Photo by Olga Abizaid. Source: https://www.wiego.org/informal-economy
This question requires a detailed definition of the terms formal and informal sectors in the context of labor and economic development. The Informal sector was a concept that first used by ILO in the 1970 in the Kenya Report and it was seen as a temporary route to full modernization. The informal sector is comprised of a set of transactions both legal and illegal in nature. Some are operated by unregistered businesses but are legitimate; others include crime and even barter at times. Informality is not confined to specific occupations or economic activities but is linked to a way of doing things. The formal sector on the other hand refers to legal economic activities with businesses that are registered with local or central governments. The main advantage of registering a business is access to better lending terms and expertise recognition by a guild or group. Thus, registering a business may only be advantageous to enterprises that can grow their business by investing in capital. For small enterprises like street vendors and family owned farms that do not intend to grow their business beyond their immediate social network, the overhead of registration far outweighs the benefits.
The informal sector plays a very important role in economic development in both complex and simple economies alike. Informality embodies the spirit of entrepreneurship and it is the way people ensure their livelihoods even when excluded from the informal sector (Allen). Development literature puts most emphasis on the establishment of democratic capitalism as the only path to economic development in low and middle-income countries. This research largely ignores the fact that some rich countries with high HDI still have a large informal sector that fuels the economy; such as it is the case of Italy (with 33%) and Sweden (15%) of their economic activity coming from the informal sector. Additionally, LDCs and LICs don’t have the resources support a complex and diverse free market economy. Joining and remaining in the informal sector is a choice as well as a way of life in some instances. I will expand upon debates around how the informal economy comes into existence as well as debates around advantages and disadvantages of government regulation of the informal sector.
There are different theories as to why the informal sector exists. Marxist view of informality (Moser and Meager) rejects the duality of the sectors and suggesting that informality is a continuum of the capitalist system that benefits from having an ‘army of the unemployed’ and unlike commonly believed, many times the unemployed has highly valuable skills that can come at a lower price if contracted than permanently hired. This structural exploitation perpetuates poverty and fuels a preoccupation with competition and remaining relevant in the job market. However, in my view, suggesting that capitalism is solely responsible for creating poverty is equivalent to claiming that poverty never existed before the industrial revolution in any of the historical socioeconomic structures. There is no literature in capitalism that asserts that excluding certain groups from the formal sector or access to credit is necessary to create wealth.
Other views of the informal economy refer to it as immoral and as a confirmation of the sad state of humanity (Wiles). While Allen emphasizes that the real informal economy is characterized by creativity and self-reliance and is born out of the necessity of surviving and reproducing. He criticized the government for criminalizing, as it is costly and ineffective. Fields claimed that the informal economy in urban settings was a way for informal rural workers to eventually integrate into the formal economy. My criticism to this view is that fields saw this process as a one-way street but did not discuss the fact that the transition can go in both directions through the lifetime of an individual and it is reflected in structural unemployment.
As mentioned before, the subject of informal sector has been largely ignored in development studies with the exception of DeSoto, who after running an experiment in Peru to set up a clothing factory, he concluded that formality was a privilege of those with power and money while the poor were relegated to informality. His experiment demonstrated that it took 289 working days equivalent to 14 months of wait and a cost equivalent to 32 months of minimum wages without counting the level of expertise need from bureaucrats to process the paperwork. It is obvious that not every enterprise has the resources available to participate in the formal sector and this can be effectively constituted as a cost of entry in an oligopoly.
Given that the informal sector has the advantages of greater flexibility for quick adaptations, and based on his own experiments, DeSoto concluded that informality should not be penalized (as it is very expensive to monitor) and instead the informal sector should be more like the formal one and vice versa. One of the main problems if informality, is the long-term vulnerability that brings to workers in that they are excluded from access to social services. Mainstream policy recommendation to achieve worker’s protection is to decrease taxation and regulation burden to create more formal jobs in the small business sector, as formality should protect workers in the long term by providing retirements and at least some protection from layoffs. In my opinion, solving the problem of worker vulnerability, which common to both the informal and formal sector to different degrees, it would be to rethink the accepted social contract to implement policies that protect the citizen throughout their life cycle and not the worker alone. Given that legitimate informal activities become a way of life for many in low income and rich countries alike reaching levels between 7%-90% (Nigeria), it is important to allow the informal sector to exist as it is more cost effective than having to provide a social net through taxation.
In conclusion, the informal sector plays an important role in economic growth and it is a more affordable alternative to setting up social nets supported by tax payers. The larger the informal sector that is already established, the more expensive it is to attempt to penalize it. Instead the government should focus on establishing protections for the citizen and no the worker while incentivizing the existence of greater percentage of formal activities. In order to increase the HDI, rich economies need the complex infrastructure of legal and financial institutions that are formed only through the formalization of the majority of their business transactions.