The logic of the informal economy

A spectre is haunting the world’s developing countries – the spectre of the “informal” economy. For some, the informal sector includes all businesses that have not been registered with the authorities. For others, it refers to businesses that escape taxation. The International Labour Organisation defines it as comprising firms that are small enough to fall outside the labour code.

Whatever the definition, what has concerned many economists and gained policy makers’ attention is that the size distribution of firms in developing countries has a long tail. Compared with developed countries, an unusually large number of small, unproductive firms coexist with a small number of large, productive firms.

According to standard economic reasoning, this is inefficient. If the small, unproductive firms closed down and the larger, more productive firms hired their workers, total output and well-being would rise. This should happen automatically through the invisible hand of competition, because the more productive firms should be able to deliver a better product at a lower price, while luring workers with higher wages.

So, why doesn’t this happen routinely in developing countries? Why do the inefficient firms survive, trapping resources in low-productivity activities? What is preventing the market from working its magic and making everyone better off?

Read also: More investors lose millions of naira to ponzi scheme

For some, the problem is that government regulations make compliance too onerous for small firms. Others claim that tax evasion creates an unfair advantage for informal firms, or that family-wide health care gives households no incentive to have more than one member pay social-security taxes. For still others, programs that target the informal sector distort the playing field.

In an effort to address the problem, governments in Colombia, Mexico, Peru, South Africa, and elsewhere have been busy changing their tax codes, redesigning their registration systems, and exploring the potentially perverse incentive problems associated with social-welfare programs. While the jury is still out on the effectiveness of any of these initiatives, I would bet against their success.

It requires many years of training and abstract economic thinking to miss the obvious. The salient characteristic of modern production is that it mobilises a lot of know-how – too much to fit in the head of any single person.

Efficient production requires a division of labour among those who know about technology, marketing, finance, logistics, human-resource management, contracts, regulations, distribution, customer service, and much else. It requires manual and intellectual skills that must be used in tandem. Just think of the different specialised skills (many of them recognised by the Oscars) that must come together to make a single film.

To bring these skills together, people have to be integrated into co-operative arrangements in the same firm or within clusters of related firms. But, in order to get together to work, people have to travel from their homes to production sites. How do they do that?

In the typical developing-country city, they do so with difficulty. Daily commute times for low-income formal-sector workers often exceed three hours, and the average direct cost of transportation is equivalent to roughly two hours of work at the minimum wage. An eight-hour shift becomes an 11-hour shift for which net pay is only six hours.

This implies an effective tax rate of 45 percent on low-income formal-sector workers. Add to this the inconvenience of travel and the potential problems caused by being far from home in case of a family emergency. With these considerations in mind, it becomes easier to understand why people would prefer to do something useful near home rather than where modern production takes place.

But in the shantytowns where developing countries’ urban poor live, there are few varieties of skill that people can mix with their own to make things productively. As a result, the only feasible forms of production use very few low-skilled workers – and thus operate at low productivity. They specialise in food preparation, retail, construction, repairs, Internet cafes, and myriad other activities that can be carried out at home and sold to neighbours (often through a window facing the street).

Economists and policy makers have disregarded the physical aspects of urban life. Housing policy is typically discussed with blatant disregard for urban transport and the locations where industrial and business zones are authorised. When planners designed Punta Cana – the very successful tourist destination in the Dominican Republic – or the giant Fiat plant in Betim, Brazil, they forgot to plan for their workers’ housing. Not surprisingly, shantytowns quickly developed.

The informal sector is mostly a consequence of the fact that people are disconnected from modern production networks – an inefficiency that will not be resolved simply by reducing the cost of registering a business or forcing small firms to pay taxes. What is required is a redesign of urban space, including subways and dedicated bus lanes, and a more integrated approach to housing, social services, and production areas. Governments will have to start doing some good things, not just stop doing some bad ones.

Ricardo Hausmann is a professor of economics at Harvard University