Informality

Cause and Symptom of Underdevelopment

Norman V. Loayza
The World Bank

Informality is an essential issue

It implies that a large number of people
and economic activities are outside the
legal-institutional framework

The positive side: flexibility and creativity

The negative side: inefficiency and danger

And informality is rampant in

the developing world

Informal Production
50
45
40
35
30
25
20

15
10
5
0
OECD

East Asia &

Pacific

South Asia

Sub-Saharan Latin America Europe & Middle East &

Africa
& Caribbean Central Asia North Africa

Informal Labor
100
90

80
70
60
50
40
30
20
10
0
OECD

East Asia &

Pacific

South Asia

Sub-Saharan Latin America Europe & Middle East

Africa
& Caribbean Central Asia
& North
Africa

Informal Production
-- across countries in Latin America
A. Schneider Shadow Economy index
80

(% of GDP)

60

LAC Countries

Comparator
40
Countries

20

USA
CHL

CRI
ARG
PRY
MEX
DOM
ECU
VEN
JAM
BRA
COL
NIC
SLV
HND
URY
GTM
HTI
PER
PAN
BOL

Informal Labor
-- across countries in Latin America
D. Non-contributor to Pension Scheme
(% of labor force)
80

LAC Countries
Comparator
60
Countries
40

20

USA
CHL URY
CRI
PAN
JAM
BRA
ARG
MEX
ECU
VEN
DOM
PER
SLV
GTM
HND
PRY
COL
NIC
BOL

Back to basics: Definition

What is informality?
Informality is the collection of firms, workers, and
activities that operate outside the legal and
regulatory frameworks.
It entails avoiding the burden of taxation and regulation
but, at the same time, not fully enjoying the protection
and services that the law and the state can provide.

Back to basics: Measurement

Although the definition of informality can be
simple and precise, its measurement is not.
Best described as a latent, unobserved variable.
Approximated through several indicators

Production
Schneider index of shadow economy: DYMIMIC
Heritage Foundation index of informal mkts: Perception

Employment
Self-employment share of labor force (ILO)
Lack of pension coverage as share of labor force (WDI)

Informality indicators are highly correlated

with each other
Variable
Schneider Shadow Economy index
(% of GDP)

Schneider
Heritage Fndn.
Self
Non-contributor
Shadow Economy Informal Market Employment
to Pension
1.00

Heritage Foundation Informal Market index

(range 1-5: higher, more informality)

0.68***

1.00

Self Employment (% of total employment)

0.71***

0.88***

1.00

Non-contributor to Pension Scheme

(% of labor force)

0.72***

0.90***

0.89***

1.00

As with all other complex issues,

informality is both a cause and a
symptom

Informality as a symptom

Informality is a symptom of
Excessive regulations
in a context of insufficient supervisory capacity by the
state

Defficient provision of public services

such as the police and judicial system, of which formal
firms participate

Low productivity
because of lack of education and other sociodemographic factors (youth, rural)

Informality and regulations

(% of labor force)

100

NGA
MOZBDI
TZA NPL
BGD
BFA
SLE
BENUGA
MRT
PAKSEN
MDG
IDN VNM
ZMB
GHA
IND
ZWE
KEN
BOL
CMR
TGO
NIC
THA
CHN
COL
PRY
HNDMAR
GTM
PER
DOM
VEN
PHL
ECU
MEX LKA
IRN
DZA
BIH JORKGZ
ALB TUR

80
60

ARG BRA
JAM MYS
GEO
AZE
EGYPAN
MUS CRI
ROM
MKD
URY
MDA
MNG

40
UKR

20
0
3

correlation: -0.70***
N = 101
CIV
RWA

SLV
KAZ
TUN

CHL
BGR ARM
SVK
HRV
SGP
KOR LVA
POL
HUN
LTU
GRCCZE
EST
SVN
BEL
PRT ESPFRA
AUTDNKSWE
ITA
FIN
DEU
GBR
AUS
USA
NLD IRL
NOR
JPN
NZL
CHE

Business Regulatory Freedom (index: higher, less regulated)

Informality and public services

(% of labor force)

