Informality in the Process of Development and Growth

• Author: Norman V. Loayza
• Date: 01 December 2016
• DOI: http://doi.org/10.1111/twec.12480
• Published date: 01 December 2016

Informality in the Process of Development

and Growth

Norman V. Loayza

The World Bank, Kuala Lumpur, Malaysia

1. INTRODUCTION

THIS paper aims at understanding informal labour, placing it in the process of develop-

ment, allowing for its heterogeneity, and linking it to migration, modernisation and

economic growth. We propose to do it through a theoretical growth model and an interna-

tional data application. The latter consists of using the model and its calibration to project the

behaviour of informal labour in the next two decades for a large number of countries.

‘Informality’ is a term used to describe the collection of firms, workers and activities that

operate outside the legal and regulatory frameworks or outside the modern economy. While

informality offers the benefits of avoiding the burden of regulation and taxation, its partici-

pants suffer the costs of not having the protection and services that the law and the State can

provide. Informality is sometimes the result of agents ‘exiting’ the formal sector as a conse-

quence of cost–benefit considerations; other times, it is the outcome of agents being ‘ex-

cluded’ from formality as this becomes restrictive and the economy segmented.

Informality is a fundamental characteristic of underdevelopment. It is best understood as a

complex, multifaceted phenomenon. It is determined by both the inherent characteristics of

developing economies (such as low physical and human capital) and by the relationship that

the State establishes with private agents (through regulation, monitoring and the provision of

public services). The received literature finds evidence that the relative size of the informal

sector declines with overall development, rises with the burden of regulation and decreases

with the strength of enforcement (see Friedman et al., 2000; Schneider and Enste, 2000;

Loayza et al., 2006).

Informality is not only a reflection of underdevelopment; it may also be the source of fur-

ther economic retardation. It implies misallocation of resources and entails losing the advan-

tages of legality, such as police and judicial protection, access to formal credit institutions

and participation in international markets. Informality can then lead to slow capital accumula-

tion, low economic growth and sluggish migration to more productive areas. The evidence

shows that informal firms tend to be smaller and have lower productivity and that differences

This paper was first delivered as The World Economy Annual Asia Lecture, University of Nottingham,

Kuala Lumpur, 18th of February 2016. I am grateful to Claudia Meza-Cuadra for excellent research

assistance in all areas of the project, from economic modelling and literature review to data collection

and analysis. For insightful comments and suggestions, I thank Ximena Del Carpio, Asli Demirguc-Kunt,

David Greenaway, Mary Hallward-Driemeier, Carlos Felipe Jaramillo, Mattia Makovec, Chris Milner,

Truman Packard, Vivi Alatas, Jamele Rigolini, Luis Serv

en and seminar participants at the University of

Nottingham, the World Bank, and the 2016 Meetings of the Peruvian Economic Association. This paper

has been partly funded by the World Bank’s Research Support Budget (RSB), under the project ‘Infor-

mality, Migration, and Growth’. The findings, interpretations and conclusions expressed in this paper are

entirely those of the author. They do not necessarily represent the views of the World Bank, its execu-

tive directors or the governments they represent. Corresponding author’s email: nloayza@worldbank.org.

©2016 The World Bank The World Economy ©2016 John Wiley & Sons Ltd

1856

The World Economy (2016)

doi: 10.1111/twec.12480

The World Economy

in the size of the informal sector can account for a significant portion of differences in output

per capita between rich and poor countries (see Prado, 2011; La Porta and Shleifer, 2014).

Although there is a great deal of heterogeneity regarding informality among developing

countries, informality is widespread in the majority of them (see Figure 1). The typical devel-

oping country produces about 35 per cent of its GDP and employs over 70 per cent of its

labour force informally (using, respectively, the Schneider Index and the rate of pension cov-

erage). These are remarkable statistics, which indicate that informality is a substantive and

pervasive phenomenon that must be explained and addressed, particularly in the design of

development policies. The goal of reducing informality can shed new light on the relevance

of short-run policies –such as streamlining regulations and strengthening monitoring and

enforcement –and long-run strategies –such as improving judicial services, providing public

infrastructure and services, and contributing to human capital formation.

For most experts, informality is likely to appear as one of the most difficult challenges fac-

ing developing countries. Not surprisingly, it is often at the top of policymakers’ priorities.

