Understanding the Informal Sector in Developing Economies
The informal sector (IS) describes economic activity that occurs outside the formal norms of economic transactions established by the state and official business practices, while not being explicitly illegal. Typically, this term applies to small or micro-businesses that result from individual or family self-employment. It includes the production and exchange of legal goods and services that lack proper business permits, violate zoning codes, fail to report tax liabilities, do not comply with labour regulations governing contracts and work conditions, and lack legal guarantees in relations with suppliers and clients. Consequently, it is conceptually, methodologically, and theoretically challenging to precisely define its nature, size, and significance.
Despite these challenges, there is widespread agreement that the sector represents a growing proportion of economic activity, particularly in less developed countries (LDCs), placing it at the centre of debates regarding its role in economic development. The presence of large informal sectors is one of the most distinguishing characteristics of developing countries. Studying the informal economy is crucial because it sheds light on how state regulatory and enforcement systems impact economic performance.
To illustrate this phenomenon in an LDC, let us take Albania as an example. The collapse of the informal money-lending activities (pyramid schemes) had a profound effect on Albanian society, showcasing how the informal sector can significantly influence a society’s political, economic, and social dimensions. Conversely, the results of the street vending survey in Tirana in 1996 show that the informal sector supported the Albanian economy during its challenging transition years. These findings reveal that informal sector activities provide families with employment and supplementary income when other opportunities are lacking. People learn to use their initiative and creativity to generate more jobs and wealth. As De Soto (1989) states, while social problems are substantial, the situation would be far worse without informal marketers. Moreover, the results suggest that joining the informal sector can be a form of protest against the inefficiencies and high transaction costs caused by excessive state regulations and bureaucratic procedures. When free enterprise and entrepreneurial creativity are not supported by formal state institutions, people resort to the informal sector.
However, Albania’s negative experience with the informal financial market raises crucial questions. Economically, the existence of this market meant that money invested in pyramid schemes did not support genuine economic investments. Politically, it caused severe instability, almost leading to civil war. Socially, many individuals lost their savings and wealth, resulting in numerous social problems.
While the situation in Albania was extreme, many LDCs experience similar circumstances and inappropriate practices by centralised governments, potentially leading to comparable outcomes depending on each country’s culture and political maturity.
What Causes the Informal Sector to Arise?
The informal sector emerges when governments impose excessive taxes and regulations but lack the capacity to enforce compliance. An overly regulated system makes the formal economy unattractive by imposing high entry costs to legality—such as licence fees and registration requirements—and high costs to remain legal, including taxes, bureaucracy, and labour and environmental regulations.
The reasons for engaging in informal activities can be both economic and non-economic. The primary economic reasons include:
(a) Tax evasion.
(b) Circumvention of regulations and licensing requirements.
(c) Coping with unemployment and an inflexible formal labour market.
Non-economic reasons encompass:
(a) Greater flexibility and job satisfaction.
(b) The opportunity for free choice.
(c) Full utilisation of one’s professional qualifications.
(d) Political dissatisfaction.
Returning to Albania as an example, specific factors contributing to the significant informal sector include:
1. Path Dependence – Albanians had been isolated for about forty-five years and had no experience with market institutions.
2. High and Attractive Interest Rates – Offered by companies (5–10% per month) and foundations (around 50%), these rates were intertwined with money laundering and other suspicious activities.
3. Banking System Inefficiency – Delays in services and the lack of a modern payment system led consumers to conduct transactions in cash.
4. Restrictive Monetary and Fiscal Policies – Coupled with strict banking legislation.
5. Governmental Failure – Lack of adequate law enforcement and even implicit support for pyramid schemes.
6. Legal System Ambiguity – Often leaving room for multiple pragmatic interpretations.
Therefore, an individual’s choice to join the informal sector can be a natural response to government practices that threaten their ability to meet basic needs, compounded by mistrust stemming from complicated political influences and governmental inefficiencies.
