Re-thinking informality: It’s all in the details

Informality is the subject of many a report, study, intervention, policy brief, political agenda and fireside chat, and due to its prevalence, rightfully so. In emerging and developing economies, the informal sector accounted for 32% of GDP and 70% of employment in 2016. This is a concern because informal firms tend to be less productive than formal firms and pay workers less than their formal counterparts. Reversing informality is enticing and promises rewards in the form of potential tax revenues, productivity gains, and poverty eradicating capabilities.  But the quest to bring more firms and workers into the formal sector has proven to be complex.
 
Understandably, finding a magic recipe to shift a significant portion of an economy’s players towards a new, unfamiliar tradition of business -  rapidly substituting informal behaviors for formal ones - is a tall order.  So far, many interventions have not lead to the desired changes in rates of formalization and have brought limited knowledge for how to address the issue, often returning to well-accepted general correlations such as creating a better business environment leading to lower rates of informality. This is neither very specific nor very helpful. It is time to rethink how we view informality, utilizing the knowledge gained thus far, and develop new ways to address changing it.
 
So, how do we move forward?

 

There is a growing discussion regarding differentiation of informal firms with the development of terms such as ‘ constrained gazelles’, ‘ defensive evader’, ‘necessity firms’, and several others.  This is helpful, but there is opportunity in further clarity and agreed upon terminology for the many different types of firms that fall under the informality umbrella. Understanding the unique characteristics they display, such as whether the firm is urban or rural, the socioeconomic status of the entrepreneur, the firm’s access credit (whether formal or informal), and whether it is legal, fiscal, or labor informality that is addressed, could help create a defined methodology for addressing the specific obstacles firms face. Developing a full informal sector breakdown, a classification matrix into which all firms could be placed, would help with analysis and lead to a more specific evidence base.
 
We see multiple avenues of exploration within this context of expanded firm differentiation, that will, with the existing evidence base, support a more holistic way of approaching informal enterprises. These include:

1. Focusing interventions on clusters of firms rather than individual firms could take advantage of formal-informal business linkages, network effects and generate large amounts of feedback in a short amount of time given the similarity of conditions firms are operating in. Specific public services and cluster support programs can be made available to firms within the cluster.
    
2. Understanding the support an informal firm needs most, and how they utilize that support, can not only help increase prosperity, but may also incidentally lead to formalization. This support might come in the form of financing, social protections, managerial trainings, or other technical assistance that does not target formalization itself.  
    
3. Intermediate and/or temporary legal forms for informal firms, much like the entreprenant status, is also an area worthy of future study. Reduced costs to access increased benefits may serve as a stepping stone to improved well-being, firm growth, increased productivity, as well as a step towards partial tax revenue gains.  An intermediate legal form can be used for informal firms to transition through before reaching a full formal status or serve as a more attainable form for microentrepreneurs that would otherwise not consider formalization.
    
4. Integrating behavioral insights into the research of formal firms is also important. Informal firms are influenced by intangible factors that extend beyond ‘rational’ economics. Examples are ‘rules of thumb’, ‘nudges,’ the political economy, government stability, and even rule of law.  In order to change informality, we need a better understanding of all these diverse sources of influence.

We believe this framework will support a new set of structured learning and help develop that new potion of reform, incentive, information and training.   
 
To Summarize:

• The quest for the solution to informality is ongoing as studies to date have found only mixed results.
• Now is the time for a re-thinking of informality, how we view it, how we go about addressing it.
• We propose the further expansion of variables studied to better understand the full scope of costs and benefits experienced by an informal firm.
• Doing so will require an advancement in the clarity of our differentiation of informal firms as well as further delving into clusters analysis, behavioral insights, indirect effects on formalization, and the effect of intermediate legal forms.