High Informality=Economic Stagnation

05.16.2006

Last week’s MSNBC story on high levels of informality and economic stagnation is an interesting one:

What do Japan, Singapore, South Korea, and Taiwan have in common? Obviously, they are Asian nations that joined the ranks of the wealthy during the second half of the 20th century. But a less well-known shared feature is that none of them have much of an informal economy.

Research on economic development from the McKinsey Global Institute [MGI] and others shows consistently that these two facts are closely related. Sadly, the converse is also true: When large numbers of businesses fail to register, ignore labor laws, flout regulations, and evade taxes, they hinder the expansion of more productive, modern companies.

The story disputes one of the myths associated with the informal sector activities – that informality is limited to small business operations:

…some are very large operations. In our studies on developing-country economies, MGI has found supermarket chains, software distributors, auto-parts suppliers, consumer-electronics assemblers, even large-scale industrial concerns — especially in labor-intensive manufacturing — operating in the gray economy.

And, finally, on the issue of job creation (surprise, surprise, Sweden!):

Policymakers in developing countries may feel that slower growth is a price worth paying for the jobs that their informal sectors create. They certainly employ a lot of people — the International Labor Organization estimates that more than 70% of the workforce in the developing world works informally.

But formal companies can create jobs just as well if they are not overburdened with taxes and red tape. Indeed, onerous labor taxes everywhere encourage employers to underreport their payrolls. Even in highly developed Sweden, informal employment is growing, because Sweden has the second-highest labor taxes in the world.

70% of the global workforce in the informal sector? Hard to believe (and even harder for me to conceptualize), but then you see news coming out of Mozambique (87% in the informal sector), Ghana (85% of female non-agricultural labor force is in the informal sector), and even China…

Check out the informal economy share of GNP numbers from the World Bank’s Doing Business Database. This might be a better statistic to look at in terms of the impact informal employment has on the economy. The numbers, certainly, reveal some trends – it is not surprising to see countries like Georgia (67.3%), Bolivia (67.3%), Panama (64.1%), and Azerbaijan (60.6%) top the list while Switzerland (8.8%), the United States (8.8%), Austria (10.2%), and Japan (11.3%) occupying the opposite side. On average, the difference between countries in Sub-Saharan Africa and Latin America (over 40% of GNP) and the OECD countries (17.4%) is hard not to recognize.

Some interesting opinions from around the world on the issue can be found in this discussion [from several years ago] on the World Bank website. I think that one of the greatest difficulties in measuring the size and the impact of the informal sector lies in identifying informality and drawing the line separating informal sector activities from formal economy. As noted in the intro, for example:

The size of informal labor market is especially hard to measure. “Underground” labor may consist of a second job after (or even during) regular working hours, informal economy work by individuals who do not participate in the official labor market, and employment of people (e.g. clandestine or illegal immigrants) who are not allowed to work in the official economy.

But should all these numbers come as a surprise to the people living in developing countries? Well, here is what Hernando de Soto had to say about this a decade and a half ago in his The Other Path:

Since 61 percent of the hours worked in Peru are informal, there is obviously a long frontier between the informal sector and the state authorities. Some informal businesses are completely clandestine, but it is inconceivable that 61 percent of all the work done could be carried out illegally without the authorities in some way turning a blind eye. This systematic corruption undermines the principle of authority in the country as a whole. It could be argued, in strictly economic terms and with the necessary doze of cynicism, that bribes replace the taxes which the informals do not pay, for they achieve similar results. However, bribes also involve an undesirable element of misconduct which is absent from taxes.

Hernando essentially equates tolerating (and supporting) informality with hindering the rule of law, the lack of which is one of the reasons for the continued plight of many fragile democracies! If that is true (and I believe it is) do we need any more incentives to wage the war on informality and its root sources – overregulation of business and micromanagement of economies?