Introduction

The aim of this chapter is to review the major competing theories of the informal economy, namely: modernization theory, which argues that economic underdevelopment and unmodern systems of governance cause large informal economies; neoliberal theory, which asserts that too much government intervention (e.g. high taxes, burdensome regulations and controls) is the cause; and political economy theory, which conversely argues that inadequate state intervention and the lack of protection of workers are the causes. This is followed by a review of institutional theory which asserts that formal institutional failures lead to an asymmetry between formal rules, and informal norms, values and beliefs, resulting in greater prevalence of the informal economy.

Modernization theory

Over the course of the twentieth century, modernization theory was the dominant explanation for large informal economies. In this theory, the informal economy is part of the pre-modern economic system and its presence in economies will reduce as the modern formal economy becomes established (Geertz 1963; Gilbert 1998; Lewis 1959; Packard 2007). As Ray Bromley (2007: xv) explains, the informal economy from this perspective is “unimportant and destined to disappear” with economic development and the modernization of governance. Sometimes referred to as “residue” or “dual economy” theory, the informal economy is portrayed as a leftover from an earlier economic system which is disappearing with economic development and modernization.

This dualistic representation of the economy as composed of discrete formal and informal economies is associated with scholars such as Julius Boeke (1942) in relation to his studies on South-East Asia, and the economist Arthur Lewis (1954). The depiction of the formal and informal economies as dualistic opposites differed to the then dominant neoclassical economic models, although Lewis was in that tradition. At the core of the dualist view was the view that less developed countries had two different sectors. One was capitalist, modern, progressive, dynamic and depicted as capital-intensive. The other, the “subsistence” or “peasant” sector (or in later terminology the “marginal” sector) was pre-capitalist, reliant on family labour, unsophisticated in its production and operations, used low technology and possessed poor productivity.

Introduction

What is the informal economy? Why is it important to study? And what needs to be known about this sphere? The aim of this opening chapter is to answer these three key questions. In the first section, the various nouns and adjectives used to denote this sphere are reviewed along with the different definitions that have been used. The second section then reviews why it is important to study. To address this, it is necessary to consider the reasons from the perspective of not only informal workers and businesses, but also formal enterprises and workers, consumers as well as governments and societies. This will show that the negative consequences far outweigh any positive implications. The third and final section of this chapter then outlines the structure and argument of the book. At the outset, however, it is necessary to define the type of activity being discussed in this book.

What is the informal economy?

Ever since Keith Hart (1973) first introduced the concept of the “informal economy” in his study of Ghana nearly half a century ago, there has been an ongoing debate about how to define this sphere of economic activity and differentiate it from the formal economy. Indeed, what is here referred to as the “informal economy” has been alternatively denoted using over 45 different adjectives and 10 different nouns. It has been variously called the “black”, “cash-in-hand”, “hidden”, “irregular”, “invisible”, “shadow”, “subterranean”, “undeclared”, “underground”, “unobserved”, “unorganized” or “unregulated” economy, sector, work, employment, activity, sphere or realm, to name but a few.

Casting one’s eyes over these adjectives, it becomes quickly apparent that all describe in various ways what is missing, insufficient or lacking about activity in the informal economy compared with activity in the formal economy (e.g. it is unorganized, unregulated or undeclared). Indeed, this is also a feature of all definitions of the informal economy. Reviewing the different types of definition used, three broad kinds can be identified, namely enterprise-, jobs- and activity-based definitions. Enterprise-based definitions describe what is absent, insufficient or lacking in informal economy enterprises compared with formal enterprises, jobs-based definitions what is absent, insufficient or lacking in informal jobs relative to formal jobs, and activity-based definitions what is absent, insufficient or lacking in informal economic activities compared with formal economic activities.

Introduction

What types of informal work exist? Who participates in the informal economy? Why do they do so? This chapter seeks answers to these questions regarding the characteristics of the informal economy. To do so, the first section introduces the different types of work in the informal economy, revealing how over recent decades a plethora of heterogeneous forms of work have been recognized to exist in the informal economy. Secondly, and to analyse who engages in the informal economy, the widely-held marginalization thesis is evaluated which holds that it is groups marginalized from the formal labour market who are more likely to participate in the informal economy. Thirdly, the reasons for participation in the informal economy are evaluated. This will analyse whether it is indeed the case that the participation of workers in the informal economy is largely necessity-driven due to their exclusion from the formal economy and alternative means of livelihood, or whether at least some workers participate in the informal economy because they desire to exit the formal economy, perhaps due to the level of public sector bribery and corruption they witness when seeking to work in the formal economy. Having reviewed who supplies informal work and their reasons for doing so, the fourth section then turns to the demand-side and evaluates who purchases goods and services in the informal economy and their motives for doing so. Whether goods and services are purchased in the informal economy solely due to them being cheaper, or whether other reasons for doing so also prevail, will be examined in the context of a case study of the 28 countries of the European Union. Finally, some conclusions will be drawn about the character of the informal economy in terms of what it is, who participates and why they do so.

