Informal sector labour markets in developing countries 0

INFORMAL SECTOR LABOUR MARKETS IN DEVELOPING
February 2007
COUNTRIES
Tim Ruffer (Oxford Policy Management)
&
John Knight (University of Oxford)
Oxford Policy Management
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38 St Aldates
Oxford, OX1 1BN
United Kingdom
Tel: +44 (0) 1865 207300
Fax: +44 (0) 1865 250580
Email: admin@opml.co.uk
Website: www.opml.co.uk

Informal Sector Labour Markets in Developing Countries
Table of contents
Preface ii
1. Introduction 1
2. Characteristics of informal labour markets 3
2.1 Opposing views on the causes of informal labour markets 3
2.2 Involuntary informal employment 3
2.3 Voluntary informal employment 8
2.4 Dual informal labour markets 9
2.5 Linkages with the formal sector 11
2.6 Informality and illegality 13
3. Definitions and measurement of the informal sector 15
3.1 Definitions 15
3.2 Scale of the informal sector 16
3.3 Trends 18
4. Policies 21
4.1 Introduction 21
4.2 Objectives and justifications for public intervention 21
4.3 Regulatory and institutional framework 22
4.4 Social protection 23
4.5 Minimum wage legislation 24
4.6 Trade unions 25
5. Conclusions 26
References 29
February 2007 i

Preface
This report is an output from a project funded by the UK Department for International Development
(DFID) for the benefit of developing countries. The views expressed are not necessarily those of
DFID.
February 2007 ii

1. Introduction
This report summarises the latest research and thinking about informal sector labour markets in
developing countries, and shows its potential relevance to DFID country economists.
The informal sector constitutes a separate market segment from the formal sector, characterised
by ease of entry, reliance on indigenous resources, family operation of businesses, small scale of
production, labour intensive and adapted technology, skills acquired outside the schoolroom and
the bypassing of regulations (including taxation) (ILO, 1972). The sector exhibits a wide range of
employment and business types from casual zero-entry-cost petty trading to small enterprises
using modern sector techniques of production and management which border on the formal sector.
Despite its diversity, the informal economy can be usefully categorised by employment status into
two broad groups: the self-employed who run small unregistered enterprises; and wage workers
who work in insecure and unprotected jobs (although some informal workers – notably
homeworkers – do not fit neatly into either of these categories) (Chen, 2004). Most of those who
work in the informal economy share one thing in common: the lack of legal recognition, regulation,
and protection.
Box 1: Official definitions of the informal sector
The Resolution concerning statistics of employment in the informal sector, adopted by the Fifteenth
International Conference of Labour Statisticians (ICLS), January 1993, describes the informal sector as
consisting of production units that:
"typically operate at a low level of organization, with little or no division between labour and capital... and on
a small scale.... Labour relations - where they exist - are based mostly on casual employment, kinship or
personal and social relations rather than contractual arrangements with formal guarantees."
For statistical purposes, the Resolution defines the informal sector as:
"a group of production units, which, according to the definitions and classifications provided in the United
Nations System of National Accounts (Rev.4), form part of the household sector as household enterprises
or, equivalently, as unincorporated enterprises owned by households..."
According to Fields (2006), the ILO defines the informal sector to comprise informal employment (work
without secure contract, worker benefit, or social protection) of two kinds: self-employment in informal
enterprises (small or unregistered enterprises) and paid employment in informal jobs (casual labour, or
outworkers, or unregistered, or temporary, or unprotected workers).
See Section 3.1 for a discussion of the challenges of defining the informal sector.
The informal sector is a pervasive phenomenon in almost all developing countries where the
majority of the poor depend on the informal sector for their livelihoods. It accounts for over half of
employment in many countries in Latin America, Africa, and Asia. The bulk of new employment
generated in recent years in developing countries has been in the informal economy. Women’s
share of informal sector employment is high, typically estimated at 60 to 80%.
Understanding the informal sector – in particular, informal employment – is therefore crucial for the
success of economic development policies and poverty reduction strategies. Its persistence and
expansion over time and across countries show that the informal sector is not a transitory
phenomenon in the development process, soon to be absorbed by the formal sector. Rather, it is
now fairly well recognised that formal and informal sectors will cohabit, and are very much
interlinked in subtle and complicated ways.
