Four Myths About the Informal Economy

FROM: Zenebe B. Uraguchi – 29. March 2019

“It all depends on who you know,” says Admir Bajram, a taxi driver in Skopje, the capital of (Northern) Macedonia. I was in Skopje in February and took the taxi that Admir was driving. We were discussing about what it takes to be successful in doing business in Macedonia. Admir’s point was: paying taxes or registering to do a business wouldn’t necessarily guarantee succeeding in a business. Some people, he insisted, don’t perceive the benefits of operating formally; connections or networks do matter.

Most Balkan enterprises are small, often based around families. Admir isn’t wrong. A study in 2018 by the European Bank for Reconstruction and Development showed that one in four firms saw unfair competition from the informal economy as the biggest obstacle to growth in the region. These firms complained about heavy burden of taxation and social insurance payments, as well as the trouble of going through inspections.

Yet I feel that most discussions about the informal and formal economies seem to be based on assumptions or myths. Informality is complex, dynamic and resilient. Simple and one-sided push for the formalisation of the informal economy, claiming informality is bad for growth, doesn’t seem to be a good solution. There are some reasons for this. Contrary to assumptions, informality doesn’t exist in isolation from the formal economy. Furthermore, such a “legalistic view” may not work because formality isn’t a permanent status. As I show below, there is evidence that firms or workers that move to the formal economy also shift back to informality for different reasons.    

Myth 1: Informality is illegal activity and bad for growth

We often assume that informality is about impoverished people working or doing business in the shadow, grey or illicit economy in developing countries. I don’t think this is right; the informal economy isn’t all about illegal businesses. I’ve encountered several businesses or workers in Africa, Asia and Eastern Europe that are in legitimate activities. They may operate outside the legal and regulatory framework, for example, fully complying with tax, labour market obligations, or product market regulations. The informal economy, however, is blamed for weakening productivity and undermining a nation's financial health. It’s true that informality prevents many people and economic activities from accessing appropriate technologies, public services and social protection.

Before demonising the informal sector for the malaise of economic growth, we need to understand the realities and positive aspects of the informal economy, which unfortunately tend to be ignored or downplayed. The informal economy is an untapped reservoir of entrepreneurial energy. Businesses and workers in the informal economy are flexible and creative – ranging from basic survivalist labour to sophisticated and skilled craft work. The informal economy, mainly in developing and transitional countries, is the most dynamic part and creates massive employment and income opportunities.

Myth 2: There is only one type of informality

Informality is more diverse and more pervasive than often assumed. It has considerable heterogeneity across regions and countries in terms of actors, activities and scales. The number and complexity of informal businesses is different by sector – in the agricultural, information technology, service or tourism sectors. Informality in employment has also different features, ranging from own account workers to casual workers and sub-contracted workers.

Many of the informal economy actors are micro-enterprises; others are very large or part of national or even international networks. Some have the dual features of formal and informal economies. They may be registered but they employ a share of their workers without offering them written contracts. This makes the distinction between formal and informal economies difficult – in other words, the difference is more a question of continuum than a sharp division.

There is also a strong relationship between gender and the informal economy. Under the changing nature of the future of work – often in complex, dynamic and unpredictable manners – women who succeed in finding employment are typically hired into low-skilled, low-productivity positions, often in the informal economy.

Myth 3: Informality disappears with growth

It’s true that the informal economy shrinks with growth. But it doesn’t necessarily disappear with growth. More than 13% of OECD countries’ economies is informal. The figure for Switzerland is 7%. It’s estimated that over two million people work in the informal economy in the UK. I’m citing these figures with caution because GDP is a bad measurement of an economy. David Pilling, the author of The Growth Delusion, cites the example of Italy. “In 1987 Italians awoke to find that their economy had overtaken that of Britain to become the fifth biggest in the world” (p. 41). The reason was that the Italian statistical agency “improved” its measurement of the informal economy.     

Far from disappearing, the informal economy has either remained stagnant or have actually increased. It’s a fact that informality happens not just by choice but also by necessity. In other words, the informal sector sometimes emerges by default (i.e. exclusion from the formal sector) and thrives under high unemployment and poverty. In the Western Balkan countries, the informal sector serves millions as a social buffer for workers with few options. Globally, it’s estimated that over two billion people work in the informal economy. In our book on financial inclusion, we showed how trust and social networks, key characteristics of social capital, are particularly important in the informal sector by reducing the costs of screening and enforcement particularly in cases where more formal rules (e.g. debt creditor rights, property rights and collateral laws) are absent.  

Myth 4: Formality is a permanent status

There is no strong evidence that supports that once people move to the formal economy, they stay in the same status. Informality isn’t normal or static, either. It’s often assumed that the formal economy is largely disconnected from the formal economy. Not true. The two are intertwined and their status shifts, to a large extent from informal to formal. The linkages are along production and consumption. The informal sector provides services for formal actors, offers a flexible labour market to absorb the surplus labour. As mentioned above, businesses which are formal also hire employees without giving them a formal recognition.   

So, what?  

My intention is neither to romanticise nor demonise the informal sector. It’s important to understand the heterogeneity in the informal economy, as well as the various factors that influence individuals’ and firms’ decisions to take their businesses to the informal economy. The problem is, as David Pilling nicely puts it, “our definition of the economy is pretty crude” (p. 4). Many of the informal sector activities don’t show up in most statistics – from farmers markets to garage sales, house chores, street vendors, open air markets and flea markets. Despite several years of studies, we still don’t know enough about transitions, adaptations and change of the informal economy.

Our approach should instead focus on stimulating a change in behaviour of players – public and private, formal and informal – so that they are better able and motivated to perform important functions effectively. Specifically, while dealing with the informal economy, the solution is neither to encourage nor suppress it, but rather to reduce barriers for all businesses and increase productivity and better quality for workers.

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Senior Advisor Value Chain & Market Development