New insights on the informal economy

I recently co-authored a Donor Committee for Enterprise Development (DCED) research report (with Will Nielsen) entitled Dealing with Firm Informality.

There is a lot of new debate on this topic. For some examples, see this recent World Bank publication on The Long Shadow of Informality: Challenges and Policies, and the International Monetary Fund’s report on The Global Informal Workforce; Priorities for Inclusive Growth. A recent critique on these reports is also very relevant and worth the few minutes it will take you to read––see the World Bank and IMF’s “flawed logic in their quest to do away with the informal sector“.

I was also commissioned to write a report recently for the ILO Asia Pacific Regional Office on Understanding Decentralization and its Impact on Transition to Formality. This looks at decentralised government systems and the issues for business and employers’ representative organisations.

Here are some major findings and recommendations from the DCED report I would like to highlight.

The informal economy is heterogeneous

Informal actors include economic units (i.e., firms) and workers. Each of these actors experience varying degrees of formality, ranging from complete formality to complete informality. Along this spectrum, there are other dimensions: legal (e.g., registered, regulatory compliance), fiscal (e.g., tax-paying) and labour (e.g., employees, minimum wage) formality.

Informal firms can be further categorized by their willingness or capacity to formalize. Different policies can serve diverse types of businesses, and in some cases, policies must recognize that formalization may not be the desired end state for all.

Women and young people are often, but not always, overrepresented. In many developing economies, the agricultural sector has the highest level of informal employment (over 93%), followed by industry (57%) and services (47%, ILO). Geographic variations also occur around the world as well as within countries, with rural areas tending to have higher rates of informality than urban areas.

The International Monetary Fund argues that ‘understanding the drivers and consequences of informality is central to sustainable and inclusive development, as informality is critically related to how fast countries grow, and to poverty and inequality, including gender inequality.’

Despite typically poor levels of earnings and job quality, among other problems, the informal economy is not all bad. Indeed, more recognition has been given to understanding the positive functions of the informal economy. For example, in this article from Zimbabwe, the use of “indigenous knowledge” by informal enterprises is described: “Respondents said the informal sector was a reliable source of good quality organic foods, including traditional foods and recipes. It also made traditional herbs and medicines more available and affordable. In these ways, the sector preserved traditional knowledge.”

Indeed, Robert Neuwirth’s book on the Stealth of Nations highlights the benefits of informality admirably. Neuwirth argues the informal method of transaction dates back as far as humans have existed and traded. It provides essential services and crucial employment to fill the gaps in the formal system. This unregulated market, he says, works smoothly and effectively, with its own codes and unwritten rules.

Business environment reform can address informality

At the aggregate level, investment climate or business environment constraints are significantly associated, either positively or negatively, with the incidence of formality. As a result, business environment reform is an important tool for policymakers to address when targeting informality. However, this alone is often insufficient to achieve formalization at the scale desired.

Specific reforms that have been shown to reduce informality include:

Legal and regulatory reform. Business entry reforms can increase firm formality and work best when delivered in tandem with other reform measures.
Fiscal reform. Because inappropriate taxation systems have been found to encourage informality, taxation reform is often particularly useful. Enterprises of all sizes tend to fail to comply with the tax system if it is too complex, expensive, opaque, or perceived to be unfair.
Labour policy reform. Labour policy that provides access to support for workers while aligning with the status with the firm (such as the number of employees, revenues, etc.) can protect informal workers, helping to bring them into increasingly formal employment, and through a stakeholder-centric policy development process, increase employer compliance that leads to increased firm formality.
Financial sector reform. Many informal firms and workers have limited access to formal banking services. Reforming the legal and regulatory framework of the financial sector can lead to better outcomes for informal firms while also supporting the transition towards formalization.

Complementary measures: Reform+

Measures to complement business environment reform can further support the informal sector. These can be delivered in tandem with conventional business environment reform to address specific challenges faced by informal firms and their workers.

Complementary measures can be placed into two themes: (1) encouraging formalization; and (2) responding to the immediate risks.

Encouraging formalization

The first theme focuses on supporting the formalization of informal firms.

The objective here is to use business environment reform and any complementary activities to shift informal firms towards formalization. Examples include:

Behavioural science. The use of behavioural insights to encourage business owners and managers to move towards formalisation, designing nudges to foster the desired changes.
Digital technologies. The emergence of digital technology in developed and developing economies around the world is changing the way business is done. This offers new opportunities for reformers, policymakers and informal business owners, managers and workers.
Trust-building between the public and private sectors. Some informal firms are informal due to limited trust in the public sector. Efforts such as public-private dialogue can support the development of trust that leads to increased tax compliance, improved policy decisions, etc.

Responding to the immediate risks faced by informal firms

The second theme of complementary measures deals with the use of business environment reform and other instruments to address the immediate needs of informal enterprises and their workers.

Here, the objective is not necessarily to push informal firms towards formalization but to help address the immediate needs of informal enterprises and their workers. Examples include:

Social protection. The lack of social protection is a major contributor to the vulnerability of informal firms and their workers. This includes helping governments extend access to social protection benefits for workers in micro and small enterprises, whether formal or informal, to increase their resiliency while helping informal enterprise owners and workers to see the value in contributing to social protection schemes.
Innovation. The promotion of innovation in the informal economy, while an under-studied field, highlights the role of the informal economy as a place of innovation, often through necessity. Targeted reforms may support productivity growth and the movement towards formalization by helping firms capture the benefits of their innovation.
Human capital development. Human capital development through lifelong learning strategies and investments in skills for informal economy workers is necessary for real progress to be made towards transitions to formality.
Increased business capacity. Enabling firms to respond to emerging new market opportunities, such as through innovative financial products, engaging with the social and solidarity economy, and targeting reforms at industry clusters can have positive results for informal economy actors.

Much of these issues respond to the critique of World Bank and IMF approaches mentioned earlier. In their critique, Mike Rogan, Max Gallien and Vanessa van den Boogaard argue for a stronger focus on progressive taxation and the expansion of social protection for the poor, regardless of employment status.

Recommendations

Here are the main areas of advice provided to policymakers and donor and development agencies.

Focus BER for firm formalization

Explicitly focus reforms on the challenges of the informal economy.
Assess the diversity of informal business owners and workers and apply a variegated approach.
Ensure reform packages are comprehensive rather than singular interventions to support formalization.
Design reforms for supporting both formalization and related policy objectives.
Apply reforms in a fair, consistent and understandable manner.
Ensure women, young people, and other vulnerable groups are included in business environment processes.
Better regulation is one tool for supporting firm formalization but should not be the only tool used.
Incentives of various forms and combinations can support formalization.

Use complementary programmes when developing BER for firm formalization

Reform design and implementation can benefit from the use of complementary tools.
Build trust between the government and informal economy actors through public-private dialogue.
Use behavioural insights to inform reform design and delivery.

Use reforms to support those in the informal economy

Extend social protection to informal firms and their workers.
Expand support to informal firms who lack the capacity to go formal.
Develop innovative financial products and services.
Work with the social and solidarity economy to improve conditions for informal firms and their workers.
Strengthen industry and sector clusters with informal firms.
Develop digital solutions to engage with and deliver solutions for the informal economy.
Work with the informal sector to support incremental innovations.

Provide supports to the informal economic units in response to the COVID-19 pandemic

Offer immediate assistance to both informal firms and workers to better respond and adjust to the ‘new normal’ of variants and economic aftershocks experienced in different regions and sectors.
Provide financial investment and human capital investment to informal firms and workers to complement immediate assistance and promote future resiliency and potential future formalization.