Excessive informal sector: a drag on productivity

By Aleksander Surdej, Poland’s Ambassador to the OECD

Photos by Victor Jiang / Shutterstock

The informal economy remains a problem when we discuss the prospects of economic development. It is perceived as a hindrance to economic progress because the informal sector does not pay taxes, does not include its employees in social insurance schemes and does little to offer labour law protections. Increasingly, various researchers (La Porta1, Shleifer2, 2014) and international organisations, like the OECD, converge in seeing the informal economy as an obstacle to economic development due to its imminent low productivity. Indeed, informal businesses are concentrated in low productivity sectors. They are, on average, smaller and hence less productive. They generate lower value added. They pay lower wages to their employees and do not train them. And the owners of informal businesses manage their firms less efficiently than their better educated formal sector counterparts.

The informal sector is hence both a symptom of economic backwardness and a drag on economic development. But, can this apparent vicious circle be broken, or is it an economic policy donquichottean task?

In many developing economies, the informal employment exceeds 60-70% (OECD, 2011) of employment outside agriculture and even more if agriculture is included. Countries such as Pakistan, the Philippines, Côte d’Ivoire or India struggle with large informal employment. Despite the economic progress registered in these countries, their level of informality far exceeds the threshold of 30% of GDP, which marks the threshold at which the gravity centre of an economy becomes formal. It is likely that these and other countries will grow, while maintaining, what development economics calls, a dual economic structure — a growing modern formal sector and an informal sector that might remain stable in absolute terms but less important in relative terms over time. The informal sector dominates small commerce, neighbourhood services, and those manufacturing industries that do not require heavy capital investments, modern technical equipment and are not engaged in international trade. It is likely that technological changes and benefits from international trading will slowly marginalise informal businesses, but the pace at which this will happen varies depending on the policy, cultural and institutional context.

So, how could the informal sector be harnessed for greater productivity and economic development?

Today, economic development does not happen without physical infrastructure –roads, bridges or airports. Contemporary states provide them as public, although not pure, goods. A sufficient quantity of public goods cannot be supplied if the state only collects in taxes an equivalent of 10-12% of GDP. The informal sector in developing countries reduces the amount of available taxes; hence, the design of taxation systems should cover as much as possible those transactions of the informal sector that can be taxed. From this perspective, the broadening of the tax basis is more important than the struggle to eliminate competition distortions due to the persistence of the informal sector.

Informal employment undermines the efforts of developing countries to lay down the foundations for a modern, work-based, social insurance. This becomes a major issue as societies change with longer life expectancy and less reliance on family support. But, growing awareness of the benefits of social insurance creates a pressure also for the formalisation of employment. As employees understand the harms to their future economic security resulting from informal employment they will more willingly work in the formal sector.

Developing states build their own taxation and regulatory systems by trying to find the best balance amongst the nature of their economies, the characteristics of firms, and an adequate level of taxation and public regulations. Certainly, their leaders consider a fully deregulated economy a dystopian vision: no efficient modern economy exists without taxes and some public regulations for health, safety and environmental matters. Yet, administrative, tax, and social regulations certainly can be less costly and less intrusive to managerial choices than they are in most places. Doing business is easier if the governments regulate smartly and collect taxes efficiently. The OECD’s product market regulations and the World Bank’s Doing Business indicators are obvious sources to search when regulating or deregulating in developing countries too. All governments could learn from their peers.

Yet, contrary to De Soto’s3  (De Soto, 1989) thesis, the informal sector does not seem to be a product of over-regulated economies. Thus, it will not disappear thanks to a simple miraculous regulatory change. Its excessive size is a sign of economic weaknesses rooted in low entrepreneurial capacities (most informal economy entrepreneurs are born out of survival and are not opportunity-driven), low financial, technological and human resources, and a poor institutional environment, which together lead to low economic productivity. Public policies should aim at strengthening all these dimensions but this takes time and perseverance.

Certainly, in the contexts of developing countries, the informal sector offers opportunities to gain means to survival. Hence, in a way, it serves inclusiveness. But, low-productivity inclusiveness does not necessarily contribute to better lives. The way to better lives in developing countries leads through high-productivity inclusiveness.

1.Andrews, D., A. Caldera Sánchez and Å. Johansson (2011),“Towards a Better Understanding of the Informal Economy”, OECD Economics Department Working Papers, No. 873, OECD Publishing, Paris.

2.La Porta, R., A. Shleifer (2014) Informality and Development, Journal of Economic Perspectives—Volume 28, Number 3—Summer, p. 109–126.

3.De Soto, H. (1989) The Other Path: The Invisible Revolution in the Third World. New York: Harper and Row.

To read more about the OECD Development Centre’s work on informality and development, click here