Informal sector labour markets in developing countries 0

February 2007

INFORMAL SECTOR LABOUR MARKETS IN DEVELOPING

COUNTRIES

Tim Ruffer (Oxford Policy Management)

&

John Knight (University of Oxford)

Oxford Policy Management 6 St Aldates Courtyard 38 St Aldates Oxford, OX1 1BN United Kingdom Tel: +44 (0) 1865 207300 Fax: +44 (0) 1865 250580 Email: [email protected] Website: www.opml.co.uk

Informal Sector Labour Markets in Developing Countries

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Table of contents

Preface ii

1. Introduction 1

2. Characteristics of informal labour markets 3

2.1 Opposing views on the causes of informal labour markets 3

2.2 Involuntary informal employment 3

2.3 Voluntary informal employment 8

2.4 Dual informal labour markets 9

2.5 Linkages with the formal sector 11

2.6 Informality and illegality 13

3. Definitions and measurement of the informal sector 15

3.1 Definitions 15

3.2 Scale of the informal sector 16

3.3 Trends 18

4. Policies 21

4.1 Introduction 21

4.2 Objectives and justifications for public intervention 21

4.3 Regulatory and institutional framework 22

4.4 Social protection 23

4.5 Minimum wage legislation 24

4.6 Trade unions 25

5. Conclusions 26

References 29


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Preface

This report is an output from a project funded by the UK Department for International Development (DFID) for the benefit of developing countries. The views expressed are not necessarily those of DFID.


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1. Introduction

This report summarises the latest research and thinking about informal sector labour markets in developing countries, and shows its potential relevance to DFID country economists.

The informal sector constitutes a separate market segment from the formal sector, characterised by ease of entry, reliance on indigenous resources, family operation of businesses, small scale of production, labour intensive and adapted technology, skills acquired outside the schoolroom and the bypassing of regulations (including taxation) (ILO, 1972). The sector exhibits a wide range of employment and business types from casual zero-entry-cost petty trading to small enterprises using modern sector techniques of production and management which border on the formal sector. Despite its diversity, the informal economy can be usefully categorised by employment status into two broad groups: the self-employed who run small unregistered enterprises; and wage workers who work in insecure and unprotected jobs (although some informal workers – notably homeworkers – do not fit neatly into either of these categories) (Chen, 2004). Most of those who work in the informal economy share one thing in common: the lack of legal recognition, regulation, and protection.

Box 1: Official definitions of the informal sector

The Resolution concerning statistics of employment in the informal sector, adopted by the Fifteenth International Conference of Labour Statisticians (ICLS), January 1993, describes the informal sector as consisting of production units that:

"typically operate at a low level of organization, with little or no division between labour and capital... and on a small scale.... Labour relations - where they exist - are based mostly on casual employment, kinship or personal and social relations rather than contractual arrangements with formal guarantees."

For statistical purposes, the Resolution defines the informal sector as:

"a group of production units, which, according to the definitions and classifications provided in the United Nations System of National Accounts (Rev.4), form part of the household sector as household enterprises or, equivalently, as unincorporated enterprises owned by households..."

According to Fields (2006), the ILO defines the informal sector to comprise informal employment (work without secure contract, worker benefit, or social protection) of two kinds: self-employment in informal enterprises (small or unregistered enterprises) and paid employment in informal jobs (casual labour, or outworkers, or unregistered, or temporary, or unprotected workers).

See Section 3.1 for a discussion of the challenges of defining the informal sector.

The informal sector is a pervasive phenomenon in almost all developing countries where the majority of the poor depend on the informal sector for their livelihoods. It accounts for over half of employment in many countries in Latin America, Africa, and Asia. The bulk of new employment generated in recent years in developing countries has been in the informal economy. Women’s share of informal sector employment is high, typically estimated at 60 to 80%.

Understanding the informal sector – in particular, informal employment – is therefore crucial for the success of economic development policies and poverty reduction strategies. Its persistence and expansion over time and across countries show that the informal sector is not a transitory phenomenon in the development process, soon to be absorbed by the formal sector. Rather, it is now fairly well recognised that formal and informal sectors will cohabit, and are very much interlinked in subtle and complicated ways.


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Academics, policy-makers and commentators have argued extensively about the nature and size of the informal sector, its welfare implications and the appropriate policy prescriptions. The debate is often obscured by the fact that the term informality is ambiguous theoretically and hazy empirically. Informality often means different things to different people. Moreover the informal sector has different characteristics in different countries. These differences arise not only from the nature of their economies but also from the nature of interventions by the state. Generalisations about the informal sector are therefore likely to be misleading in any particular context: an analytical taxonomy is required which can be applied to each economy. The report uses examples from particular countries to bring out the similarities and the differences and thus to develop the necessary analytical framework.

The remainder of the report is structured as follows. In Section 2 we present two opposing views of the informal sector labour market . Section 3 considers issues relating to the nature, definition and measurement of informal sector labour markets in developing countries, and provides some evidence of how they are evolving. Section 4 considers the policy implications of the analysis. Section 5 concludes, summarising the report and providing diagnostic criteria for an assessment of the informal sector labour market in any particular country.


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2. Characteristics of informal labour markets

2.1 Opposing views on the causes of informal labour markets

There are currently two opposing views of informal labour markets. On one view, the informal sector is a ‘residual sponge’ which absorbs that part of the growing labour force that cannot be employed in the more productive and remunerative formal sector: its growth is a sign of economic failure, and policies are needed to reduce poverty within it. This view further perceives the informal sector as a state between formal employment with social protection and open unemployment. A form of market failure prevents individuals from moving from the informal to the formal sector. This is based on an ‘insider-outsider’ model where those in formal employment are insiders and those in the informal sector and the unemployed are outsiders. In the presence of such labour market segmentation, wages in the two sectors of the economy will differ for two employees of equal potential productivity. On the other view, the informal sector is a dynamic sector, containing much budding entrepreneurship: its growth is a sign of economic success, and policies are needed for its encouragement. On the former view, informal employment is likely to be involuntarily imposed, and on the latter view it is likely to be voluntarily chosen. In fact, both views can be correct: they might apply in different countries, and in the same country in different proportions.

In different countries, different sets of laws and institutions create different types of informal sector and the characteristics that distinguish it from the formal sector. On one definition, the informal sector is the sector ‘beyond the reach of the state’. However, the reach of the state may be viewed as a continuum, along which a dividing line has to be drawn. Moreover, the state may reach in different ways, favouring one sector in some dimensions and disfavouring another, or even the same sector, in other dimensions. The form of state intervention is therefore likely to determine whether the informal sector is voluntarily chosen or involuntarily imposed.

The following are common forms of state intervention that tend to divide the labour market into formal and informal segments. They can operate either in the labour market or in the product market, which then has implications for the labour market. Consider the labour market. The government might lay down various regulations which apply only to employers above a certain employment size, or only to officially registered employers. These might relate to minimum wages, formal contracts of employment, security of employment, unemployment benefit and other forms of social security, membership of pension schemes, training levies, or some combination of these. Alternatively, all employers might be subject to the regulations but small employers, less visible to the authorities, might be able to evade them. Section 2.2 provides some specific examples of the impact of such interventions on involuntary informal employment from China, South Africa and India. Section 5 looks in more detail at the implications of some of these interventions.

2.2 Involuntary informal employment

2.2.1 The impact of state intervention on labour market segmentation

In order to illustrate how the nature of labour market segmentation can depend on the forms of state intervention, we start with the examples of two countries with highly segmented labour markets, and where informal employment is largely involuntary: China and South Africa. The case of school teacher employment in India is also discussed. In each case the basic reason for expecting informal sector employment to be involuntary is the existence of a large difference in


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wages and conditions between the two sectors, which makes the formal sector the preferred but rationed sector for workers.

Segmentation driven by state support for urban residents: China

The Chinese labour market has been divided into a privileged formal sector, comprising urban-born employees in the state and collective sectors, and the informal sector, comprising urban-born workers retrenched from their formal jobs, young city-dwellers, rural-urban migrants, and rural workers employed in rural industry. Wages and conditions in the formal sector are institutionally determined, are often improved by profit-sharing, and are supplemented by firm-level mini welfare states which are only now being dismantled, whereas those in the informal sector are subject to market forces and are greatly inferior (Knight and Song, 2005). The segmentation is maintained by institutions such as residence registration which restrict the rights of migrants in the cities, and by the collectivist mentality of many formal sector enterprises. The underlying political economy has required the protection of urban-dwellers against the competition of rural people.

