but such reforms change more the incentive of agents to invest in nancial assets and most of the impact on output is due to changes in factor accumulation. Changes in the legislation law which decrease job stability in the public sector also produce important quantitative eects on aggregate output and productivity. They nd that when the job destruction rate in the public sector increases from 0 percent to 1 percent the number of applicants to public sector jobs decreases by nearly 15 percent and output increases by more than 3 percent.

# 4.3 Subsidies to national innovation and low management quality

In addition to a more ecient allocation of resources across rms, one important source of productivity gains is innovation. In the last decades Brazil has implemented several innovation policies, most of them involving scal incentives. For instance, the Lei de Informática (Informatics Law), instituted in 1991 and renewed in 2001, 2004 and most recently in 2014, promotes increased local content of ICT hardware and related electronics assembly plus investments in local R&D operations. Similarly, the Lei do Bem (Fiscal Incentives Law), which was instituted in 2007 and replaced a prior 2005 law, expanded incentives for investments in R&D, authorizing companies that invest in R&D and meet certain requirements to claim tax incentives automatically for certain types of spending.

Several papers show that the incentives for innovation and R&D provided by the Lei de Informática have not been eective.<sup>21</sup> In particular, Kannebley Júnior and Porto (2012) show that it has been ineective in stimulating productivity-enhancing R&D. Although the incentives have contributed to leading global ICT hardware rms to produce locally, the ben-

> 21See Bank (2017b) for a review of the eect of innovation policies on productivity in Brazil.

20
eciaries have not been able to produce internationally competitive ICT products. Regarding the Lei do Bem, the evidence suggests that the program had a positive but modest impact on innovation. For instance, Devereux and Guceri (2015) nd that the average realized R&D intensity is relatively low. They argue that this is because the legislation design favors incumbent, older and larger rms and it does not reach most small or new companies. This is due to the fact that Lei do Bem excludes rms that declare income tax returns based on their presumed prot, which includes most of the young rms.<sup>22</sup> To the extent that Lei do Bem favors incumbent rms, it may have contributed to slow down the reallocation process from low-growth incumbents to high-growth young rms. A recent paper by De Souza (2021) studies a Brazilian innovation program implemented in 2001 that taxed the leasing of international technology to subsidize national innovation. The Brazilian Technology Substitution Program (TSP) created a 10 percent marginal tax rate on the payments of any international intellectual property. The revenue raised by the tax was used to subsidize innovation projects by rms in targeted sectors. The author uses a novel rm-level dataset with information on international technology leasing, patent applications, and employment of Brazilian rms and calibrates a model to analyze the eects of the innovation policy. He shows that the program led rms to replace technology licensed from developed countries with in-house innovations, which led to a decline in employment and an increase in the share of low-skilled workers. He nds that rms more exposed to the TSP program had an increase of 4.47 percentage points in the probability of having at least one patent, in comparison to the control rms, while drastically reducing the probability of leasing technology from developed countries.

Another important source of eciency gains at the level of the rm is through an increase in management quality.<sup>23</sup> Bank (2017b) provides evidence on the average management quality of rms in Brazil relative to some peers (Mexico, Chile, Turkey and Argentina) and to higherincome OECD countries.<sup>24</sup> It shows that average management quality of Brazilian rms is lower than most comparator countries. Moreover, management quality dispersion of rms in Brazil is higher than in other countries, with a much larger share (18 percent) of rms being poorly-managed. This contrasts with 2 percent of rms in the U.S., 6 percent in China, and 11 percent in Mexico.

This evidence is consistent with the stylized facts previously discussed according to which Brazil has a larger productivity dispersion and a higher proportion of low-productivity rms than other emerging economies. The existence of a large segment of poorly-run rms suggests

> 22See Klenow and Li (2020) for evidence on the importance of young rms for innovation.

> 23See Bloom et al. (2013).

> 24There is available data for many countries, including Brazil, in the World Management Survey.

21
insucient management training and lack of market competition.<sup>25</sup>

# 4.4 Rent-seeking

Another potentially important source of misallocation in Brazil is rent-seeking. A few recent papers have explored rich data sets to examine the eects of patronage and corruption on public employment selection and rm performance in Brazil. Colonnelli et al. (2020) use a detailed matched employer-employee data on the universe of public employees in Brazil over 19972014 and a regression discontinuity design in close electoral races to examine the role of political connections for public employment selection in Brazil. In particular, they empirically investigate whether discretion in public employment decisions is used as a patronage tool, and the consequences on the selection process in the context of the Brazilian public sector. Patronage represents an obvious friction in the selection of a high-quality public workforce, since political support can act as a substitute for individual competence in the process of government hiring. They establish three main ndings. First, political connections are a key and quantitatively large determinant of employment in public organizations in Brazil, for both bureaucrats and frontline providers. Second, patronage is an important mechanism behind this result. Third, political considerations lead to the selection of less competent individuals. In addition to patronage, there is recent evidence on the eect of corruption on rm performance in Brazil. Colonnelli et al. (2020) estimate the economic eects of a randomized anticorruption crackdown on local economic activity. On average, they nd a 0.9 percent increase in the number of rms and business establishments operating in treated municipalities in the three years after the audit. They also nd that audits increase real economic activity, with an increase in sales by local rms by about 6 percent. There is also evidence of large spillover eects, as a nearby audit has an impact on non-audited municipalities that is similar to their main eects. They also show that their magnitudes can be rationalized by an average corruption tax on rms in the range of 5-23 percent. Finally, they provide evidence that is informative of the role of corruption as a source of misallocation across rms. Consistent with the presence of a corruption tax, they nd that incumbent rms in government-dependent sectors grow the most after an audit. On the other hand, politically connected rms shrink considerably, suggesting that a potential channel through which corruption aects local economic activity is by allowing connected but inecient rms to operate and stie competition. They conclude the paper by highlighting the central role

