The Informal Economy

Measures, Causes, and Consequences

Ceyhun Elgin

• Publisher: Routledge
• Year: 2020
• ISBN:
  9781000163803
• Edition: 1
• Topic: Economics
• Subtopic: Economic Theory
• Index: Economics

The Informal Economy: Measures, Causes, and Consequences provides a comprehensive account of the economics of informality through the lenses of various economic perspectives.

Although informal economic activity is widespread all around the world, many issues around its nature and consequences remain largely under-explored or unresolved. Most importantly, the evidence presented in the existing literature on informality has failed to generate a consensus on the measurements, causes, and effects of the informal sector among researchers. Most, if not all, of the empirical results are inconclusive or dependent on the nature of the dataset used in the analysis. This book aims to address that gap by exploring different definitions and measures of the informal economy, including different perspectives, then subjecting these measures to a battery of empirical tests to examine the determinants and effects of informality. Through this analysis and an extensive review of the literature, the book explores many of the economic, political, and social factors of the informal economy including the relationship between informality and the tax burden, tax enforcement, and institutional quality.

This key text makes for compulsive reading to scholars and students interested in the informal or shadow economy.

1 Informality
Curse or opportunity?

Informality is one of the most widely cited and published topics in the financial and economic pages of emerging market newspapers and magazines. Turkish newspapers generally love to refer to it as a bleeding wound of the economy. This makes sense if one considers the famous circular-flow diagram that economists use in introductory textbooks as it absorbs some of the resources of the formal economy. However, the informal sector is mostly populated by firms and workers that were not able to find opportunities in the formal sector; if they could, most if not all would go formal. Eliminating the informal sector is thus very detrimental to these agents. In Elgin et al. (2013), sponsored by MasterCard Turkey in 2012, my two co-authors and I found that eliminating Turkey’s informal sector (approximately 30% of GDP in 2012) would increase the formal sector by a mere 1.67%. While this is only an estimate, it is striking in the sense that one cannot merely add the informal sector on top of the formal one. Most workers, enterprises, and households that engage in informal sector activities do so because they face barriers to participating in the formal sector, so they will not be able to transition to the formal sector if the informal sector shrinks. Therefore, even though the informal sector has several detrimental effects on the wider economy, eliminating it might not benefit all segments of society.

The informal sector also provides an oasis for entrepreneurs (including selfemployed) that could otherwise not operate in the formal sector because they mostly lack the resources to work formally. Eliminating the informal sector would mean that these informal entrepreneurs would either go unemployed or work as unskilled workers in the formal sector. Thus, the informal sector may benefit them, as well as for the wider economy, especially when such entrepreneurs eventually join the formal economy after developing their entrepreneurial skills in the informal sector. In this sense, the informal sector may provide an opportunity for entrepreneurs and workers who would otherwise become unemployed in the absence of this sector.

All this being said, working in the informal sector is usually not a very lucrative prospect for employer or worker as it mostly requires working for less than the minimum wage, with little (if any) compliance with labor, health, or environmental standards. Recent studies show that the informal sector work is closely associated with lower maternal, prenatal, and infant health, lower life expectancy, less human capital, less growth, and greater income inequality. Zero or partial social security coverage for informal workers also creates several problems in their lifecycles. Further complicating the issue, there is also a massive asymmetry in terms of the gender composition of the informal and formal sectors in that a substantial fraction of the global female labor force works informally. Finally, informality also creates several problems and difficulties for governments by severely distorting their policies and policy-making processes, especially in countries where the sector is large. However, as seen throughout the book, the relationship of informality with these variables is somewhat complicated and interacts with several other variables. Nevertheless, it should be clear by now why the informal sector may be either a curse or a bleeding wound for an economy.

As is evident from the earlier discussion, there are several different aspects and effects of informality, both positive and unfavorable, which is why the title of this introductory chapter is “Is informality a curse or an opportunity?” I sincerely hope that, by the end of the book, the answer will become more apparent to my readers.

Although informality is widespread globally, economists disagree about its measurement, causes, and effects. While there have been various studies of informality, including the relationship between informality and different factors, such as measures of taxes, law enforcement, institutional quality, and other economic, political, and social factors, many issues regarding its nature and consequences remain largely under-investigated. In addition, most (if not all) empirical results are inconclusive or depend on the nature of the data set used in the analysis. One of the issues behind this lack of consensus, as will be explained in this book, is the difficulty of measuring informality. The different methods to measure the extent of informal economic activity can sometimes produce strikingly different findings. I still remember being interviewed in 2015 by one of the major newspapers in Turkey on the informal economy. After the interview was published the next day, I got an unexpected phone call from the General Director of the Revenue Administration of the Ministry of Finance, who somewhat tensely complained about the Interview, especially about my estimates of the informal sector’s size in Turkey.

This book aims to provide a comprehensive account of the economics of informality through the lenses of different economic perspectives. While the existing literature will be extensively reviewed, the scope of the book is not limited to a simple review. Instead, I aim to subject a range of different definitions and measures to a battery of empirical tests to obtain robust results on the determinants and effects of informality. One point to note here is that, as its title suggests, the book focuses on the economics of informality. However, I should acknowledge that there are also vast literatures on informality in other scientific disciplines, including sociology, anthropology, finance, and political sciences. Nevertheless, as an economist, I mostly focus on its economic aspects.