Segmentation driven by the power of organised workers: South Africa

Reflecting the sophisticated nature of the formal sector and the political alliance between the ruling African National Congress and the trade union coalition, there is sharp segmentation between the formal and informal sectors in South Africa (Kingdon and Knight, 2007). The formal sector is the sector of choice: very few workers would prefer to be employed in the informal sector. The formal sector is officially defined to cover ‘registered’ employers, i.e. employers large enough to qualify for VAT payments must register. Registered employers fall within the scope of the extensive industrial relations regulations. These cover the recognition of trade unions and collective bargaining, the right to strike, protection against dismissal, and minimum standards concerning hours of normal and overtime work, minimum wages and minimum leave provision.

The informal sector generally falls outside the labour regulation system, and informal sector wages, being more subject to market forces, are predictably lower. This can be shown through the estimation of earnings functions which include sector of employment as an explanatory variable: even with correction for bias arising from selection into the two sectors, informal sector earnings, standardising for all other characteristics, are about 60% of those in the formal sector (Kingdon and Knight, 2007). Trade unions and collective bargaining are important to this segmentation: Kingdon, Sandefur and Teal (2005) show rigorously that the ‘union premium’ on wages is high and has recently risen as unemployment rose. The formal sector premium, together with the employment protection legislation, provides formal sector employers with an incentive to employ workers on a temporary, casual basis. Although the extent of this predictable practice is unclear, some of the employees of formal sector firms are likely to be de facto informal employees. Similarly, some informal sector workers are de facto formal employees if they receive the minimum wages and working conditions laid down in Bargaining Council agreements. This can come about through the so-called extension clauses which extend an agreement to all employers in the relevant industry and area. Although there is provision for exemptions, generally granted on the basis of small scale and inability to pay, extension has been a bone of contention for small firms. The motivation of the bargainers may be more to protect their members against undercutting competition than to protect less-well-paid workers.

Segmentation driven by worker organisation in the public sector: India

India provides a further example of segmentation which divides the labour market into a protected but rationed sector and a residual market-clearing sector. In this case we choose an occupational labour market: the employment of school teachers. The terms and conditions of teachers in the state and (equivalent) government-aided schools are the result of collective bargaining and political


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pressures by the teachers’ unions. Wages are well above the levels that would be determined by market forces but teachers are protected institutionally and politically, with respect to both pay and employment security. In private schools, by contrast, wages are determined competitively in conditions of relatively abundant supply. One estimate shows private sector pay to be only 48% of that in the state sector (Pritchett & Mugai, 2007). The management of state sector teachers is very weak, reflecting their entrenched positions, and the greater scope for effective management makes the private sector more efficient. For instance, Kingdon (1996) conducts a comparison of efficiency and finds that private schools produce higher academic achievement than state schools and at lower cost. The underlying problem is one of political economy. There is a clear case for liberalising and integrating the market for teachers, but there is a predictable resistance to such a policy initiative.

2.2.2 Segmentation driven by economic forces: wage differentials by size of firm

It is possible for wages in the formal sector to be higher than those in the informal sector without any intervention by the state. There are profit-maximising reasons why producers might choose to pay wages above market-clearing levels. The explanations for this phenomenon are known as efficiency wage theory or labour turnover theory, and derive from the firm’s concern to raise labour productivity or reduce labour turnover with its associated training costs. Large firms, by reason of their management style and technological level, generally require committed and high-quality workers, with whom they commonly enter a long term relationship. Small firms, by reason of their generally simple products and production processes, do not have the same incentive to motivate and train their workers or to maintain a long term relationship with them. This contrast is likely to be reflected in wage differences by firm size.

Indeed, there is evidence of firm size effects on wages in many developing countries. For instance, Sandefur, Serneels and Teal (2006) estimate that, standardising for many other determinants of earnings, a worker in a firm with 100 employees earns 52% more than one in a firm with 5 employees in Ghana, and 76% more in Tanzania. Even more dramatic evidence comes from a 1993 enterprise survey in Zimbabwe (Jenkins and Knight, 2002). Again standardising for everything else – including education, race and gender – compared with workers in small firms (1-10 employees), those in medium firms (11-100 employees) earn 39% more, those in large firms (101-250 employees) 62% more, and those in very large firms (over 250 employees) 106% more.

Some of the wage differences arise because, even when firms are in the same sector, the small firms tend to produce different products, often simpler and less sophisticated. The nature and quality of the technology used in the production process also tend to vary by firm size. Small firms normally operate in competitive conditions, whereas large firms are more protected from competition by their products or their technologies, and can therefore earn economic rents, which are sometimes shared with workers as a result of collective bargaining.

The wage differences by firm size existed in Zimbabwe despite the fact that trade unions and workers’ organisations were perceived to be ineffective, and probably not responsible for the higher wages of larger firms. Blanket minimum wages can have the effect of raising the pay of small firm employees in particular, but they were not relevant in Zimbabwe at that time. Two conclusions might be drawn. First, wage differentials by firm size can and do exist without intervention, or effective intervention, by the state, because of the advantage which larger firms gain from paying higher wages. Second, minimum wage intervention, insofar as it particularly affects the labour costs of small firms in the informal sector, can make them less able to compete with larger firms and more generally (see Section 4 for further discussion on minimum wages).


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In some of the poorest countries, the state is the dominant formal sector employer. For instance, in Benin, where only 7% of non-agricultural employment is formal, the civil service and public services account for the majority of formal sector employees. In such circumstances, the state is normally the wage leader, setting pay levels that the tiny private sector either follows or tries to surpass in order to recruit the best workers. If there is wage segmentation between the formal and informal sectors, the reason can then be traced to state pay policies.

2.2.3 Segmentation driven by a rural-urban divide

In many developing countries, urban wages are raised above the rural supply price, i.e. the wage at which rural people would be willing to come to work in the urban areas. This can happen either for economic or for institutional reasons of the sorts mentioned above. The underlying reason is often the nature of the political economy - one which accords urban-dwellers a political power or influence disproportionate to the numbers. The existence of an urban formal sector wage above the level that would be determined by market forces the acts as a lure for rural-urban migrants. More are attracted into the cities than there are jobs available for them, and many end up either as openly unemployed, at least for a time, or in the free-entry informal sector, where they eke out a living. Often they are willing to continue in informal employment only in the hope of securing a formal sector job eventually. The inflow continues until, at the margin, the uncertain prospect of success or failure in the city is no more attractive than life in the village. Thus, the existence of segmentation between urban and rural wages, can create a large informal sector in the city that is characterised by low incomes, possibly even lower than the incomes that the migrants would have earned if they had remained in the village.

2.2.4 Involuntary informal employment and the Lewis model

The Lewis model (Lewis, 1954) provides a helpful theoretical framework for assessing how workers pushed into and kept in the informal sector will fare with economic development and with the passage of time. The model contrasts the (first) labour-surplus stage of the development process and the (second) labour-scarce stage: beyond the turning point, a shortage of labour begins to raise labour incomes generally in the economy. In practice, some developing countries (such as Taiwan and Korea) are clearly in the second stage, some (such as China and Malaysia) are growing rapidly and are approaching general labour scarcity, and some (such as South Africa and Zimbabwe) appear to be moving further away from the turning point on account of fast labour force growth in relation to slow economic growth. Where the turning point is being approached, the proportion of the labour force in free-entry informal activities declines while leaving a more vibrant and productive informal sector intact. Where the turning point is receding, the free-entry informal sector and open unemployment together have to absorb the growing residual labour force, and the informal sector increasingly becomes a poverty sink. Such differences provide one reason why the analysis of informal sector labour markets has to be country- and context-specific, and so lends itself to illustration with particular examples.

To assist an understanding of how economic success or failure can affect the informal sector, we contrast recent labour market trends in the two countries referred to above, China and South Africa, drawing on Knight and Song (2005), Kingdon and Knight (2007), and Knight (2007). Both these countries are characterised by severe labour market segmentation, with the formal sector being preferred and entry to the informal sector generally being involuntary. In both countries the informal labour market, unlike the formal, is subject to competitive forces. In the more successful economy, China, labour market trends (i.e. the more rapid growth of formal sector employment than of the labour force) imply that the segmentation will decline and informal sector workers will share in the benefits of economic growth. By contrast, in the less successful economy, South


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Africa, labour market trends (i.e. the more rapid growth of the labour force than of formal sector employment) imply that the segmentation is growing and that informal sector incomes will continue to decline.

