Excessive informal sector: a drag on productivity

The informal economy remains a problem when we discuss the prospects of economic development. It is perceived as a hindrance to economic progress because the informal sector does not pay taxes, does not include its employees in social insurance schemes and does little to offer labour law protections. Increasingly, various researchers (La Porta1, Shleifer2, 2014) and international organisations, like the OECD, converge in seeing the informal economy as an obstacle to economic development due to its imminent low productivity. Indeed, informal businesses are concentrated in low productivity sectors. They are, on average, smaller and hence less productive. They generate lower value added. They pay lower wages to their employees and do not train them. And the owners of informal businesses manage their firms less efficiently than their better educated formal sector counterparts.

The informal sector is hence both a symptom of economic backwardness and a drag on economic development. But, can this apparent vicious circle be broken, or is it an economic policy donquichottean task?

In many developing economies, the informal employment exceeds 60-70% (OECD, 2011) of employment outside agriculture and even more if agriculture is included. Countries such as Pakistan, the Philippines, Côte d’Ivoire or India struggle with large informal employment. Despite the economic progress registered in these countries, their level of informality far exceeds the threshold of 30% of GDP, which marks the threshold at which the gravity centre of an economy becomes formal. It is likely that these and other countries will grow, while maintaining, what development economics calls, a dual economic structure — a growing modern formal sector and an informal sector that might remain stable in absolute terms but less important in relative terms over time. The informal sector dominates small commerce, neighbourhood services, and those manufacturing industries that do not require heavy capital investments, modern technical equipment and are not engaged in international trade. It is likely that technological changes and benefits from international trading will slowly marginalise informal businesses, but the pace at which this will happen varies depending on the policy, cultural and institutional context.

So, how could the informal sector be harnessed for greater productivity and economic development?

This text was published in the Blog of OECD: Development Matters – more: