IZA World of Labor

Informal employment in emerging and transition economies

Reducing informality requires better enforcement, more reasonable regulation, and economic growth

NRU Higher School of Economics, Russian Federation, and IZA, Germany

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Elevator pitch

In developing and transition economies as much as half the labor force works in the informal sector (or “shadow economy”). Informal firms congest infrastructure and other public services but do not contribute the taxes needed to finance them. Informal workers are unprotected against such negative shocks as ill-health, but for certain groups there can be scarce opportunities to enter the formal sector. Reducing informality requires better enforcement, more reasonable regulation, and economic growth.

The shadow economy around the world

Key findings

Pros

Informal entrepreneurship is a source of upward mobility.

Informality is a rational response to excessive regulation and low institutional quality.

In some cases, informality is an escape from extortion by corrupt officials and inspectors.

Informal employment can be the opportunity of last resort for excluded workers.

Cons

Workers might be locked in to informal jobs.

Informal enterprises free-ride on public services and undercut formal competitors.

Informal workers are largely unprotected from the risks of ill-health, old age, maternity, and so on.

Generalized informality can lead to severe problems for public finance.

Informal firms are suboptimally small and lack access to credit and contract enforcement.

Author's main message

Informality can be the result of restrictions that exclude some workers from formal positions. But many studies suggest that labor markets are well integrated, implying that a large fraction of informal employment is voluntary. Poverty alleviation efforts should thus be focused on vulnerable groups and bad times (recessions). And reforms that improve the balance of benefits and costs of formal employment can reduce informality.

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