China: rapid employment growth and involuntary informality

The Chinese economy has been a labour-surplus economy par excellence. Unemployment has taken a disguised form in agriculture, and also in formal sector industry and services as it was government policy to ensure that all urban-born workers were employed. The urban informal sector was until recently heavily restricted. The remarkable growth of the Chinese economy – averaging nearly 10% per annum over the last 25 years – together with the one-child family policy that restricted the growth of the urban-born labour force, required a great influx of labour into the cities and towns. However, rural-urban migration took a peculiar form: with urban settlement made very difficult, most rural-urban migration has been of a temporary, oscillatory nature. Migrants either enter the informal sector as self-employed workers or are employed in the formal sector on a discriminatory, informal basis in the least attractive jobs, with none of the employment rights that urban workers generally enjoy.

Between 1990 and 2000, the Chinese labour force grew by 87 million (1.3% per annum). While state and collective employment declined, the increased labour force was entirely absorbed (105 million) by the urban private sector, much of it informal. Another part of the informal sector, rural industry, absorbed 36 million, and the number of rural household workers (essentially farmers) fell by 56 million. Wages and conditions in the burgeoning informal sector, being subject to market forces, are distinctly worse than those of the protected and privileged urban-born workers in state, collective and large-scale private firms. Informal sector wages and conditions depend on whether the Chinese economy is being propelled into the second, labour-scarce stage of the Lewis model. There is still surplus labour in China, especially in the interior provinces. However, the surplus is declining, e.g. the number of people working in the rural areas began to fall in the mid-1990s. If rapid economic growth can be maintained, the labour scarcity that is already felt in a few growth points will gradually spread across China. As migrants move up the job skill ladder in urban enterprises, so the economic need for stable long term employment will grow, and this will be recognised by employers and government. The current sharp wage and skill distinctions between formal and informal workers can be predicted gradually to decline.

South Africa: rapid labour force growth and involuntary informality

Between 1995 and 2003 the labour force in South Africa increased by a remarkable 4.2% per annum, reflecting a high natural rate of increase, in-migration and increased labour force participation, especially among women. By contrast, wage employment grew relatively slowly over that period, by 1.8% per annum. Those who could not obtain wage jobs entered self-employment or open unemployment. There are two measures of the labour force in South Africa: the (official) narrow measure and the broad measure, which includes those reporting that they wanted to work but had not actively searched recently. It is probable that most of these are discouraged workers, for whom it is not worth searching. However, even on the narrow definition, which we use here, the trends are depressing.

The labour force grew by 4.6 million over the eight years, wage employment (similar to formal sector employment in South Africa) by 1.3 million, self-employment by 0.7 million, and unemployment by 2.6 million. The informal sector is very small by international standards and, although employment grew rapidly (by 5.1% per annum), it could not absorb much of the increased labour force; the rest was drawn into unemployment. The result of these trends was growing labour market segmentation between the formal and informal sectors. Real earnings per worker in formal employment fell a little (by 1.6% per annum), being propped up by wage bargaining in the large-


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and medium-scale firms. However, real earnings in self-employment imploded, falling by 11.4% per annum. The informal sector acted as a sink for those who could not obtain formal sector wage employment. Only part of the informal sector was easy for the unemployed to enter, and the low and falling incomes in these free-entry activities kept or made many workers unemployed.

2.3 Voluntary informal employment

The alternative view is that the informal labour market is voluntarily chosen and that informality is a response by small enterprises to over-regulation by government bureaucracies, and the result of a decision that the cost of being informal is lower than that of being formal. The firm’s costs of being formal can be separated into two: the cost of entering the formal sector, which comes from the procedures, fees and bureaucratic requirements for starting a formal business, and the cost of staying in the formal sector, including regulation, of which labour regulation costs are significant, and taxation

When the criterion for regulation is official registration of the firm, it is relevant to consider the benefits and costs of registration. There are benefits to registration: the government often provides better services to registered firms, e.g. the ability to solve disputes through the judicial system, and the provision of standardised procedures that can reduce transaction costs. However, there can also be costs. The act of registration can itself be costly: in Peru it took 290 days and US$1,240 to fulfil all the bureaucratic procedures (de Soto, 1989), and Djankov et al (2002) found similar results for a large number of developing countries. Staying formal can also be costly: for a sample of manufacturing firms in Peru, de Soto (1989) found that the cost of remaining registered represented 350% of after-tax profits. Most of this cost was due to regulatory and bureaucratic requirements. Firms may choose to remain informal in order to avoid regulations, but the penalties, which apply when firms are caught by government enforcement agencies, can be severe; the alternative, bribes, can also be costly. Informal firms may have to stay small, and thus potentially inefficient, in order to avoid detection. When regulation decreases or enforcement increases the informal sector becomes relatively less attractive. The regulatory framework of governments often favours large firms, and this can push small firms into informality, which in turn compels them to remain small and hidden without legal protection of their investment .

In the case of developing countries, voluntary informality has been most documented in Latin America. For example, Maloney (2003) develops a view of the informal sector in developing countries primarily as an unregulated micro-entrepreneurial sector and not as a disadvantaged residual in a segmented labour market. Informalisation is seen as a response by firms – facing product market competition – to reduce legislated or union-induced rigidities and high labour costs, particularly by subcontracting production out to be done by unprotected workers.

Mexico: high levels of voluntary informality

Taking the example of Mexico, Maloney argues that despite the inflexibility, inefficiency and costliness of the Mexican labour code, the usual sources of wage rigidity that would segment the market seem absent: minimum wages have not been binding for the last decade, unions to date have primarily been concerned about preserving employment rather than raising remuneration, and wages have shown extraordinary downward flexibility during crises. The picture that emerges from this evidence corresponds more to an unregulated entrepreneurial sector than one comprised of involuntary, disadvantaged, precarious, underpaid workers.

Self-employment in Mexico constitutes the largest source of employment among men (25%), after formal wage employment (50%). Of those workers who started in the formal wage sector but moved into informal self-employed sector later, two-thirds reported moving voluntarily, citing a


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desire for greater independence or higher pay as the principal motives. If workers initially enter formal sector employment, they often do so as a means of accumulating human and physical capital. This possibility in turn requires formal sector firms to pay high market wages in order to retain their skilled workers. Maloney finds a similar pattern in some other Latin American countries, including Argentina and Paraguay.

Brazil: high mobility between the formal and informal sectors

Additional evidence from Latin America that contradicts the model of labour market segmentation and involuntary employment comes from Brazil. Barros et al. (1990) investigate the mobility of formal and informal employees in Sao Paulo and find high mobility rates between the two sectors: nearly 50% of informal workers in any given year will be employed in formal jobs in the following year. There cannot be wage segmentation between sectors if there is such free mobility between them. More recently, Curi and Menezes-Filho (2006) have found that in Brazil during the 1980’s and 1990’s, transitions from formality to informality and from informality to formality were associated with small wage decreases and increases (around 7%) respectively. They conclude that labour market segmentation of this limited magnitude is unlikely to have significant effects on the wage distribution or on workers’ welfare.

Where most individuals work in the informal sector out of choice, competition ensures that there is an equilibrium relationship between wages in the two sectors. Thus, a widening of the wage differential between the formal and informal sectors caused informality to fall in Brazil (Carneiro and Henley, 2003). More employees, faced with a rising opportunity cost of remaining in the informal sector, opted to work in the formal sector.

2.4 Dual informal labour markets

Informal labour markets often contain both voluntary and involuntary sub-sectors, although their relative shares can differ greatly form one country to another. Even if the formal sector wage is set above competitive levels and formal sector employment is consequently rationed, it is still possible that some workers will prefer the informal sector because either their utility or their income is higher than in the formal sector. Their utility might be higher despite lower income on account of non-pecuniary advantages such as greater freedom, and their wages might be higher because their particular characteristics, such as entrepreneurial talent, are better rewarded in the informal sector. This would imply that that the income-generating functions of the formal and informal sectors are different. Although some workers might be in the informal sector by choice, it is possible that others are in it involuntarily. They have lower income, and lower utility, than they could obtain if they were employed in the formal sector.

Gunther and Launov (2007) use a household survey for urban Cote d-Ivoire to test these ideas. They define the formal sector as comprising firms that engage in formal bookkeeping or offer written contracts, or payslips, to their workers. There are big differences in the characteristics of workers in the two sectors: on average, earnings in the formal sector are 2.5 times those of the informal sector, workers in the formal sector have 5.2 more years of education, and training is three times as common in the formal sector. The authors use a statistical methodology to divide the informal sector into two groups; intuitively, they are the two groups that are most distinct. The ‘upper tier’ has higher pay and higher returns to human capital, and the evidence is consistent with its members receiving higher earnings than they would obtain in the formal sector, and thus with having chosen it voluntarily. The ‘lower tier’, by contrast, is at a clear disadvantage and appears to be in the informal sector involuntarily and as a result of labour market segmentation.