100

GIN MOZ
BGD NGA MDG
SLE
SEN
PAK
SDN CIV
GHAIDN
ZWE KEN
BOL
CMR
YEM
GAB
TGO
IRQ

80COL HND
GTM PRY
SLV
PER
DOM

PHL VEN
ECU
MEX
DZA
LKA
ALB
BRA
ARG
JAM
YUG
MYS

60

PAN
URY

40

ARM

20

GRC

0
1

correlation:
TZA -0.72***
N = 99

BFA UGA
ZMB
VNM
IND

NIC CHN
THA

MAR

LBNIRN
JOR
KAZ
TUR
AZE
EGY
CRI
TUN
ROM
MDA
CHL
MNG
BGR
LBY
SVK
HRV
UKR KOR
SGP
LVA
POL
HUN
LTU
EST
SVN CZE
BEL
PRT
AUT
ITA FRA
ESP
FIN
SWE
DNK
DEU USA GBR
AUS
NLD
NOR
IRL
JPN
NZL
CHE

Law and Order (index: higher, better)

Informality and education

(% of labor force)

100 MOZ
TZA BGD
SLE NPL
BEN
SEN
MRT
UGA
80

correlation: -0.84***
N = 78

PAK
ZMB
GHA
IDN
IND
RWASDN
ZWE
BOL
CMR
YEMKEN
TGO
NIC
IRQ THAMAR
CHN
COL
PRY
HND

GTM DOM VEN PER

SLV
PHL
ECU
MEX
DZAIRN
JOR LKA

60

BRA

40

TUR

ARG
JAM
MYS
PAN
EGY
CRI
TUN MUS
URY
CHL
POL
HUN

20

SGP

KOR

GRC
BEL
PRT ESP ITA
FRA
FIN
DNK
GBR NLD
AUS
IRL
NZL
JPN

AUT

DEU
USA SWE
NOR
CHE

Average Years of Secondary Schooling

Informality and sociodemographics

100

(% of labor force)
GIN
NGA
MOZ
TZA
NPL
BFA
BGD
SEN
BENSLE
MRT
PAK
UGA BDI
MDG
IDN
ZMB
SDN
GHA
VNM
IND
CIV
RWA
ZWE
KEN
GAB BOL NIC YEMCMR
TGO
THA
IRQ
WBG
CHN
MAR
COL
PRY
HND

80

SLV GTM
DOM
VEN PER
PHL
ECU
LBN
MEX
DZAIRN LKA
JOR
BIH

60

ALB
KAZ
TUR
ARG
BRAYUG
JAM
MYS
GEO
AZE EGY
PAN
CRI
TUN
MUS
ROM
MKD
URY
MDAMNG
CHL
BGR
ARM
SVK
HRV
UKR
SGP
KOR
LVA
POL
HUNLTU
EST
CZEGRC
SVN
BEL ITA
PRT
AUT
ESP
FRA
SWE
DNK
DEU
GBR
USAFIN IRL
AUS
NLD
NOR
JPNNZL
CHE

40

20

0
-2

-1

KGZ

correlation: 0.87***
N = 109
1

Sociodemographic Factors, standardized

Informality determinants (or correlates)

Explanatory variables:
Average of 2000-2005 by country

Schneider Shadow
Economy index
(% of GDP)
[1]

Law and Order

(ICRG, index ranging 0-6: higher, better)

Business Regulatory Freedom

(The Fraser Institute, index ranging 0-10: higher,
less regulated)

Average Years of Secondary Schooling

(Barro and Lee 2001)

Sociodemographic Factors
(average of share of youth population, share of
rural population, and share of agriculture in GDP)

Constant

No. of observations
Adjusted R-squared

Informality measures
Heritage Foundation
Self
Non-contributor to
Informal Market index
Employment
Pension Scheme
(1-5: higher, more) (% of total employment) (% of labor force)
[2]
[3]
[4]