The Pros and Cons from a Developmental Perspective
The impact of the informal sector on the overall economy is highly debated. Some view it negatively, arguing that its marginal role relative to key macroeconomic indicators warrants its reduction. Others adopt a positive stance, highlighting its dynamism, flexibility, and potential for wealth accumulation, advocating for its integration into the formal economy.
These divergent views become more pronounced when considering different types of countries. In developed nations, the informal sector often holds potential for economic investment and growth and maintains income levels comparable to the formal sector. In less developed countries, however, the characteristics of the informal sector often indicate the opposite.
The International Labour Organization (ILO) has proposed that the informal sector could address unemployment in LDCs. Although it views the sector as a collection of survival strategies hindered by undercapitalisation, lack of skills, and the small size of enterprises, the ILO argues that if these challenges can be mitigated, the informal sector can absorb employment.
De Soto goes further, asserting that the informal sector comprises entrepreneurial activity constrained by the high ‘costs of formality’ in many LDCs. Complex, time-consuming, and expensive regulations make it nearly impossible for small firms to comply. As a result, these entrepreneurs must remain small and hidden to avoid detection, lacking legal protection for their investments and thus discouraging growth and capital investment.
In Albania, while informal activities like street vending undoubtedly offer benefits, they also pose significant risks. High levels of unlicensed activities among street vendors correlate with high levels of unreported income. Consequently, there are financial losses in state revenue, under-provision of public goods, and distorted macroeconomic indicators such as unemployment, tax rates, inflation, and growth rates. Policy decisions may thus be based on a misleading view of the economy. Additionally, the lack of insurance for informal workers creates a future burden on social assistance and welfare programmes. As the Albanian example suggests, the drawbacks of the informal sector outweigh its benefits, necessitating formalisation.
Measures to Integrate the Informal Sector into the Formal Economy
The heterogeneity of the informal sector and its connections to both formal businesses and illegal activities complicate its definition and measurement. For instance, macroeconomic estimates of the informal economy often cannot differentiate between ‘legal’ and ‘illegal’ activities, such as prostitution, drug dealing, and contraband. Even at the micro-level, the sale of unlicensed products resembles that of legal goods, making it challenging to distinguish.
Further research is needed to explore the conditions under which informal sector activity is entrepreneurial or exploitative and how it might relate to economic growth. Additionally, the political interests of informal sector actors warrant deeper examination.
Governments in LDCs can adopt certain regulations to help integrate the informal sector into the formal economy, including:
– Preserving Basic Securities – Providing support for the informal working poor.
– Developing Measures for Informal Businesses – Introducing incentives to join the formal economy.
– Detection and Repression of Harmful Informal Economies – Combatting illegal and damaging activities.
– Publicity – Raising awareness about the benefits of formalisation.
Although decentralisation is generally advocated by reformers, integrating the informal sector into the formal one may require centralised decisions. However, wise governance involves taking steps based on raising awareness rather than imposing mandatory measures.
To transition from the informal to the formal sector, individuals need to be free from severe fear of the future. This can be achieved by establishing appropriate security and insurance systems, including healthcare. Additionally, governments should support the working poor to foster independent citizens capable of securing their livelihoods. Encouraging small businesses to join the formal sector can be facilitated through developmental programmes and the elimination of negative governmental practices that drive them away from formality.
Importantly, this approach should exclude harmful or criminal economic activities like drug dealing and prostitution. While these may offer economic benefits, their severe social and moral consequences result in greater long-term losses. Thus, governments must foster an environment of trust through dependable practices that genuinely care for and support the working poor, leading to a visible shift towards formality.
References
Open Air. “Cross-National Research on Informal Sector.” Accessed 5 October 2007, http://www.openair.org/cross/infdef2.html.
University of Amsterdam Institute for Advanced Labour Studies (AIAS). “Working Paper 12.” Accessed 5 October 2007, http://www.uva-aias.net/files/aias/WP12.pdf.
United Nations Development Programme (UNDP). “The Informal Sector in Romania.” Accessed 5 October 2007, http://www.undp.ro/publications/pdf/informal_sector_in_romania1.pdf.