Five reasons to be concerned about the shadow economy

Informal activity—sometimes dubbed the “shadow economy”—is widespread in emerging market and developing economies.  Its pervasiveness is of particular concern at the current juncture, because it may make it harder for these economies to achieve the inclusive development that is needed to undo the damage of the COVID-19 pandemic.

Reason 1: Informality is widespread. In emerging market and developing economies (EMDEs), the informal sector accounts for about one-third of GDP and more than 70 percent of employment, of which about one-half is self-employment  (Figure 1). Among the six EMDE regions, output informality is highest in Sub-Saharan Africa, Europe and Central Asia, and Latin America and the Caribbean. Employment informality (measured as self-employment) is highest in Sub-Saharan Africa, South Asia, and East Asia and Pacific.

Figure 1. Output and employment informality in EMDEs

Reason 2: High informality is linked to low productivity. In EMDEs, labor productivity in informal firms, on average, is only-quarter of labor productivity in formal firms.  Informal workers are paid 19 percent less than their formal counterparts, on average. This is largely due to differences between the characteristics of workers employed in the formal and informal sectors. Once low education, lack of experience, and other characteristics of informal workers are taken into account, this wage gap becomes negligible (Figure 2).

Figure 2. Wage premium for formal over informal employment

Reason 3: Informality is linked to a wide variety of development challenges. It is associated with higher poverty, lower per capita incomes, slower progress toward the Sustainable Development Goals (SDGs), greater inequality, lower human capital, and weaker investment. About one-quarter (26 percent) of the population of EMDEs with above-median informality lives in extreme poverty, compared with just 7 percent of the population in EMDEs with below-median informality (Figure 3).

Figure 3. Extreme poverty

Reason 4: High informality usually means weak government capacity. More informality is associated with significantly lower revenues and expenditures, less effective public institutions, more burdensome tax and regulatory regimes, and weaker governance.  Government revenues in EMDEs with above-median informality are 5-12 percentage points of GDP below those with below-median informality (Figure 4).

Figure 4. Government revenues and expenditures

Reason 5: There is no easy fix. For some people, working in the informal sector is a choice. For others, it is a last resort. Informal workers range from those who are self-employed to smallholder farmers and employees without work contracts.  In EMDE regions with the highest employment informality, agricultural sectors, where workers are commonly employed informally, remain particularly large (Figure 5).

That means there is no easy solution: the causes of informality are too varied for that. Policy reforms, accordingly, need to be comprehensive and tailored to circumstances of each country.

In Sub-Saharan Africa—where informal activity is often a matter of last resort—policies have focused on boosting human capital and improving access to finance, markets, and inputs to increase labor productivity. But in Europe and Central Asia, Latin America and the Caribbean, and much of the Middle East and North Africa, policies have centered on easing regulatory burdens and building more effective and accountable institutions—in particular, strengthening enforcement and reducing corruption.

Figure 5. Agricultural share of output, by region

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