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A survey of urban informal sector workers in Ethiopia asked the reason for choosing their current activity. Less than 20% gave reasons that suggested voluntary choice, and almost 80% gave reasons suggesting that it was the only sector that was possible or that they had no choice. The informal sector contained a disproportionate percentage of women (disadvantaged by societal norms, home work, and lower education) and young people (unable to compete for formal sector jobs against incumbents). A statistical cluster analysis attempted to divide informal sector workers into an ‘upper tier’ and a ‘lower tier’. In this case the differences were not large, and the upper tier constituted only a small minority. In Ethiopia the vast majority of informal sector workers cannot afford to be unemployed and earn too little to lift themselves out of poverty

The informal sector can display dualism even in the absence of barriers to entry. However, it is very common for entry barriers to keep workers out of the more productive informal sector activities, with the consequence that the residual labour force is pushed into the free-entry parts, which are then liable to overcrowding, underemployment, and low incomes. We illustrate with contrasting case studies from Africa and Latin America.

Dual informal labour markets in southern Africa

In a South African survey of informal sector small businesses (Chandra et al, 2002), respondents mentioned crime, lack of access to credit, lack of access to infrastructure and services, and need for training as the top four constraints on their businesses. Their operations had required substantial start-up capital (2.5 times their average monthly earnings) and there was very little access to formal or even informal credit. The great majority had not received business assistance or training. Such problems are common in all developing countries. However, there are some reasons why barriers are particularly high in South Africa: the repression of entrepreneurial activities under apartheid and the associated inhibition of entrepreneurial skills and social networks, and continuing restrictive bye-laws. Moreover, the crime rate is particularly high in South Africa: when respondents in a survey of unemployed workers were asked why they did not enter self-employment activities, the most common answer was the fear of crime against their business (Fields, 2006).

The policies of the South African government that support small, medium and micro enterprises (SMMEs) have focussed on the provision of finance and facilities, but even that support is said to be concentrated on the formal sector and to neglect the informal sector: most small operators had not had access to official ‘small business support centres’ (Chandra et al., 2002). Moreover, informal sector firms face another obstacle to their development. The extension provision, which requires each bargaining Council agreement about minimum wages and working conditions to be extended to all employers in the industry and area, places crippling labour market burdens on small and micro firms. Although they have the advantage of being generally more labour-intensive, they tend also to be less efficient than their formal sector competitors. It is possible that, by attempting to extend the boundaries of the formal sector, the state will harm the small-scale enterprise sector. Some of these informal workers will be formalised but others will be driven to activities beyond the reach of the state, so increasing their deprivation

In Zimbabwe in the 1990s, there was evidence that entry to the productive parts of the informal sector was limited by lack of skills and capital. Most instances of voluntary entry were formal sector workers who had accumulated experience, knowledge, and skills (Jenkins and Knight, 2001). It was difficult for educated young people to set up immediately in successful self-employment: if they could not find formal sector jobs they preferred unemployment to free-entry self-employment.


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Informal apprenticeships in Ghana

Skill formation in the informal sector is a potentially serious form of market failure. There is often simply no market by which workers wanting to set up in self-employment or to establish small businesses in the informal sector can acquire the skills they need. However, it is interesting that a traditional and indigenous market operates in Ghana, in the form of informal apprenticeships. Valenchik (1995) uses a survey of manufacturing enterprises in Ghana to investigate this system. No fewer than 54% of micro-enterprises (1-4 employees), and 66% of small enterprises (5-29 employees) were owned by former apprentices, 37% and 57% of their workers respectively were former apprentices, and 37% and 72% respectively of the firms were training apprentices. The apprenticeships were generally in production crafts, such as baker, tailor, welder, and carpenter. Often the apprentices came from within the same social network, so increasing trust. Workers were either paid a low wage, determined in the largely competitive conditions by their productivity minus their training cost

Latin America informal labour markets: dual, but predominantly voluntary

Maloney (2004) has also argued, but with respect to Latin American experience, that informal sector workers tend to be older and to enter from the formal sector after they have accumulated knowledge, capital and contacts. The study finds that in Brazil and Mexico 60-70% of the informally self-employed report preferring informal self-employment for reasons of independence and higher earnings.

Attempts to compare welfare more directly find a premium to being informally self employed in Bolivia (Arias and Sosa, 2004), consistent with the sociological evidence from Mexico that self employment is often considered a step up from salaried work. Women appear to find that self employment allows a better balancing of home and work responsibility. For some workers, informality offers more flexibility and mobility opportunities than the patronage-tenured-based formal sector. For instance, Bolivian indigenous workers do not face earnings gaps with respect to non-indigenous in informal jobs contrary to the formal sector (LAC Labour Team, 2004).

2.5 Linkages with the formal sector

In traditional poor economies almost every activity was informal (Lewis, 1954). It was commonly thought that, with economic development, the formal sector would expand and the informal sector would wither away. In many developing countries this has not happened, for two main reasons. First, the inadequate growth of formal sector employment in countries with labour market segmentation means that the informal sector acts as a residual sponge for the growing labour force. Second, in some countries the informal sector is preferred, and is entered voluntarily. An important reason for this is the complementarities that can exist between the two sectors.

Chen (2004) argues that that most informal enterprises and workers are intrinsically linked to formal firms and describes three broad schools of thought regarding the informal sector and its links to the formal sector:

• Dualists. Dualists subscribe to the notion that informal units and activities have few, if any, linkages to the formal economy and operate as a distinct and separate sector. Wage rigidities – raising wages above market-clearing levels – segment the labour market, and informally employed workers are in the residual, disadvantaged segment of the labour market.


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• Structuralists. Structuralists see the informal and formal economies as intrinsically linked. In the interest of increasing their competitiveness, firms in the formal economy are seen to reduce their input costs, including labour costs, by promoting informal production and employment relationships with subordinated economic units and workers. According to structuralists, both informal enterprises and informal wage workers are subordinated to the interests of capitalist development.

• Legalists. Legalists focus on informal enterprises and the formal regulatory environment rather than the informal sector labour market and its workers. While they do not focus on the relationship between informal enterprises and formal firms, the legalists acknowledge that capitalist interests collude with government to set the bureaucratic ‘rules of the game’ (de Soto 1989).

Given the heterogeneity of the informal economy, each of these three approaches has potential value. Here we concentrate on the structuralist approach, following Chen (2004).

Informal enterprises and formal firms

Apart from some survival activities, few informal enterprises operate in isolation from formal firms. Most source raw materials from or supply finished goods to formal firms either directly or through intermediary (often informal) firms. Sourcing and supplying of goods or services can take place through individual commercial relationships or a value chain of sub-contracted relationships. To understand the linkages between informal enterprises and formal firms it is important to consider the nature of the production system through which they are linked. The nature of the linkage – specifically, the allocation of authority and risk between the informal and formal firm – varies according to the nature of the production system. For instance, a garment maker might produce for the open market (with some authority and all of the risk) or for a supply firm linked to a multinational company (with little authority but much of the risk in the form of non-wage costs, rejected goods, and delayed payments).

Informal workers and formal firms

Historically, around the world, the ‘employment relationship’ has represented the cornerstone around which labour law and collective bargaining agreements have sought to recognise and protect the rights of workers. Whatever its precise definition in different national contexts, it has represented “a universal notion which creates a link between a person, called the employee (frequently referred to as ‘the worker’) with another person, called the employer to whom she or he provides labour or services under certain conditions in return for remuneration” (ILO 2003). The concept of employment relationship has always excluded those workers who are self-employed.

Increasingly, some categories of wage workers have found themselves to be, in effect, without legal recognition or protection because their employment relationship is either disguised or ambiguous or not defined.

• Disguised: the employment relationship is deliberately disguised by giving it the appearance of a relationship of a different legal nature. For example, the lead firm in a sub-contracting chain may claim that it has a ‘sales-purchase’ – or commercial - relationship with those who produce goods for it, rather than a subcontracted employment relationship.

• Ambiguous: the employment relationship is kept deliberately ambiguous to create doubt about whether or not an employment relationship really exists. This is the case, for instance, with street vendors who depend on a single supplier for goods or sell goods on a commission for a distributor.


