by
The informal sector (IS) describes economic activity that takes place outside the formal norms of economic transactions established by the state and formal business practices but which is not clearly illegal in itself. Generally, the term applies to small or micro-business that are the result of individual or family self-employment. It includes the production and exchange of legal goods and services that involves the lack of appropriate business permits, violation of zoning codes, failure to report tax liability, non-compliance with labor regulations governing contracts and work conditions, and/or the lack of legal guarantees in relations with suppliers and clients. As such, it is conceptually, methodologically and theoretically difficult to define in terms of its precise nature, size and significance, leading some authors to criticize the term for lack of clarity (Peattie 1989; Bromley 1990).
Nevertheless, widespread agreement that the sector represents a growing proportion of economic activity, particularly in less developed countries (LDCs), has placed it at the center of debate about its role with respect to economic development. The fact that the IS appears to provide at least some economic opportunities for the urban poor and particularly for women--often providing services and commercial activities at a very low level of economic utility--not only means that the terciary sector has often grown faster in many LDCs than the secondary (industrial) sector, but also creates a question of whether regulatory norms should be enforced at the risk of reducing these opportunities. The term was originally coined by Hart (1970) to describe the multitude of often temporary economic strategies adopted by migrant workers in Ghana in the face of a marginal job market which, in the aggregate, responded to real social needs. Challenging the marginality literature, which had seen these survival strategies as irrelevant or even counter-productive for national development, he argues: "Planners who look primarily for entrepreneurial persons overlook those who are currently performing the entrepreneurial function." (115. Original emphasis.)
The International Labour Office (ILO) and PREALC turned to the IS as a potential solution to unemployment in LDCs. While still seeing it as a collection of survival strategies held back by undercapitalization, lack of skills, and the small size of the enterprises, they argue that the IS is capable of absorbing employment if these negative conditions can be reversed (Sethuraman 1981).
Going further, De Soto argues that the IS comprises entrepreneurial activity that is constrained from full development by the high "costs of formality" present in many LDCs--complex, time-consuming and expensive regulations that are almost impossible for small firms to observe and which tended to favor large firms. At the same time, he argues that the characteristics that the ILO and PREALC view as symptomatic of the problems of the IS firms are the result of the regulatory system itself. IS entrepreneurs, he argues, need to stay small and hidden to avoid detection while they also lack legal protection for their investment, both factors creating disincentives for growth and capital investment.
Confronting these positive assessments of the IS, DEPENDENCY and WORLD SYSTEMS theorists argue that the IS represents an area of DISGUISED UNEMPLOYMENT and super-exploitation that is either directly tied to the formal sector through outsourcing or distribution channels or indirectly as a RESERVE ARMY OF LABOR. Formal sector firms, they argue, cut labor costs by using home workers, sweatshops, street vendors, neighborhood shop keepers and others in the IS who, while nominally self-employed, are actually "disguised workers" with none of the benefits or safeguards of formal employment. (Portes & Walton 1981)
To some extent, the differences between these perspectives have been muted as scholars have recognised the heterogeneity of the sector, including both entrepreneurial as well as exploitative forms of economic activity. (Castells, Portes and Benton 1989; Rakowski 1994)
Development agencies in LDCs generally focus on the positive assessments of the IS. By providing credit and training, their goal is to promote the growth of individual firms within the sector while ignoring the question of whether they may be inadvertently creating more exploitation and social problems as these unregulated or semi-regulated firms violate labor relations laws or safety, health and environmental regulations. They also ignor De Soto's analysis of the limits of IS firm growth due to the need to avoid regulatory control.
Modifying De Soto's argument, a model of the dual market behavior of the formal and informal sectors can be developed that allows us to understand the behavior and interests of IS actors. The small size of IS firms allows them to escape regulatory enforcement and thus reduce their operating costs, giving them a competitive advantage relative to larger firms that are compelled to pay regulatory costs. This can be seen as a system of "informal subsidies" that counterbalance the economies of scale of large firms and the formal subsidies and political preference that such firms may enjoy.
This creates different optimisation strategies for IS firms. Most regulatory controls impose costs on labor and are most efficiently handled through capital investment or administration. Thus, formal firms are optimised when they substitute capital for labor and strive to grow large enough to capture economies of scale. IS firms, on the other hand, evade the regulatory costs on labor while their capital is subject to much greater risks (because of lack of legal protection), and thus are optimised when they substitute labor for capital and remain small enough to capture economies of flexibility. Thus, the appearance of a "dual market" arises from this polarisation of incentive structures.
This duality also explains why IS activity is proportionately more common among women and the poor, since these groups are less likely to have access to the amount of capital necessary to make formality a viable economic option.
Between these two poles exists a "semi-formal" economy comprising activities that are partly regulated, often because state officials have recognised and sanctioned a certain degree of informality in exchange for a degree of control over them. Thus, collective taxis, land invaders, street vendors and garbage collectors have, in many cases, been given either tacit or explicit permission to carry out their activity, at times in exchange for support for the current regime, but without fully bringing them within the formal system. Often, this may lead to a continual process of conflict and renegotiation between the administration and IS actors that politicises the sector. Another form of "semi- formality" exists in the case of partly formal firms that may use the ability to bribe officials in order to escape particular aspects of the regulatory system.
The heterogeneity of the IS, as well as the close linkages in some cases with formal businesses on the one hand and illegal services on the other, makes it difficult to define and measure. For example, macro economic estimates of the size of the informal economy cannot distinguish between "legal" and "illegal" ends such as prostitution, drugs, the sale of stolen goods, contraband and the production and sale of pirated goods. All of these involve the production and/or sale of goods or services that are clearly illegal in themselves, but which are difficult, if not impossible, to separate out in most studies. Even at the micro-level, the sale of contraband or unlicensed products is carried out in much the same way as the sale of legal products, and thus is difficult to distinguish.
Further research is needed to determine in particular the conditions under which IS activity may be entrepreneurial or exploitative and in which it may be positively related to economic growth or simply a reflection of the externalisation of economic costs onto society and the environment. Furthermore, the political interests of IS actors and how those interests are manifested also needs to be examined at greater depth.
Back to Theoretical papers