> 25Ranasinghe (2020) nds substantial dierences in the extent of misallocation across male and female establishments spanning over 75 low and middle-income countries. In South American and South Asian countries female establishments face higher distortions on production, whereas in Eastern European countries male establishments face higher distortions.

22
played by public procurement in the empirical ndings they document. They suggest that an eective anti-corruption policy would be to improve governance and best practices in public procurement.<sup>26</sup>

# 5 Reforms and productivity growth

This section will discuss the literature that analyzes the eect on productivity of several reforms implemented since the 1990s. Several of them tried to reduce distortions that were discussed in the previous section and thus improve the eciency of factor allocation.

## 5.1 Trade liberalization

In the late 1980s Brazil started a process of trade liberalization that lasted until the mid1990s. This episode consisted of large, unilateral, import tari reductions. Average taris fell from 31 to 13 percent, and there was ample variation in the magnitude of tari cuts across sectors. After 1995, taris remained relatively constant. Using a panel of manufacturing rms, Ferreira and Rossi (2003) measure the impact of trade reform on productivity growth. The results show that the tari reduction had a substantial positive impact on the growth rates of TFP and output per worker. Moreover, this eect was widespread in the manufacturing sector, with most activities experiencing large productivity improvements. Lisboa et al. (2010) show that one important mechanism through which the tari reduction increased productivity was that it allowed national producers to have access to more technologically advanced equipment and components from abroad. Despite the evidence that the trade liberalization reform increased productivity at the rm level, there were not sizable aggregate eects in the 1990s. Menezes Filho and Muendler (2011) provide evidence that is informative about this issue. They nd that even though output shifted to highproductivity export-oriented rms, there was a labor ow away from these rms because their labor productivity increased faster than their production. The labor that was shed from these productive rms moved to low-productivity service activities, unemployment and out of the labor force. As a result, despite sizable gains at the rm level, the labor reallocation induced by trade liberalization seems to have reduced its aggregate eect. Using

> 26Zaourak (2019) argues that rent-seeking activities, in the form of bribes, have aggregate eects through two channels. First, they generate misallocation of resources across rms, since they prevent resources from owing to the most productive rms. Second, rent-seeking activities aect the allocation of resources within rms, since they drive resources away from innovation activities. He then quantitatively shows that these two channels can help explain why Brazil has both more misallocation across rms and less investment in research and development than developed economies.

23
data from Brazil, Dix-Carneiro (2014) shows that the slow reallocation of workers and capital toward export-oriented industries leads to substantially lower gains from trade compared to traditional frictionless models. He estimates 11 to 26 percent lower gains from trade compared to a situation where reallocation occurs immediately. In addition, he estimates that adjustment costs are heterogeneous across the population. In particular, older, less educated, and female workers face substantially higher barriers to mobility across sectors. These workers in import-competing sectors experience substantial losses following liberalization, so governments willing to compensate the losers from trade should pay particular attention to workers with these characteristics. Dix-Carneiro and Kovak (2017) investigate how Brazilian region-specic labor market outcomes have responded to local shocks induced by the tari cuts, tracking the evolution of these eects over time. They show that regions facing larger negative shocks induced by liberalization experienced declines in formal sector employment relative to regions facing smaller shocks. These eects gradually increased following the beginning of liberalization and only stabilized fteen years afterward. These results indicate that formal sector employment adjustment in response to trade liberalization was large but slow. They also document that wages in harder-hit locations steadily declined for years and never recovered. The slow reallocation of capital led to a steady amplication of the initial local labor demand shock, making workers in harder-hit regions even less productive over time compared to those in more favorably aected regions. Agglomeration economies also amplify the labor market eects of trade liberalization. As rms in harder-hit regions leave the market, the productivity of remaining local rms gradually declines, further reducing local wage and employment growth. This evidence focused on how aggregate formal sector and regional-level labor market outcomes responded to liberalization. In another study, DixCarneiro and Kovak (2019) analyzed how individual labor market trajectories responded to the trade-induced labor demand shocks. Following individual workers over time using the Relação Anual de Informações Sociais (RAIS) data, they show that tradable sector workers initially employed in harder-hit locations were more likely to switch to nontradable sectors in response to liberalization. However, this response did not oset the large losses in employment in tradable sectors. Finally, they document that the formal employment trajectories of workers initially employed in nontradable sectors were aected almost as much as those of tradable sector workers, indicating the presence of important spillovers from tradable to nontradable sectors locally. Dix-Carneiro and Kovak (2019) also investigate how the structure of local labor markets responded to the trade-induced local shocks over longer time periods. In the medium run (1991 to 2000), nonemployment and informal employment increased in harder-hit locations relative to the national average. Yet in the long run (1991 to 2010), nonemployment did not respond to local trade shocks, but informal employment strongly 24
increased in harder-hit regions. This indicates that trade-displaced workers spend some time unemployed or out of the labor force, but eventually nd reemployment in the informal sector. The evidence thus suggests that informal employment constitute an important margin of labor market adjustment in response to trade shocks. In order to shed light on this issue, Dix-Carneiro et al. (2021) build an equilibrium model of a small open economy with labor market frictions and imperfectly enforced regulations. They estimate the model using data from Brazil and use counterfactual simulations to understand how trade aects economic outcomes in the presence of informality. They nd that trade openness leads to large declines in informality in the tradable sector. On the other hand, the eects of trade openness on informality in the non-tradable sector are more context-dependent. As a result, the overall eect of trade on informality is ambiguous, and generally small. They also nd that trade openness is associated with substantive increases in productivity and that the productivity gains from trade are understated in studies focusing exclusively on the formal sector of the economy.