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• Not defined: the employment relationship clearly exists but it is not specified who the employer is, what rights the worker has, and who is responsible for securing these rights. For example, in value chain production, it is not clear who the real employer is - the lead firm, the supply firm, or the sub-contractor.

Similarly, in the case of temporary work, it may be unclear who the real employer is - whether it is the agency that supplies temporary workers or the firm that hires them on a temporary basis.

Under each of these employment relationships, workers tend not to be protected under labour law or collective bargaining agreements. By this definition, they are informally employed. In many such cases, the employer seeks to disguise the employment relationship or avoid definition of who is responsible; and the employer in question may well represent a formal firm, not an informal enterprise.

Beginning in the 1980s, formal firms in developed countries began to favour flexible labour relationships. This form of labour market segmentation took place in the interest of flexible specialised production, not in response to rising wage rates or labour costs (Piore and Sabel, 1984). Also increasingly since the 1980s, many formal firms in developed countries have decided to sub-contract production out to unprotected workers in developing or transition countries. There is often further segmentation between the core semi-permanent workforce and a peripheral temporary workforce that is mobilised during peak seasons and demobilised during slack seasons (what has been called a ‘permanent temporary workforce’).

In summary, many formal firms prefer informal employment relationships, in order to reduce labour costs. Formal firms choose these types of informal employment relationships as a means of avoiding their formal obligations as employers. In such cases, it is the formal firm and not the informal worker that chooses to operate informally and enjoys the benefits of informality. Workers may therefore be employed in the informal sector not by choice but for the lack of formal sector alternatives.

2.6 Informality and illegality

There has traditionally been a widespread assumption that the informal sector comprises unregistered and unregulated enterprises whose owner-operators choose to evade registration and, thereby, legally imposed burdens such as taxation. Lest this be regarded as convincing argument against such informality, we should note the following:

• There is a distinction between illegal processes or arrangements and illegal goods and services. While production or employment arrangements in the informal economy are often semi-legal or illegal, most informal workers and enterprises produce or distribute legal goods and services. Although the criminal sector not only operates illegally but also deals in illegal goods and services, this is only a small part of a sector that is, for the most part, not illegal or criminal.

• It is important to note that, in the case of informal wage work, it is not the workers but their employers, whether in formal or informal firms, who are avoiding registration and taxation. Many owner-operators of informal enterprises operate semi-legally or illegally because the regulatory environment is too punitive or cumbersome. Many would be willing to pay the costs of registration and pay taxes if they were to receive the incentives and benefits of formality that are often enjoyed by registered businesses.

• Those who work in the informal sector involuntarily generally associate operating outside the legal regulatory framework with costs rather than benefits. Such informal sector


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workers are deprived of secure work, employer-sponsored benefits, social protection, legal protection, and representation or voice. Partly as a result of this, a much higher proportion of people working involuntarily in the informal economy than of those working in the formal sector are poor.


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3. Definitions and measurement of the informal sector

3.1 Definitions

The attempts at defining the informal sector provided in the introduction in Box 1 are contentious because the definitions require interpretation in particular contexts and it begs the question as to the reason for seeking a definition. In the case of the informal sector, it is not true that ‘one size fits all’. There is a continuum between informality and formality, with formalisation being a gradual process. Few firms follow all the rules governing enterprise behaviour and few follow none of them. Entrepreneurs make repeated economic calculations of the costs and benefits of following the rules, and embrace formality up to the point where the potential benefits outweigh the costs.

The production unit and type of employment status of those commonly described as informal are highly diverse. They include own-account workers in survival-type activities, such as street vendors, shoeshiners, garbage collectors and scrap- and rag-pickers; paid domestic workers employed by households; homeworkers and workers in sweatshops who are “disguised wage workers” in production chains; and the self-employed in micro-enterprises operating on their own or with contributing family workers or sometimes apprentices/employees. It is important to note the diversity of those working in the informal economy because the problems and needs are different. For example, they differ for those engaged in survival activities, for homeworkers, whose employment relationship with an employer is not recognised or protected, and for the self-employed and employers, who face various barriers and constraints to setting up and operating formal enterprises. These different groups have been termed “informal” because they share one important characteristic: they are not recognised or protected under the legal and regulatory frameworks. This is not, however, the only defining feature of informality.

It is relevant to ask: in what circumstances can the distinction between the formal and the informal sectors be non-existent or irrelevant, and in what circumstances does it become important? This inevitably directs attention to the underlying policy concerns. These are likely to include both efficiency and equity objectives. On the efficiency side, is there inefficient resource misallocation as a result of the distinction, in particular misallocation of labour or inadequate investment in workers? On the equity side, does the division between formal and informal contribute to poverty in its various dimensions, such as low income, economic inequality, economic insecurity, and bad conditions of workers?

These considerations mean that there is no right definition of the informal sector labour market, independent of economic and institutional context and underlying objectives. In principle, we are looking for a sharp segmentation between groups of workers that leads to problems of equity or efficiency. In practice, the informal sector might be defined in terms of not having a legal contract, or not being covered by social security provisions, or being self-employed or employed by a small firm, or not being a trade union member, or not having employment with an officially ‘registered’ establishment. Even though there is likely to be overlap, the size and composition of the informal sector can vary greatly according to which of the available definitions is used, and so it is important to be clear why it is that the informal sector raises policy concerns.

The availability of a rich data set makes Brazil a good case study for evaluating the definition and measurement of the informal sector (Henley et al, 2006). The labour market is regulated by means of a Labour Code. This mandates the official registration of all contracts of employment and requires employers to provide each contracted employee with a signed ‘labour card’, stating the terms of employment and conferring legal entitlement to a wide range of contract terms. There is an incentive for employers not to register contracts and for employees to be registered. Social


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security (mainly in the form of pensions) is provided by the employee’s membership of a ‘social security institute’. Thus there are three possible definitions of informality: not having a formal contract, not having social security, and being employed in a small firm. The Brazilian household survey permits the application of all three definitions. In 2001, 40% of the employed were informal on all three definitions, and 36% were formal on every definition of informality. The remaining 24% were informal on one or two of the definitions: 11% on only one and 13% on two of the three. Which definition is the most appropriate? Although Henley et al (2006) did not analyse wages and their relationship to informality, insofar as we are concerned about income poverty, the firm size definition is the most appropriate because it is the one most likely to identify low-paid workers.. Insofar as we are concerned about insecurity, each the other two is very relevant. If policy-makers want to address both poverty and insecurity, then the 40% of employees who qualify by all three criteria can be regarded as the group most vulnerable.

The official definition of the informal employment used in Ethiopia requires that all three conditions be met: employees are informal if the employer has no book of accounts, no official ‘license’, and has fewer than ten employees. On that basis, 38% of urban employees were informal in 2005. However, if domestic servants, self-employed workers, apprentices and unpaid family workers are included – as seems appropriate if the criterion is to identify workers with low incomes - the proportion rises to 71%.

At an operational level, the combination of proxy indicators (e.g. employment size of the enterprise, non-wage employment, or whether the enterprise is officially registered) used in household and establishment surveys to identify the informal sector varies from country to country. Whatever definition is used, it is unlikely to represent the concept most useful to policy-makers in any particular context. It may not be a good guide to identifying low-paid or insecure workers, and it may not pick up all informal activities. For instance, labour force and household surveys typically count only one's primary occupation, thus effectively excluding secondary activities in the informal sector.

3.2 Scale of the informal sector

Attempts to estimate the importance of informal sector employment find vast differences across countries in standardised measures of its size. This is partly because standardised measures are misleading if different concepts are required, but the research also suggests that certain characteristics increase informality on almost any measure. Countries with lower GDP per capita tend to have larger informal sectors; when the state and its institutions impose high regulatory or fiscal costs on formal enterprises, informality is a form of evasive action; when formality provides access to public services and favours, informality dwindles (Loayzi and Rigolini, 2005).

Despite these measurement difficulties, it is still valid to review evidence of the scale of the informal sector in developing countries. ILO data on informal sector employment as a percentage of total employment is available for 42 countries. Out of these countries, 17 have more than half of their total employment in the informal sector and only four countries have less than 10% of total employment in the informal sector. Among the regions covered, sub-Saharan African countries tend to have the highest proportion of informal to total employment, and the transition countries of Central and Eastern Europe and the Commonwealth of Independent States (CIS) have the lowest shares (see table 3.1). The table shows that there is considerable variation among countries as regards informal employment as a percentage of total employment, from 5% to over 70%. Among the regions, countries of West and East Africa, South Asia and the Andean region tend to have the highest proportions of informal to total employment.


