Informality: Issue 2

Most low- and middle-income countries are characterised by a large informal sector, which accounts for 30-70% of GDP, 20-80% of the labour force and an equally large share of firms (Ulyssea 2020). This means that a substantial fraction of economic activity in these countries is completely unregulated, taking place at the margin of tax, labour and other relevant regulatory frameworks.

An equally large, but often overlooked, dimension of informality refers to housing. Informality in land and housing markets is widespread in low- and middle-income countries. A striking example is the prevalence of informal urban settlements, often referred to as “slums”. These areas are estimated to house 1.1 billion people corresponding to around 25% of urban dwellers globally. Projections indicate an additional 2 billion residents over the next three decades (UN, The Sustainable Development Goals Report 2023).[1]1. The majority of those living in slum-like conditions are concentrated in three key regions: Latin America and the Caribbean (110 million), Sub-Saharan Africa (228 million), and East and South-eastern Asia (589 million) (UN Habitat 2024).

These high informality levels have deep implications for individual behaviour – not only firms and workers, but also families and consumers – which build all the way up to aggregate outcomes, generating important effects on outcomes such as productivity, output, human capital, inequality, welfare and growth. Thus, a complete understanding of the causes and consequences of informality requires integrating both its micro and macro dimensions. This VoxDevLit does this by covering a wide range of studies that go from wellidentified empirical analyses to macro and structural equilibrium models of informality across different dimensions.

We start by defining what informality is. We define informal firms and workers as those who do not comply with the relevant laws and regulations. For firms, this can correspond to, for example, not being registered with the tax authorities, while informal workers are those who do not have a formal labour contract. This is the definition used throughout this review. While this criterion might be straightforward for workers, it is less so for firms, as their compliance decision is unlikely to be a binary choice. In both developed and developing countries, many formally registered firms underreport revenue to evade taxes and are therefore in partial compliance with tax regulations. Similarly, many formal firms hire informal workers to evade labour regulation costs. We thus use the same definitions from Ulyssea (2018) and distinguish between the following margins of informality: (i) extensive margin, whether firms register and pay entry fees to achieve a formal status; and (ii) intensive margin, whether firms that are formal in the first sense hire workers without a formal contract.[2]2. We restrict the definition of the intensive margin to compliance or not with labour regulations because of data limitations, as information on tax evasion at the firm level – another important intensive margin of informality – is typically unavailable.

Regarding informal housing, there is no universal consensus on what defines a slum. The UN’s definition includes tenure insecurity as one of five sufficient but not necessary conditions, alongside lack of durable housing, insufficient living area, and lack of access to water and sanitation (UN-HABITAT 2006/7). In this review article we use the term “informal settlements” or slums interchangeably to refer to areas that are lacking formal property rights and that exhibit slum-like conditions. Using these definitions as a starting point, in Section 2 we summarise the main informality facts established in the literature regarding firms, workers, and housing. These facts set the scene for the discussion that follows and highlight many of the key dimensions of informality. Section 3 discusses the main determinants of informality investigated in the existing literature. We start in Section 3.1 by covering the main empirical studies that use both experimental and non-experimental designs to investigate the causal effects of different determinants of firms’ decisions to formalise. These determinants can be classified into two broad groups: (i) those associated to the costs of entering the formal sector, such as the costs of formally registering a business; and (ii) those related to the costs of remaining formal, such as tax payments and administrative costs associated to being formal (e.g. tax compliance). In Section 3.2 we focus on the evidence on the roles of tax structure (and not only the tax burden), trade, and minimum wages in determining the levels of informality. Section 3.3 discusses the determinants of workers’ informality, while Section 3.4 reviews the latest evidence on the nexus between rural-urban migration and informality. Section 3.5 covers the determinants of slum formation and growth.

In Section 4 we review the literature that investigates the consequences of the different dimensions of informality for firms, taxation and redistribution, human capital accumulation, labour market power, social mobility, productivity, output and growth. On the latter, most of the literature covered in this Section combines extensive use of rich micro data, with partial or general equilibrium models that aim at rationalising a broad set of empirical regularities. In that sense, most of them build from micro behaviour to aggregate outcomes to assess the potential effects of different formalisation policies on the levels of informality and other key aggregate outcomes of interest.

This is the second release of the VoxDevLit on informality. The first edition largely built on a previous and quite comprehensive review by Ulyssea (2020), while this second edition expands in several exciting directions, most notably by incorporating the broad topic of housing informality. As this is a dynamic literature review, this document will be updated regularly to include new and exciting studies as this body of academic work continues to evolve. We look forward to readers’ feedback on the review, and to ongoing discussions on this fascinating topic.

References

Ulyssea, G (2018), “Firms, informality, and development: Theory and evidence from Brazil”, American Economic Review, 108:2015–47

Ulyssea, G (2020), “Informality: Causes and consequences for development”, Annual Review of Economics, 12:525-546.

United Nations (2023), The Sustainable Development Goals Report 2023: Special Edition, United Nations.

UN Habitat (2006), State of the World’s Cities 2006/2007: The Millennium Development Goals and Urban Sustainability, United Nations Human Settlements Programme. https://unhabitat.org/state-of-theworlds-cities-20062007.

UN-Habitat (2024), Global Monitoring of Slums. https://data.unhabitat.org/pages/global-monitoring-ofslums.