The economy is a vast and intricate system that shapes our world, influencing everything from our daily lives to global trends. While often discussed in terms of formal structures and institutions, a significant portion of economic activity operates outside these official frameworks. This less visible, yet crucial, part is known as the informal economy. Understanding what the economy truly encompasses requires acknowledging and examining this informal sector and its profound implications.
The informal economy encompasses all economic activities that are not officially recognized, registered, or regulated by governments. These activities, though unrecorded, possess market value and would contribute to a nation’s tax revenue and Gross Domestic Product (GDP) if they were formally accounted for. Globally, this sector is remarkably widespread. The International Labour Organization estimates that around 2 billion workers, representing 60% of the world’s employed population aged 15 and above, engage in informal work for at least some part of their livelihoods. As economies progress, the size of the informal sector tends to gradually decrease, yet the pace of this reduction varies significantly across different regions and countries. Even today, in low- and middle-income countries, the informal sector constitutes about one-third of all economic activity, and it still accounts for approximately 15% in advanced economies.
The prevalence of informality manifests in diverse forms across and within nations, stemming from a complex interplay of factors. One common, though often oversimplified, perception is that individuals and businesses deliberately choose to operate informally to evade taxes and social security contributions, or to sidestep regulatory compliance and licensing requirements. While tax avoidance can be a factor, it’s crucial to recognize that informality is not solely driven by intentional evasion. For many, particularly in developing economies, engaging in informal activities is more of a necessity than a choice. Individuals may turn to the informal sector as a safety net, especially when they lack the necessary education, skills, or opportunities for formal employment. Poverty and limited access to public and financial services can also push individuals and businesses into informality as a means of survival and operation outside the reach of formal systems that may seem inaccessible or burdensome.
The widespread and persistent nature of informal labor, particularly in emerging markets and developing economies, is increasingly recognized as a significant impediment to sustainable development. Informal businesses, by their very nature, do not contribute to the national tax base. This lack of tax contribution limits the resources available to governments for essential public services, infrastructure development, and social programs that are crucial for overall economic progress and societal well-being. Furthermore, informal enterprises often remain small in scale, characterized by low productivity and restricted access to formal financial systems. Without access to credit, investment, and the benefits of formal business support structures, these businesses struggle to grow and innovate, hindering their potential contribution to the broader economy. Consequently, regions and countries with substantial informal sectors tend to experience economic growth that falls short of their full potential.
Informal workers are disproportionately vulnerable to poverty compared to their counterparts in the formal sector. This vulnerability arises from several factors. Informal employment typically lacks formal contracts, leaving workers without job security and legal protections. Moreover, informal workers are often excluded from social protection programs, such as unemployment benefits, health insurance, and pensions, which are vital safety nets in times of economic hardship or personal crisis. Compounding these challenges, informal workers often have lower levels of education and skills compared to formal sector employees, further limiting their earning potential and opportunities for advancement.
The prevalence of informal work is also strongly linked to high levels of economic inequality. Workers with comparable skills sets tend to earn less in the informal sector than their formally employed peers. This wage gap between formal and informal workers is often more pronounced at lower skill levels, exacerbating income disparities and hindering social mobility. The experience of Latin America over the past two decades provides a compelling illustration of this link. The significant decline in informality observed in the region during this period was accompanied by notable reductions in income inequality, demonstrating the potential of formalization to promote more equitable economic outcomes.
Gender inequality is another critical dimension intertwined with informal work. In a majority of low- and lower-middle-income countries, women are disproportionately represented in informal employment compared to men. Furthermore, women are more likely to be concentrated in the most precarious and lowest-paying segments of the informal economy. This gendered dimension of informality underscores the need for targeted interventions to address the specific challenges faced by women in the informal sector and to promote gender equality within the broader economy.