# 5.2 Credit reforms

## 5.2.1 Repossession of collateral

There is a large literature documenting the relationship between collateral and better credit conditions, in particular larger loan volumes and lower interest rates.<sup>27</sup> To remove ineciencies in the auto loan and other credit markets, the Brazilian government enacted in 2004 the Law 10.931, the Lei de Alienação Fiduciária (Fiduciary law), which aected the auto loan, mortgage, and capital markets. Among other changes, the credit reform simplied the sale of repossessed cars used as collateral for auto loans. Before the reform, even though banks were allowed to repossess the autos of borrowers who failed to repay their loans, they could not resell these repossessed cars without court approval. As a result, the time from repossession of a car to its resale by the bank averaged more than two years. After the reform the process of reselling a repossessed car became simpler and faster. Borrowers and creditors engaged in direct relationships and courts played a signicant role only when borrowers explicitly requested it. The law thus avoided unnecessary trials, reduced the reliance on courts and increased the enforceability of auto loan contracts.

Assunçao et al. (2014) use micro-level data from one of the largest banks in Brazil to provide direct evidence on the consequences of the reform. They show that the reform resulted in larger loans with lower spreads and longer maturities. It also expanded credit

> 27See Djankov et al. (2007).

25
to riskier, low-income borrowers for newer, more expensive cars. They thus concluded that collateral and repossession play a crucial role in the liberalization and democratization of credit in Brazil.

# 5.2.2 Payroll lending reform

In December 2003, the Brazilian Congress passed a law (Law 10.820) that allowed banks to oer loans with repayment through automatic payroll deduction (Lei do Crédito Consignado), which turned future income into collateral. The law regulated the procedures through which commercial banks underwrite payroll loans to private sector employees and to those receiving social security benets from the Instituto Nacional do Seguro Social (INSS), the federal payas-go pension system. Payroll lending has existed in Brazil since the establishment of Law 8.112, which was enacted in December 1990 to regulate the provision of such loans to public sector retirees and public servants. However, private sector retirees and employees were not included in the scope of the law. The new legislation introduced in 2003 extended the mechanism of payroll lending to private sector workers and social security beneciaries. Coelho et al. (2012) estimate the impact of the new law. They nd that payroll lending caused a reduction in interest rates and a large surge in personal loans in Brazil. Their results suggest that policies that strengthen collateral have a major impact on lenders' ability to underwrite, and they thus improve borrowers' access to nance.

