The rise of the informal sector and why it should be taxed

April 28, 2009

     By Duncan Green     

I’ve been reading a couple of interesting things on the informal economy recently. The OECD has a new book out with the engaging title ‘Is Informal Normal?’ which gives a pretty decent overview.

Informal employment refers to jobs or activities that are not registered or protected by the state. Informal workers are excluded from social security benefits and the protection afforded by formal labour contracts. The majority of them cannot opt for scarce better jobs in the formal sector. Others voluntarily opt out of the formal system. For them, the savings from being completely or partly informal – no social security contributions, no tax payments, no binding labour regulations, and more freedom for business activities – outweigh the benefits accrued through registration and compliance. The prevalence of informal employment in the developing world is striking. Even before the current crisis, over half of non-agricultural jobs there could be considered informal.

Development thinkers and the ILO used to view the informal economy as an outdated relic of under-development destined to be replaced by regular paid jobs. But informality is actually growing in many countries, and is often a face of modernity, rather than its antithesis (hence the OECD’s title).

To some extent its rise is a consequence of the kinds of policies advocated by the World Bank and others since the 1980s eg the need to ‘flexibilize’ labour markets. This has helped blur the boundary between formal and informal, eg in the case of garment factories outsourcing to homeworkers; or the greater use of temporary contracts and gang labour in farms and factories.

Arguments for informality:
– flexibility can be good as long as it isn’t a euphemism for vulnerability, e.g. it can improve work/life balance, for example allowing parents (usually mothers) to set work hours around childcare
– freeing people from red tape can help budding entrepreneurs
– In crises, the informal economy has been a vital sponge to help people survive after losing their jobs – there are few ‘barriers to entry’ when setting up a street stall
– the informal economy is particularly important where there is no welfare state to offer alternative sources of security and income

But these benefits are often exaggerated – the informal economy is here to stay and we have to understand and work with it, but it is generally not something to celebrate:
– informal means you are outside the law, and so more vulnerable to abuse over wages, conditions, maltreatment, dismissal etc
– informal jobs are associated with low pay
– informal often means very low productivity – I once talked to a man selling satellite dishes at the traffic lights in Managua and he said in a good week he sold one – is that a good use of a human being’s talents?!

What to do:
I like the OECD’s emphasis on carrots as well as sticks:
Carrots: make the formal sector more attractive through support to small businesses, simplifying paper work etc.
Sticks: especially for those that deliberately opt out, strengthen labour inspectorates to make sure they are not doing so just to exploit their workforce more

But there are some deeper consequences of informalization that the OECD misses – for example taxation largely bypasses the informal sector (that’s one reason why people go there!), but that in turn undermines the links that taxation creates between citizen and state. Moreover, over-taxing a shrinking formal sector leads to a lot of resentment and increased tax avoidance there as well, so overall tax take falls.

One of the most interesting chapters in ‘Taxation and State-Building in Developing Countries’, which I reviewed last week, concerned why and how the state can tax the informal sector. This is a missing piece in contemporary tax debates, which focus instead on taxing a shrinking formal sector – VAT, tax authority reform etc. the authors, Anuradha Joshi and Joseph Ayee, got interested in the issue through Ghana, the informal passenger transport operators’ unions collect taxes from their members and pass them to the state. This arrangement was originally part of a corporatist deal between Jerry Rawlings and mass movements, but has survived the transition to democracy.

The advantages of taxing the informal sector via its associations are that
a) they already have a degree of legitimacy in the eyes of their members
b) it reduces the high costs of trying to collect taxes from a myriad of small, diverse enterprises in the shadows of the informal economy
c) it builds up levels of organization and so of active citizens’ ability to negotiate with the state on other issues

Comparing Ghana with less successful examples from Peru and Senegal, the authors conclude that you need two things to tax the informal sector in this way:

1. strong fiscal pressure (e.g. a crisis) on governments to increase revenues – that helps them break old bargains with informal sector organizations

2. collective actors in the informal economy that have an institutionalized channel of negotiation with the state.

The authors estimate that taxing the informal economy could add 35-55% to total tax revenues in some countries. Moroever, informal business people are not always as anti-tax as you might think. Often the reason for going informal is not to avoid taxes, but to avoid the hassle of excessively complex and chaotic tax systems. Formal taxes may even work out less costly than the endless bribes extracted from informals by public officials.

The flip side of this is of course a ‘devil’s deal’ in which populist politicians buy votes by promising not to tax informal businesses. Both situations exist, but the second seems more prevalent (the authors fail to provide other examples beyond Ghana) and is very hard to break once it is established – hence the need to use major crises to galvanize state action.