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Academics, policy-makers and commentators have argued extensively about the nature and size
of the informal sector, its welfare implications and the appropriate policy prescriptions. The debate
is often obscured by the fact that the term informality is ambiguous theoretically and hazy
empirically. Informality often means different things to different people. Moreover the informal
sector has different characteristics in different countries. These differences arise not only from the
nature of their economies but also from the nature of interventions by the state. Generalisations
about the informal sector are therefore likely to be misleading in any particular context: an
analytical taxonomy is required which can be applied to each economy. The report uses examples
from particular countries to bring out the similarities and the differences and thus to develop the
necessary analytical framework.
The remainder of the report is structured as follows. In Section 2 we present two opposing views of
the informal sector labour market . Section 3 considers issues relating to the nature, definition and
measurement of informal sector labour markets in developing countries, and provides some
evidence of how they are evolving. Section 4 considers the policy implications of the analysis.
Section 5 concludes, summarising the report and providing diagnostic criteria for an assessment of
the informal sector labour market in any particular country.
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2. Characteristics of informal labour markets
2.1 Opposing views on the causes of informal labour markets
There are currently two opposing views of informal labour markets. On one view, the informal
sector is a ‘residual sponge’ which absorbs that part of the growing labour force that cannot be
employed in the more productive and remunerative formal sector: its growth is a sign of economic
failure, and policies are needed to reduce poverty within it. This view further perceives the
informal sector as a state between formal employment with social protection and open
unemployment. A form of market failure prevents individuals from moving from the informal to the
formal sector. This is based on an ‘insider-outsider’ model where those in formal employment are
insiders and those in the informal sector and the unemployed are outsiders. In the presence of
such labour market segmentation, wages in the two sectors of the economy will differ for two
employees of equal potential productivity. On the other view, the informal sector is a dynamic
sector, containing much budding entrepreneurship: its growth is a sign of economic success, and
policies are needed for its encouragement. On the former view, informal employment is likely to be
involuntarily imposed, and on the latter view it is likely to be voluntarily chosen. In fact, both views
can be correct: they might apply in different countries, and in the same country in different
proportions.
In different countries, different sets of laws and institutions create different types of informal sector
and the characteristics that distinguish it from the formal sector. On one definition, the informal
sector is the sector ‘beyond the reach of the state’. However, the reach of the state may be viewed
as a continuum, along which a dividing line has to be drawn. Moreover, the state may reach in
different ways, favouring one sector in some dimensions and disfavouring another, or even the
same sector, in other dimensions. The form of state intervention is therefore likely to determine
whether the informal sector is voluntarily chosen or involuntarily imposed.
The following are common forms of state intervention that tend to divide the labour market into
formal and informal segments. They can operate either in the labour market or in the product
market, which then has implications for the labour market. Consider the labour market. The
government might lay down various regulations which apply only to employers above a certain
employment size, or only to officially registered employers. These might relate to minimum wages,
formal contracts of employment, security of employment, unemployment benefit and other forms of
social security, membership of pension schemes, training levies, or some combination of these.
Alternatively, all employers might be subject to the regulations but small employers, less visible to
the authorities, might be able to evade them. Section 2.2 provides some specific examples of the
impact of such interventions on involuntary informal employment from China, South Africa and
India. Section 5 looks in more detail at the implications of some of these interventions.
2.2 Involuntary informal employment
2.2.1 The impact of state intervention on labour market segmentation
In order to illustrate how the nature of labour market segmentation can depend on the forms of
state intervention, we start with the examples of two countries with highly segmented labour
markets, and where informal employment is largely involuntary: China and South Africa. The case
of school teacher employment in India is also discussed. In each case the basic reason for
expecting informal sector employment to be involuntary is the existence of a large difference in
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wages and conditions between the two sectors, which makes the formal sector the preferred but
rationed sector for workers.
