{BSOX-21(N)}

INFORMAL
ECONOMY

Qazi Areeb
202005578
Sem-II, B.A. (H) English
Define informal economy and
briefly discuss its different
schools of thought.
The informal economy is the diversified set of economic
activities, enterprises, jobs, and workers that are not regulated
or protected by the state. The concept originally applied to
self-employment in small unregistered enterprises. It has been
expanded to include wage employment in unprotected jobs.

The original use of the term 'informal sector' is attributed to

the economic development model put forward in 1955 by W.
Arthur Lewis, used to describe employment or livelihood
generation primarily within the developing world. It was used
to describe a type of employment that was viewed as falling
outside of the modern industrial sector.

The informal sector is largely characterized by several

qualities: skills gained outside of a formal education, easy
entry, a lack of stable employer-employee relationships, and a
small scale of operations. Workers who participate in the
informal economy are typically classified as employed. The
type of work that makes up the informal economy is diverse,
particularly in terms of capital invested, technology used, and
income generated.

The most prevalent types of work in the informal economy are

home-based workers and street vendors. Home-based workers
are more numerous while street vendors are more visible.
Combined, the two fields make up about 10–15% of the non-
agricultural workforce in developing countries and over 5% of
the workforce in developed countries.

In some societies the informal economy is the dominant mode

of economic activity. It is especially prominent in developing
countries where the majority of the population may engage in
various types of economic exchanges outside any formal
regulation, cash economy, or state supervision. Yet informal
activity is not limited to developing nations. Increasingly,
economists, sociologists, and others who study work and
labour markets recognize that the informal economy is very
much present in first world industrial and post-industrial
economies. The shadow, black, grey, underground,
subterranean, or parallel economy are among the common
euphemisms for an informal economy that exists side by side
with its more studied and theorized counterparts in developed
as well as developing nations, first and third worlds, urban
and rural communities, and everything in between.

 Despite growing awareness of the ubiquity of the informal

sector, a precise definition remains elusive, and numerous
issues remain unresolved. Typically, informal activity is
defined by what it is not; that is, it is not formal, it is not
regulated, and it is not counted in official statistics and
national accounting schemes. Castells and Portes (1989)
provide an influential definition using this approach: "The
informal economy is . . . a process of income-generation
characterized by one central feature: it is unregulated by the
institutions of society, in a legal and social environment in
which similar activities are regulated".
Work in the informal economy is often characterized by small
or undefined work places, unsafe and unhealthy working
conditions, low levels of skills and productivity, low or
irregular incomes, long working hours and lack of access to
information, markets, finance, training and technology.
Workers in the informal economy are not recognized,
registered, regulated or protected under labour legislation and
social protection. The root causes of informality include
elements related to the economic context, the legal, regulatory
and policy frameworks and to some micro level determinants
such as low level of education, discrimination, poverty and, as
mentioned above, lack of access to economic resources, to
property, to financial and other business services and to
markets. The high incidence of the informal economy is a
major challenge for the rights of workers and decent working
conditions and has a negative impact on enterprises, public
revenues, government’s scope of action, soundness of
institutions and fair competition.

A second way to define the informal economy is by

examining its work force. There are three general categories
of employment in the informal economy: employers, the self-
employed, and wage workers. Employers are comprised of
owners of informal enterprises and owner- operators. The
self-employed are heads of family businesses, own account
workers, and unpaid family workers. Wage workers consist of
employees of informal enterprises, domestic workers, casual
employees with no fixed employer, homeworkers, and
temporary and part time workers.
There are many conflicting opinions on the relationship
between the formal and informal economies. Depending on
the school of thought, the relationship is described as a
complete integration of the economies or a total separation.
Legalists acknowledge that there is a connection between the
two, but that the relationship is exploitative. For example,
formal businesses often subcontract some aspects of
production to the informal economy where they can pay
informal workers lower wages and benefit from the cheaper
cost of production. The chart on the next page further
classifies the differences of the nature of the formal and
informal economies.

Over the years, the debate on the large and heterogeneous

informal economy has crystallized into four dominant schools
of thought regarding its nature and composition, as follow:

a. The Dualist School

b. The Structuralist School
c. The Legalist School
d. The Voluntarist School
 The Dualist School

