Policy pathways for addressing informality

By Juan R. de Laiglesia, Senior Economist, OECD Development Centre

street-vendor-informality
Vendor selling fresh vegetables in Galle, Sri Lanka

The prevailing international discourse on informality has shifted. The conceptual “discovery” of the informal sector by the ILO’s Kenya mission in 1972 noted not only its scale but also that it was “…economically efficient and profit-making…” Today, the view that informality is a drag on productivity growth and progress has gained ground in the international community and is consistent with the recommendation that the informal economy should be formalised.

One contention is that balanced development and policy action that lifts the financial, technological, institutional and human capital constraints to productivity will also enable higher productivity in informal firms and thereby formalisation. A growth-inducing productivity agenda is a necessity, but growth alone is not enough to reduce informality.
When it comes to concrete policy action, what can be done? Thinking about informality in binary, black and white, terms can lead to misguided interpretations of the evidence, and ultimately, bad policy decisions. Public action can only address the informal economy if it begins to see the shades of grey in the informal economy, recognises the diversity of its actors, motivations and causes, and learns from the men and women who work, and – for some – prosper, in informal activities. It is only then that policy measures aimed at specific informal groups can be designed to great effect.

The first key distinction is between formalising informal enterprises and formalising employment. Firms are formalised by registering and taxing them and by enforcing laws and regulations. Employment is formalised by registering labour contracts and ensuring social protection and the protection of labour rights. Yet, no consensus has emerged on whether policies that seek to formalise firms by discouraging informal activity or imposing costs on informal entrepreneurs are desirable. If informal firms are indeed inefficient, the extra costs associated with regulation, licensing and taxation will drive them out of business, destroying economic activity and employment. If they are gaining a competitive advantage from evading the law, better enforcement will level the playing field and enhance both equity and efficiency. This case exemplifies the importance of looking beyond averages. The evidence suggests that formal firms are much more productive than informal firms on average. But within sectors, evidence from Brazil and Colombia, for example, find that those productivity gaps are much smaller than differences between the most productive and the least productive formal firms.

It is necessary to acknowledge the informal economy’s great heterogeneity. Theorists have conceptualised the informal sector in very different manners:

  • as a set of petty occupations that acts as a reserve of labour (Hart, 1973), which can include niche or traditional segments of the economy not yet reached by the state and only competing in their local markets,
  • as a series of entrepreneurs who gain competitive advantage from evading taxes and licenses (Lewis, 2004),
  • as a subordinate sector of subcontractors for formal enterprises (Castells and Portes, 1989), and
  • as an entrepreneurial sector excluded from the mainstream economy through entry barriers (de Soto, 1989).

The appropriate policy response to each of these situations is dramatically different. The reality is that these motivations coexist, among others, in the same country. In all, the informal economy includes a lower tier where many remain informal out of necessity or under constraint, as well as an upper tier in which workers and entrepreneurs choose to remain out of self-interest. As a policy response, countries can take the pragmatic approach developed in the Development Centre’s work on informality (Jutting and de Laiglesia, 2009). This approach takes a three-pronged strategy to address the various segments of informality by (i) creating more and better formal jobs, (ii) providing incentives for formality for those who voluntarily choose to remain informal, and (iii) protecting and promoting the productivity of those in the lower tier. What does this strategy look like in action.

First, ensuring conditions in the long run for economies to create good formal jobs is a necessary condition for informality to recede in the long run. The evidence (Bruhn and McKenzie, 2014) suggests that reducing the cost of registering a firm has at best a small impact on the formalisation of informal firms, although it does increase the chances that new firms will be formal. Informal firms are largely created informal and remain informal. It is possible that policy interventions have not managed to address the binding constraints to formalisation and need to look elsewhere. But as long as policy makers don’t have better tools to encourage the formalisation of firms, the most promising strategy is to encourage the creation and growth of productive, formal firms.