Yet, there is much confusion on basic definitions and measurement of informality and about

its causes and consequences. For example, if labour informality is measured only in connec-

tion with firms (or multiperson enterprises), its largest segment composed of the self and

family-employed will be missing. In turn, confusion on definitions and causes can lead to mis-

guided advice about confronting informality. For instance, if it is perceived as solely the

result of weak enforcement, the advice may be to strengthen monitoring and harden penalties

against informal firms, which could result in worse problems –unemployment, self-employ-

ment and further reductions in the size of firms. Likewise, if informality is perceived as

purely the result of State regulations, the recommendation may be to lift them, only to realise

that the consequent reduction in informality is limited and small.

Estimated Share of the Labour Force in the

Informal Sector (%), 2008–2012

Production by the Informal Sector

(% of GDP), 2007

100

(a) (b)

0

OECD EAP ECA LAC MENA SAR SSA OECD EAP ECA LAC MNA SAR SSA

10

20

30

40

50

60

70

80

90

100

0

10

20

30

40

50

60

70

80

90

FIGURE 1

The Prevalence of Labour and Production Informality Around the World

Note:

The box plots show the minimum value, the range from the 25th percentile to the median (shaded light), the range

from the median to the 75th percentile (shaded dark) and the maximum value for each region.

Source: (a) Own estimates using Active contributors to a pension scheme (latest available) from World Bank HDNSP

pensions database and Total Labour Force and Employment (2008–12) from World Bank (2013). (b) Schneider et al.

(2010). [Colour figure can be viewed at wileyonlinelibrary.com]

©2016 The World Bank The World Economy ©2016 John Wiley & Sons Ltd

INFORMALITY, DEVELOPMENT AND GROWTH 1857

Informality is a well-researched topic with contributions from different perspectives. How-

ever, there is no encompassing study that endogenises informal labour alongside worker

migration and capital accumulation, considering how they affect and are affected by each

other. Moreover, there is no study that allows comparing the expected trajectories of the

basic types of informal labour across developing countries. This paper contributes to fill in

these gaps. First, it seeks to clarify the definition, causes and consequences of informality,

studying it in the process of development. Allowing for heterogeneity of labour informality –

that is, whether linked to firm or self-employment – is critical for analysis and measurement.

To accomplish this objective, we develop a tractable theoretical model that connects inform-

ality, government regulations, economic growth and labour migration. Second, the paper

looks to obtain sensible estimates for the evolution of the informal sector in developing

countries over the next few decades, linking this evolution to other underlying forces in the

economy under various scenarios. For this purpose, we build a secondary database on recent

estimates of the informal sector and related variables, and then use it to calibrate and simu-

late the model for a large selection of countries around the world. We provide a spreadsheet-

based toolkit that contains these simulations and allows researchers to modify parameters,

initial conditions, and assumptions to construct their own scenarios.

1

The rest of the paper proceeds as follows. Section 2 presents a literature review. Section 3

develops the theoretical model and describes the data and calibration exercise. Section 4 pre-

sents and discusses the informality projections. Section 5 offers some concluding remarks.

2. LITERATURE REVIEW

The literature on the economics of informality is deep and diverse. It gained mom entum in

the late 1980s with the publication of The Other Path, where Hernando de Soto and co-

authors present the informal sector as the private sector’s response to an overly regulated

economy and an inefficient State. This approach departed from the then prevailing one in

which informality was regarded as merely a symptom of underdevelopment rather than the

result of misguided policies. This tension between development and policies as determinants

and constraints of informality is present, in one way or another, in all modern studies of the

subject.

At the risk of oversimplification, the informality literature can be divided into two basic

strands, according to the trade-offs that generate the informal sector. One takes a public

finance perspective, emphasising the trade-off between taxes and public services: informal

firms avoid taxes at the cost of reduced access to public services and being subject to penal-

ties (See Loayza, 1996; Johnson et al., 1998; Ihrig and Moe, 2004; Prado, 2011; D’Erasmo

and Moscoso Boedo, 2012). Another strand takes a labour perspective, focusing on the trade-

off between labour and capital costs: informal firms avoid mandated labour costs (such as

minimum wages, benefits and firing constraints) at the cost of higher capital costs (which may

result from informal agents’ inability to enter into contractual agreements). The two trade-offs

are indeed related, but choosing one of them provides tractability and emphasis: if the interest

1

As companion to this paper, we have prepared a ‘Toolkit for Informality Scenario Analysis’ (Loayza

and Meza-Cuadra, 2016), which is publicly available and allows interested researchers and practitioners

to change conditions in order to formulate their own projections.

©2016 The World Bank The World Economy ©2016 John Wiley & Sons Ltd

1858 N. V. LOAYZA