# 5.2.3 Bankruptcy reform

In early 2005, the Brazilian Congress approved a new bankruptcy law (Law 11.101, Lei de Falências). One of the most signicant changes was to enhance the protection given to creditors, which was implemented through two channels. First, the new law increased their priority order to receive proceeds. Second, it allowed them to actively participate in the reorganization procedure. The law also aimed at increasing the eciency of the bankruptcy system by reducing the cost and time of both reorganization and liquidation, leading to an increase in the value of distressed rms. It improved on existing rules by providing in- and out-of-court options to reorganize, and by allowing the conversion of reorganization proceedings into liquidation. Using data from Brazilian and non-Brazilian rms, Araujo et al. (2012) estimated the eect of the bankruptcy reform on debt variables. In particular, they compared Brazilian rms to non-Brazilian rms from Argentina, Chile and Mexico with respect to the behavior of debt related variables. They found a reduction of approximately 8 percent in the cost of debt and increases of 10 percent and 23 percent in the amount of both total debt and long-term debt in Brazil, respectively. Since secured creditors have beneted more from 26
the new law than unsecured ones, the eect is more pronounced on long-term debt, which is known to be more correlated with secured debt. Brazilian judicial districts are highly heterogeneous in terms of eciency. In some districts, cases are closed within time frames comparable to those observed in the United States. In others, the functioning of courts is undermined by the large number of pending cases. Therefore, when the new bankruptcy law entered into force, the eciency of local courts became a key determinant of the ability of both creditors and rms to reap the benets of the reform. Ponticelli and Alencar (2016) exploit variation in the congestion of civil courts across Brazilian municipalities to estimate the eect of enforcement of the new bankruptcy law on rm access to nance, investment, and size. The paper assessed the impact of a potential misallocation frictionthe ineciency of local judicial institutions -on credit markets as well as rm investment and growth. They nd that rms operating in municipalities with less congested courts experienced a larger increase in the use of secured loans, as well as a larger increase in investment and value of output in the years after the reform. To establish the direction of causality, they use an instrumental variable strategy that exploits dierences in court congestion across otherwise similar neighboring municipalities located across judicial district borders within the same state. The evidence shows that dierences in court enforcement aect the impact of bankruptcy reform on rm access to nance, investment, and size. The authors argue that their results make the case that an ecient judiciary is a necessary precondition for rms to benet from these reforms. In this sense, to increase the impact of reforms on productivity it is important to nd the right balance between promoting necessary changes in legal rules and investing to increase the eciency of the judicial institutions in charge of enforcing. Judicial decisions in bankruptcy are often inuenced by the goal to preserve employment in nancially distressed rms. Araujo et al. (2021) construct a new court-level measure of pro-labor bias based on the text of judicial decisions and exploit the random assignment of cases to courts within judicial districts in the state of São Paulo in Brazil to study the eect of pro-labor bias on labor market outcomes. They motivate their focus on Brazil for a number of reasons. First, Brazil has relatively strict labor-protection laws and a judicial system often described by local observers as biased in favor of debtors and workers. They cite survey evidence that shows that a large fraction of the Brazilian Judiciary perceives itself as having a redistributive role. Second, according to the data collected for the paper, there is a large degree of variation in the degree of pro-labor bias across Brazilian courts dealing with bankruptcy cases. They nd that workers of rms assigned to high-pro-labor courts experience 4.4 percent lower post-bankruptcy earnings. They also try to identify what explains the negative eect of pro-labor bias on workers' earnings. They show that courts with higher pro-labor bias tend to facilitate the continuation of insolvent rms, by either rejecting liquidation requests at a 27
higher rate, or converting reorganization cases into liquidations at a lower rate. Then they show that employees of insolvent rms whose cases were assigned to a high-pro-labor court are more likely to stay with the same employer in the post-bankruptcy period. Finally, the authors try to understand why do employees remain with the same employer when they could potentially earn more if searching for a new job. They nd that the relative decline in earnings is stronger in areas with limited internet coverage. Their interpretation of this result is that when information costs are high, individuals limit their search and are more likely to stay with their current employer for longer, even if this implies a wage reduction. Overall, their empirical ndings suggest that judicial bias matters for employees' earnings and employment trajectories in Brazil and have important policy implication for the role of bankruptcy institutions. This is consistent with the results of Ponticelli and Alencar (2016) and their implication that an ecient judiciary is an important precondition for rms to benet from these reforms.

# 5.2.4 Financial deepening

Catão et al. (2009) examine empirically a link between credit markets and formalization. Since access to bank credit typically requires compliance with tax and employment legislation, rms are more likely to incur such formalization costs once bank credit is more widely available at lower cost. Since the cost of remaining an unregistered rm is that of having either limited or no access to formal credit markets, nancial deepening would tend to shrink the relative size of the informal sector. They exploit the fact that in the 2000s Brazil experienced both a sizable credit expansion and a large decline in labor informality. The share of workers with a formal labor contract (carteira assinada) rose from 38 percent in 2003 to nearly 45 percent of the urban labor force by early 2008. They note that this upward trend in formality took place with a simultaneous credit expansion. The ratio of credit to rms rose from 15 percent of GDP in 2003 to 22 percent in 2008. They investigate this credit channel for Brazil using the Rajan-Zingales measure of nancial dependence and a dierence-in-dierences approach applied to household survey data. They nd that formalization rates increased with nancial deepening, especially in sectors where rms are typically more dependent on external nance. They also highlight that the main channel through which formalization took place was through shifts in the formality rate within each rm size category. To a lesser extent, they also nd some evidence that nancial deepening shifted the composition away from self-employment and towards larger rms. Regarding the interpretation of their results, they note that one important implication is that nancial deepening may lead to better resource allocation and hence to higher productivity through 28
a reduction of informality.<sup>28</sup> Another implication is that public programs of credit subsidies to small enterprises should be designed with the requirement that such rms comply with a host of regulations and nancial obligations associated with formal employment.

# 5.3 Formalization policies

## 5.3.1 Special tax regimes for micro and small rms

Most of the formalization policies analyzed in the literature have been in the direction of reducing the costs of formality. In particular, great emphasis has been placed on reducing registration costs, which are often regarded as a major constraint to rm creation and formalization.<sup>29</sup> However, the available evidence suggests that reducing the costs of entering the formal sector has a very limited eect on formalization.<sup>30</sup> This suggests that the perceived benets of formalization are very low for most small-scale entrepreneurs. In the last decades several formalization policies were implemented in Brazil. In general, they reduced the costs of entering and operating in the formal sector. Most prominent among them were special tax regimes for micro and small rms. I will discuss next some of these programs and their evaluations. In 1996 a federal reform was enacted to reduce red tape costs and simplify the tax system for micro and small enterprises (MSEs). The SIMPLES program combined six dierent federal taxes and social contributions into one single monthly-based rate. The reform reduced the tax burden considerably and red tape costs as well. In the beginning, only a few sectors were covered by the new law.<sup>31</sup> With the Complement Law No.123 of December 14, 2006, several additional activities were included. Moreover, under the new system (SIMPLES Nacional), state and municipal taxes were combined with the federal taxes and contributions into one single monthly-based rate. Fajnzylber et al. (2011) used the change in legislation at the end of 1996 as a natural experiment to estimate the causal eects of the program on formalization rates and performance outcomes. They found that the program led to an increase in the formalization rates of about 11 percentage points (or 50 percent). They also found a positive impact on revenues, prots and employment. A study published a year later obtained dierent results. Monteiro and Assunção (2012) found positive eects of SIMPLES on formalization rates only for rms in the retail sector. For the whole sample of rms, their estimates suggest that SIMPLES did not aect formalization

