Informality: Issue 2

This VoxDevLit review attempts to provide a comprehensive coverage of the extensive economic literature that analyses the causes and consequences of informality in developing countries. This literature is not only extensive but also quite broad in terms of methodologies used, ranging from well-identified empirical studies (both experimental and non-experimental) to equilibrium macro models and structural empirical models. This seems not only natural but necessary for a more complete understanding of this important economic phenomenon.

We believe that this review piece shows that the literature has made substantial progress in understanding the main determinants of firms’ choices regarding informality, both theoretically and empirically. Indeed, the literature has put a lot more emphasis on the analysis of firms’ than workers’ behaviour. However, even on firms’ side there remain many important unanswered questions. In particular, the literature has only started to explore more the dynamics of firms’ decisions regarding the different margins of informality and how they potentially interact with different frictions that firms face. For example, does informality work as a steppingstone for entrepreneurs with high-growth potential but who might be constrained by, say, credit constraints?

On the workers’ side, the gaps in knowledge are arguably wider. We need a deeper understanding of the determinants of workers’ choice/allocation between formal and informal jobs, what determines their permanence and evolution in either, as well as the main tradeoffs they face. As in the case of firms, we do not know how much informal jobs represent a stepping-stone for younger workers versus the extent to which there is an “informality trap” that makes future transitions into formal employment very unlikely. Related to this point, there are still very few studies that investigate the life-cycle dimensions of informality.

Regarding housing informality, there are several avenues for future research. Key open questions remain about upward and intergenerational mobility, human capital accumulation, and labour market dynamics for slum residents. Addressing these aspects would also have direct policy implications to help design personbased interventions to complement the prevailing place-based ones. Advancements in big data sources, such as cell phone records or imagery, offer the potential to generate richer datasets, which will be useful to capture higher-frequency dynamics of slum evolution and to link people to places. An understudied but crucial aspect is the role of the formal housing supply and the “missing market” for lowincome formal housing. The lack of housing finance systems that are accessible to the low-income sector should also be brought to the attention of policymakers. Also, it should be recognised that housing informality is connected with informality in other key markets for urban residents, including labour, transportation, and credit. Housing, employment, and commuting decisions are taken jointly. Integrating research on slums with research on urban labour markets, transportation, and firm location choices will be important to understand the tradeoffs that slum residents face, advance our understanding of slum economies, and ultimately inform policy.

Finally, on the analysis of the aggregate implications of informality, a very important unexplored dimension is the transition dynamics between equilibria. This is arguably very important to understand both the political economy of informality and formalisation policies, but also to provide a more accurate assessment of the welfare implications of different formalisation policies.