Impact of the Informal Economy on Development

What is Informal economy? Simply put the informal economy refers to those economic activities that are neither taxed nor monitored by a government and are therefore not included in that government’s Gross National Product (GNP) However in literature this phenomenon is discussed using different concepts such as informal, unofficial, irregular, parallel second underground, underground, grey markets, subterranean, hidden, invisible, unrecorded, shadow, ghosting and moonlighting. Illegal or criminal activities such as drug dealing or prostitution have been excluded from this definition, as have exchanges of unpaid work.

My paper is therefore prepared with this omission in mind. Introduction “In many developing countries, unofficial economic activity (that conducted by unregistered firms or by registered firms but hidden from taxation) accounts to between a third and a half of the total. This share declines sharply as the economy develops. Despite the sheer magnitude of this unofficial activity, little is understood about its role in the process of economic development, and in particular about how important “officializing” these hidden resources might be for economic growth. ” (Rafael La Porta and Andrei Shleifer pg 1)

Role of informal economy on development A recent cross-country report presented by authors Rafael La Porta and Andrei Shleifer that appeared in the Brookings Papers on August 2008 aims to improve the understanding of the relationship between economic development and the informal economy. The report distinguishes between three alternative views of the role of informal economy in development. The Romantic View: According to this view unofficial firms are either actually or potentially extremely productive, and are held back by government taxes and regulations, as well as by lack of secure property rights and of access to finance.

Pending the necessary legal reforms “four billion people around the world are robbed of the chance to better their lives and climb out of poverty, because they are excluded from the rule of law” (United Nations, 2008, page 1). If the barriers to officialdom are lowered and capital is supplied through micro finance, unofficial firms will register, borrow, take advantage of other benefits of official status, and by doing so expand and spark economic growth. The key aspect of this optimistic view is that unofficial firms are fundamentally similar to the official ones, but kept down by policy.

In particular, unofficial firms should look similar to official firms with respect to characteristics not affected by government policies, such as the characteristics of entrepreneurs (e. g. , their education, level of expertise etc). The two authors carried out a research on the unofficial economy and economic development using data from World Bank firm level surveys. According to their findings the tentative picture that emerges is inconsistent with the romantic view. It shows that unregistered firms have been around for a long time (7 to 10 years), but their sales are still trivially small.

Moreover, few registered firms started out unregistered. The small size of unregistered firms is symptomatic of uneducated management and low? quality assets. When public goods are unreliable, unregistered firms are too small to afford owning generators, computers, or transportation equipment. They do not have large firms as clients. They do not export. Despite emphasis on access to credit as the key to igniting the growth of unregistered firms, lack of external finance appears to be an attribute of all small firms in poor countries and not just of unregistered firms.

Conclusively it can be inferred that the limitations of unregistered firms appear to be far more severe than acknowledged by proponents of the romantic view. Unlike the parasite view, the dual model does not see the unofficial firms as threatening the official ones, because they are hugely inefficient and are unlikely be able to charge lower prices for the same products. Indeed, official and unofficial firms operate largely in different markets and have different customers.

The dual view sees the unofficial firms as providers of livelihood to millions, perhaps billions, of extremely poor people and cautions against any policies raising the costs of the unofficial firms. The dual view sees the hope of economic development in policies, such as human capital, tax, and regulatory policies that promote the creation of official firms, letting the unofficial ones die as the economy develops. The official firms will be new firms run by new people, not the previously unofficial ones.

The parasite and dual view are skeptical about the unofficial firms, and in particular see them as quite unproductive not just because they are deprived of the benefits of the official status, but also because they are run by lower human capital entrepreneurs. The parasite view sees the unofficial firms primarily from the perspective of their illegality. These firms need to stay small to avoid detection and, therefore, lack the necessary scale to produce efficiently. However, the “substantial cost advantage that informal companies gain by avoiding taxes and regulations more than offsets their low productivity and small scale” (Farrell, 2004, page 28).

The cost advantage conferred by avoiding taxes and regulations allows unofficial firms to undercut official firms in prices. Informal firms then hurt growth both because their small scale makes them unproductive and because they take away Impact of informal economy on development Despite the fact that the informal economy supports the formal sector and plays a part in redistributing wealth, there are some problems associated with it. When large numbers of businesses fail to register, ignore labour laws, flout regulations, and evade taxes, they hinder the expansion of more productive, modern companies.

According to Mckinsey’s Diana Farrell, ‘ Tiny traders in the informal economy put a powerful brake on a country’s growth rate, locking it into a condition of “emerging but never quite making it,” and condemning those living and working in the gray economy to a lifetime of insecurity and poor living standards. For Asian nations with large informal economies — the Philippines, Indonesia, Thailand, India, and Vietnam among them — this is bad news indeed. ” The existence of an informal economy results in an unhealthy relationship between the government and its citizens.

An imbalance between the tax amount paid and the public services that the tax payers’ benefit from may result in dissatisfaction of tax payers and force them to go into the informal sector. As a consequence of this reaction there may be problems in financing the public services and goods which are necessary for the economic and social structure of the country. A company acting informally can get its input with a lower price, compared to a firm working formally. Thus the informal firm can decrease its variable costs and may reflect this advantage to its prices. Decreased prices affect the competitors’ profits by attracting the demand.

As a result of this it may be expected for the enterprise acting in the formal economy to either leave the market or start to produce in informal sector. Productiveness and efficiency of Businesses operating informally is hampered by a lack of legal protection, restricted access to capital and business support, lack opportunity to grow beyond a certain size. They also risk detection and prosecution and as a result may not operate at their optimum level. Informal firms can also affect the society by creating a culture whereby formalised businesses are tempted away from complying with employment law.

Tax avoidance and benefit fraud results in a loss of state revenue which in turn hinders the ability of government to pursue socially beneficial initiatives. The loss of state revenue may cause a rise in taxes which can in turn encourage an expansion of the informal economy, leading to a descending spiral. The informal economy leads ineffective development policies. This is because undeclared work skews statistics (such as employment figures), meaning that public policy is premised on inaccurate information. Conclusion The informal economy therefore plays an integral part in economic development be it positive or negative.

This is especially so in developing countries which are characterized by a vast majority of people working and earning their livelihood in this sector. It is of paramount importance for policy makers to develop appropriate policies and strategies which take into account both the positives and negatives of the informal economy and their direct or indirect link to the formal economy. REFERENCES: Farrell, Diana (2004), “The Hidden Dangers of the Informal Economy. ” McKinsey Quarterly 2004, no. 3: 26–37 and (2006) “Tackling the Informal Economy.