Informality: Issue 2

This is latest version (Issue 2) of this VoxDevLit, previous versions can be downloaded at the top of this page. Senior Editor Gabriel Ulyssea and Co-Editor Mariaflavia Harari discussed what we have learned about the informal sector from this living literature review on our podcast.

Abstract

Most low- and middle-income countries are characterised by a large informal sector, which implies that a substantial fraction of economic activity and livelihoods in these countries goes on completely unregulated. This has important implications for the behaviour of firms, workers, families, and consumers, which combine to have important effects on aggregate outcomes such as productivity, output, growth, and overall economic wellbeing. This VoxDevLit summarises a wide range of studies from well-identified empirical analyses to macro and structural equilibrium models of informality. The final goal is to provide an accessible, integrated understanding of the causes and consequences of informality for economic development.

Informal Sector Policy Summary

Low- and middle-income countries are typically characterised by high levels of informality, which has significant implications for firms, workers, families, and consumers that, in turn, can result in potentially large aggregate effects. This VoxDevLit summarises a wide range of studies to understand what we have learned about the causes of informality and its consequences for economic development.

This review is structured around three key dimensions: firms, workers, and housing. We start by summarising the main informality facts established in the literature. There are two key margins of informality regarding firms: (i) the extensive margin, whether firms register and pay entry fees to achieve a formal status; and (ii) the intensive margin, whether firms that are formal in the first sense hire workers without a formal contract – which is large and represents, for example, 56% of informal employment in Mexico and 40% in Brazil. Informal firms are typically smaller, pay lower wages, and earn lower profits than formal firms. Nevertheless, there is no empirical support for the “dual view” of informality, as formal and informal firms operate in the same industries, produce similar products, and there is a substantial overlap in formal and informal firms’ productivity distributions, even within industries.

Informal employment exhibits a U-shaped relationship with age, is higher among women and decreases with education. Informal employment expands during economic downturns, potentially providing a buffer against unemployment. However, flows in and out of informal jobs are typically associated with poor labour market outcomes and with a slippery job ladder. In housing markets, informality is widespread, with approximately 1.1 billion people (25% of urban dwellers globally) living in informal settlements or “slums”, characterised by a lack of formal property rights, inadequate infrastructure, and distinctive built environments.

The survey then moves on to discuss the main determinants of informality. We start with empirical studies that use both experimental and non-experimental designs to investigate the causal effects of different determinants of firms’ decisions to formalise. Research shows that simply reducing registration costs has limited effects on firm formalisation. The most effective approaches to increase formalisation include reducing ongoing costs of being formal (such as the tax burden), increasing benefits of formality (like access to credit), and increasing enforcement through inspections.

On the determinants of workers’ informality, we emphasise the role of public policies – such as conditional cash transfer programmes – and the role of human capital. The evidence suggests that social protection programmes sometimes create incentives for workers to remain informal. However, the evidence at the individual level is mixed, while at the local labour market level there is evidence that conditional cash transfer programmes can increase overall formal employment. Fertility plays a key role in women’s prevalence in the informal sector, as they show a much higher probability of being informally employed after the birth of their first child, while men are unaffected. Human capital levels significantly impact informality rates, with education being a key determinant of formalisation. Finally, the empirical evidence on the effects of minimum wages on informality is mixed, but evidence from quantitative equilibrium models indicates that the overall effect is negative: high minimum wages slow down the expansion of the formal sector or increase informality. Slum formation is influenced by rural-to urban migration, land market institutions, strategic behaviour of local governments, and rapid immigration.

In the final part of the review, we summarise research that investigates the consequences of informality. For firms, the literature shows that formalisation alone has no significant impacts on profitability or growth for most small businesses. Even when firms do formalise due to policy incentives, they rarely change behaviour in meaningful ways such as opening business bank accounts or accessing formal credit. However, the broader macroeconomic impacts of informality are significant. Higher enforcement against informal firms may increase aggregate productivity through several channels – by eliminating low-productivity informal businesses, reallocating resources to more productive formal firms, improving job matching, and encouraging human capital investment. Enforcement policies can also have adverse effects, potentially increasing unemployment and hurting vulnerable populations.

In the housing sector, informal settlements create potentially important equity-efficiency trade-offs. While slums provide affordable housing for low-income residents and may offer better access to labour market opportunities than peripheral formal housing, they create land misallocation issues that reduce overall urban productivity. Research shows mixed results regarding social mobility among slum residents, depending on the context. Some studies suggest slums provide pathways for advancement while others indicate persistent intergenerational poverty.

The timing and transition costs of formalisation policies remain important yet understudied issues. While the long-term equilibrium might show productivity gains, the transition period could involve substantial hardship for those directly affected. For instance, recent research on rural-urban migration shows stark differences between short-term negative impacts on formal employment (increasing informality) versus long-term positive effects that actually reduce informality and increase formal sector jobs.

Various policy approaches have been implemented to address informality. For firms and workers, enforcement policies can increase formalisation but may have adverse employment effects. Reducing tax burdens and entry costs has limited but positive effects. Education and skill development can significantly reduce informality rates. For housing, titling programmes have positive but not transformative impacts. Relocation schemes often fail due to reduced labour market access in new locations. Slum upgrading can provide immediate relief but may prolong slum persistence.

The informal economy represents a complex challenge for developing countries, with important trade-offs for policymakers. Successful approaches must account for the heterogeneity of informal actors and the multiple dimensions of informality. Future research should focus on the dynamics of informality over time, the interconnections between different forms of informality, and the transition costs of formalisation policies.

Informality: Presentation of key takeaways from Issue 1

For our launch event, Gabriel Ulyssea joined us to present the key takeaways from this VoxDevLit, highlighting policy relevant results from recent research on the causes and consequences of informality and the informal sector.