> 28Barbosa Filho and Veloso (2016) provide some evidence that the reallocation of labor from the informal to the formal sector contributed to increase aggregate productivity in the 2000s.

> 29Djankov et al. (2002).

> 30Andrade et al. (2013).

> 31Retail, manufacturing, transportation, construction, and other services that do not require professionals with regulated occupations, such as auditors and engineers, among others.

29
# rates.<sup>32</sup>

Piza (2018) evaluates the SIMPLES program with the same data sets used in both studies and shows that the large eects of the program on formalization rates found previously were likely confounded by measurement error in the assignment variable and seasonal shocks that aected more intensely the sectors that the reform initially targeted. He then suggests two alternative empirical strategies to deal with the identication problems present in the two studies. The new estimates suggest that SIMPLES did not increase formalization rates of micro- and small rms. The author then argues that given the expansion of the program over the years, it would be important to evaluate SIMPLES in its current format so that the potential eects of the program on tax collection through higher formalization rates of micro- and small businesses could be confronted with its large scal costs.<sup>33</sup> Rocha et al. (2018) estimate the impact of another large-scale formalization program implemented in Brazil, the Individual Micro-Entrepreneur Program (Programa do Microempreendedor Individual, MEI). Introduced in 2009, the program targeted entrepreneurs with at most one employee, and was designed to reduce both registration and ongoing costs of remaining formal, by reducing monthly taxes and red tape. In its rst phase, the program eliminated entry costs for eligible entrepreneurs, and in the second phase it substantially reduced the tax burden. The authors exploit this staggered implementation to assess the eects of reducing the tax burden faced by small formal rms. They nd that the rst phase had no eect on formalization, while the second led to an increase of around 11 percent. This result is entirely driven by the formalization of existing informal rms and not by the creation of new formal businesses, nor by greater survival among formal rms. However, the authors argue that these interventions were not cost-eective, since the program led to net losses in tax revenues. Taken together, these results indicate that reducing the costs of entering the formal sector had very limited or no formalization eects in Brazil, while reducing the ongoing costs of formality was more eective, but the eects were not large and the policies do not seem to be cost eective.<sup>34</sup> This raises the question of why reducing the costs of formality have such limited eects.

As discussed previously, Ulyssea (2018) nds that only 9.3 percent of informal rms in Brazil are potentially productive rms hindered by high regulatory costs. The informal

> 32Monteiro (2016) shows that SIMPLES is not cost-eective. Even in the retail sector the increase in revenues that results from formalization does not compensate for the revenue loss of already formal micro and small rms that have a reduction in their tax burden.

> 33Corseuil and Moura (2016) evaluated the eect of SIMPLES on several rm performance indicators in the manufacturing sector for several years, including the SIMPLES Nacional in 2007. They found no eect of SIMPLES on rm performance.

> 34See Ulyssea (2020b) for a discussion of the evidence on formalization policies in Brazil and other countries.

30
rms that could formalize once formal sector's entry costs are removed, but choose to remain informal to enjoy the cost advantages of informality, correspond to 41.9 percent of all informal rms. Finally, the remaining 48.8 percent correspond to rms that are too unproductive to ever become formal. Hence a very small fraction of informal rms in Brazil seems to be constrained by high formalization costs, and therefore reducing them will have a limited eect on formalization. Since these policies involve scal costs, they are in general not costeective even when they have positive formalization eects.

