History & Debates

Since its “discovery” in the early 1970s, the informal economy and its role in economic development have been hotly debated. Some observers view the informal economy in positive terms, as a “pool” of entrepreneurial talent or a “cushion” during economic crises. Others view it more problematically, arguing that informal entrepreneurs deliberately avoid regulation and taxation. Still others see the informal economy as a source of livelihood for the working poor. Each of these perspectives is right in regard to specific components or aspects of the informal economy. Contrary to early predictions, the informal economy has continued to grow and has appeared in new forms. Today, it represents a significant share of the global economy and workforce.

Historical Perspective

1950s – 1960s

It was widely assumed during the 1950s and 1960s that, with the right mix of economic policies and resources, poor, traditional economies could be transformed into dynamic, modern economies. In the process, the traditional sector comprised of petty traders, small producers and a range of casual jobs would be absorbed into the modern capitalist economy, the formal economy, and, thereby, disappear. This assumption was reinforced by the successful rebuilding of Europe and Japan, and the industrial expansion in Europe and North America in the decades following the Second World War. By the middle of the 1960s, however, the optimism about the prospects for economic growth in developing countries began to give way to concerns about persistent, widespread unemployment. Reflecting this concern, the International Labour Organization (ILO) mounted a series of large, multi-disciplinary “employment missions” to various developing countries.

1970s

The first ILO World Employment Mission was to Kenya in 1972. As detailed in their official report, the mission team found that the traditional sector had not just persisted, but had expanded to include profitable and efficient enterprises as well as marginal activities (ILO 1972). To highlight this, the team chose to use the phrase “informal sector” rather than “traditional sector” for the range of small-scale and unregistered economic activities. This phrase had been coined the year before by a British anthropologist, Keith Hart, during his 1971 study of economic activities among rural migrants in Accra, Ghana (Hart 1973). See a summary of Keith Hart’s pioneering study.

Although both Hart and the Kenya mission noted the efficiency, creativity and resilience of the informal sector, the concept got a mixed reception in development circles. Many observers held that the informal sector in developing countries was marginal or peripheral and not linked to the formal sector or to modern capitalist development, and that it would disappear once these countries achieved sufficient levels of economic growth or modern industrial development. Other observers argued that industrial development might take a different pattern in developing countries than it had in developed countries, including the expansion of informal economic activities.

1980s – 1990s

By the 1980s, the terms of the debate about the informal sector expanded to include changes that were occurring in advanced capitalist economies, where production was being reorganized into small, decentralized and more flexible economic units. Mass production was giving way to “flexible specialization” or, in some cases, reverting to sweatshop production (Piore and Sabel 1984). These changes were (and are still) associated with the informalization of employment. Standard jobs were being turned into non-standard or atypical jobs, with hourly wages and few benefits or on piece rate with no benefits; production was being contracted to small, informal units and industrial outworkers. In the process, the informal economy became a permanent, albeit subordinate and dependent, feature of capitalist development (Portes, Castells and Benton 1989).

Meanwhile, the Latin American economic crisis in the 1980s highlighted another feature of the informal sector: namely, that employment in the informal sector tends to grow during periods of economic crisis (Tokman 1992). This was repeated in the Asian economic crisis of the 1990s, when millions of people who lost formal jobs tried to find jobs or create work in the informal economy (Lee 1998). Meanwhile, structural adjustment in Africa and economic transition in the former Soviet Union and in Central and Eastern Europe also were associated with an expansion of employment in the informal economy. Why does employment in the informal economy tend to expand during periods of economic instability or uncertainty? When enterprises shrink or shut down, the workers who are laid off may find that the informal economy is the only alternative to being unemployed. As well, in such times high inflation often means that households need to supplement formal-sector incomes with informal earnings.

During the 1990s, globalization of the economy contributed to the informalization of the workforce in many industries and countries (Standing 1999). Whereas globalization can generate new jobs and open new markets, many of the jobs are unattractive and many of the new markets are inaccessible to disadvantaged producers. This is because, in response to global competition, formal firms tend to hire most workers under informal arrangements or to contract the production of goods and services to other countries (Rodrik 1997), and because global integration reduces the competitiveness of many informal firms or self-employed producers vis-à-vis imported goods in domestic markets and vis-à-vis larger, more formal firms in export markets.

Recent Years

At present, there is renewed interest in the informal economy worldwide. In part, this stems from the fact that, contrary to the predictions of many economists, the sector has not only grown, but also emerged in new guises and in unexpected places. It represents a significant, but largely over-looked, share of the global economy and workforce, a fact that has become more apparent in the recent global downturn (Horn 2009). That renewed interest also stems from the recognition of the links between informality, growth, poverty and inequality. There is increased recognition that the informal economy is linked to the formal economy and contributes to the overall economy, and that supporting the working poor in the informal economy is important for reducing poverty and inequality, just as supporting the female working poor in the informal economy is important for reducing gender inequality.

In sum, although interest in the informal economy has waxed and waned since the early 1970s, the concept has continued to be useful to many policymakers, activists and researchers. This is because of the significance of the reality that it seeks to capture,  the large share of the global workforce and production that remains outside the world of full-time, stable and protected employment. See a thumbnail history of the concept of informality.

Now, the informal economy is a field of study in its own right, involving those from other disciplines such as economics, industrial relations, gender studies, political science, sociology and urban planning. Much of the recent scholarship focuses on the size and composition of the informal economy, what drives or causes informality, what are the consequences of informality in terms of welfare or productivity, and the linkages among informality and formality, growth, poverty and inequality. This resurgence of interest in the informal economy has generated significant rethinking of the concept and improvement in official measurement of the phenomenon.