Addressing informality is therefore not just an economic imperative but also a matter of social justice and inclusive development. It is essential and urgent to tackle informality to foster inclusive economic development and reduce poverty on a global scale. The COVID-19 pandemic has served to amplify this urgency. The pandemic’s devastating impact on informal activities worldwide has starkly highlighted the vulnerability of informal workers and the limitations of existing social protection systems. Governments have been compelled to recognize the critical need to provide support and lifelines to large segments of their populations who operate outside the formal economy and are often not adequately covered by traditional social safety nets.
However, designing effective policies to address informality is a complex undertaking, given its diverse causes and manifestations, both across different countries and within individual economies. Informality is not a monolithic phenomenon but rather a multifaceted response to a unique combination of country-specific characteristics and institutional frameworks. There is no single, universally applicable solution to formalization. Nevertheless, extensive research and policy experiments conducted in both developing and advanced economies have yielded a set of common guiding principles that can inform effective policy design. Four broad categories of policies have demonstrated particular promise in tackling informality:
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Improving Access to and Quality of Education: Investing in education is arguably the most powerful long-term strategy for reducing informality. Education reforms should prioritize both enhancing equitable access to education for all segments of the population and ensuring that students remain in the education system at least until the completion of secondary education. Furthermore, expanding access to technical and vocational training opportunities is crucial to equip individuals with the skills needed for formal sector employment.
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Tax System Design for Formalization: The design of tax systems should be carefully considered to avoid inadvertently creating or reinforcing incentives for individuals and firms to remain in the informal sector. A general consensus has emerged that simpler value-added tax (VAT) and corporate tax systems, characterized by minimal exemptions and loopholes and lower overall rates, can help to reduce informality. Similarly, keeping payroll taxes at a reasonable level is important to encourage formal employment. Complementary social protection systems, including progressive income taxes and targeted support for the poorest segments of society, are essential to address distributional concerns and ensure fairness.
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Enhancing Financial Inclusion: Policies aimed at promoting financial inclusion by expanding access to formal (or bank-based) financial services can play a significant role in lowering informality. Lack of access to finance is a major constraint for informal firms and entrepreneurs, hindering their productivity, limiting their growth potential, and perpetuating their informal status. Countries with higher levels of financial inclusion tend to experience faster economic growth and lower income inequality, underscoring the importance of this policy lever.
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Structural Policies to Reduce Formalization Costs: A range of structural policies can be implemented to increase the incentives for formalization and reduce the associated costs for businesses and workers. Simplifying labor market regulations to enhance flexibility and facilitate the transition of informal workers into formal employment is crucial. Competition policy can be leveraged to promote the entry of small firms into various sectors by addressing monopolies and anti-competitive practices. Eliminating excessive regulations and bureaucratic requirements that disproportionately burden small businesses can also significantly reduce the barriers to formalization. The adoption of digital platforms, including government-to-person mobile payment systems, can contribute to inclusive growth by bringing financial services to the unbanked, empowering women economically through greater financial control, and supporting the growth of small and medium-sized enterprises within the formal sector.
Informality has profound implications for the pace of economic growth, development, and the ability of economies to provide decent economic opportunities for their populations. Achieving sustainable development necessitates a gradual reduction in informality over time. However, it is essential to recognize that this process will inevitably be gradual because the informal sector currently serves as the primary or only viable source of income for billions of people worldwide. Tackling informality effectively requires a commitment to steady, long-term reforms, such as sustained investment in education, and the implementation of well-designed policies that address the underlying causes of informality. Approaches that simply target the informal sector with punitive measures, based on the misconception that it is solely driven by illegal activities and tax evasion, are unlikely to be effective and may even be counterproductive. A more nuanced and supportive approach, focused on creating enabling environments and addressing the root causes of informality, is essential for fostering inclusive and sustainable economic progress.
CORINNE DELÉCHAT is a division chief in the IMF’s African Department.
LEANDRO MEDINA is a senior economist in the IMF’s Strategy, Policy, and Review Department.
Opinions expressed in articles and other materials are those of the authors; they do not necessarily reflect IMF policy.