# 5.3.2 Other formalization policies (reduction of entry costs, increase in enforcement)

Even though reforms targeted at the reduction of formal sector's entry costs have not been eective in inducing rms to formalize, they might still produce important aggregate eects. Indeed, some papers show that reducing entry costs into the formal sector can produce positive and sizable aggregate eects in general and specically in Brazil. Ulyssea (2010) develops a two-sector matching model that incorporates the main features of Latin American labor markets. The model is numerically solved using Brazilian data and several policy simulations are performed. The simulation results show that lowering the costs of entry into the formal sector substantially improves employment composition. Making formal sector's entry costs similar to informal sector's would increase formal employment by nearly 31 percent and reduce unemployment by 36 percent. As a consequence of the changes on employment composition and the reduction of unemployment rate, average productivity and specially welfare show a substantial increase. Hence, high entry costs not only play an important role in determining employment composition, but also generate a considerable deadweight loss. This latter eect comes from the fact that high creation costs reduce the number of formal vacancies created and, as the informal sector is not able to completely absorb all workers, unemployment increases. In a recent article, Ulyssea (2018) shows that reducing entry costs into the formal sector eliminates deadweight losses from wasteful barriers to entry, which leads to more competition and an increase in aggregate production in the formal sector. It also increases high-skill wages, since the formal sector is more intensive in high-skill labor. Since the formalization process is concentrated among low-productivity rms, there is a negative composition eect that leads to a decrease in aggregate TFP. Nevertheless, total output increases because there is a substantial increase in the mass of active rms in the economy. In contrast, increasing enforcement can have a substantial impact on informality and productivity, since a large fraction of rms could be formal but optimally choose to remain informal. However, this policy can have potentially large negative eects, since nearly 31
half of all informal rms in Brazil are not productive enough to ever survive in the formal sector. De Andrade et al. (2016) randomly assign municipal inspectors to rms in order to assess whether higher enforcement can induce rms to formalize in the state of Minas Gerais, Brazil. Their results show that being assigned to the enforcement treatment increases registration rates with the municipality by 24 percentage points. The authors nd no evidence of spillovers on neighboring rms, which they attribute to the relatively low increase in inspections and to the fact that many rms indicate that they do not communicate with their neighbors. Meghir et al. (2015a) nd that reducing informality by increasing enforcement does not increase unemployment and increases welfare by enabling the reallocation of workers to higher productivity jobs. As a consequence, overall wages go up and inequality is decreased. These results keep labor market regulation xed and greater welfare gains may be obtainable from deregulation. In any case, they argue that an intermediate world where the informal sector is tolerated at the current levels of enforcement is not a welfare-enhancing policy. Ulyssea (2018) also analyzes the eects of enforcement on informality and productivity. He uses the estimated model to conduct counterfactual analyses of two enforcement policies. One is to increase the cost of the extensive margin of informality through greater enforcement on informal rms. The other is to increase the costs of the intensive margin through tighter enforcement on formal rms that hire informal workers. The results show that increasing enforcement on the extensive margin nearly eradicates informal rms, which generates a large positive eect on aggregate TFP due to composition eects, as this policy eliminates many small and unproductive informal rms. This positive eect on aggregate TFP more than compensates the reduction in the mass of active rms, and total output increases by more than 3 percent. On the other hand, an increase in enforcement on the intensive margin may induce small formal rms to move to the informal sector. As a result, aggregate informality may increase when there is more enforcement on the intensive margin. Despite reducing informality and increasing productivity, a policy of increased enforcement may generate an overall welfare loss in the economy due to the elimination of informal rms and possible unemployment consequences. If the adjustment of labor from the informal to the formal sector takes a long time and diers across skill levels, the overall welfare cost might be substantially higher. In addition to adjustment costs, an increase in enforcement probably involves signicant implementation costs, given that informal rms are numerous, small and often geographically spread.

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# 5.3.3 Payroll tax reform

The evidence of reducing payroll taxes on labor market outcomes is quite mixed. A few studies nd that the incidence of such costs is fully on wages with no signicant eects on employment for the U.S. and Latin American countries. Other papers show that only part of the increase in the payroll tax burden was passed onto wages. More recent work nds a sizable impact on employment in Sweden and Colombia.<sup>35</sup> A few studies reviewed in Bank (2017b) nd that a large reduction in payroll taxes for selected sectors in Brazil had very limited eects on formal employment creation. However, a recent paper found dierent results. Baumgartner et al. (2021) study the eects of Plano Brasil Maior (PBM). Such tax reform altered the tax base upon which payroll taxes are calculated for selected sectors in Brazil. Instead of paying a payroll tax of 20 percent on wages, rms were required to contribute to social security with tax rates between 1 percent and 2 percent on gross revenue. This amounted to a de facto average reduction in the total tax burden associated with payroll of more than 50 percent. The authors exploit the gradual implementation of the PBM payroll tax reform across 65 sectors from 2011 to 2014. Their empirical ndings show a sizable positive eect on total employment due to both rm entry and rm growth in treated sectors, but no impact on wages. Moreover, the eects are driven by labor markets with relatively low levels of concentration, which is consistent with predictions of an oligopsony model. They also perform a cost-benet analysis of the PBM payroll tax reform. They nd that each created job was around 2.1 times more costly than estimates from a major federal program that transfers funds to municipalities to nance local public spending in Brazil. Hence, despite having achieved a signicant impact on employment in treated sectors, the costs of the program in terms of foregone tax income were substantial. The authors also argue that this cost-benet analysis does not take into account other consequences of this kind of reform, such as the likely welfare consequences related to lower social security tax revenues and the deterioration of government ́s scal position. They conclude that a more complete and quantitative general equilibrium would be needed to assess such tradeos. Other researchers have used structural models in order to assess the general equilibrium impact of payroll tax reductions. In a recent review of the literature, Ulyssea (2020b)argues that the counterfactual results from both macro and structural models indicate that reductions in payroll tax seem to generate some formalization but with a low elasticity. If one dierentiates the eects on the intensive and extensive margins of informality, the eects are stronger on labor informality (intensive margin) and weaker on rm informality (extensive margin). Consistent with the limited eects on informality, the results from dierent papers

> 35See Baumgartner et al. (2021) for a review of the literature.

