What is the Informal Economy?
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Bibliographic details
- Authors: CORINNE DELECHAT, LEANDRO MEDINA
- Published: December 1, 2020
Overview and scale
- The informal economy comprises activities that have market value and would add to tax revenue and GDP if they were recorded.
- According to the International Labour Organization, 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 and 15 percent in advanced economies.
Causes and forms of informality
- Informality covers a wide range of situations within and across countries and arises for a number of reasons:
- Voluntary avoidance: individuals and firms may choose to remain outside the formal economy to avoid taxes and social contributions or compliance with standards and licensing requirements.
- Safety-net and access constraints: individuals may rely on informal activities because they lack education and skills for formal employment or are too poor to access public and financial services.
- Informality is a response to a set of country-specific characteristics and institutions; there is no one-size-fits-all solution.
Economic and social consequences
- Fiscal and growth impacts:
- Informal firms do not contribute to the tax base and tend to remain small, with low productivity and limited access to finance.
- Economic growth in regions or countries with large informal sectors remains below potential.
- Poverty and inequality:
- Informal workers are 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.
- The prevalence of informal work is associated with high inequality: workers with similar skills tend to earn less in the informal sector than their formal-sector peers, and the wage gap between formal and informal workers is higher at lower skill levels.
- The large decline in informality in Latin America over the past 20 years was associated with significant reductions in inequality.
- Gender dimensions:
- In two out of three low- and lower-middle-income countries, women are more likely than men not only to be in informal employment, but also to be in the most precarious and low-paying categories of informal employment.
- COVID-19 implications:
- The COVID-19 pandemic’s 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.
Policy guidance and effective interventions
- Guiding principles: extensive research and policy experiments point to a common set of guiding principles despite country-specific differences.
- Four types of policies that have proved effective:
- Improving access to and quality of education:
- Education reforms that enhance equality of access and ensure that students remain in school until the end of the secondary cycle.
- Ample technical and vocational training opportunities.
- Described as "probably the single most powerful way to lower informality."
- Tax system design and social protection:
- Tax design should avoid inadvertently increasing 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.
- Financial inclusion:
- Policies to enhance financial inclusion by promoting expanded access to formal (or bank-based) financial services can help 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 and regulatory reforms:
- Labor market regulations can be simplified 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.
- Elimination of excessive regulations and bureaucratic requirements also helps.
- 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.
Policy implications and trajectory
- Informality critically affects how fast economies can grow, develop, and provide decent economic opportunities.
- Sustainable development requires a reduction in informality over time, but this process will inevitably be gradual because the informal sector is currently the only viable income source for billions of people.
- Informality is best tackled by steady reforms—such as investment in education—and policies that address its underlying causes.
- Approaches focused on attacking the sector as generally illegal and tax-evading are not the recommended solution.
Source: F&D Magazine — "What Is the Informal Economy?" CORINNE DELÉCHAT and LEANDRO MEDINA, December 2020.
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- Vuelta a lo esencial: ¿Qué es la economía informal? ● Finanzas y Desarrollo ● Diciembre de 2020
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- What is the Informal Economy? – IMF F&D