Dominant Schools of Thought

Since its discovery in the early 1970s, the informal economy and its role in economic development have been hotly debated. Some observers view the informal economy in positive terms, as a pool of entrepreneurial talent or a cushion during economic crises. Others view it more problematically, arguing that informal entrepreneurs deliberately avoid registration and taxation. Still others see the informal economy as a source of livelihood for the working poor. Underlying these varying perspectives are four schools of thought regarding the informal economy in developing countries.

1. The dualist school sees the informal sector of the economy as comprised of marginal activities that are distinct from and not related to the formal sector and that provide income for the poor and a safety net in times of crisis (Hart 1973; ILO 1972; Sethuraman 1976; Tokman 1978).
2. The structuralist school sees the informal economy as subordinated economic units (micro-enterprises) and workers that serve to reduce input and labour costs and, thereby, increase the competitiveness of large capitalist firms (Moser 1978; Castells and Portes 1989).
3. The legalist school sees the informal sector as comprised of plucky micro-entrepreneurs who choose to operate informally in order to avoid the unnecessary and burdensome costs, time and effort of formal registration and who need legal rights to convert their assets into formal property (de Soto 1989, 2000).
4. The voluntarist school sees the informal sector as comprised of micro-entrepreneurs who choose to operate informally in order to avoid taxation, commercial regulations, electricity and rental fees, and other costs of operating formally (e.g. Maloney 2004).

In yet another approach, often focussed on transitional and developed countries, the informal sector is seen as activity that is illegal, or is hidden or underground. The System of National Accounts (SNA) (1993) defines illegal production as production activities which are forbidden by law or which become illegal when carried out by unauthorized producers; and underground production as production activities which are legal when performed in compliance with regulations, but which are hidden, deliberately concealed from authorities. Any type of production unit (formal sector enterprise, informal sector enterprise or household) can be engaged in any type of activity: legal but not underground; legal and underground; illegal. Nevertheless, it is widely known that most informal sector activities in developing and transitional countries are not underground or illegal, but instead are a survival strategy for the people involved in them and their households and, therefore, can be captured in surveys of the informal sector in these countries (Hussmanns 2004).

Each school of thought subscribes to a different causal theory of what gives rise to the informal economy.

1. The dualists argue that informal operators are excluded from modern economic opportunities due to a) imbalances between the growth rates of the population and of modern industrial employment; and b) a mismatch between people’s skills and the structure of modern economic opportunities.
2. The structuralists argue that informality is due to the nature of capitalism/capitalist growth: specifically, the attempts by formal firms to reduce labour costs and increase competitiveness; the reaction of formal firms to the power of organized labour, state regulation of the economy (notably, taxes and social legislation) and global competition; and the process of industrialization (notably, off-shore industries, sub-contracting chains, and flexible specialization).
3. The legalists argue that a hostile legal system leads to informal activities and informal, extralegal norms. 
4. The voluntarists argue that informal operators choose to operate informally – after weighing the costs-benefits of informality relative to formality.

See Summary of Dominant Schools of Thought.

The debates between these dominant schools of thought have tended to generate more heat than light in large part because each school of thought has focused on one or another “slice of the (informal economy) pie,” not the whole pie. The dualists focus on those engaged in traditional and survival activities; the structuralists on petty traders and producers as well as sub-contracted workers; both the legalists and voluntarists on informal enterprises and entrepreneurs.

A Holistic Approach

Given the heterogeneity of the informal economy, there is merit to each of these perspectives as each school reflects one or another part of the informal economy. But the informal economy as a whole is more heterogeneous and complex than the sum of these perspectives would suggest.

Some of the self-employed choose - or volunteer - to work informally in order to avoid registration and taxation, while others do so out of necessity or tradition. Also, many of the self-employed would welcome efforts to reduce barriers to registration and related transaction costs, especially if they were to receive the benefits of formalizing. Further, much of the recent rise in informal wage employment is due to the informalization of once-formal employment relationships. In many such cases, it is the employers, not their employees, who are avoiding regulation and taxation. Employers often choose to (a) retain a small, core, regular workforce and hire other workers on an informal basis; (b) avoid payroll taxes and employer’s contributions to social security or pensions; or (c) avoid other obligations as employers. In some such cases, payroll taxes and social security contributions are avoided by mutual consent of the employer and employee, as when employees prefer to receive greater take-home pay instead of employer contributions to social security. This may be the case when social security systems are managed poorly – or their terms and conditions are not transparent or well understood – with the result that employees do not expect any benefits in return for contributions.

In sum, some informal entrepreneurs choose, or volunteer, to work informally. Yet informal employment tends to expand during economic crises or downturns, suggesting that necessity – in addition to choice – drives informality. Also, informalization of employment relations is a feature of contemporary economic growth and the global economy. Further, in many developing countries, the vast majority of the workforce has never had a formal job and continues to engage in traditional or survival activities.

What is called for is a holistic approach to the informal economy which takes into account all aspects of informality and all categories of informal workers. In their 2007 publication called Informality: Exit and Exclusion, a team of authors from the Latin American Division of the World Bank proposed a holistic model of the composition and causes of informality: See more information on the World Bank framework. In 2009, Ravi Kanbur posited a conceptual framework for distinguishing between four types of economic responses to regulation. See more information on Kanbur’s holistic framework. The WIEGO Network has also developed a holistic model of the composition and causes of informality. See more on WIEGO’s holistic framework.

This Informal Economy site is designed to provide a holistic overview of informal enterprises, activities, and workers, with the notable exception of that part of the informal economy that deals in illegal goods and services, or otherwise engages in criminal activities.