Informal Labour and Credit Markets
Informality, usually regarded as an economic activity that is neither taxed nor monitored by the government, is common in emerging markets and developing countries where burdensome regulations and taxes coexist with poor public services and government’s weak enforcement capabilities. From this perspective, informality is often the result of inefficient public policies and the presence of an informal sector ultimately reflects the failure of political institutions to protect and promote an efficient and equitable market economy.
That said, there is disagreement over the definition of informality; whilst we refer to it in a general way above, in fact it is a changing term with a focus on either the firm (ILO (1972)) or the worker (ILO (2002)).2 Furthermore, in some countries, i.e., India, the informal sector is identified with the unorganized sector whilst in advanced economies the term usually refers to the ‘hidden’ economy implying some kind of tax evasion. Finally, it is also evident that informality is a general term and it needs to be defined with respect to both product and factor markets.3
Is informality actually good or bad? The evidence is mixed. On the one hand, informality is often viewed as bad for a number of reasons: It leads to inferior working conditions, social vulnerabilities, low productivity, unfair competition, disrespect for the rule of law, erosion of the legitimacy and integrity of public institutions, corruption, and last but not least, low fiscal revenues. The latter in turn prevent improving public services and strengthening institutions in charge of tax and regulation enforcement, making it harder to get rid of informality in the first place. Importantly, as reviewed in chapter VI.B, informality has been found to be negatively correlated with economic growth by compressing productivity and restricting access of informal firms and workers to necessary public services. The costs of informality appear even larger considering that the inability of enforcing environmental, workers’ welfare and consumers’ protection eventually hinders the integration of many developing countries into the global market in various ways.
On the other hand we report evidence revealing that informal credit markets are associated with positive growth rates (see chapter VI.B). In a world with imperfections in the product, credit and/or labour markets informality can increase efficiency and so can have a positive impact on the formal economy. This needs to be considered to arrive at a final conclusion on the overall impact of informality. For this reason, instead of focusing only on one aspect, a literature has emerged that assesses both the costs and benefits of informality4
Recent accurate data on the size of the informal sector are available for a number of emerging market and developing economies as reported in chapter II.B of this survey. In some of these countries, for example in Bolivia, India, Nigeria, Panama, Pakistan, Paraguay, Peru, informality has been estimated to characterize over three quarters of the labour force and little less than a half of total sales-implying a shadow economy as large as 60 to 70 percent of GDP. (See Perry et al. (2007) for more details).
Recognition of the impact of informal behavior on economic activity has given impetus to a growing literature on informality over the past few years. This literature includes work that attempts to quantify the extent of informality in various countries and work seeking to explain the causes and the nature of the informal sector, either by establishing regularities in the data or by devising economic models for policy analysis that stylize informal behavior.
Given that a large informal economy is generally thought to be detrimental for the official economy, not surprisingly, research effort has been directed to analyze possible ways to reduce its size. Understanding what drives informal behavior and how the informal sector evolves and reacts to various combinations of public policies—including fiscal, financial, social protection, labour market and enforcement policies—is crucial for the design of measures conducive to significant reductions in present informality levels. Moreover, a knowledge of informal labour and credit markets is important to understand the monetary policy transmission mechanism and the conduct of an effective monetary policy.
This survey reviews this literature and can serve as a point of departure for future research in those areas that remain uncharted or that require a deeper understanding. Our survey goes beyond existing surveys on informality that limit their review to either labour markets ,regional evidence that focuses exclusively on Latin America), or one type of equilibrium. (1999) that focuses uniquely on partial equilibrium models of informal credit markets). By contrast we emphasize the need for dynamic general equilibrium (DGE) and ultimately dynamic stochastic general equilibrium (DSGE) models for a full understanding of the costs, benefits and policy implications of informality.
The rest of the paper is organized as follows. Chapter II surveys the empirical evidence on informality. describes early models of informal labour markets. Chapter IV introduces the three margins of informality and the standard search-matching model. First, it discusses the intersectoral margin for workers and the traditional concerns of wage dualism. Second, it analyzes theoretical developments on the intersectoral margin for firms and finally resents the most recent theoretical developments on the intrafirm margin and the occupational choice. Chapter V discusses informality in the credit sector. Chapter VI describes the move to a dynamic general equilibrium approach to informality. Chapter VII concludes with a summary of a number of open questions.
The literature on the empirical evidence on informality takes at heart four main questions:
1. How do we measure the informal economy?
2. How large is the informal economy in the world?
3. What are the main drivers of the informal behavior? And last but not least,
4. What impact does informality have on the formal economy? Below we summarize key findings in these areas.