298 33320 privatesector P U B L I C P O L I C Y F O R T H E NUMBER NOTE 2005 Rising Informality AUGUST Vincent Palmade and Reversing the Tide Andrea Anayiotos By some estimates more than 30 percent of the developing world's Vincent Palmade GDP and 70 percent of its workers are outside the official economy. (vpalmade@ifc.org) is a lead economist at the The implications: Most small firms are trapped in low-productivity Foreign Investment operations with little access to finance, key government services, and Advisory Service (FIAS), a joint facility of the formal customers. Workers lack safety and social protection. And World Bank and PRESIDENCY bigger, better-connected firms use "unfair" informal practices to beat International Finance out more productive formal competitors. The result is slower VICE Corporation that helps governments improve economic growth and a growing social divide between the informal their country's investment and formal parts of society. climate. Andrea Anayiotos is a consultant with FIAS. Informality is a common term for the output estimates that more than 70 percent of the DEVELOPMENT and workforce of firms not registered with the workforce in the developing world is informal government as well as the unreported activities (this larger percentage reflects the fact that SECTOR and workforce of registered firms. Thus by def- informal activities are less than half as produc- inition the size of informal activity is difficult to tive as formal ones). estimate. But the various methods devised to The Russian Federation and countries in PRIVATE "measure" informality, while yielding somewhat Sub-Saharan Africa, Latin America, and different estimates, all show that informality is Central Asia have the highest levels of infor- big and growing rapidly, especially in the poor- mality, often more than 50 percent of GDP. est developing countries. They have also seen the greatest increase in GROUP An authoritative measure--developed by informality since 1990. Informality also is grow- Friedrich Schneider, a professor at the ing fast in South Asia and the Middle East and BANK University of Linz, by synthesizing the methods North Africa, though from relatively low levels. and estimates of other analysts--shows that By contrast, in Central Europe the growth of informality accounted for more than 30 percent informality is slowing in the wake of extensive of all economic activity in the developing world microeconomic reforms, while in East Asia, WORLD in 2003 (Schneider and Klinglmair 2004). The where firms face smaller regulatory and tax picture in employment is even worse: the burdens, informality remains stable at fairly low THE International Labour Organization (2002b) levels (around 20 percent of GDP). In the R I S I N G I N F O R M A L I T Y R E V E R S I N G T H E T I D E industrial world informality accounts for less ing regulations designed to protect workers than 15 percent of GDP (figure 1). have instead discouraged firms from hiring for- mal employees--because compliance is so cum- Root causes bersome and expensive (World Bank 2004). What are the root causes of informality? Overly stringent and expensive government regula- Product informality tions in the labor, product, and land markets, Informal firms beat formal ones through product and an ever increasing tax burden imposed on informality. A large share of products and ser- an ever shrinking formal sector. vices in the developing world are informal, 2 because they fail to comply with product market Labor informality regulations or have been produced by unregis- Informal workers in developing countries have tered or unlicensed firms. Indeed, cumbersome few social rights, with no social security, sever- and expensive business registration procedures ance pay, minimum wage, or standards for work- are among the most talked about sources of infor- ing conditions. Moreover, they receive little mality. Industry-specific licensing restrictions are vocational training. Housing developers, for even more damaging. Developing countries example, commonly rely on labor contractors often have hundreds of such licensing regimes, providing very cheap informal labor and thus covering the entire range of economic activities. have few means and little incentive to train their The food sector shows how overly stringent volatile workforce. For the economy, the result regulations--in this case health standards on is low productivity. food products--end up doing more harm than Ironically, labor informality is largely a con- good, just as in the labor market. Consider the sequence of labor laws and regulations whose Arab Republic of Egypt, which continues to very aim is to provide workers with protections impose obsolete quality standards (rather than and benefits. Why the perverse results? The laws minimal health standards) on food products, and regulations tend to be either poorly with the result that more than 80 percent of its designed or too generous given the enforce- food