Bringing the Informal Sector into the Fold

By Masood Ahmed

(Version in عربي)

Unemployment rates in the Middle East and North Africa have remained above 10 percent over the past decade, the highest in the world. For the young the rates are even more daunting, at a persistent 25 percent: one in four of the region’s young people are without work. Many people who cannot find jobs in the formal economy are relegated to working in the informal sector, for lower wages and without the protections and opportunities that workers enjoy in the formal economy.

The informal economy is large and pervasive—and, often, ignored; however, the experience of those who work in the informal sector came under the media spotlight when Tunisian street vendor Mohamed Bouazizi set himself on fire that fateful day in December last year, sparking the Arab Spring protests.

Estimates indicate that the informal economy in the oil-importing countries of the Middle East and North Africa is substantially larger than in several Asian and Latin American countries. In Morocco, for example, the informal economy is estimated at 44 percent of officially measured GDP. In most other oil importers, it is estimated at close to one-third.

Trying to bring the informal sector into the fold has several advantages. Not only is it unregulated and untaxed, it typically provides only low-wage and low-productivity jobs. Rigid labor market and business regulations often reinforce the barriers between the formal and informal sectors. Trying to break these down will not only spur the economy but also help promote more inclusive growth.

Burdensome red tape, excessive taxes

So, why do people and enterprises remain in the informal sector? A large informal economy is often the consequence of a difficult business environment—one that is characterized by burdensome red tape, excessive taxes, and weak governance. Our analysis of the drivers of the informal economy in oil-importing countries in the Middle East and North Africa finds that

  • Labor market regulations―especially in Egypt, Lebanon, Morocco, and Syria―are often more restrictive than in other regions of the world, and contribute to the high cost of employment in the formal sector. In Egypt, for example, the high cost of firing employees impedes the expansion of formal employment; firms will either operate completely in the informal sector or hire employees informally to avoid these costs.
  • Weak institutions and governance mean that access to public services—and to the benefits of operating in the formal sector–is unavailable except to a privileged, well-connected few individuals or firms. Lack of transparency and weak governance often foster corruption, creating inequality of access to opportunities, finance, and services, eroding trust in public institutions, and making the formal sector inaccessible.
  • Overly restrictive product market regulations and high tax burdens raise compliance and entry costs, so that firms have strong incentives to avoid them by operating informally. If it is too costly or if it takes too long for a firm to comply with regulations in the formal sector, this will drive firms toward the informal sector. It may be cheaper for an informal firm to pay a bribe for public services or to avoid the enforcement of regulations.

Lost opportunities

Some may ask what’s wrong with having a large informal sector?

While the informal sector may provide some useful services, often both workers and the government lose out—workers because they operate in an unregulated environment, without protection, and the government because it loses an important source of tax revenue. In addition to not having access to social benefits, they also—over time—tend to see their skills dimish, because they don’t use their talents to the full and don’t get the chance to acquire new ones. They face little or no prospect of career advancement.

Lack of access to well-paying and productive jobs—particularly for the growing number of young labor-force entrants—translates into lost opportunities and is a source of tension, for individuals and for society as a whole.

What can policymakers do?

To improve access to economic opportunities and achieve more inclusive growth, policymakers will need to reduce the costs and burdens of entering the formal economy.

Changing labor regulations can make it less expensive for employers to hire workers formally.

More straightforward rules for establishing and operating a business will encourage entrepreneurs to start businesses on a formal basis. Enforcing the rules fairly and consistently means that firms share not only the responsibilities but also the benefits of operating formally.

Simpler tax regulations and stronger administration will complement these reforms. At the same time, workers in the informal sector will need help in acquiring the skills demanded by the formal sector.

The Arab Spring has reminded us that growth is not enough in itself, particularly if its gains are captured by a privileged few and not spread broadly. Indeed, the presence of a large informal sector serves as a red flag that a country’s growth is not inclusive enough.

10 Responses

  1. Thank you Mr Masood to have presented the causes of the the informal economies (like many economists you have a culture, which looks for economic abnormalities in causes — To me, this is fine)
    Who is benefiting? (another way to look at these unformal/formal issues). Also what about outside causes–there maybe other viewpoints like decision-taking that are beneficial for some and detrimential for others.

  2. Are there reliable estimates of the size of informal economies by country?

    • Barry,
      In Annex 2.1 (Addressing Informality and Promoting Inclusion) of the IMF’s Middle East regional economic outlook October 2011, we provide estimates of the size of the informal economy of Egypt, Jordan, Lebanon, Morocco, Syria, and Tunisia. These estimates are derived using a Multiple Indicator–Multiple Cause model typically used in the literature (see Friedrich Schneider, Andreas Buehn, and Claudio Montenegro, 2010, “New Estimates for the Shadow Economies All Over the World,” International Economic Journal, 24(4), pp. 443–61). That source also includes a table showing the development of the shadow economy in 162 countries between 1999 and 2007.