According to this trend of thinking, the informal sector of the

economy is made up of small-scale activities that are different
and not related to those in the formal sector of the economy
and that provide the income of the poor, as well as a safety net
in the crisis of those who cannot work in the formal sector of
the economy. The representative work that promotes this
stream of thought belongs to Hart (1973), the International
Labour Office (1972), Sethuraman (1976), Tokman (1978). It
sees the informal sector of the economy as comprising
marginal activities. The Dualists argue that informal operators
are excluded from modern economic opportunities due to
imbalances between the growth rates of the population and
modern industrial employment, and a mismatch between
people’s skills and the structure of modern economic
opportunities.
The partisans of this stream of thought are of the opinion that
people working in the informal sector of the economy are
excluded from the formal economic sector from two causes,
namely: on the one hand, due to an imbalance between
population growth rates and employment rates (population is
growing faster than the formal economy is capable of
generating new jobs) and on the other hand because of the low
flexibility of workers that make a difference between the
professional training and the skills of the workers and the
employers' requirements in the formal area of the economy.
As a solution to diminishing the informal sector of the
economy, dualists argue that governments should create more
jobs and give informal economic agents access to credit and
business development programs as well as social protection
services for their families.
Characteristics of Dualists School of thoughts of Informal
Economy:

 Easy of entry
 Reliance on indigenous resources
 Family ownership of enterprises
 Small scale of operations
 Labour intensive and adapted technology
 Skills acquired outside the formal school system
 Unregulated and competitive markets

Governments should create more formal jobs and provide

financial and business development services to informal
enterprises. This is the policy response.

Economics policies of Dualistic school of thoughts of

informal economy are capacity building, micro-credit, sub-
contracting and workfare programmes. Main characteristics
are micro-enterprises and labour intensive. Economic
behaviour is to generate their own job and income.

Causal theory of Dualists Schools of thoughts are:

Informal operators are excluded from modern economic
opportunities due to

a. Imbalances between the growth the population and of

modern industrial employment
b. A mismatch between people’s skills and the structure of
modern economic opportunities.
 The Structuralist School

According to the stream of structuralist thought, informality is

due to capitalism and capitalist growth. In contrast to the
dualists, structuralists believe that formal and informal forms
of production are interdependent, and the growth of the
informal economy is due to the nature of capitalist
development rather than the lack of economic growth, as the
dualists claim.
It sees the informal economy as subordinated economic units
(micro-enterprises) and workers that serve to reduce input and
labour costs and, thereby, increase the competitiveness of
large capitalist firms. The Structuralists argue that the nature
of capitalism/capitalist growth drives informality: specifically,
the attempts by formal firms to reduce labour costs and
increase competitiveness and the reaction of formal firms to
the power of organized labour, state regulation of the
economy (notably, taxes and social legislation); to global
competition; and to the process of industrialization.
Increased competition and the market competitiveness, the
reaction of formal firms to the increased bargaining power of
employees, due to the strong unionisation of formal
employees, excessive state regulations (especially the tax
system and social legislation), global competition, new
methods of competition of the postmodern world (offshore
industry, subcontracting chains, multinational companies etc.)
causes formal firms to reduce their production costs and
especially labour costs.
As solutions to diminishing informality, structuralists propose
public policies to address the unequal relationship between
large, formal firms and informal, subordinate firms that offer
cheap labour.
Practically, cross-sectoral relationships arise due to the large
inequalities between formal businesses and those developed
by informal firms. This is particularly the case of developing
or transition economies where multinational companies, when
they enter a market in an emerging economy with their
financial strength, allow themselves to practice for a while at
times even below the cost of production, until they finally
eliminate their competition, respectively the small domestic
firms that will no longer be competitive to stay in the formal
sector of the economy and for this reason they will enter in the
informal economy. Here, they will shortly be subordinated to
a large company, and will survive, especially through fiscal
noncompliance.
Introduced by Manuel Castells and Alejandro Portes 1989, the
structuralist school of thoughts focusses on petty traders and
producers; sub-contracted workers; casual workers. They
view the informal economy as subordinated economic units
(informal enterprises) and workers that serve to reduce input
and labour costs of large capitalist firms and increase their
competitiveness.
Governments should regulate both commercial and
employment relations to address the unequal relationship
between “big business” and subordinated producers and
workers.
Informality is due to the nature of capitalism and capitalist
growth: specifically, the attempts by formal firms to reduce
labour costs and increase competitiveness; the reaction of
formal firms to the power of organized labour, state regulation
of the economy (notably, taxes and social legislation) and
global competition; and the process of industrialization.
 The Legalist School