Segmentation driven by state support for urban residents: China
The Chinese labour market has been divided into a privileged formal sector, comprising urban-born
employees in the state and collective sectors, and the informal sector, comprising urban-born
workers retrenched from their formal jobs, young city-dwellers, rural-urban migrants, and rural
workers employed in rural industry. Wages and conditions in the formal sector are institutionally
determined, are often improved by profit-sharing, and are supplemented by firm-level mini welfare
states which are only now being dismantled, whereas those in the informal sector are subject to
market forces and are greatly inferior (Knight and Song, 2005). The segmentation is maintained by
institutions such as residence registration which restrict the rights of migrants in the cities, and by
the collectivist mentality of many formal sector enterprises. The underlying political economy has
required the protection of urban-dwellers against the competition of rural people.
Segmentation driven by the power of organised workers: South Africa
Reflecting the sophisticated nature of the formal sector and the political alliance between the ruling
African National Congress and the trade union coalition, there is sharp segmentation between the
formal and informal sectors in South Africa (Kingdon and Knight, 2007). The formal sector is the
sector of choice: very few workers would prefer to be employed in the informal sector. The formal
sector is officially defined to cover ‘registered’ employers, i.e. employers large enough to qualify for
VAT payments must register. Registered employers fall within the scope of the extensive industrial
relations regulations. These cover the recognition of trade unions and collective bargaining, the
right to strike, protection against dismissal, and minimum standards concerning hours of normal
and overtime work, minimum wages and minimum leave provision.
The informal sector generally falls outside the labour regulation system, and informal sector
wages, being more subject to market forces, are predictably lower. This can be shown through the
estimation of earnings functions which include sector of employment as an explanatory variable:
even with correction for bias arising from selection into the two sectors, informal sector earnings,
standardising for all other characteristics, are about 60% of those in the formal sector (Kingdon
and Knight, 2007). Trade unions and collective bargaining are important to this segmentation:
Kingdon, Sandefur and Teal (2005) show rigorously that the ‘union premium’ on wages is high and
has recently risen as unemployment rose. The formal sector premium, together with the
employment protection legislation, provides formal sector employers with an incentive to employ
workers on a temporary, casual basis. Although the extent of this predictable practice is unclear,
some of the employees of formal sector firms are likely to be de facto informal employees.
Similarly, some informal sector workers are de facto formal employees if they receive the minimum
wages and working conditions laid down in Bargaining Council agreements. This can come about
through the so-called extension clauses which extend an agreement to all employers in the
relevant industry and area. Although there is provision for exemptions, generally granted on the
basis of small scale and inability to pay, extension has been a bone of contention for small firms.
The motivation of the bargainers may be more to protect their members against undercutting
competition than to protect less-well-paid workers.
Segmentation driven by worker organisation in the public sector: India
India provides a further example of segmentation which divides the labour market into a protected
but rationed sector and a residual market-clearing sector. In this case we choose an occupational
labour market: the employment of school teachers. The terms and conditions of teachers in the
state and (equivalent) government-aided schools are the result of collective bargaining and political
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pressures by the teachers’ unions. Wages are well above the levels that would be determined by
market forces but teachers are protected institutionally and politically, with respect to both pay and
employment security. In private schools, by contrast, wages are determined competitively in
conditions of relatively abundant supply. One estimate shows private sector pay to be only 48% of
that in the state sector (Pritchett & Mugai, 2007). The management of state sector teachers is very
weak, reflecting their entrenched positions, and the greater scope for effective management makes
the private sector more efficient. For instance, Kingdon (1996) conducts a comparison of efficiency
and finds that private schools produce higher academic achievement than state schools and at
lower cost. The underlying problem is one of political economy. There is a clear case for
liberalising and integrating the market for teachers, but there is a predictable resistance to such a
policy initiative.
2.2.2 Segmentation driven by economic forces: wage differentials by size of firm
It is possible for wages in the formal sector to be higher than those in the informal sector without
any intervention by the state. There are profit-maximising reasons why producers might choose to
pay wages above market-clearing levels. The explanations for this phenomenon are known as
efficiency wage theory or labour turnover theory, and derive from the firm’s concern to raise labour
productivity or reduce labour turnover with its associated training costs. Large firms, by reason of
their management style and technological level, generally require committed and high-quality
workers, with whom they commonly enter a long term relationship. Small firms, by reason of their
generally simple products and production processes, do not have the same incentive to motivate
and train their workers or to maintain a long term relationship with them. This contrast is likely to be
reflected in wage differences by firm size.