-3.2360**
-2.57

-0.0969*
-1.76

-1.6925*
-1.84

-2.9764*
-1.67

-2.0074*
-1.80

-0.5333***
-9.95

-2.5196**
-2.17

-5.8675**
-2.28

-1.9684*
-1.70

-0.1152**
-2.00

-2.1527**
-2.25

-5.8114***
-3.27

3.8438**
2.00

0.5027***
4.99

5.9743***
3.77

21.6130***
7.31

60.3429***
10.48

6.6326***
31.72

54.7254***
14.06

113.3110***
11.40

84
0.57

86
0.89

57
0.78

70
0.88

Informality is not explained by a

single source.
It is a complex phenomenon that arises
from the combination of several forces

Actual vs. Predicted Informality

A. Schneider Shadow Economy index
70

Actual values
(% of GDP)

BOL
PAN
PERTZA

60

B. Heritage Foundation Informal Market index

5

ZWE

HTI

50
40
30
20

SWE
NOR
FIN
DNK
HKG
DEU
CAN
IRL FRA
AUS
SGP
NLD
NZL
GBRJPN
AUT
CHE
USA

10

3
2

CHN

Predicted values
(% of GDP)

0
0

10

20

NER
COG
MLIBGD
HTI
IDN
KEN CMR
IND
MOZ
BOL
NIC
VENPAK
PHL
ZMB HND
UGA
TZA
ZWE
ECU
GUY
COL GTM MWI
CHNEGY SEN
PER
ARG
BRA
DOM
PAN
POL
TUR
SLV
MEX
JORZAFJAM
THA
MAR
LKA DZA
GHA
GRC
CRIPNG
URY
KOR
TUN MYS TTO
BWA
HUN
ITA
KWT PRT
ESP
JPN
FRA
BEL
CHL
ARE
HKG USA
DEU
AUT IRL
DNKGBR
FIN
SWE
ISL
SGPNZL
CAN
NOR
CHE
AUS NLD

THA
GTM
URY ZMB COG
HND ZAR
SLV
SEN
NIC
LKA
PHL
UGA
MLI
SLE
GHA
MOZ NER
COL
MWI
BRA
TGO
TUN
PAK
PNG BGD
JAM
MAR EGY
ECU
VEN
DZA KEN
CMR
BWA
TUR
DOM
MYS
MEX
PRY
POL
KOR ARE
GRC
ARGZAF
ITA
HUN CRI
IND
IDN
ESP
PRT JOR
BEL
KWT
SYR
CHL
IRN

30

40

50

60

Actual values
(% of total employment)

IRN
SYR

70

100

CMR

Actual values
(% of labor force)

ITA

20

NZL
IRL ESP
ISL
CAN
CHE
SGP
BEL
AUS
GBR
HKG
AUT
NLDJPN
DEU
FRA
DNK
USA
NOR

10

10

20

60

SGP

20
Predicted values
(% of total employment)

30

CHLURY

40

MYSTTO
ZAF

40

MOZ
TZA
BGD
SENSLEUGA
PAK
IDN
ZMB GHA
IND
ZWEKEN
BOL
TGO CMR
THA NIC
CHN
MAR
COL
PRY
HND
GTM
SLV
PER
DOM
VEN
PHL
ECU DZA
JOR MEXIRN LKA
TUR

80
IDN
DOM
BOL
COL
ZMB
PAK
HNDBGD
PER PHL
JAM GTM
IRN
THA
SYR
ECU
VEN
SLV
LKA
GRC PAN
BRA
DZA
CHL URY MEX
MAREGY
KOR
CRI
ARG
PRT TUN

30

D. Non-contributor to Pension Scheme

50
40

PRY
SLE

Predicted values
(Higher, more informality)

C. Self Employment
60

TGO

Actual values
(Higher, more informality)

50

60

KOR

HUN
GRC
AUT BELFRA
ITA PRT
ESP
FIN
SWE DEU
DNK
GBR
USA
AUS
NLD
NOR
IRL
NZL JPN
CHE

20

40

ARG BRA
JAM
MYS
PAN
EGY
CRI
TUN
POL

Predicted values
(% of labor force)

60

80

Note: In each graph, a 45-degree line is drawn to show a distance between predicted and actual levels.