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indicate that reducing payroll taxes has positive by small eects on productivity. Haanwinckel and Soares (2020) estimate a model for Brazil to analyze a reduction in payroll taxes for lowwage workers while also keeping track of the scal burden imposed on the government. Lower payroll tax rates can lead to a decline in informality, but they can also substantially reduce government revenues. However, only a fraction of government revenues come from payroll taxes on unskilled workers, since their wages are lower and they account for a smaller fraction of formal employment. Thus, a policy in which governments subsidize the employment of low-wage formal workers through a progressive payroll tax may have a larger impact on informality while simultaneously minimizing the implications for government revenue. They compare the introduction of a progressive payroll tax with a reduction in the overall payroll tax. Their results show that progressive payroll taxes achieve unequivocally better results for unemployment and formalization while minimizing impacts on government revenue. Lower taxes among unskilled workers induce marginal rms to comply, enlarging the tax base. Taxes raised from rms that formalize help oset part of the foregone revenue. Moreover, the policy is clearly benecial for unskilled workers, lowering their unemployment and increasing average wages. Thus, they conclude that progressive payroll taxes can help alleviate poverty and income inequality without placing an excessive burden on the government scal position.

# 6 Potential reform agenda

Demographic dividends are nearly exhausted, with Brazil being one of the fastest aging societies in the world. This implies that in the next decades improvements in living standards and reductions in poverty and inequality will crucially depend on productivity growth. This paper discussed the literature on reforms and growth in Brazil in order to understand why productivity growth has been so low despite several reforms in the last decades. The evidence indicates that reforms such as trade liberalization and improvements in credit collateral had a positive impact on productivity. However, these eects were not strong enough to place Brazil in a sustained growth trajectory. Alongside reforms that aimed to increase competition, several policy-induced distortions were introduced in the last decades, such as credit subsidies, tax exemptions and local content requirements. The evidence reviewed in this paper suggests that these distortions may have contributed to oset the positive eect of reforms on productivity. Moreover, the analysis showed that the eects of reforms may have been dampened by shortcomings related to other determinants of productivity, such as the low average schooling of the labor force and poor management quality. At the heart of Brazil's low and stagnant productivity is a business environment that discourages competition and induces misallocation of resources. The lack of competition in both domestic 34
and external markets in turn reduces eciency and undermines productivity growth. Highproductivity rms face several barriers to grow and low-productivity rms stay in the market. To a large extent, the development model of state intervention and import-substitution that prevailed from the 1930s until the 1980s is still present. In order for Brazil to increase productivity growth in the next decades it will be necessary to a competitive market-based economy. It is thus necessary to remove distortions that protect incumbents, that is reduce entry barriers, and prevent the reallocation of factors of production from low-productivity to high-productivity rms. In order to facilitate factor reallocation, it will be important to complement market reforms with policies that enable rms and workers to take advantage of the new opportunities that will be created, especially by enhancing the human capital of workers and entrepreneurs. Between 2003 and 2005, several credit reforms aimed at improving collateral were implemented. These included the simplication of selling repossessed cars used as collateral for auto loans, allowing banks to oer loans with automatic payroll deduction, and bankruptcy reform. These reforms increased loan volumes, extended maturities, and lowered interest rates. They also expanded credit to riskier, low-income borrowers, promoting nancial inclusion. Additionally, the credit expansion in the 2000s contributed to the decline in informality, potentially boosting aggregate productivity.

However, after the 2008 nancial crisis, there was a signicant expansion of credit by public banks, especially BNDES. The evidence suggests that this had a small impact on productivity, possibly increasing credit misallocation in the manufacturing sector. These policies were likely not cost-eective due to heavy subsidies. Since 2015, government intervention in the credit market has been gradually reversed. The creation of TLP in 2017 reduced subsidies in credit provided by BNDES, but housing and rural credit still receive substantial subsidies. Extending the TLP to these sectors could increase competition.

Another issue is the high level and dispersion of private credit spreads. Despite reforms, there is still room for improvement. Reforms are underway to increase the dissemination of debtor information, enhance competition, and improve collateral through electronic guarantees. Regulatory changes are facilitating the entry of new nancial institutions, especially ntechs. These reforms have the potential to increase competition, expand credit, lower interest rates, and reduce misallocation by providing credit to young innovative rms lacking collateral.In addition to removing domestic barriers, it is important to increase the exposure of Brazilian rms to international competition. There is evidence that the trade liberalization reform of the 1990s improved productivity through several channels, such as competitive selection and imports of better quality capital and intermediate goods. However, since the mid-1990s there has been little progress. In fact, several distortions were created in the last decade, especially an increase in non-tari barriers such as local content requirements. There 35
are some promising liberalization possibilities, in particular the Mercosur-European Union trade agreement. Another important initiative is the process that has already been initiated of application to OECD membership. This could trigger a process of regulatory convergence to developed countries best regulatory practices, which in turn would contribute to a more competitive domestic business environment. Finally, there is much room for tari reduction of capital and intermediate goods. That could be an important channel of technology adoption.<sup>36</sup> The evidence reviewed in this paper shows the crucial role of the informal sector in the productivity agenda in Brazil, both in its extensive (rm registration) and intensive margins (labor registration). Since formal rms are much more productive than informal enterprises, a reallocation of labor from the informal to the formal sector has the potential to increase productivity signicantly. However, formalization policies in Brazil had a very limited eect. Special tax regimes for micro and small rms, such as SIMPLES and MEI, had little impact on formalization rates and rm performance variables. In addition, they are not cost-eective. One additional negative eect of size-dependent tax policies such as SIMPLES and MEI is the potential increase in misallocation that they entail by favouring small rms. One implication of this analysis is that one important reform would be to simplify the tax system for all rms and reduce the scope of special tax regimes for micro and small rms. This would increase competition and reduce the large scal costs associated with ineective programs. There are already some tax reforms in Congress that make proposals along these lines.<sup>37</sup> The small impact of formalization policies in Brazil is consistent with a study reviewed in this paper which shows that almost half of informal rms in Brazil are too unproductive to ever become formal.<sup>38</sup> Moreover, there is some evidence that average management quality is low and that the proportion of rms that are poorly managed in Brazil is higher than in other countries.<sup>39</sup> This suggests that policies targeted at micro and small business should focus on human capital and management improvements instead of tax reduction. The credit reforms that are underway will also help providing more credit at lower rates for talented but creditrestricted entrepreneurs. This points to an important theme that is present in the analysis of several studies reviewed in this paper. Since labor reallocation to high-productivity rms is a crucial mechanism for productivity growth in Brazil, the smooth functioning of the labor market is crucial to maximize the eects of reforms and reduce possible negative welfare consequences associated with labor transitions.