is produced by informal, small-scale, low- ment and financial capacity of most developing productivity providers. Indeed, most food con- countries. As the World Bank's Doing Business sumed in the developing world evades all health project has shown, for example, hiring and fir- regulations. Product informality also results from poor enforcement of intellectual property rights and Figure Worsening informality lack of consumer information. Substandard 1 counterfeit products, increasingly widespread, 1990 Informal economy as a percentage of GDP 2003 can cause serious health hazards (such as 0 10 20 30 40 through outdated medicines) or reduce pro- Sub-Saharan Africa ductivity (through diluted fertilizers). Trade barriers are another source of informality, lead- South Asia ing to informal trade that puts formal manufac- East Asia and Pacific turers and retailers, which cannot risk relying on Middle East and smuggled goods, at a serious disadvantage. In North Africa the utility sector subsidized prices or govern- Latin America and ment monopolies lead to informality, by dis- the Caribbean couraging or preventing formal private Europe and Central Asia investment. Thus in Mumbai the inhabitants of Developing countries slums must cope with substandard and expen- (excluding China) sive water provided by informal water Industrial countries distributors--even as the rich residents of down- town penthouses enjoy almost free water pro- Source: World Bank 2004. vided by the state-owned monopoly. Land informality China) similarly avoided imposing a big tax bur- In the land market the root causes of informality den, by keeping public spending under control are unsecured and expensive land registration even while providing outstanding infrastruc- processes (see World Bank 2004), government ture, education, and health care. ownership of land, low property taxes, and subsi- dized utility prices that make developing new land Reversing the rising tide of informality a losing proposition for governments. As a result Fighting informality calls for a major simplifica- of all this, the supply of formally developed land tion of labor, product, land, and tax regulations indevelopingcountrycitieshasnotkeptpacewith along with privatization and drastic improve- 3 growth in the working-age population and migra- ment of governance in the public sector. tion from rural areas--and the price is often on a Reducing the stock and flow of regulations and par with that in rich country counterparts. This sit- procedures. Every country should conduct a uation leads to nearly half the urban population systematic inventory of its rules and regula- in the developing world living in slums. tions to eliminate all those that cannot be jus- But the economic cost of informal land is also tified. An independent body of professionals high. Companies operating on informal land should carry out this review (with participa- have no access to mortgage-backed financing, tion from the private sector)--and should which even in the United States remains the also review any new regulatory proposals. main source of long-term financing for small The McKinsey studies show that tackling and medium-size enterprises. In addition, land product market regulatory issues (entry and informality distorts competition in such key trade barriers, product standards, pricing industries as retail and housing construction as regulations) will have the greatest benefits. "land mafias" use their connections to obtain These issues also are relatively easy to deal informal land in prime locations at very low with, at least from a technical standpoint. prices (as housing developers and operators of Reducing and simplifying taxes and import tariffs. open-air markets do in Russia, for example). Governments always raise the specter of falling revenues as justification for imposing Tax evasion new or higher taxes--but in fact reducing Avoiding taxes is a key motivation for being and simplifying taxes and import tariffs often informal. Industry studies in developing coun- increases revenues by encouraging business tries by the McKinsey Global Institute point to activities and reducing the incentive for tax tax evasion as among the main reasons for per- evasion. If it does not, in some developing sistent low productivity in most large domestic countries donors could make up the differ- sectors, such as retail, food processing, and ence until unnecessary public spending is cut housing construction.1 A vicious cycle is at work: or new or better taxes (such as land property tax evasion by informal operators takes away the taxes) are put into place. productivity advantage of large formal firms, Increasing the stock of formal land. Many land leading to more informality--and forcing gov- reform attempts are mired in small-scale land ernments to collect more and more taxes from titling programs. A better way to start is to an ever shrinking formal sector. make government land available for private Industrial