Indeed, there is evidence of firm size effects on wages in many developing countries. For
instance, Sandefur, Serneels and Teal (2006) estimate that, standardising for many other
determinants of earnings, a worker in a firm with 100 employees earns 52% more than one in a
firm with 5 employees in Ghana, and 76% more in Tanzania. Even more dramatic evidence comes
from a 1993 enterprise survey in Zimbabwe (Jenkins and Knight, 2002). Again standardising for
everything else – including education, race and gender – compared with workers in small firms (1-
10 employees), those in medium firms (11-100 employees) earn 39% more, those in large firms
(101-250 employees) 62% more, and those in very large firms (over 250 employees) 106% more.
Some of the wage differences arise because, even when firms are in the same sector, the small
firms tend to produce different products, often simpler and less sophisticated. The nature and
quality of the technology used in the production process also tend to vary by firm size. Small firms
normally operate in competitive conditions, whereas large firms are more protected from
competition by their products or their technologies, and can therefore earn economic rents, which
are sometimes shared with workers as a result of collective bargaining.
The wage differences by firm size existed in Zimbabwe despite the fact that trade unions and
workers’ organisations were perceived to be ineffective, and probably not responsible for the
higher wages of larger firms. Blanket minimum wages can have the effect of raising the pay of
small firm employees in particular, but they were not relevant in Zimbabwe at that time. Two
conclusions might be drawn. First, wage differentials by firm size can and do exist without
intervention, or effective intervention, by the state, because of the advantage which larger firms
gain from paying higher wages. Second, minimum wage intervention, insofar as it particularly
affects the labour costs of small firms in the informal sector, can make them less able to compete
with larger firms and more generally (see Section 4 for further discussion on minimum wages).
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In some of the poorest countries, the state is the dominant formal sector employer. For instance, in
Benin, where only 7% of non-agricultural employment is formal, the civil service and public
services account for the majority of formal sector employees. In such circumstances, the state is
normally the wage leader, setting pay levels that the tiny private sector either follows or tries to
surpass in order to recruit the best workers. If there is wage segmentation between the formal and
informal sectors, the reason can then be traced to state pay policies.
2.2.3 Segmentation driven by a rural-urban divide
In many developing countries, urban wages are raised above the rural supply price, i.e. the wage
at which rural people would be willing to come to work in the urban areas. This can happen either
for economic or for institutional reasons of the sorts mentioned above. The underlying reason is
often the nature of the political economy - one which accords urban-dwellers a political power or
influence disproportionate to the numbers. The existence of an urban formal sector wage above
the level that would be determined by market forces the acts as a lure for rural-urban migrants.
More are attracted into the cities than there are jobs available for them, and many end up either as
openly unemployed, at least for a time, or in the free-entry informal sector, where they eke out a
living. Often they are willing to continue in informal employment only in the hope of securing a
formal sector job eventually. The inflow continues until, at the margin, the uncertain prospect of
success or failure in the city is no more attractive than life in the village. Thus, the existence of
segmentation between urban and rural wages, can create a large informal sector in the city that is
characterised by low incomes, possibly even lower than the incomes that the migrants would have
earned if they had remained in the village.
2.2.4 Involuntary informal employment and the Lewis model
The Lewis model (Lewis, 1954) provides a helpful theoretical framework for assessing how
workers pushed into and kept in the informal sector will fare with economic development and with
the passage of time. The model contrasts the (first) labour-surplus stage of the development
process and the (second) labour-scarce stage: beyond the turning point, a shortage of labour
begins to raise labour incomes generally in the economy. In practice, some developing countries
(such as Taiwan and Korea) are clearly in the second stage, some (such as China and Malaysia)
are growing rapidly and are approaching general labour scarcity, and some (such as South Africa
and Zimbabwe) appear to be moving further away from the turning point on account of fast labour
force growth in relation to slow economic growth. Where the turning point is being approached, the
proportion of the labour force in free-entry informal activities declines while leaving a more vibrant
and productive informal sector intact. Where the turning point is receding, the free-entry informal
sector and open unemployment together have to absorb the growing residual labour force, and the
informal sector increasingly becomes a poverty sink. Such differences provide one reason why the
analysis of informal sector labour markets has to be country- and context-specific, and so lends
itself to illustration with particular examples.