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Table 3.1 Persons employed in the informal sector 1

Number (000’s) % of total employment Country Year Total Men Women

Women per 100 men

Total Men Women

Latin America Mexico 1999 9,141.6 5,693.8 3,447.7 61 31.9 32.7 30.7 Barbados2 1998 6.9 4.2 2.7 63 5.9 6.8 4.9 Peru 2,3 1999 3, 606.1 1,897.8 1,708.3 90 53.8 48.9 60.6 Brazil4 1997 18,113.3 8,652.6 9,460.6 109 34.6 28.3 43.4 Africa Mali3,4 1996 370.6 214.3 156.3 73 71.0 n.a. n.a. Benin3 1999 275.5 174.8 100.7 58 46.0 50.0 41.4 Botswana4 1996 60.5 21.1 39.4 187 19.3 12.3 27.6 South Africa4

1999 2, 705.0 1,162.0 1,544.0 133 26.1 19.3 35.5

Ethiopia2,3 1999 1,149.5 485.6 663.9 137 50.6 38.9 64.8 Kenya 1999 1,881.0 1,090.4 790.6 73 36.4 43.9 29.5 Tanzania2,5 1995 345.9 221.0 124.9 57 67.0 59.7 85.3 Asia India 2000 79,710.0 63,580.0 16,130.0 25 55.7 55.4 57.0 Nepal4 1999 1,657.0 1,052.0 605.0 58 73.3 67.4 86.5 Philippines 2,6

1995 539.3 282.8 256.5 91 17.3 15.8 19.4

Turkey 2000 10,319.5 1,183.0 136.5 12 9.9 10.6 6.2 Central and Eastern Europe FYR Macedonia

1999 152.0 96.0 56.0 58 27.8 n.a. n.a.

Slovakia 1999 450.0 343.5 106.5 31 23.0 30.5 12.9 Poland2,4 1998 1,166.0 817.0 349.0 43 7.5 9.5 5.0 Lithuania2,3 1997 93.0 68.3 24.7 36 8.5 11.9 4.8 Ukraine 2,3,4 1997 755.9 345.4 420.5 122 4.9 4.5 5.3 Georgia7 1999 103.3 73.6 28.6 39 6.9 10.0 3.8

Notes: 1. In the same geographic areas, branches of economic activity, age limits, etc, 2. Agriculture included, 3.Urban areas, 4. Paid domestic workers included, 5. Dar-es-Salaam, 6. National Capital Region, 7. Agriculture included for urban areas, n.a.: Not available.

Source: ILO Bureau of Statistics on the Basis of Official National Data

In about half of the countries included in table 3.1, the share of informal in total employment is higher for women than for men. In some countries (Botswana, Brazil, Ethiopia, South Africa and Ukraine), there are more women than men in informal employment, even in absolute numbers. However, the gender bias in the informal economy is probably underestimated. Women are more likely than men to be in those informal activities that are undercounted, such as production for own consumption, paid domestic activities in private households and home work.

The composition of the informal sector is likely to depend on the relative importance of voluntarily and involuntarily entered employment. In Ethiopia, where the informal employment is predominantly involuntary, informal workers tend to be young, female, and poorly educated. Young people entering the labour market find it difficult to compete with incumbents of formal sector jobs, who can be protected by law or by their firm-specific human capital. Women are often at a disadvantage as a result of societal norms, demands of the home, and their relative lack of education. Education is more valuable in larger and technically more sophisticated economic


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activities than are generally found in the informal sector. Moreover, as the Chinese case study above illustrated, the informal sector is often the natural entry point to the urban economy for migrants from the countryside. By contrast, in Mexico, where voluntary employment is reported to predominate, informal sector workers tend to be older, more experienced workers who have entered from the formal sector having accumulated skills, contacts, and savings.

In surplus labour countries the distribution of residual labour between disguised unemployment in the free-entry informal sector and open unemployment has to be explained. In South Africa, where the informal sector employs an unusually small proportion of the labour force, Kingdon and Knight (2007) estimate the proportion in informal employment, formal employment and (narrowly defined) unemployment to be 24, 47 and 29% respectively in 2003. This is on the official definition of informal employment (own-account workers plus workers whose employers are too small to be VAT registered) plus agricultural workers. A broader definition that includes employees of registered firms if they do not receive paid leave, pension rights or employment insurance doubles the proportion of informal employees in non-agricultural employment, from 28 to 59%, but this definition may be too encompassing to identify the people whom the policy-makers wish to reach.

Our account above of the barriers which restrict informal sector employment helps to explain why South Africa is an international outlier. However, the question arises: why do the unemployed not enter the informal sector activities which are relatively open to access, such as crafts and petty trade? Much of the explanation has to do with the small size of this sector, given competition from the efficient formal sector, and the consequent collapse of real incomes in those activities as the growing residual labour force poured into them. Provided that the unemployed receive some support from within or beyond the household, they prefer to remain outside the informal sector (Kingdon and Knight, 2007). However, in lower income countries possessing a smaller formal sector, unemployment is lower insofar as the poor cannot afford to be unemployed and have no prospect of formal sector employment.

3.3 Trends

ILO (2002) describes how the bulk of new employment in recent years, particularly in developing and transition countries, has been in the informal economy. However, the report recognises that the term informal sector is an inadequate term to reflect various dynamic, heterogeneous and complex aspects of the phenomenon.

One aspect is the 'flexibilisation' and 'informalisation' of production and employment relationships in the context of global competition and information and communications technology (ICT). More and more firms, instead of using a fulltime, regular workforce based in a single, large registered factory or workplace, are decentralising production and reorganising work by forming more flexible and specialised production units, some of which remain unregistered and informal. A global variation of flexible specialisation is the rapid growth in cross-border commodity and value chains in which the lead firm or large retailer is in an advanced industrialised country and the final producer is an own-account worker in a micro-enterprise or a homeworker in a developing or transition country. As part of their efforts to enhance competitiveness, firms are increasingly operating with a small core of wage workers employed on regular terms and conditions and a growing periphery of workers employed on different, normally inferior, in different workplaces scattered over different locations and sometimes different countries. These measures often include outsourcing or subcontracting arrangements and more flexible and informal employment relationships.

It has been argued that periods of economic boom can lead to the formalisation of informal sector workers: government is more able to enforce regulations when enterprises can afford their cost,


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and has to be more lenient when times are tough.. Moreover, informal sector employment expands in periods when formal sector employment contracts. For instance, in the East Asian economic crisis millions of people who lost formal jobs in the affected countries tried to find or create jobs in the informal economy (Lee, 1998). Structural adjustment in Africa and economic transition in the former Soviet Union and in Central and Eastern Europe were also associated with an expansion of employment in the informal economy. Informal employment tends to expand during periods of economic adjustment or transition because retrenched workers who cannot find alternative formal jobs turn to the informal economy for work because they cannot afford to be unemployed. In response to falling living standards, brought on by recession or inflation, households may try to supplement incomes from formal jobs with informal earnings.

The ILO’s World Labour Reports show the importance of informal sector employment growth in recent years. In Latin America, the urban informal sector was the primary job generator in the 1990s. An average of 6 out of every 10 new jobs were created by micro-enterprises, own-account workers and domestic services. Informal sector employment grew by 3.9% per annum while formal sector employment grew by only 2.1% in that region. In Africa, urban informal employment is estimated to absorb 61% of the urban labour force. This sector was estimated to have generated more than 93% of all additional jobs in the region in the 1990s.

Figure 3.1 Trends in informal sector employment as a percentage of total employment, selected Latin American countries

Source: ILO: Key Indicators of the Labour Market 2001-2002, op. cit., table 7.

There are only 17 countries for which ILO time-series data are available that permit monitoring of the evolution of informal employment over time. They show that in virtually all cases, the share of informal in total employment in the corresponding branches of economic activity has increased during the 1990s (figure 3.1 gives some examples of trends in informal employment). Where there has been an increase in informal employment, it has grown for both men and women. In some


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countries, however, particularly in Latin America, women’s participation in informal employment has risen much more rapidly than men’s.

The reasons why the informal employment has grown in importance can very from one country to another. For instance, in South Africa the informal sector had to absorb the residual labour force and its growth, in Brazil the explanation might be the growing attractiveness of informality, and in China informal sector employment has increased on account of marketisation and privatisation. More generally, however, the trend towards globalisation has also contributed, by making out-sourcing and sub-contracting more feasible.