countries never had this problem, development (developing country govern- because they managed to avoid imposing a big ments own a lot of unused land) and to pri- tax burden on companies. France and the vatize utilities (or at least allow public-private United States in 1913--at the same level of eco- partnerships in new projects). This strategy nomic development as Brazil today--collected would have the double advantage of generat- less than 10 percent of GDP in overall taxes, ing the funds needed to develop infrastruc- compared with more than 30 percent for Brazil ture while lowering the price of formal land. today. The few developing economies that Relaxing tenant laws, zoning restrictions, and became rich in the 20th century (such as Japan, building codes is also a relatively quick and the Republic of Korea, Singapore, and Taiwan, easy way to increase the availability of formal R I S I N G I N F O R M A L I T Y R E V E R S I N G T H E T I D E land. Finally, rates of land property taxes (rel- Note atively easy to enforce equally) should be 1. See reports for Brazil (1998), Russia (1999), India increased to discourage speculators from (2001), and Turkey (2003), available at http://www.mc holding vacant land and to provide local gov- kinsey.com/mgi. ernments with the financial means and viewpoint incentive to develop more land for commer- References cial and residential use. CGAP (Consultative Group to Assist the Poor) and Improving access to credit. Since access to World Bank Financial Sector Network. 2004. Scaling Up is an open forum to affordable finance is among the main incen- Poverty Reduction: Case Studies in Microfinance. Washington, encourage dissemination of tives for companies to become formal, gov- D.C.: CGAP. public policy innovations for ernments should make lending to small Charmes, Jacques. 1998. "Informal Sector, Poverty and private sector­led and companies much more attractive to banks-- Gender: A Review of Empirical Evidence." Background market-based solutions for such as by strengthening creditor rights, paper for World Development Report 2001. World Bank, development. The views enabling secured lending (with both land Washington, D.C. published are those of the and movable assets as collateral), and raising de Soto, Hernando. 2000. The Mystery of Capital. New authors and should not be interest rate ceilings. New evidence from the York: Basic Books. attributed to the World Consultative Group to Assist the Poor, show- Djankov, Simeon, Ira Lieberman, Joyita Mukherjee, Bank or any other affiliated ing that private banks under competitive and Tatiana Nenova. 2002. "Going Informal: Benefits and organizations. Nor do any of pressure are much more likely to devise inno- Costs." World Bank, Washington, D.C. the conclusions represent vative ways to serve small businesses prof- International Labour Organization. 2002a. Decent Work official policy of the World itably, suggests that governments also should and the Informal Economy. Report VI, International Labour Bank or of its Executive privatize banks and reduce licensing require- Conference, 90th Session, Geneva. Directors or the countries ments on financial institutions to ease entry ------. 2002b. Key Indicators of the Labour Market. they represent. (CGAP and World Bank Financial Sector Geneva. Network 2004). ------. 2002c. Women and Men in the Informal Economy: To order additional copies Improving public sector governance. By reducing A Statistical Picture. Geneva. contact Suzanne Smith, the scope for government interference in the Schneider, Friedrich, and Robert Klinglmair. 2004. managing editor, economy,allthesereformsshouldhelpweaken Room F 4K-206, "Shadow Economies around the World: What Do We theimpactofpoorgovernanceandfocusscarce The World Bank, Know?" CESifo Working Paper 0403. CESifo (Center for 1818 H Street, NW, enforcement capacity on the main offenders. Economic Studies and Ifo Institute for Economic Washington, DC 20433. But it is also critical to improve governance. Research), Munich. Increasing transparency and accountability World Bank. 2004. Doing Business in 2005: Removing Telephone: would encourage companies to join the formal Obstacles to Growth. New York: Oxford University Press. 001 202 458 7281 economy (promoting e-government solutions Fax: that are easily replicated and scaled up is one FOREIGN 001 202 522 3480 way to help in this). Improving government ser- INVESTMENT ADVISORY Email: vices such as the police and judiciary would pro- SERVICE ssmith7@worldbank.org vide another strong incentive to do so. Forceful action along these five fronts is the Produced by Grammarians, only way to transform the vicious cycle of infor- Inc. mality into a virtuous one of formality--as more and more companies find that the benefits of Printed on recycled paper joining the formal economy exceed its costs. T h i s N o t e i s a v a i l a b l e o n l i n e : h t t p : / / r r u . w o r l d b a n k . o r g / P u b l i c P o l i c y J o u r n a l