      Hope this helps

  3. I think the same issues bedeviling governments right now, such as poor governance practices, manipulation of markets and loss of income from retrogressive fiscal polices or the absence of proper revenue collection systems, are the same things start ups, the informally employed and SMEs are having to grapple with. Something has to be done to harness the talent out there, subject it to a systematic process of refinement and development. Pragmatic policies have to be put in place to assist the informally run businesses to approach a more structured best practice way of doing things, to assist them to model the markets they aim to navigate and score sustainable sales and to raise finances through professional financial management practices. Government must view the informal sector as a bastion for creativity and encourage innovation by exposing the informal sector to a conducive environment conducive to the brooding and hatching of enterprise.

  4. What happens is that the formal sector turns into the informal sector as the informal sector grows so employers can pay less in wages and conditions! This is happening in every country.

    The more people there are, the greater number of people looking for work and applying for the same job.

    No matter how much the government of a country cuts taxes and red tape, the employer will still want the cheapest possible worker they can get, so what needs to happen in that the laws need to be changed and enforced where the worker is protected and employers to pay the correct amount and conditions, but then again the governments are making money from this as well!

    • Yes, indeed the contribution of the informal economy in most developing countries, notably in Africa, is overlooked or underestimated. There are a number of reasons as to why enterprises remain in the informal sector — unattractive business environment, red tape, high tax rate and a non-transparent tax regime, etc, etc. Reducing taxes, firing costs, etc, can play a role to reduce informality in an economy. However, it should be emphasized that these should be accompanied by other equally important considerations such as the provision of efficient business development services, better access to finance, and capacity building to the enterprises in the formal sector. This provides a signal to the informal sector operators that being in the formal sector is not as costly as they imagine it to be (reasonable tax rates, easy registration and start-up, etc.), but it also comes with additional advantages — such as better access to finance and business services, etc. that are not available for informal enterprises).
      However, in addition to such incentives, policymakers should also have a clear strategy and action plans for formalization that may be costly in the short term, but will a significant long term positive effects (through improved tax collection, better enterprise linkages, improved firm level productivity and improved national outputs…).

  5. With a sluggish economy in many parts of the world, the informal sector is going to increase unless and until governments are willing, at the least, to implement these suggestions and others as the situation warrants.

    The prevalence of these informal sectors have also led to the growth and spread of urban slums, a rise in crime, lawlessness, sprawling unplanned commercial real estate, a strain on the limited available social services (which only the formal sector supports via taxes).

    Strict labor laws and requirements for starting a business have also contributed to brain drain and discouraged investment, two significant factors that could have furthered progress, created jobs, and paid taxes.

  6. The world population has touched the figure 7 billion.The biggest economies of the world, including those of the EU and America, are facing acute economic pains related to debts and deficits. There is unemployment, slowing GDP growth, rising commodity prices, especially oil and more. The income levels of even those employed remain the same due to the on going crisis. Under the circumstances, the employers in the formal sector are always in search of loopholes in the rules of the game to pay less taxes and squeeze the employees by reducing working hours, slashing the strength of the working force and depriving them of rise in pay and fringe benefits.
    Foe example in America there are reportedly 12 million illegal immigrants –skilled or unskilled. They work here to feed themselves and also remit money home for rest of the families outside. And according to informal sources of information most of them work on a cash basis or some are self employed. So what to talk about their will and ability to pay tax. In fact these are the basic factors for the abnormal growth of the informal sector. And it is not confined only to the ‘Arab Spring’ or Africa. For information, according to the latest report the European Commission’s task force on Greece has reported billions of euros of tax evasion while its economy is almost sinking for want of cash to pay its employees and pensioners.
    Therefore whatever is said about the formal and informal sector being brought into the grip of rules, regulations, and the desirable practices of trade and industry is a myth. I say this because it is next to impossible to try to ‘amake silver purse out of a sow’s ear’ under the prevalent circumstances. It is also worth noting that GDP growth follows growth in employment and boost in trade/industrial activities; not the other way around. And the cure lies in fiscal/financial reforms so that ways and means are developed to put money in the pockets of people to be able to spend and look forward to a brighter future.

  7. Yes, the informal sector is unregulated which is a loss for the government and the people. But if the government or the economy is unable to create jobs for the all of them where do these guys go?

    I recently read an article that the informal sector combined all over the world is worth almost $10 billion, which is huge and still profitable in these times.. may be the regulated (so called educated sector) might have a lot to learn from the informal guys

  8. [...] View detail here: iMFdirect – The IMF Blog [...]

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