> 36Lisboa et al. (2010).

> 37PEC 45/2019 and PEC 110/2019 combine federal, state and municipal taxes into one single VAT tax. Another legislative project (PL 3.887/2020) proposes the unication of two federal taxes into one VAT tax.

> 38Ulyssea (2018).

> 39Bank (2017b).

36
In 2017, a labor market reform was enacted with the goal of increasing exibility in hours worked and by allowing for new types of contracts (Law 13.467). It also increased the scope of labor benets that may be freely negotiated between employers and employees. It is dicult to evaluate the eects of this reform since in the recent period the labor market in Brazil has been much aected by the great recession of 2014-2016 and the pandemic in 2020. It will be important to assess whether the labor reform will generate more exibility in the coming years and if new reforms will be necessary.

Another crucial area for productivity gains is education. As discussed in the text, there is evidence that the improvement in skill composition was the most important determinant of the informality decline in the 2000s.<sup>40</sup> Better schooling is also necessary to facilitate labor market transitions associated with trade liberalization reforms.<sup>41</sup> Moreover, there is some evidence that the human capital of the entrepreneur is one the main determinants of the decision to formalize a rm and for the upgrading of rm capabilities.<sup>42</sup> In addition to better schooling, an improved infrastructure may facilitate the process of factor reallocation to more productive sectors and rms.<sup>43</sup> A recent paper nds that an increase in electricity access contributed to the process of structural transformation in Brazil, beneting mostly the manufacturing sector.<sup>44</sup> One study suggests that diculties in setting up national distribution systems because of the low quantity and quality of rail and road networks might have prevented productivity gains in the retail sector.<sup>45</sup> There is also some evidence that better internet connections may improve access to information about job opportunities and thus facilitate labor reallocation to more productive rms.<sup>46</sup> Finally, the studies reviewed in this paper point to the crucial role of a public sector reform in order to reduce rent-seeking and increase the eectiveness of business support policies. In particular, there is evidence that patronage and corruption have signicant negative impacts on productivity in Brazil, and that there is misallocation on the allocation of labor between the public and the private sector. In addition, there is evidence that business support policies in Brazil are in general not eective and have high scal costs.<sup>47</sup> One important reason is that they are very poorly coordinated and there is almost no evaluation of their eects. The

> 40Haanwinckel and Soares (2020).

> 41Dix-Carneiro (2014).

> 42See La Porta and Shleifer (2014) for evidence on the importance of entrepreneur ́s schooling for formalization. Cusolito and Maloney (2018) highlight the importance of entrepreneur ́s human capital for the identication of business opportunities and the upgrading of rm capabilities.

> 43See Frischtak (2013)for a review of the literature about infrastructure and development in Brazil.

> 44Perez Sebastian et al. (2020).

> 45De Vries (2008).

> 46Araujo et al. (2021).

> 47Bank (2017b).

37
agenda of public sector reform should involve several components, such as more transparency and accountability, as well as a reduction of the public wage premium. Moreover, there should be a thorough revision of existent business support policies and the establishment of regular evaluation procedures. It is necessary to establish clear goals, monitor policy implementation and conduct ex-ante and ex-post evaluation. It would also be important to introduce sunset clauses so that policies that do not show positive eects could be discontinued. In order to increase policy coordination, one interesting possibility would be to create a Productivity Commission, following the model rst introduced in Australia and later reproduced in several countries, such as New Zeland, Mexico and Chile.<sup>48</sup> This a challenging but politically feasible productivity agenda that could potentially reduce Brazil ́s income gap with developed countries in the next decades. The recent pandemic caused by Covid-19, as well as global megatrends, including demographic ageing, globalization, technological and climate change, represent an additional challenge, but they could also serve to disrupt the existing equilibrium and be harnessed for change.

> 48See Azevedo (2017) for a discussion of Productivity Commissions and their possible adoption in Brazil.

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