Financial Satisfaction and (in)formal Sector
in a Transition Country
Abstract
This paper examines the relationship between working in the formal or
informal sector and self-reported individual financial satisfaction in a country
in transition. It does so by allowing for individual heterogeneity in terms of
perceived financial insecurity and tax morale. The empirical analysis uses a
dataset for Albania, a country in transition. The method applied is the ‘self-
administered questionnaire’, which combines personal contacts with written
questionnaire. The results indicate that, for most individuals, working in the
informal sector has negative effects on their self reported financial
satisfaction. For some individuals, however, this effect is positive. The
characteristic defining these two groups of individuals is their attitude towards
the perceived financial insecurity related to not paying taxes. These findings
have important implications, in particular for transition countries with large
informal sectors. Given the involuntary participation in the informal sector in
these countries, the majority of individuals working in this sector will remain
financially dissatisfied as long as they have no other social safety net.
Introduction
An important episode in the previous century was the rise and fall of
communist economies in Central and Eastern Europe and the Baltic states.
The collapse of these economies led to the emergence of so-called transition
countries, which are characterized by rapid economic and institutional
change. This transformation has been accompanied by the appearance of a
substantial informal sector. From an economic sociology perspective, the
informal sector is important for social (in)equality through both the re-
allocation of resources it causes and its impact on individuals’ welfare. This
paper focuses on the latter.
Early studies argue that average individual earnings in the informal sector are
lower than in the formal sector (Harris and Todaro 1970; Merrick 1976; Kugler
et al. 1979; Bourguignon 1979; Banerjee 1982; Heckman and Hotz 1986;
Pradhan and van Soest 1995; Pisani and Pagán 2003). Thomas (1990)
presents evidence that this mainly holds for less developed countries. Other
studies suggest that the earnings distributions in the formal and informal
sectors have substantial overlap (Fields 1990), so that the differences may be
smaller than is commonly thought (Charmes 1990). These findings have
,identified two sub-sectors within the informal sector. One is called the ‘upper-
tier informal sector’. This is characterized by limited-entry and high wages
(relative to the formal sector), and is preferred by workers to formal sector
employment. The other is called the ‘easy-entry informal sector’, which
consists of employment that is characterized by free-entry and low wages.
Workers consider the latter to be undesirable relative to formal sector
employment. Based on this distinction, Fields (1990) reports that individuals
working in the upper-tier informal sector have voluntarily moved there from
the formal sector and are happy about their choice. For these individuals, the
disadvantages of working in the informal sector are outweighed by the
advantages. Individuals who participate in the easy-entry informal sector are
dissatisfied with working in the informal sector and are typically looking for
jobs in the formal sector.
In other words, other factors than (net) income may affect the well-being
associated with the informal sector compared to the formal sector. For
example, aside from the financial advantage of not paying taxes (e.g.,
Hansson 1982), the informal sector sometimes provides more flexibility and
opportunities for individual initiative and creativity than the formal sector (De
Grazia 1982; Renooy 1990; Marcouiller et al. 1997). However, in addition to
lower earnings, working in the informal sector may have other disadvantages:
workers often experience worse working conditions, face higher job insecurity,
have no labor contract and, as a consequence are excluded from various social
benefits.Footnote1 For these reasons, a comparison based on subjective measures of
well-being may be preferable to direct comparisons of net income. In this
paper, we present such a comparison in an attempt to better understand the
motivations behind working in the informal sector and the consequences
thereof for individual welfare.
Though the existing literature touches upon welfare differences between the
two sectors, a systematic analysis is missing. Income is often used to compare
individuals across sectors, but as mentioned above, there is more to welfare
than just income (e.g., (un)certainty about the future and (lack of) social
security). In this paper, we use instead a broader concept of economic welfare,
which is captured by individuals’ own evaluation of their financial situation,
i.e., their financial satisfaction. Reported financial satisfaction is a measure of
the contentment that individuals derive from their economic situation and it is
therefore correlated but not identical to individuals’ income and wealth.
Financial satisfaction relates to how individuals perceive their economic
situation, which typically depends on the individual socio-economic situation
and on how their financial situation compares to the past, to other individuals
in the society, and to what individuals expect in the future. This paper fills the
existing gap by offering a first (econometric) analysis of the effect of working
, in the (in)formal sector on individual self-reported financial situation. It is
through such an analysis that we are able to systematically understand
individual motivations of working in the informal sector and their
implications for individuals’ financial satisfaction.