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4. Policies

4.1 Introduction

Historically, policy makers have taken differing policy stances on the informal economy: some observers view informal workers as a nuisance to be eliminated or strictly regulated; others see them as a vulnerable group to be assisted through social policies; still others see them as dynamic entrepreneurs to be freed from cumbersome government regulations. Another perspective sees the informal workforce as comprised of unprotected producers and workers who need to be covered by labour legislation and social protection.

At the core of the policy debate on the informal economy is the oft-repeated and greatly-misunderstood question of whether or not to ‘formalise’ the informal economy. Experience suggests that no simple rule exists that increasing or decreasing formalisation necessarily improves or worsens the well-being of the poor or welfare of society at large (Guha-Khasnobis et al, undated). Policy makers must be aware of the risk that attempts at formalisation can lead to increased levels of unemployment and poverty for those who cannot be formalised.

It is also unclear what is meant by ‘formalisation’. To many policy makers, formalisation often means that informal enterprises should obtain a license, register their accounts, and pay taxes. But to the self-employed, these represent the costs of entry into the formal economy. For entrepreneurs to be willing to meet these costs, they must be offset by benefits, such as: enforceable commercial contracts; legal ownership of the place of business and means of production; membership in formal trade associations; and statutory social protection. To informal wage workers, formalisation means obtaining a formal wage job – or converting their current job into a formal job – with secure contract, worker benefits, and social protection.

4.2 Objectives and justifications for public intervention

In considering policy approaches towards informal sector labour markets, it is relevant to question whether the issue is one of labour market inefficiency to be redressed by government or institutional interventions, or one of labour market efficiency marred by government or institutional interventions. The same country might harbour both: for instance, efforts to encourage the emergence of entrepreneurs might fall into the former category, and attempts at excessive regulation into the latter. Determining the policy stance will additionally depend on a diagnosis of whether informal labour is voluntary or involuntary.

Even in countries where the informal sector has to absorb much surplus labour into unproductive, poorly remunerated, wage or self-employment activities, there is nevertheless often a case for intervention to promote productive informal sector activities. This is liable to take the form of weakening the barriers to entry to such activities - some artificial and some having an economic basis. These policies might include overcoming market failures in the acquisition of technical and business skills and in the provision of credit to self-employed persons and small businesses, and in the creation of an environment conducive to business (such as ensuring legal redress and security of property).

In many countries, the informal sector is divided between parts which are protected by barriers to entry and parts with relative freedom of entry. The unemployed and entrants to the labour market find it difficult to enter the former – normally self-employment activities – because they lack the


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factors of production which must accompany labour or they face high transaction costs. Thus, it is necessary for them to obtain capital or skills – both of which might require access to credit - or to build up social networks. An important role for government is to assist people to overcome such barriers, and thus contribute to a reduction in labour market segmentation. In some cases it is relatively easy to assess what should be done. For instance, artificial restrictions imposed by incumbents to exclude newcomers should be outlawed, artificial constraints on access to workplaces should be removed, and it is the responsibility of government to ensure that firms are free from harassment and crime. In other cases policy-making is more difficult. Private credit markets tend to fail and official micro-credit schemes typically run into a series of problems, such as the difficulty and cost of assessing applications, the politicisation of lending, and the hazard of bad debts. Training schemes can suffer from inadequate official information about skill needs and poor choice of workers to be trained.

There is scope for government to provide or fund training, credit, and other business development services to firms and would-be entrepreneurs, but only if evaluations demonstrate that they have positive results. There is need for an evidence-based approach to such interventions. Nevertheless, the overcoming of barriers to entry to self-employment activities and for small businesses is one of the clearest examples of market failure in developing countries which require government intervention to improve on the market outcomes.

The formal and informal sectors generally compete with each other in product markets, although sometimes their relationship is complementary, e.g. through sub-contracting. It is an important issue whether such competition is ‘fair’ or ‘distorted’, e.g. through government favouring of the formal sector. These product market issues have implications for informal sector employment and therefore require policy attention.

It is well established that there is a strong positive relationship between firm size and benefits to workers (in the forms of e.g. wages, conditions, unionisation, pension schemes, and training). This can be the result of official intervention and regulation but often it is what large firms would choose to do anyway, for ‘efficiency wage’ reasons or because they can afford it. Often small and micro enterprises struggle to compete with larger enterprises, and yet they have the social advantage, in countries with surplus labour, that they employ more labour-intensive methods. It is a debateable question - and one which would normally require examination of particular cases - whether in such circumstances the state and its institutions should extend to the small-scale sector regulations relating to e.g. minimum wages, labour contracts, social security coverage, and training. There is a risk that such an extension could reduce the competitiveness (and hence viability) of small-scale labour intensive enterprises, which is partly based on relatively lower wages and greater flexibility.

The following sections consider specific policy areas in more detail, including the regulatory and institutional framework, social protection, minimum wage legislation and trade unions.

4.3 Regulatory and institutional framework

Where informality is voluntary, the decision by workers to comply with formal sector regulations is based on weighing the value of social benefits relative to what arrangements can be made informally, against the tax, implicit or explicit, that being a registered employee implies. High levels of voluntary informality is often blamed on excessive regulations that create barriers and costs to working formally. Ulyssea (undated) finds for Latin America that reducing formal sector’s entry costs significantly reduces informal employment and increases the formal employment and overall labour market performance. Moreover, reducing entry costs generates an improvement in most labour market indicators: the formal-informal wage differential is significantly reduced, exit probabilities out of unemployment increase - which causes a reduction in the unemployment rate -


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and there is an increase in average labour productivity. Strengthening enforcement of labour regulations is also very effective in reducing the size of the informal sector, but it also significantly increases unemployment and reduces the aggregate product and average productivity. Overall, the results from this study indicate that the best option to reduce labour market segmentation and improve performance is to reduce the costs of entry into the formal sector instead of intensifying punishment and auditing of informal activities.

Three types of legislation and regulations are important:

1. Commercial or business regulations governing the establishment and operation of enterprises. 2. The laws pertaining to property rights, which could affect the ability to transform assets into

productive capital. 3. Labour legislation governing employment relationships and the rights and protection of

workers.

What needs to be understood is whether existing laws and institutions are poorly or well designed in terms of their influence on the costs and benefits to enterprises and workers of becoming and staying formal or informal. Where such rules and regulations are cost effective, are predictable and provide the requisite business information, people are more likely to conform to and pay for them. Rules which are poorly designed, are burdensome and involve dealing with corrupt and inefficient bureaucracies increase transaction costs, discourage compliance, impede economic participation and encourage endemic corruption, thus enhancing segmentation between the formal and informal economies.

Improving the legal framework does not necessarily mean deregulation. It is important to remember that laws do not only constrain entrepreneurship and formalisation, they can also play a facilitating or enabling role and serve to enforce fundamental principles and rights. An enabling legal system can offer security, incentives, safeguards and protections. Reforms should focus on the most binding constraints and consider the interactions between labour regulations and other aspects of the investment climate affecting the incentives to become formal. Good practice in reducing segmentation between the formal and informal sectors will in most cases include the following measures:

• Support broad programmes of regulatory reform.

• Design measures to create a business friendly culture in government and to improve service provision.

• Simplify official administration for business.

• Simplify tax administration.

• Rationalise business registration and licensing regimes.

• Limit licensing to those activities where it is justified.

• Reduce registration fees and statutory requirements.

• Promote labour law reform which, whilst protecting essential rights, makes it easier to hire and fire workers and to employ people on flexible contracts.

4.4 Social protection

The term social protection is usually used to describe arrangements made for those people and communities who encounter adverse contingencies. These arrangements aim to provide some form of maintenance of income and services to these people to ensure that they are catered for in


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times of need. Social protection includes public social security schemes and also private or non-statutory schemes. Workers in the informal economy generally have little or no social protection and receive little or no social security, either from their employer or from government.

Social protection is an area in which there is likely to be market failure. In a developing country there can be a dearth of private insurance providers, and in any case poor, often myopic, workers are generally reluctant themselves to pay for insurance. Thus the state may need to take the initiative, and to design and implement the scheme. This makes it likely that the arrangements will be suited to formal sector employees and not to informal sector workers. Governments often require the employer to pay the costs of the scheme on behalf of the employees, or at least to contribute to the costs. This raises the question of the ultimate incidence of the charge: economic theory predicts that in market equilibrium the costs will be shared between employers and employees according to the elasticities of supply and demand. Nevertheless, the initial incidence is clear, and this might persuade firms to be informal in order to escape these costs.

