In most emerging economies, the informal sector is crucial. Estimates put over 90% of India?s labour force in the informal sector, producing the equivalent of over 50% of our GDP. The benefits of the presence of such a large informal sector in the economy is a question worth considering.?
There are three dominant views on these potential benefits or costs. The first is the so-called ?romantic view?, first proposed by De Soto in 1998. This views the informal secor as extremely productive but held back by government taxes or regulation. In other words, once measures like delicensing or capital availability are ensured, the informal sector will in itself engage with the rest of the economy and provide impetus to economic growth and development. The second view is more pessimistic, and is characterised as the ?parasite view?. It views informal firms primarily as illegal operations run by inefficient entrepreneurs?firms need to stay small to avoid legal detection and their cost-savings via tax evasion helps keep them in business.? The third view, also known as the ?dual view? is more balanced. It sees the informal sector as an inherently inefficient substitute to the formal sector,? which also serves as the provider to livelihood for millions of poor people. Informal and formal firms are not linked in terms of final customers or markets, although there may be overlap in intermediate goods during the production process. ?
Rafael Porta and Andrei Shliefer of the International Monetary Fund examine each of these views and the potential costs/benefits of formalising the informal sector under them. They conduct an empirical examination of 14 emerging economies (including India) in their paper ?The unofficial economy and economic development?, using data from the World Bank Enterprise Survey, as well as the World Bank informal sector and micr-sector questionnaire. Overall, they find that the data most closely bears out the dual view of the informal sector. That is, the productivity of formal firms is much higher than that of informal firms, but informal firms provide employment on a much larger scale. ?
Their first main finding is that informal firms are much smaller in size than formal firms.? Also, they are less likely to own the land and infrastructure that they use for their operations. Interestingly, the authors find no evidence that informal firms turn formal as they grow, or that formal firms were once informal. The small size of informal firms is therefore a matter of choice, and there is no natural progression from being informal when small, to formal beyond a certain size. ?
However, consistent with the dual view, there are many supply-side links between informal and formal firms. Informal firms often act as suppliers of intermediary, and sometimes even final goods, for formal firms. Despite this link which suggests similar production processes, informal firms were seen to have significantly lower quality assets than formal firms (?assets? in this definition include technology access and infrastructure). Formal firms are also more likely to have educated managers. Formal firms are much more productive than informal firms. ?
Another interesting finding is related to access to finance for informal versus formal firms. The authors find that over 75% of informal firms and over 60% of small formal firms have never had access to any commerical source of finance. This begs the question of the relative importance of size to credit availability, and that smaller firms in general have much more difficulty accessing finance, irrespective of whether they are formal or informal.
However, the importance of the informal sector becomes evident in employment generation. The authors find that employment generation in unregistered firms can be as high as 24% per year, although the wages paid in the informal sector reflect poorly against those in the formal sector due to differences in productivity. ?
Their overarching conclusion is that given the size and productivity of the informal sector, attempts to encourage higher economic growth may have to begin with the formal sector, by removing the barriers to the growth of formal firms. But from the point of view of employment, livelihoods and economic development, the informal sector remains as important.
The author is consultant, NIPFP. These are her personal views