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Tackling the Problem of Informality

Ravi Kanbur's picture

Ravi Kanbur is T.H. Lee Professor of World Affairs, International Professor of Applied Economics and Management, and Professor of Economics at Cornell University.​

In recent years, there has been a strong interest in the informal economy, which is estimated to comprise 50-75 percent of the non-agricultural labor force in developing countries. It is seen as problematic by many observers, not least because of its association with poverty and low productivity. But little consensus exists on the diagnosis of the problem, let alone on policies to address it.

One view, held by many economists and policy analysts, is that the informal economy arises and flourishes because of regulations that are typically poorly designed (and if decently designed, poorly enforced). This viewpoint was well articulated by The Economist (PDF) in a 2010 survey of Latin America. “Thanks largely to baroque regulation,” said the magazine, “half the labour force toils in the informal economy, unable to reap the productivity gains that come from technology and greater scale.”

Local vendor. Yemen. Photo: Scott Wallace / World Bank

However, many civil society activists and non-economist analysts disagree. As argued byChen and Doane (2008, PDF), “Economic stagnation and labour market rigidities alone cannot explain the extent of informal employment...” Rather, they point to credit constraints, poor education and training, and various infrastructure impediments as explanations for the persistence of the informal sector. This is notably the position taken by Women in Informal Employment: Globalizing and Organizing (WIEGO).

What would help bridge these divergent views and facilitate policy conclusions is a simple framework that clearly delineates what constitutes formal and informal activities. At this point, different types of informal activities are often lumped together, but the reality is that the type of informal activity may dictate how to improve productivity, boost incomes, and improve job safety and benefits (like pensions and health coverage).


A Key Step to Bridging the Divide

We can begin by defining formality and informality of economic activity relative to a set of laws and regulations. For purposes of illustration, suppose that enterprises larger than nine workers must register for taxation, make social security contributions, and pay a minimum wage. Then four categories arise (Kanbur, 2009, PDF).

A.      Activities that come under the purview of regulation and comply. This would be an enterprise with more than nine workers that registers for taxation, makes social security contributions, and pays a minimum wage. This is the normal conceptualization of formality. By definition, everything else is informal.

B.      Activities that come under the purview of regulation but do not comply – “the evaders.” This would be an enterprise that has more than nine workers but does not register or meet the other requirements. This is straightforward evasion and illegality. The size of category B depends on the costs of the regulation and the effectiveness of enforcement.

C.      Activities that do not come under the purview of regulation but only because they have adjusted out of the ambit of controls – “the avoiders.”This would be an enterprise that would have employed 10 workers without the regulation, but is now employing only eight workers to avoid the costs (net of benefits) of the regulation. The size of category C depends on the relative costs and benefits of avoiding the regulation – the diseconomies of operating at lower scale than would be optimal without the regulation.

D.      Activities that would not come under the purview of the regulation at all– “the outsiders.” This would be an enterprise that employed three workers before the regulation, and continues to do so after. The size of category D depends on a range of constraints on enterprises, from growing in size to credit constraints and infrastructure impediments – but not on regulations.

In other words, the design of regulations and their enforcement matter for formal activities and for the evaders and avoiders, but not for the outsiders. Yet empirical studies largely fail to disaggregate the informal sector. Hence, we lack estimates of the sizes of the informal categories and solid evidence on how policies affect these categories. Rather, what we have are estimates for informal activities as a whole, which are interpreted as applying to evaders and avoiders by one group of analysts and advocates, and as applying to outsiders by another group.


Policy Implications: Key Questions

Thus, it is vital to disaggregate the categories if we want better research and a better consensus on policy priorities for informality.

Take the case of a country that wants to sharply reduce poverty. Should it use the limited financial, administrative, and political resources to raise productivity and incomes for the outsiders or should it reform regulations to discourage more evaders and avoiders? The answer depends on the size of the various informal categories, how laws and regulations affect the avoiders and evaders, how technological changes and global trading conditions shift the balance between the formal sector and the evaders and avoiders, the productivity differences between the formal sector and the evaders and the avoiders, the productivity differences between outsiders and the other informal groups, and what can increase productivity for the outsiders.

One scenario is that the outsiders are small relative to the avoiders plus evaders, regulations have a big impact on the size of the evaders plus avoiders, globalization and technical change increase this impact, and productivity losses from adjusting out of the formal sector into evaders and avoiders are large. In this situation, a policy focused on reforming regulations to reduce adjustment out of the formal sector into the evaders and avoiders (that is, the policy thrust of The Economist view) would seem advisable. However, if the answers are opposite to those above, the WIEGO view would have greater credence –the focus should be on direct interventions to provide credit, training, and support to the outsiders rather than on deregulation.

This post was first published on the Jobs Knowledge Platform.

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