Mainly from a heterodox perspective, Chen (2012) classifies four distinct schools of thought on economic informality: Dualists, Structuralists, Legalists, and Voluntarists. Chen (2012) defines and identifies major studies in each school as follows:

• Dualists locate the informal economy on the fringes of the main economy, whereby it can be an economic resource for the poor, especially in crises; key studies include Hart (1973), ILO (1972), Sethuraman (1976), and Tokman (1978).
• Structuralists see the informal economy as the formal sector’s attempt to reduce wages and production costs; key studies include Moser (1978) and Castells and Portes (1989).
• Legalists argue that the informal economy is a reaction to excessive government regulations; key studies include de Soto (1989, 2000).
• Voluntarists argue that some agents choose to operate in the informal economy after weighing the advantages and disadvantages of doing so; a key study is Maloney (2004).

These are not the only schools of thoughts interested in informality, as the interest of both the mainstream and other schools has been growing over time (Hart, 2008).

Research on many aspects of informality is quite recent, especially compared to other subfields within economics. One reason is that, for several reasons, economics has disproportionately focused on issues concerning developed economies. Informality is mostly seen as a developing country phenomenon, although it is also quite large in developed economies. Nevertheless, interest in this phenomenon has been accelerating.

Figure 1.1 illustrates the evolutions of papers containing the terms “informal sector” and “shadow economy” published from 1960 to 2018. The data were obtained from a year-by-year manual search in Google Scholar. The number of papers containing the term “informal sector” fluctuated in single digits or low two digits throughout the 1960s and early 1980s. However, after the publication of the seminal paper by Keith Hart in 1973 (see Hart, 1973), the number of papers jumped to three digits in 1973 before growing exponentially. Use of another frequently used, albeit somewhat less popular term, “shadow economy” also grew rapidly, particularly after the mid-1990s. For 2018 alone, for example, Google Scholar lists 13,900 papers including ‘informal sector” and 3,480 papers including “shadow economy”.

Figure 1.1 Number of papers on “Informal Sector” and “Shadow Economy” over time.

During the second year of my Ph.D., when I was thinking about several potential research ideas, one of my classmates from Mexico, Mario Solis-Garcia, suggested working jointly on an idea related to informality. Since before admission to his Ph.D. he worked at the Ministry of Finance, he was interested in the subject. Considering that Turkey and Mexico among OECD member economies have the largest informal sectors as a percentage of GDP, such a collaboration was also not very surprising. Having grown up and completed a bachelor’s degree in economics in Turkey, I was very much aware of its informal economy. However, I had not considered it a sufficiently important topic to be worth exploring with the tools of modern economics compared to much more significant and essential issues such as inflation, monetary policy, growth, inequality, and unemployment. Considering that most of the profession, including doctoral candidates, work on economic issues facing developed economies, I was not alone in my undervaluation of the field. I remember that, even after obtaining my Ph.D., publishing several papers, and completing several national and international projects on informality, several of my colleagues at Bogazici University were cynical regarding my work on informality. I remember with sadness comments like, “Again, something on informality?” or “Aren’t you bored with the subject?”, which exemplified the general stance of the profession toward the field. Thankfully, during my second year in my Ph.D. studies, it did not take me long to realize that I was wrong in undervaluing the field. As soon as I started to delve deeper, I noticed that there are considerable gaps in the literature on informality. The first and most important chapter of my dissertation, which economists choose to call the “job market paper”, concerned informality (Elgin, 2015). Although my classmate from Mexico had not written his dissertation on informality, we managed to publish two papers after we graduated (Elgin and Solis-Garcia, 2012, 2015). More importantly, in the past ten years, I have published more than 30 papers, two book chapters, and one encyclopedia entry on informality as well as conducting several national and international scientific projects, including one from the World Bank and one from the European Commission. I am mentioning these to emphasize that the field is still growing (as is also evident from Figure 1.1), and that there are still various unanswered or open questions in the literature. Hopefully, this book will both shed light on several issues regarding informality and motivate some readers to attempt to answer these unanswered questions in the literature.

Finally, I should also acknowledge that this is not the first book on the economics of the informal sector. Leaving aside books focusing on a single country (e.g. Krstic and Schneider, 2015) or a single characteristic of informality (Pickhardt and Prinz, 2012; Schneider and Williams, 2016), at least three books have already been written from a global perspective. These are Chaudhuri and Mukhopadhyay (2010), Schneider and Enste (2013), and Williams (2019). However, there are several key differences between these manuscripts and the current book. First, as explained in Chapters 3 and 4, the current book utilizes the most recently updated version of the largest available data set of informality. Second, this book has been written from a substantially more technical perspective than the above-mentioned books. Third, the current book is the most comprehensive, especially considering the detailed analysis of various determinants and effects of informality presented in Chapters 5 and 6.

The book is organized as follows. Chapter 2,”Definitions of Informality”, reviews existing definitions used by economists in both the early and recent literature. The chapter also includes a thorough literature review of different aspects of informality. Chapter 3 provides a comprehensive account of different methods used to measure the extent of informal economic activities while Chapter 4 documents the extent of informal economic activities worldwide, using the most recent estimates of informality. Chapters 5 and 6 discuss the determinants and effects of informality, respectively. Finally, Chapter 7 provides some concluding remarks and suggests future directions in the literature on informality.

References

1. Castells, M., Portes, A. 1989. World Underneath: The Origins, Dynamics, and Effects of the Informal Economy. In A. Portes, M. Castells, Lauren A. Benton, eds. The Informal Economy: Studies in Advanced and Less Advanced Developed Countries. Baltimore, MD: Johns Hopkins University Press.
2. Chaudhuri, S., Mukhopadhyay, U. 2010...

Table of contents

• Cover
• Half Title
• Series Page
• Title Page
• Copyright Page
• Dedication
• Table of Contents
• Preface
• 1 Informality: curse or opportunity?
• 2 Definitions of informality
• 3 Measuring informality
• 4 Size of the informal sector worldwide
• 5 Determinants of informality
• 6 Effects of informality
• 7 Concluding remarks
• Index