Informality and development

Abstract

Informality, often referred to as the informal sector, is crudely defined as all unregistered economic activity. To be a bit more specific it may be defined as the value-added from all unobserved economic activity that is not included in the calculation of the gross domestic product (GDP). This definition captures the production of households, self-employed and unregistered small-scale enterprises that create value added to the economy. In developing countries this phenomenon makes up a large part of the overall economy; by some estimates it accounts for 30 to 60 percent of the official GDP, while as much as over 70-80 percent of the labour force is characterized as informal in the most extreme cases. There is no evidence that this phenomenon is on the retreat; most experts seem to believe that the numbers have increased recently.

Considering that informality is such a large part of economic life, especially in developing countries, we are curious to find out if it has any effect on the economic development of nations. Since the most commonly used measure of economic development is the growth rate of national income, we analyze the relationship between the magnitude of the informal sector and GDP growth. We use estimates of the size of the informal sector that is provided by Schneider (2005). These estimates are made using a structural equation model called the dynamic multiple indicators multiple causes (DYMIMIC) model, and they are expressed as the size of the informal sector as a share of GDP.

The analysis is based on entering the estimated relative size of the informal sector into an empirical growth model, where the real GDP per capita growth rate is the dependent variable. We then run random and fixed effects regressions on growth for 109 countries from all regions of the world over three periods in the last decade, in 1990-91, 1994-95 and 1999-2000. All data transformations and regressions are performed using Stata Intercooled 9.0.

We find that the size of the informal sector has a negative effect on GDP growth in developing countries. Increasing the size of the informal sector with one percentage point to GDP leads to 0.42 percentage points decline in GDP growth. The results for developed economies and economies in transition from a formerly planned economy are less clear, indicating a small positive effect of increasing the informal sector. The latter result is not significant at conventional levels of confidence.

Before we take on the empirical analysis we will discuss important features of informality. First we will address the question of what informality actually is. Informality is associated with many economic activities and the issue of how to define informality is still unresolved. Thus we will discuss some different approaches that have been made to define informality.

A central part of this treatment discusses the causes and consequences of informality. An important aspect is the effect of an increasing informal sector. We also discuss different hypotheses on the effects of informality on growth.

Another important issue for most economists in this field of research is the pursuit of a method to measure the “size” of the hidden and unobserved informal sector. We will discuss several different methods that has been developed to measure informality, with emphasis on the multiple indicators multiple causes (MIMIC) model that is the most modern approach to measure the relative size of the informal sector.