Types of informal work

During the latter half of the twentieth century until around the 1980s, a widely-held view was that work in the informal economy was low-paid waged employment conducted under “sweatshop-like” exploitative conditions in which legislation on health and safety standards, minimum wages, holiday entitlements, working hours and so on, did not apply.

Introduction

The aim of this concluding chapter is to synthesize the material from the previous chapters and to draw conclusions about the way forward for measuring, explaining and tackling the informal economy. To do so, the starting point is the set of questions posed at the start of this book. What different theories have been used to explain the informal economy and how have the dominant theoretical explanations changed over time? How can the informal economy be measured and what is its size? What types of informal work exist, who does it and what are their motives for participating in the informal economy? And what policy options are available for tackling the informal economy? What is the current approach being pursued and why, and what alternative policy approaches and measures might be instead used to tackle the informal economy? In this concluding chapter, how these questions have been answered will be reviewed along with fruitful future directions for research on the informal economy.

Defining the informal economy

Reviewing the competing enterprise-, jobs- and activity-based definitions, the informal economy was defined in Chapter 1 as socially legitimate paid work that is not declared to, hidden from, or unregistered with, the authorities for tax, social security and/or labour law purposes when it should be declared. If the activity is illegal in other respects and/or deemed socially illegitimate, then this activity is not considered part of the informal economy but instead part of the criminal economy (e.g. forced labour, selling stolen goods, trafficking illegal drugs) which is both illegal from the viewpoint of formal institutions and illegitimate from the viewpoint of informal institutions. Given the strong consensus amongst scholars about what is the informal economy, and what is not, there is seen to be little need for future research to expend much energy on defining the informal economy.

The only issue that might be considered in this regard is that the above definition of the informal economy adopted in this book gives a little too much emphasis to agency when defining the informal economy.

Introduction

Those hearing figures regarding the size of the informal economy for the first time, akin to more seasoned scholars, are correct to be deeply sceptical about these estimates of its magnitude. Not only is the informal economy by its very nature a hidden phenomenon and therefore difficult to measure but estimates of its size often vary markedly. For example, estimates of the size of the informal economy in Romania range from 9.5 to 37.8 per cent of GDP, and in Germany from 1.0 to 17.1 per cent (GHK & Fondazione Brodolini 2009). To understand such startlingly different measurements of the size of the informal economy, however, it is necessary to comprehend the various methods being used to measure its magnitude.

In this chapter, therefore, the next section briefly introduces the various measurement methods. These range from indirect methods that seek statistical traces of the informal economy in data collected for other purposes to more direct survey methods. Following this, the third section then reports a study of the variations in the size of the informal economy in the European Union using an indirect measurement method, namely the labour input method (LIM), and then uses these estimates to evaluate the theories discussed in the last chapter by comparing whether there is a significant correlation between cross-national variations in the size of the informal economy using this indirect measurement method and cross-national variations in the structural determinants highlighted to be important in each theorization. This is then followed, in the fourth section, by a reporting of the cross-national variations in the size of the informal economy in developing countries using a direct survey approach, along with whether similar correlations are identified between the size of the informal economy and various structural determinants. The fifth and final section then draws some conclusions about the measurement methods and the validity of the different theorizations discussed in the last chapter that seek to explain the country-level variations in the size of the informal economy.

Methods for measuring the size of the informal economy

Two broad types of method exist for measuring the size of the informal economy: indirect and direct.

Introduction

Having shown the multifarious forms of informal work, diverse population groups who participate and wide range of motives for participation, we now turn to the issue of tackling the informal economy. To do so, this chapter reviews each of the four possible hypothetical policy goals available to governments: taking no action; eradicating the informal economy; deregulating the formal economy; or formalizing the informal economy. In each case, the disadvantages and advantages of these policy options are reviewed. This will reveal that if no action is taken, the disadvantages far outweigh the advantages. Secondly, if eradicating the informal economy is pursued as the policy goal, the disadvantages again outweigh the advantages, as is also the case when deregulation of the formal economy is pursued. In consequence, this chapter will argue that formalizing the informal economy is the most viable policy goal. Indeed, this is also the conclusion of the supra-national agencies when considering what is to be done about the informal economy (European Commission 2016; ILO 2015; OECD 2016).

Given this goal of formalizing the informal economy, the second section of the chapter reviews the policy measures available for achieving this objective. This will set out two broad sets of policy measures. On the one hand, there are direct policy measures, which seek either to dissuade participation in the informal economy and/or to incentivize and encourage participation in the formal economy. To do so, measures are used that directly increase the costs and reduce the benefits of informality, as well as reduce the costs and increase the benefits of operating in the formal economy. The aim in doing so is to address the formal institutional failing, namely the powerlessness of formal institutions, which results in the greater prevalence of the informal economy. Using these direct policy measures on their own, however, does not tackle the other formal institutional failures and imperfections that produce institutional asymmetry and thus the greater prevalence of the informal economy.

On the other hand, and to address these other formal institutional failures that lead to institutional symmetry and to large informal economies, indirect policy measures can be used.