To assist an understanding of how economic success or failure can affect the informal sector, we
contrast recent labour market trends in the two countries referred to above, China and South
Africa, drawing on Knight and Song (2005), Kingdon and Knight (2007), and Knight (2007). Both
these countries are characterised by severe labour market segmentation, with the formal sector
being preferred and entry to the informal sector generally being involuntary. In both countries the
informal labour market, unlike the formal, is subject to competitive forces. In the more successful
economy, China, labour market trends (i.e. the more rapid growth of formal sector employment
than of the labour force) imply that the segmentation will decline and informal sector workers will
share in the benefits of economic growth. By contrast, in the less successful economy, South
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Africa, labour market trends (i.e. the more rapid growth of the labour force than of formal sector
employment) imply that the segmentation is growing and that informal sector incomes will continue
to decline.
China: rapid employment growth and involuntary informality
The Chinese economy has been a labour-surplus economy par excellence. Unemployment has
taken a disguised form in agriculture, and also in formal sector industry and services as it was
government policy to ensure that all urban-born workers were employed. The urban informal sector
was until recently heavily restricted. The remarkable growth of the Chinese economy – averaging
nearly 10% per annum over the last 25 years – together with the one-child family policy that
restricted the growth of the urban-born labour force, required a great influx of labour into the cities
and towns. However, rural-urban migration took a peculiar form: with urban settlement made very
difficult, most rural-urban migration has been of a temporary, oscillatory nature. Migrants either
enter the informal sector as self-employed workers or are employed in the formal sector on a
discriminatory, informal basis in the least attractive jobs, with none of the employment rights that
urban workers generally enjoy.
Between 1990 and 2000, the Chinese labour force grew by 87 million (1.3% per annum). While
state and collective employment declined, the increased labour force was entirely absorbed (105
million) by the urban private sector, much of it informal. Another part of the informal sector, rural
industry, absorbed 36 million, and the number of rural household workers (essentially farmers) fell
by 56 million. Wages and conditions in the burgeoning informal sector, being subject to market
forces, are distinctly worse than those of the protected and privileged urban-born workers in state,
collective and large-scale private firms. Informal sector wages and conditions depend on whether
the Chinese economy is being propelled into the second, labour-scarce stage of the Lewis model.
There is still surplus labour in China, especially in the interior provinces. However, the surplus is
declining, e.g. the number of people working in the rural areas began to fall in the mid-1990s. If
rapid economic growth can be maintained, the labour scarcity that is already felt in a few growth
points will gradually spread across China. As migrants move up the job skill ladder in urban
enterprises, so the economic need for stable long term employment will grow, and this will be
recognised by employers and government. The current sharp wage and skill distinctions between
formal and informal workers can be predicted gradually to decline.
South Africa: rapid labour force growth and involuntary informality
Between 1995 and 2003 the labour force in South Africa increased by a remarkable 4.2% per
annum, reflecting a high natural rate of increase, in-migration and increased labour force
participation, especially among women. By contrast, wage employment grew relatively slowly over
that period, by 1.8% per annum. Those who could not obtain wage jobs entered self-employment
or open unemployment. There are two measures of the labour force in South Africa: the (official)
narrow measure and the broad measure, which includes those reporting that they wanted to work
but had not actively searched recently. It is probable that most of these are discouraged workers,
for whom it is not worth searching. However, even on the narrow definition, which we use here, the
trends are depressing.
The labour force grew by 4.6 million over the eight years, wage employment (similar to formal
sector employment in South Africa) by 1.3 million, self-employment by 0.7 million, and
unemployment by 2.6 million. The informal sector is very small by international standards and,
although employment grew rapidly (by 5.1% per annum), it could not absorb much of the increased
labour force; the rest was drawn into unemployment. The result of these trends was growing labour
market segmentation between the formal and informal sectors. Real earnings per worker in formal
employment fell a little (by 1.6% per annum), being propped up by wage bargaining in the large-
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and medium-scale firms. However, real earnings in self-employment imploded, falling by 11.4%
per annum. The informal sector acted as a sink for those who could not obtain formal sector wage
employment. Only part of the informal sector was easy for the unemployed to enter, and the low
and falling incomes in these free-entry activities kept or made many workers unemployed.