The lack of social protection is a key defining characteristic of the informal economy. ILO (2002) estimates that only 20% of the world’s workers have what they describe as “truly adequate social protection” and more than half of the world’s workers and their dependants are excluded from any type of formal social security protection. In sub-Saharan Africa and South Asia, formal social security personal coverage is estimated at 5 to 10% of the working population, and in some cases is decreasing.

We would expect to find informality falling when the level, and thus the cost, of social insurance that must be provided by employers falls, by making the employer’s decision to hire an additional worker more affordable. By contrast, an improvement in the administration of social insurance, such as the government simplifying the process for employers in the event of a claim, could reduce informality by encouraging more employers to enter the formal sector.

With social protection being increasingly considered as a right of workers, the informal economy poses a difficulty for policy-makers. The irregularity of informal employment makes it unreliable as a source of income for social insurance contributions. Moreover, informal workers normally do not have other sources of income to contribute to compulsory social insurance schemes. For workers in disguised employment relationships, it is difficult to get the ultimate employer (or lead firm in a global chain) to assume responsibility for protecting these workers’ rights, including the right to basic social protection, especially as there are definite financial and legal implications.

As argued in Canagarajah & Sethuraman (2001), attempts to extend orthodox social protection measures to those in the informal sector in developing countries are therefore unlikely to succeed in providing effective protection. In response to this problem, increasing emphasis is being placed on organisations of workers (or small producers) in the informal economy in order to pool risks, and thereby lower the cost of insurance, e.g., group insurance schemes. Such informal mechanisms are still in an experimental stage; despite innovations and adaptations few schemes seem to reach workers in the informal sector. They also face considerable challenges relating to problems of 'scaling up' and doubtful financial sustainability, quite apart from the problems of institutional capacity and governance.

4.5 Minimum wage legislation

The impact of minimum wage legislation on informality appears to be mixed. As we saw in Section 2.2.2, minimum wages can make small – often informal sector – firms less able to compete. They can also displace workers from the formal sector. Jones (1998) shows that Ghana’s minimum wage policies during the 1970s and 1980s led to a reduction of formal sector jobs and an increase


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in informal sector jobs. The study also provides some evidence that a large proportion of the displaced workers from the formal sector ended up working in the informal sector, and that there was a corresponding reduction in the wages of those in the informal sector. However evidence from Latin America (e.g. Maloney & Nunez Mendez, 2004 & Cunningham et al, 2004) suggests that the minimum wage is often as binding in the informal as in the formal sector. This adds support to the idea that in these countries, the informal sector is not completely unprotected by social norms, but in fact is covered by notions of fair wages.

4.6 Trade unions

Trade unions are generally associated with the formal economy and tend to exclude informal workers. However in many developing countries, a more ‘informal’ labour movement is developing, particularly championing the rights of poor women workers. By securing better conditions for their members, trade unions can help to tackle poor labour conditions – by promoting human rights, core labour standards, and social responsibility in business, consumption and investment.

In each developing country there is a particular relationship between government and the trade unions. For instance, they are subordinated in China, suppressed in Zimbabwe, and taken into an alliance in South Africa. This underlying political economy determines the role that trade unions can and do play. Where they are important in wage determination, they tend to segment the urban labour market between unionised and non-unionised segments.

Considerable care must be taken in regard to policies affecting trade unions and the informal sector. As described earlier, in the case of South Africa, trade unions and collective bargaining can have a significant impact on formal sector wage premiums. Such premiums can create an incentive for enterprises to reduce their employment and to engage workers on a casual basis, both effects being to increase the size of the informal labour force. The extent to which this is likely to happen will depend on individual country conditions; it is most likely to represent a problem where there is considerable involuntary informality.


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5. Conclusions

This paper has introduced several, often contrasting, case studies to show how, if we are to understand informal sector employment issues, we need to study the economic circumstances and institutions of particular countries and of the contexts in which policy objectives are pursued. It is certainly not the case that the formal sector is necessarily good and the informal sector necessarily bad. It has not been possible to make other than broad generalisations. We have argued that policies towards the informal sector would be generally be better if they attempted to reduce labour market segmentation rather than reduce informality.

It is also clear that where there is market failure, there is a case for intervention to prevent it; and where there is government failure, there is a case to remedy the inefficient intervention. Examples of the former argument are the inadequacy of skill formation in the informal sector and the failure of markets for social protection to develop. It is renewed emphasis on the latter argument that explains the recent prevailing tendency among developing nations towards labour market liberalisation or deregulation.

Two conflicts have emerged from differing views of the informal sector:

• Improving livelihoods within the informal economy while encouraging formalisation. Some researchers and donor programmes view the informal economy as a long-term structural feature of modern economic development. Given this, some interventions are aimed at improving the welfare of people who find themselves in the informal economy, rather than helping them to formalise. Other donor interventions consider formalised economic growth to be a central goal of development and a primary driver of poverty reduction. These are accordingly focused on encouraging formal economy growth. In between these two views is a place for interventions that help actors in the informal economy to take gradual steps in the formalisation process, for instance by creating associations with a formal status to facilitate access to such services as micro-credit, insurance, land tenure and physical market places. The challenge is to determine how interventions can be devised that improve the livelihoods of the poor while not removing incentives to formalisation.

• Improving employment conditions for informal sector workers versus increasing competitiveness of the private sector. Some approaches look for ways to improve labour market conditions in the informal sector. This approach has the potential to conflict with approaches that emphasise the competitiveness of informal economy enterprises, the need to ensure workforce flexibility so as to maintain competitive advantage and the need to keep employment law compliance burdens to a sensible minimum.

To ensure that appropriate policies are put in place, the informal workforce needs to be recognised and understood by policy makers. To ensure that the policy approach is well-informed, it needs to be evidence-based. The availability of periodic and labour force surveys has improved greatly in recent years in many developing countries. Yet there is still limited information on the informal sector, in the sort of detail that is required for policy-making.. Greater priority needs to be given to the collection of data on informal employment, which is a relatively new topic in labour statistics.

Before arriving at appropriate policy for the informal sector in any particular country, it is necessary to classify it by a set of diagnostic criteria. We set these out below, and indicate the sorts of information and data required for this purposes. The following diagnostic tests might be applied.

• The labour market institutions – such as regulations about minimum wages and conditions, employment protection, social protection, and differential treatment of rural-urban migrants,


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and the coverage of such regulations – would help to identify the likely dividing line between the formal and informal sectors.

• The division between the formal and informal sectors that is suggested by the institutional information should be compared with the actual division that is available from official or other statistical sources: discrepancies might distort the analysis.

• The underlying political economy that often produces segmentation between formal and informal sectors is relevant to understanding government policies and the feasibility of any proposals for policy change.

• A rigorous test of the degree of segmentation between the formal and informal sectors could be obtained from a labour force1 or household survey providing information on individual workers. The criterion is whether there is sharp wage or other segmentation between the two sectors, after standardising for the other determinants of the dependent variable and correcting for any bias arising from unobserved selection into the two sectors. A less rigorous test would simply compare average earnings in the two sectors.

• A similar test could be conducted on workers within the informal sector to decide whether they can be divided into an upper tier and a lower tier, distinguished by a difference in income. Such a division would probably be based on the extent of barriers to entry. Evidence on the extent and nature of barriers to entry could be helpful in making this distinction.

• The composition of workers in the informal sector – both absolutely and relative to the formal sector – could provide pointers as to whether it has been voluntarily or involuntarily entered, or whether the informal sector itself is divided between a voluntarily entered and an imposed sub-sector. The relevant characteristics of workers might include age, education, training, vocational skills, gender, previous activity and income, and migrant status.

• Evidence on the level and nature of unemployment in a country can help to indicate the state of the labour market, and thus whether informal employment is of a voluntary or involuntary character.

These diagnostics are summarised in the table below.

Diagnostic Information source

Segmentation between formal and informal sectors

• labour market regulations and their coverage

• labour force or household surveys (wage divergences?)

Segmentation within informal sector

• labour force surveys (wage dispersion within informal sector)

• extent of barriers to entry

Extent to which informality is voluntary or involuntary

• labour force surveys (characteristics of workers might include age, education, training, vocational skills, gender, previous activity and income, nature and level of unemployment and migrant status)

1 For a list of labour force surveys available online, see http://www.ilo.org/dyn/lfsurvey/lfsurvey.home


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It is not possible to provide simple formulae for the task of understanding the informal sector in any particular economy. Rather, that task requires a combination of the sort of evidence indicated above, a knowledge of the policy-makers’ underlying value judgements about efficiency and equity, and the application of the analyst’s own judgement.


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