Second, some of the most rapid successes in reducing informality have come from removing specific legal obstacles that prevented workers from being formal in the first place. The 2008 Labour Contract Law in China, by requiring employers and employees to sign a labour contract that should include social insurance regardless of the worker’s origin, partly removed the de facto exclusion of rural migrant workers from social insurance. By 2009, the rate of coverage of work-related medical insurance had increased by 20 percentage points among migrant workers. Similarly, domestic workers have traditionally been excluded from the provisions of labour law and are often systematically counted as informal workers. In Latin America, where they are over 6% of the urban labour force, legal reforms undertaken since 2011 have defined labour rights for the majority of domestic workers, although only a quarter of them are covered by social protection to this date.

Better enforcement of labour regulations in the formal sector is key. In Brazil and Argentina, for instance, where the share of informal employment receded rapidly (about 1 percentage point per year during 2000-2010), most transitions from informality to formality were in the same job and over 40% were among unregistered employees. The gains from better enforcement can be large and relatively quick. Interestingly, formalisation happens in the margins of the most formal sectors – in the public sector, among better educated male workers.

And third, when it comes to protecting and promoting informal sector workers, the policy trend is at a tangent from the formalisation objective. Many countries have embraced the expansion of health coverage through universal access reforms that are based on non-contributory national health services or subsidised systems. In some cases, these are parallel to the social security system that provides coverage for formal workers, which has been decried by some as subsidising informality (Levy, 2008).

The next step now is to develop a toolbox that will account for each country’s specificity and identify the particular policy package most likely to be effective. The shift in the development discourse on informality has given rise to a mounting body of research and evidence, which despite its gaps, can certainly be leveraged to provide such actionable policy tools.


References

Bruhn, M. and D. McKenzie (2014) “Entry Regulation and the Formalization of Microenterprises in Developing Countries“, The World Bank Research Observer, Vol. 29 (2), August.

Castells, M. and A. Portes (1989) “World Underneath: The Origins, Dynamics and Effects of the Informal Economy”, in A. Portes, M. Castells and L. A. Benton (eds) The Informal Economy: Studies in Advanced and Less Developed Countries, Johns Hopkins University Press, Baltimore.

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

Freeman, R. and X.Li (2013) Has China’s new labour contract law worked? VOX, 22 December 2013.

Hart, K. (1973) “Informal Income Opportunities and Urban Employment in Ghana” The Journal of Modern African Studies, Vol. 11(1).

ILO (1972) “Employment, incomes and equity: a strategy for increasing productive employment in Kenya“, Report of an inter-agency team financed by the United Nations Development Programme and organised by the International Labour Office, Geneva, 1972).

ILO (2015) Recommendation 204 — Recommendation concerning the transition from the informal to the formal economy, adopted by the 104th session of the International Labour Conference, Geneva.

Jütting, J. and de Laiglesia, J. R. (eds) (2009) Is Informal Normal? Towards more and better jobs in developing countries, OECD Development Centre Studies, Paris.

La Porta, R. and A. Schleifer (2008) “The Unofficial Economy and Economic Development“, Brookings Papers on Economic Activity, Fall

Levy, S. (2008) Good Intentions, Bad Outcomes. Social Policy, Informality, and Economic Growth in Mexico, Brookings Institution Press, Washington DC.

Lewis, W. W. (1954) The power of Productivity: Wealth, Poverty and the Threat to Global Stability, University of Chicago Press, Chicago.

Lexartza, L., M. J. Chaves and A. Carcedo (2016) “Politicas de formalización del trabajo doméstico remunerado en América Latina y el Caribe”, Regional Office for Latin America and the Caribbean, FORLAC, ILO, Lima.

Maurizio, R. (2014), “Labour formalization and declining inequality in Argentina and Brazil in the 2000s: A dynamic approach“, ILO Research Paper No. 9, International Labour Office, Geneva.

Pagés, C. (ed.)(2010) The Age of Productivity. Transforming economies from the bottom up, Development in the Americas, 2010, Inter-American Development Bank, Washington DC.