Governments (and donors alike) don’t like dealing with informality. It’s messy, dirty, essentially unmeasurable, and its character varies dramatically. From one industry to the next. From one city to the next. It’s also beset with fiendishly difficult problems – informal firms are often household enterprises (employing mainly family labour, and not hired labour). Thus, they have to make impossible trade-offs between production and consumption.
And yet – the size and the importance of the informal sector in most countries shows no signs of abating. On average the informal share of employment ranges from 24 per cent in transition economies, to 50 per cent in Latin America and over 70 per cent in sub-Saharan Africa. In India, employment within the informal sector is growing, while that in the formal sector remains stagnant. Yet - very little is known about the relationship, whether symbiotic or competitive, between the two sectors.
In a new paper, I notice that in India formal firms tend to cluster with informal firms – especially in industries like apparel, furniture and meal-making. The firms coagglomerate not only so that they can buy from and sell to one another – but importantly, also because formal firms tend to share equipment with and transfer technical knowledge to their informal counterparts. Such technical and production spillovers are found in clusters of domestic-foreign, exporter-non-exporter and high-tech-low-tech firms. It is no surprise then that formal and informal activity could be complementary. Informal can also be an outlet for entrepreneurial activity, especially in places with high levels of corruption, or where formal firms are often mired in complex regulations.
This coagglomeration, or co-clustering, can have positive knock-on effects for formal firms. In India, I find that formal-informal coagglomeration leads to an increase in entrepreneurial activity in the formal manufacturing sector – specifically for small and medium enterprises. This could be a function of labour market regulations in the formal sector, or simply because SMEs find it cost-effective for other reasons to outsource production. Similarly, Ejaz Ghani and his co-authors find that output and employment is higher in places where presence of informal suppliers is greater. Research in Kenya and Nigeria suggests that large informal firms also benefit from subcontracting with formal firms. These findings suggest that policies that try to limit the development of informal activities and attempt to shift the balance to formal activities might be fraught with danger. It might be efficient to allow these clusters to grow.
There is no reason to assume that informal firms don’t benefit from clustering with one another. In the absence of access to formal credit facilities, or alternatively since they are untouched by changes in regulations, buyer-supplier linkages and informal networks of social interaction could be more important to informal firms than to firms operating in the formal sector. Research in India indicates that informal entrepreneurial activity tends to favour regions where incumbents enjoy input-output linkages. In fact, the existence of female-owned informal firms is the strongest predictor of new female entrepreneurial activity.
In their new paper, Louise Fox and co-authors argue that almost half of new jobs in sub-Saharan Africa will be generated within the informal sector (the remainder distributed between the formal and the agricultural sector). Research in India shows that informal enterprises help increase female participation in the labour force. In fact, agglomeration and urbanization are associated with the growth of informal activity, both firm entry and job creation. Is informal then the new normal? Given that job creation is of paramount importance to political leaders, much more evidence is needed – first, on how informal activity contributes to employment and growth directly, and second, how formal-informal linkages lead to positive spillovers. If informality is an important input to the formal production process, then it ought to be seen as a help, and not a hindrance, to growth.