## What Is the Informal Economy? — Basics

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### Definition and scale
- The informal economy comprises activities that have market value and would add to tax revenue and GDP if they were recorded.
- About 2 billion workers, or 60 percent of the world’s employed population ages 15 and older, spend at least part of their time in the informal sector.
- The informal sector slowly decreases as economies develop, but with wide variations across regions and countries.
- Today, the informal sector still accounts for about a third of low- and middle-income countries’ economic activity—15 percent in advanced economies.
- Regional groupings referenced include: Sub-Saharan Africa, Latin America, South Asia, Middle East and North Africa, East Asia, Europe, OECD; and income-level groupings include Low-income countries, Emerging market economies, Advanced economies.
- Time ranges shown for informality trends include 1991–99, 2000–09, and 2010–17.

### Causes and heterogeneity
- Informality arises from multiple and country-specific reasons; it covers a wide range of situations within and across countries.
- Motivations for remaining informal:
  - Voluntary avoidance of taxes, social contributions, or compliance with standards and licensing requirements (related to the common but misconceived view that informality is caused mainly by firms and individuals “cheating” to avoid paying taxes).
  - Reliance on informal activities as a safety net due to lack of education and skills for formal employment or being too poor to access public and financial services.
- Informal firms:
  - Do not contribute to the tax base.
  - Tend to remain small, with low productivity and limited access to finance.
- Informal workers:
  - More likely to be poor than workers in the formal sector because they lack formal contracts and social protection and tend to be less educated.
- Inequality links:
  - Workers with similar skills tend to earn less in the informal sector than their formal-sector peers.
  - The wage gap between formal and informal workers is higher at lower skill levels.
  - Large decline in informality in Latin America over the past 20 years was associated with significant reductions in inequality.
  - In two out of three low- and lower-middle-income countries, women are more likely than men to be in informal employment and to be in the most precarious and low-paying categories.

### COVID-19 and urgency
- The COVID-19 pandemic has reinforced urgency to address informality: its crushing impact on informal activities worldwide highlighted the need for governments to provide a lifeline for large segments of the population not covered (or not well covered) by existing social protection programs.

### Economic consequences
- Informality critically affects how fast economies can grow, develop, and provide decent economic opportunities.
- Regions or countries with large informal sectors tend to have economic growth below potential.
- Sustainable development requires a reduction in informality over time, but the process will be gradual because the informal sector is currently the only viable income source for billions of people.

### Effective policy principles and recommendations
Four types of policies have proved effective:
- Improve access to and quality of education
  - Education reforms aimed at enhancing equality of access and ensuring students remain in school until the end of the secondary cycle are particularly important.
  - Ample technical and vocational training opportunities matter.
- Tax system design
  - Avoid tax designs that inadvertently increase incentives to remain informal.
  - Simpler value-added and corporate tax systems (with no or minimal exemptions and loopholes) with lower rates, as well as low payroll taxes, help reduce informality.
  - Supportive social protection systems, including progressive income taxes and protection for the poorest, help address distributional aspects.
- Enhance financial inclusion
  - Promote expanded access to formal (or bank-based) financial services to lower informality.
  - Lack of access to finance is a key constraint for informal firms and entrepreneurs, stifling productivity and business growth.
  - Countries where access to finance is greater tend to grow faster and have lower income inequality.
- Structural policies to increase incentives and lower the cost of formalization
  - Simplify labor market regulations to ensure greater flexibility and facilitate informal workers’ entry into formal employment.
  - Competition policy can boost entry of small firms in some sectors by eliminating monopolies.
  - Eliminate excessive regulations and bureaucratic requirements.
  - Digital platforms, including government-to-person mobile transfers, can bring financial accounts to the unbanked, empower women financially, and help small and medium-sized enterprises grow within the formal sector.

### Implementation outlook
- Informality is best tackled by steady reforms—such as investment in education—and policies that address its underlying causes.
- Attacks on the sector motivated by the view that it is generally operating illegally and evading taxes are not the answer.

*Corinne Deléchat and Leandro Medina, FINANCE & DEVELOPMENT, December 2020.*

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_Source: https://www.imf.org/-/media/files/publications/fandd/article/2020/december/what-is-the-informal-economy-basics.pdf_