The empirical analysis uses a dataset for Albania, a country in transition. After
the collapse of communism, a combination of economic, social and
institutional factors created suitable conditions for the informal sector to be
prevalent in Albania (Gërxhani and Schram 2006).Footnote2 Moreover, individual
involvement in the informal sector in this country is not voluntary. This is due
to a limited number of jobs available in the formal sector combined with trivial
and short-termed financial support by the Albanian welfare system. As shown
by Gërxhani (2004b), this lack of choice is a fundamental difference between
the informal sector in developed countries and that in transition countries like
Albania. In the latter countries, ‘survival’ plays an important role in the
decision to participate in the informal sector. Footnote3 In another study, on the
dichotomous sectoral composition of labor in Nicaragua, Pisani and Pagán
(2003) argue that “unlike developed countries which have a functional social
safety net for unemployed people to ‘wait’ or queue for formal sector
employment, Nicaragua has virtually no social safety net; this compels
potential formal sector job seekers to work in the informal sector (which acts
as the de facto social safety net) while awaiting formal sector employment.” (p.
574). Clearly, transition (undeveloped) countries provide special cases. This is
not only related to their large shadow economies, but also to the fact that most
individuals in these countries are often constrained to work in the informal
sector which is characterized by labor intensive and low technology. As a
consequence, the allocation of resources and success within the society will be
distorted, resulting in support rather than moderation of social inequality
(Bromley and Gerry 1979; Ditton and Brown 1981; Moser 1994; Leonard
2002). Hence, individual motivations for working in the (in)formal sector are
expected to have important implications for individual welfare and social
(in)equality in such countries.
Finally, this paper takes the analysis one step further by recognizing that
individuals are not homogenous economic agents with identical perceptions of
their own welfare. In the empirical application, it identifies two groups of
individuals, distinguished by their attitudes towards taxes. An important
distinction between working in the formal and informal sector is whether or
not individuals pay taxes. Individuals may, however, differ in (1) how they
perceive the financial consequences of (not) paying taxes and in (2) their
beliefs about contributing to public goods by paying taxes. By allowing for
these differences in individual motivations to work in the (in)formal sector,
in a Transition Country
Abstract
This paper examines the relationship between working in the formal or
informal sector and self-reported individual financial satisfaction in a country
in transition. It does so by allowing for individual heterogeneity in terms of
perceived financial insecurity and tax morale. The empirical analysis uses a
dataset for Albania, a country in transition. The method applied is the ‘self-
administered questionnaire’, which combines personal contacts with written
questionnaire. The results indicate that, for most individuals, working in the
informal sector has negative effects on their self reported financial
satisfaction. For some individuals, however, this effect is positive. The
characteristic defining these two groups of individuals is their attitude towards
the perceived financial insecurity related to not paying taxes. These findings
have important implications, in particular for transition countries with large
informal sectors. Given the involuntary participation in the informal sector in
these countries, the majority of individuals working in this sector will remain
financially dissatisfied as long as they have no other social safety net.
Introduction
An important episode in the previous century was the rise and fall of
communist economies in Central and Eastern Europe and the Baltic states.
The collapse of these economies led to the emergence of so-called transition
countries, which are characterized by rapid economic and institutional
change. This transformation has been accompanied by the appearance of a
substantial informal sector. From an economic sociology perspective, the
informal sector is important for social (in)equality through both the re-
allocation of resources it causes and its impact on individuals’ welfare. This
paper focuses on the latter.
Early studies argue that average individual earnings in the informal sector are
lower than in the formal sector (Harris and Todaro 1970; Merrick 1976; Kugler
et al. 1979; Bourguignon 1979; Banerjee 1982; Heckman and Hotz 1986;
Pradhan and van Soest 1995; Pisani and Pagán 2003). Thomas (1990)
presents evidence that this mainly holds for less developed countries. Other
studies suggest that the earnings distributions in the formal and informal
sectors have substantial overlap (Fields 1990), so that the differences may be
smaller than is commonly thought (Charmes 1990). These findings have
,identified two sub-sectors within the informal sector. One is called the ‘upper-
tier informal sector’. This is characterized by limited-entry and high wages
(relative to the formal sector), and is preferred by workers to formal sector
employment. The other is called the ‘easy-entry informal sector’, which
consists of employment that is characterized by free-entry and low wages.