Legalist current sees the informal sector of the economy as

consisting of informal entrepreneurs choosing to operate
informally in order to avoid costs, time and effort for formal
registration. Legalists believe that cumbersome bureaucracy
creates barriers to formalization and thus inhibits the
productive potential of informal entrepreneurs. Among the
prominent representatives of the law school are Soto (1989,
2000).
As a solution to diminishing informality, legalists believe that
the state should simplify bureaucratic procedures to encourage
informal entrepreneurs to register and extend the legal rights
to property for assets held by informal businesses so that they
can capitalize on their productive potential by converting the
assets they own in addition value.
Introduced by Hernaldo De Soto, it focuses on informal
enterprises and entrepreneurs. It sees the informal sector as
comprised of “plucky” micro-entrepreneurs who choose to
operate informally to avoid the costs, time, and effort of
formal registration and who need property rights to convert
their assets into legally recognized assets. The Legalists argue
that a hostile legal system leads the self-employed to operate
informally with their own informal extra-legal norms.
Government should introduce simplified bureaucratic
procedures to encourage informal enterprises to register and
extend legal property rights for the assets held by informal
operators in order to unleash their productive potential and
convert their assets into real capital. This is the policy
responses of the legalists school of thoughts of informal
economy. Economic policies- market-friendly policies,
liberalisation, state retrenchment and property rights. Main
characteristics are micro-enterprises and entrepreneurial skills.

Despite this assertion, some scholars feel that the legalist

approach functions best in a Peruvian, Latin American, or
Western context. They conclude that in Asian, African,
Middle Eastern, or other cultures, this paradigm fails to yield
the same results because the native culture is not compatible
with a modern market economy. Some scholars propose that
societies have large informal economies because their cultures
develop in such a way that the informal economy is a natural
manifestation, and thus, their people actively shy away from
the form economy. But perhaps the most largely cited
discordance is the insistence that indigenous institutions are
not compatible with a modern market economy. Believers of
this school of reasoning claim that either culture must be
changed in order to achieve development through modern
market activities or that these cultural groups will continue
their own brand of economics regardless of whether they
attain improved living standards.
 The Voluntarist School

The voluntaristic school considers the informal sector of the

economy as consisting of economic agents who choose to
operate informally in order to avoid fiscal, financial and
commercial regulations of the state. Unlike legalists, the
voluntaristic school does not invoke the complicated
bureaucracy of formality, but only the financial benefits of
informality by tax payments elusion, this option being the
result of a cost-benefit analysis of the two sectors of the
economy. The principal representative of the volunteer school
is William Maloney.
In assessing the opportunity cost of choosing the informal
sector of the economy, economic agents also take into account
contravention or penal sanctions the informality.
In order to reduce informality, voluntarists propose public
measures that usually aim at relocation of the fiscal system by
reducing fiscal pressure, widening the tax base, more drastic
measures to sanction informal operators, and better regulation
of the tax framework, knowing that the tax evasion practiced
by economic agents encompasses both the "illicit" (tax fraud)
and the "licit" form (at the limit of the law), the latter
speculating on the existing "legislative vacuum" in a state
(Maloney, 2004).
Introduced by William Maloney 2004, the voluntarist school
of informal economy focuses on informal entrepreneurs who
deliberately seek to avoid regulations and taxation but, unlike
the legalist school, does not blame the cumbersome
registration procedures. Each school of thought subscribes to
a different causal theory of what gives rise to the informal
economy. The Voluntarists argue that informal operators
choose to operate informally—after weighing the costs
benefits of informality relative to formality.
It also focuses on the self-employed, notably entrepreneurs-
especially male entrepreneurs- and their informal enterprises.
It view the informal economy as comprised of entrepreneurs
who choose to operate informally in order to avoid taxation,
commercial regulations, electricity and rental fees, and other
costs of operating formally.
The Voluntarists believe that informal operators choose to
operate informally – or even criminally – after weighing the
costs and benefits of informality relative to formality. Unlike
the legalist school, this school does not blame cumbersome
registration procedures but says informal is a deliberate choice
by entrepreneurs to enjoy the benefits of informality.
Introduced by William Maloney, Informal operators who
choose to operate informally or even criminally after
weighing the costs and benefits of informality relative to
formality. Unlike the legalist school, this school does not
blame cumbersome registration procedures but says informal
is a deliberate choice by entrepreneurs to enjoy benefits of
informality.

Government should bring informal enterprises under the

formal regulatory environment in order to increase the tax
base and reduce unfair competition by informal enterprises.
Characteristics of Voluntarists:
 Costs of formality- payroll taxes and social protection
contributions
 Benefits of informality- way to earn income while
avoiding costs of formality.

From my point of view, the differences in the approach of the

concept of "informality" between the four schools of thought
are due both to the different interpretation of the informal
sector of the economy but, in particular, to the different
legislative framework under which the research was carried
out due to the differences existing legislation in countries
where researchers have conducted their studies. Here are the
different conclusions, which is why we consider it important
that informality needs to be approached holistically, taking
into account all aspects of informality and all categories of
informal workers.

Thanks!
Submitted by:

Qazi Areeb
202005578
Sem-II
B.A. (H) English