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    This blog highlights effective ideas in the fight against poverty and exclusion, and analyzes the impact of development projects in Latin America and the Caribbean.
  • Informal sector: hidden capital or vampire?



    informal sector

    In some of the development literature, the informal sector is seen as a locked source of capital and growth. Find the key to unlock it and the dam of repressed innovation will water the fertile fields of formal capitalism. In the opposite view, the informal sector is outright a dangerous parasite that sucks life from the formal sector and hinders economic growth. This is not a trivial question as it is estimated that “in developing countries, informal firms account for up to about half of all economic activity.”

    A new paper takes a different view. Informal firms stay that way, are unproductive and policies designed to formalize them may have the effect of driving them out of business. The only cure is economic growth. Informality will only decline (slowly) with development.

    The paper highlights five facts on the informal economy in developing countries.

    First, it is huge, reaching about half of the total in the poorest countries.

    Second, it has very low productivity compared to the formal economy: not formal firms are typically small, inefficient, and run by poorly educated entrepreneurs.

    Third, although avoidance of taxes and regulations is an important reason for informality, the productivity of informal firms is too low for them to thrive in the formal sector. Lowering registration costs neither brings many informal firms into the formal sector, nor unleashes economic growth.

    Fourth, the informal economy is largely disconnected from the formal economy. Informal firms rarely transition to formality, and continue their existence, often for years or even decades, without much growth or improvement.

    Fifth, as countries grow and develop, the informal economy eventually shrinks, and the formal economy comes to dominate economic life.

    One Response to “Informal sector: hidden capital or vampire?”

    • I think the authors have the causality the wrong way around, or at least are trying to promote an incorrect picture of causality.

      The informal sector is a sign of poverty. “Not formal firms are typically small, inefficient, and run by poorly educated entrepreneurs”: this is a sign of poverty. The purpose of these informal firms is not to be efficient (though that we be nice), but to allow the poor to survive.

      Economic growth will not help everyone. In the United States, for instance, poverty seems stuck at 14% of the population. Many of these are classed as “working poor”, whose lives were documented by Ehrenreich in “Nickel and Dimed”. They work in the formal sector, holding multiple “McJobs” at $8 an hour. This does not make them less poor. Formality does not mean an end to poverty: just its formalisation.

      So the question is: does a poor person have a choice? Start their own used clothing stall in the black economy, or work as a fast food process worker? I think the best economy is one in which there is no poverty, but the second best is one in which the poor at least have that choice, and aren’t regulated into scooping fries. (And need I say it? “… in the service of capital.”)

      Rather than focus on a generalised economic growth, how about allowing the poor the option of small enterprises, and (a) legalising them, (b) providing education and training to make them more efficient, and (c) providing pathways to growth? Of course, that might involve allowing a poor food vendor to sell on the sidewalk outside McDonalds, and even training them to improve the product and service. And someone might not like that.

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