Workers consider the latter to be undesirable relative to formal sector
employment. Based on this distinction, Fields (1990) reports that individuals
working in the upper-tier informal sector have voluntarily moved there from
the formal sector and are happy about their choice. For these individuals, the
disadvantages of working in the informal sector are outweighed by the
advantages. Individuals who participate in the easy-entry informal sector are
dissatisfied with working in the informal sector and are typically looking for
jobs in the formal sector.
In other words, other factors than (net) income may affect the well-being
associated with the informal sector compared to the formal sector. For
example, aside from the financial advantage of not paying taxes (e.g.,
Hansson 1982), the informal sector sometimes provides more flexibility and
opportunities for individual initiative and creativity than the formal sector (De
Grazia 1982; Renooy 1990; Marcouiller et al. 1997). However, in addition to
lower earnings, working in the informal sector may have other disadvantages:
workers often experience worse working conditions, face higher job insecurity,
have no labor contract and, as a consequence are excluded from various social
benefits.Footnote1 For these reasons, a comparison based on subjective measures of
well-being may be preferable to direct comparisons of net income. In this
paper, we present such a comparison in an attempt to better understand the
motivations behind working in the informal sector and the consequences
thereof for individual welfare.
Though the existing literature touches upon welfare differences between the
two sectors, a systematic analysis is missing. Income is often used to compare
individuals across sectors, but as mentioned above, there is more to welfare
than just income (e.g., (un)certainty about the future and (lack of) social
security). In this paper, we use instead a broader concept of economic welfare,
which is captured by individuals’ own evaluation of their financial situation,
i.e., their financial satisfaction. Reported financial satisfaction is a measure of
the contentment that individuals derive from their economic situation and it is
therefore correlated but not identical to individuals’ income and wealth.
Financial satisfaction relates to how individuals perceive their economic
situation, which typically depends on the individual socio-economic situation
and on how their financial situation compares to the past, to other individuals
in the society, and to what individuals expect in the future. This paper fills the
existing gap by offering a first (econometric) analysis of the effect of working
, in the (in)formal sector on individual self-reported financial situation. It is
through such an analysis that we are able to systematically understand
individual motivations of working in the informal sector and their
implications for individuals’ financial satisfaction.
The empirical analysis uses a dataset for Albania, a country in transition. After
the collapse of communism, a combination of economic, social and
institutional factors created suitable conditions for the informal sector to be
prevalent in Albania (Gërxhani and Schram 2006).Footnote2 Moreover, individual
involvement in the informal sector in this country is not voluntary. This is due
to a limited number of jobs available in the formal sector combined with trivial
and short-termed financial support by the Albanian welfare system. As shown
by Gërxhani (2004b), this lack of choice is a fundamental difference between
the informal sector in developed countries and that in transition countries like
Albania. In the latter countries, ‘survival’ plays an important role in the
decision to participate in the informal sector. Footnote3 In another study, on the
dichotomous sectoral composition of labor in Nicaragua, Pisani and Pagán
(2003) argue that “unlike developed countries which have a functional social
safety net for unemployed people to ‘wait’ or queue for formal sector
employment, Nicaragua has virtually no social safety net; this compels
potential formal sector job seekers to work in the informal sector (which acts
as the de facto social safety net) while awaiting formal sector employment.” (p.
574). Clearly, transition (undeveloped) countries provide special cases. This is
not only related to their large shadow economies, but also to the fact that most
individuals in these countries are often constrained to work in the informal
sector which is characterized by labor intensive and low technology. As a
consequence, the allocation of resources and success within the society will be
distorted, resulting in support rather than moderation of social inequality
(Bromley and Gerry 1979; Ditton and Brown 1981; Moser 1994; Leonard
2002). Hence, individual motivations for working in the (in)formal sector are
expected to have important implications for individual welfare and social
(in)equality in such countries.
Finally, this paper takes the analysis one step further by recognizing that
individuals are not homogenous economic agents with identical perceptions of
their own welfare. In the empirical application, it identifies two groups of
individuals, distinguished by their attitudes towards taxes. An important
distinction between working in the formal and informal sector is whether or
not individuals pay taxes. Individuals may, however, differ in (1) how they
perceive the financial consequences of (not) paying taxes and in (2) their
beliefs about contributing to public goods by paying taxes. By allowing for
these differences in individual motivations to work in the (in)formal sector,