2.3 Voluntary informal employment
The alternative view is that the informal labour market is voluntarily chosen and that informality is a
response by small enterprises to over-regulation by government bureaucracies, and the result of a
decision that the cost of being informal is lower than that of being formal. The firm’s costs of being
formal can be separated into two: the cost of entering the formal sector, which comes from the
procedures, fees and bureaucratic requirements for starting a formal business, and the cost of
staying in the formal sector, including regulation, of which labour regulation costs are significant,
and taxation
When the criterion for regulation is official registration of the firm, it is relevant to consider the
benefits and costs of registration. There are benefits to registration: the government often provides
better services to registered firms, e.g. the ability to solve disputes through the judicial system, and
the provision of standardised procedures that can reduce transaction costs. However, there can
also be costs. The act of registration can itself be costly: in Peru it took 290 days and US$1,240 to
fulfil all the bureaucratic procedures (de Soto, 1989), and Djankov et al (2002) found similar results
for a large number of developing countries. Staying formal can also be costly: for a sample of
manufacturing firms in Peru, de Soto (1989) found that the cost of remaining registered
represented 350% of after-tax profits. Most of this cost was due to regulatory and bureaucratic
requirements. Firms may choose to remain informal in order to avoid regulations, but the penalties,
which apply when firms are caught by government enforcement agencies, can be severe; the
alternative, bribes, can also be costly. Informal firms may have to stay small, and thus potentially
inefficient, in order to avoid detection. When regulation decreases or enforcement increases the
informal sector becomes relatively less attractive. The regulatory framework of governments often
favours large firms, and this can push small firms into informality, which in turn compels them to
remain small and hidden without legal protection of their investment .
In the case of developing countries, voluntary informality has been most documented in Latin
America. For example, Maloney (2003) develops a view of the informal sector in developing
countries primarily as an unregulated micro-entrepreneurial sector and not as a disadvantaged
residual in a segmented labour market. Informalisation is seen as a response by firms – facing
product market competition – to reduce legislated or union-induced rigidities and high labour costs,
particularly by subcontracting production out to be done by unprotected workers.
Mexico: high levels of voluntary informality
Taking the example of Mexico, Maloney argues that despite the inflexibility, inefficiency and
costliness of the Mexican labour code, the usual sources of wage rigidity that would segment the
market seem absent: minimum wages have not been binding for the last decade, unions to date
have primarily been concerned about preserving employment rather than raising remuneration,
and wages have shown extraordinary downward flexibility during crises. The picture that emerges
from this evidence corresponds more to an unregulated entrepreneurial sector than one comprised
of involuntary, disadvantaged, precarious, underpaid workers.
Self-employment in Mexico constitutes the largest source of employment among men (25%), after
formal wage employment (50%). Of those workers who started in the formal wage sector but
moved into informal self-employed sector later, two-thirds reported moving voluntarily, citing a
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desire for greater independence or higher pay as the principal motives. If workers initially enter
formal sector employment, they often do so as a means of accumulating human and physical
capital. This possibility in turn requires formal sector firms to pay high market wages in order to
retain their skilled workers. Maloney finds a similar pattern in some other Latin American
countries, including Argentina and Paraguay.
Brazil: high mobility between the formal and informal sectors
Additional evidence from Latin America that contradicts the model of labour market segmentation
and involuntary employment comes from Brazil. Barros et al. (1990) investigate the mobility of
formal and informal employees in Sao Paulo and find high mobility rates between the two sectors:
nearly 50% of informal workers in any given year will be employed in formal jobs in the following
year. There cannot be wage segmentation between sectors if there is such free mobility between
them. More recently, Curi and Menezes-Filho (2006) have found that in Brazil during the 1980’s
and 1990’s, transitions from formality to informality and from informality to formality were
associated with small wage decreases and increases (around 7%) respectively. They conclude
that labour market segmentation of this limited magnitude is unlikely to have significant effects on
the wage distribution or on workers’ welfare.
Where most individuals work in the informal sector out of choice, competition ensures that there is
an equilibrium relationship between wages in the two sectors. Thus, a widening of the wage
differential between the formal and informal sectors caused informality to fall in Brazil (Carneiro
and Henley, 2003). More employees, faced with a rising opportunity cost of remaining in the
informal sector, opted to work in the formal sector.
