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.