100

Decomposing Informality
--country by country

Predicted differences in informality w.r.t. benchmark

A. Schneider Shadow Economy index

B. Heritage Foundation Informal Market index

(% of GDP)

60

(Higher,
more informality)
Max

Max
50
GTM

40

COL
BOLBRA
ARG

DOM
ECU

HTI
HND
PRY

GUY

HTI

JAM
MEXNIC
PANPER

SLV

CRI

VEN

URY

HND
GTM
GUY
ECU
DOM

BOL
ARG BRACOL
CRI

30

VEN
PRY
NIC
JAMMEX
PANPER
SLV
URY

CHL 2

CHL

20
1

Min

Min

10

C. Self Employment

D. Non-contributor to Pension Scheme

120

(% of total employment)
Max
50

40

30

BOL
BRACOL
ARG

DOMECU

CRI

GTM HND
GUY

80

PRY

NIC
JAM
MEX
PANPER

SLV

BOL
DOMECU
BRACOL
CRI

VEN

60

URY

20

HTI

100

HTI
GTM HND
GUY

Max
(% of labor force)

40

NIC
JAM
MEX

PRY
SLV

PANPER

VEN

ARG
URY

CHL

CHL
20

10
Min

Note: Presented are all predicted levels, which may be above/below the actual max/min values.

Min

Decomposing informal production

Argentina
60

Bolivia
60

40

40

20

20

Brazil
60

El Salvador
60

40

40

20

20

Law and Order

Education

Regulatory Freedom
Sociodemographic Factors

Decomposing informal labor

Argentina

Bolivia

80 %

80 %

60

60

40

40

20

20

Brazil

El Salvador

80 %

80 %

60

60

40

40

20

20

Law and Order

Education

Regulatory Freedom
Sociodemographic Factors

Policy implications

1. Policy evaluation:
Does this promote informality?
PERU -- POLICY MEASURES

GRADE

Law of Positive Administrative Silence

Special financial transaction tax

Law of Promotion of Small Enterprises

Municipal procedure facilitation, Tramifcil

Increase in minimum wage

Requirement of periodic testing of teachers
Port concessions

2. Mechanism: How to formalize?

The objective should be to formalize, but not at all
costs !
If policies are focused on punishment,
Unemployment will increase
Policies should focus on making formality attractive,
Streamlining regulations
Improving public services

Then, efficiency, employment, and growth are likely to

improve

Thanks

Informality as a cause

Informality implies
A trap of marginalization and exclusion
which worsens and is worsened by poverty

Distortions in the use of private and public

resources
which lowers economic growth

How does informality affect growth?

Informal firms
In order to evade,
do not reach their optimal size and technology
use irregular procurement and distribution channels
waste resources in bribes

Use inefficient mechanisms to replace the police and

judicial system
Do not contribute to the renewal and improvement
of public infrastructure

Effect of informality on
per capita GDP growth, 1985-2004
OLS

Initial GDP per capita

(2000 US$, 1985, in logs)

Schneider Shadow Economy

(% of GDP)

IV

[1]

[2]

[3]

[4]

-0.1966
1.29

-0.3519
1.54

-0.3498*
1.88

-0.6910*
1.98

-0.0747***
3.87

Heritage Foundation Informal Market

[6]

[7]

[8]

-0.6976*** -0.7684*** -1.2819*** -1.7200***

3.06
2.83
2.69
2.95
-0.1479***
4.39

-0.8009**
2.41

(ranging 1-5: higher, more informality)

Self Employment

-1.3294***
4.05
-0.0657***
3.11

(% of total employment)

Non-contributor to Pension Scheme

-0.1775***
3.21
-0.0423***
2.80

(% of labor force)

Constant

[5]

-0.0872***
3.39

5.4231***
3.15

6.9131**
2.57

6.6475***
3.35

9.2161**
2.59

No. of observations

119

127

72

91

84

87

59

68

R-squared

0.20

0.08

0.13

0.11

0.48

0.21

0.30

0.70

Hansen J Statistic (P-value)

11.8634*** 11.7604*** 17.1971*** 19.8890***

4.29
3.80
3.18
3.33