Bridge over ocean
1 December 2014 CFA Institute Journal Review

Informality and Development (Digest Summary)

  1. Derek W. Johnson, CFA

Informal firms that are unregulated and do not pay taxes can account for up to half of the economic activity in developing countries, especially the poorest ones. The authors compare informal and formal firms and find that they are fundamentally different and that informal firms are small and unproductive and remain stagnant. In addition, as GDP grows, the number of informal firms declines.

What’s Inside?

The informal economy accounts for up to half of economic output in developing countries. Informal firms are those that do business without paying taxes and do not adhere to government regulations. The authors compare the informal economy with the formal economy in these countries. They establish that there are five important facts about the informal economy: (1) It is very large, especially in developing countries; (2) its productivity is extremely low; (3) even though avoidance of taxes and regulations is a benefit of informality, the low productivity keeps informal firms from achieving success in the formal economy; (4) the informal economy is disconnected from the formal economy and can continue for years without much growth or improvement; (5) the informal economy shrinks as countries grow and become more developed.

One of the main reasons informal firms stay small and stagnant is management by uneducated entrepreneurs. The authors conclude that informal firms are fundamentally different from formal firms. They also find a strong negative correlation between informal firms and GDP growth, although this trend occurs slowly over several generations. They recommend that policymakers of developing countries focus on growing the formal economy through immigration or education and training to increase the supply of educated entrepreneurs.

How Is This Research Useful to Practitioners?

The informal economy makes up a huge part of developing economies. It has been argued that informal firms should be supported through relaxed government regulations so that they can grow into formal ones; others claim that these firms are unfairly taking business from regulated firms. The authors find that the informal firms are small, unproductive, and stagnant. The evidence seems to support dual models of informality that indicate that informal and formal economies are separate and will remain so despite government efforts to relax regulation and encourage the growth of informal firms.

The informal economy is largely the result of poverty and inequality. Any effort to regulate informal firms would result in even greater poverty. The authors find that economic development results in fewer informal firms because the formal, efficient, productive firms replace informal, unproductive ones—that is, the dual model of informality.

Educated entrepreneurs are the key difference in the dual model. As a developing country grows, its workforce becomes more educated and informality shrinks. The dual model suggests that regulators and practitioners should focus on increasing the population of educated entrepreneurs through immigration or training and education. The authors find that there is a strong correlation between economic growth and a decline in informal firms.

How Did the Authors Conduct This Research?

The authors measure informality by self-employment. They run a regression of the change in the percentage of the labor force that is self-employed to GDP growth among 68 countries from 1990 to 2012 and find a strong negative correlation between the two. They run this regression in first differences to alleviate the concern that the strong negative correlation between self-employment and GDP per capita is driven by omitted variables. A doubling of GDP per capita is associated with a reduction in self-employment of 4.95 percentage points.

They find, however, that the reduction in self-employment is very slow, especially when labor force growth is fast. Economic growth comes from the formal sector, which absorbs labor in part from the informal sector but mostly from a new generation of workers. Productivity and income in the informal sector stagnate and eventually decline as the economy grows.

An example of this process comes from a survey from Peruvian slums. In this example, it is mostly the children of the informal sector workers, rather than the workers themselves, who become educated entrepreneurs. The informal economy declines because unproductive informal firms cannot survive in the modern economy.

Abstractor’s Viewpoint

A common belief about informal firms is that they are small, entrepreneurial companies and, given the support of regulators and the government, could grow into larger, more productive, formal firms. The authors show that this argument could not be further from the truth. They find that as the educated workforce grows, the levels of informality decline. This knowledge is useful for policymakers so that they can devote the proper resources and focus to raising the levels of education within the developing country either through immigration or internally.

We’re using cookies, but you can turn them off in Privacy Settings.  Otherwise, you are agreeing to our use of cookies.  Accepting cookies does not mean that we are collecting personal data. Learn more in our Privacy Policy.