2.4 Dual informal labour markets
Informal labour markets often contain both voluntary and involuntary sub-sectors, although their
relative shares can differ greatly form one country to another. Even if the formal sector wage is set
above competitive levels and formal sector employment is consequently rationed, it is still possible
that some workers will prefer the informal sector because either their utility or their income is
higher than in the formal sector. Their utility might be higher despite lower income on account of
non-pecuniary advantages such as greater freedom, and their wages might be higher because
their particular characteristics, such as entrepreneurial talent, are better rewarded in the informal
sector. This would imply that that the income-generating functions of the formal and informal
sectors are different. Although some workers might be in the informal sector by choice, it is
possible that others are in it involuntarily. They have lower income, and lower utility, than they
could obtain if they were employed in the formal sector.
Gunther and Launov (2007) use a household survey for urban Cote d-Ivoire to test these ideas.
They define the formal sector as comprising firms that engage in formal bookkeeping or offer
written contracts, or payslips, to their workers. There are big differences in the characteristics of
workers in the two sectors: on average, earnings in the formal sector are 2.5 times those of the
informal sector, workers in the formal sector have 5.2 more years of education, and training is
three times as common in the formal sector. The authors use a statistical methodology to divide
the informal sector into two groups; intuitively, they are the two groups that are most distinct. The
‘upper tier’ has higher pay and higher returns to human capital, and the evidence is consistent with
its members receiving higher earnings than they would obtain in the formal sector, and thus with
having chosen it voluntarily. The ‘lower tier’, by contrast, is at a clear disadvantage and appears to
be in the informal sector involuntarily and as a result of labour market segmentation.
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A survey of urban informal sector workers in Ethiopia asked the reason for choosing their current
activity. Less than 20% gave reasons that suggested voluntary choice, and almost 80% gave
reasons suggesting that it was the only sector that was possible or that they had no choice. The
informal sector contained a disproportionate percentage of women (disadvantaged by societal
norms, home work, and lower education) and young people (unable to compete for formal sector
jobs against incumbents). A statistical cluster analysis attempted to divide informal sector workers
into an ‘upper tier’ and a ‘lower tier’. In this case the differences were not large, and the upper tier
constituted only a small minority. In Ethiopia the vast majority of informal sector workers cannot
afford to be unemployed and earn too little to lift themselves out of poverty
The informal sector can display dualism even in the absence of barriers to entry. However, it is
very common for entry barriers to keep workers out of the more productive informal sector
activities, with the consequence that the residual labour force is pushed into the free-entry parts,
which are then liable to overcrowding, underemployment, and low incomes. We illustrate with
contrasting case studies from Africa and Latin America.
Dual informal labour markets in southern Africa
In a South African survey of informal sector small businesses (Chandra et al, 2002), respondents
mentioned crime, lack of access to credit, lack of access to infrastructure and services, and need
for training as the top four constraints on their businesses. Their operations had required
substantial start-up capital (2.5 times their average monthly earnings) and there was very little
access to formal or even informal credit. The great majority had not received business assistance
or training. Such problems are common in all developing countries. However, there are some
reasons why barriers are particularly high in South Africa: the repression of entrepreneurial
activities under apartheid and the associated inhibition of entrepreneurial skills and social
networks, and continuing restrictive bye-laws. Moreover, the crime rate is particularly high in South
Africa: when respondents in a survey of unemployed workers were asked why they did not enter
self-employment activities, the most common answer was the fear of crime against their business
(Fields, 2006).
The policies of the South African government that support small, medium and micro enterprises
(SMMEs) have focussed on the provision of finance and facilities, but even that support is said to
be concentrated on the formal sector and to neglect the informal sector: most small operators had
not had access to official ‘small business support centres’ (Chandra et al., 2002). Moreover,
informal sector firms face another obstacle to their development. The extension provision, which
requires each bargaining Council agreement about minimum wages and working conditions to be
extended to all employers in the industry and area, places crippling labour market burdens on
small and micro firms. Although they have the advantage of being generally more labour-intensive,
they tend also to be less efficient than their formal sector competitors. It is possible that, by
attempting to extend the boundaries of the formal sector, the state will harm the small-scale
enterprise sector. Some of these informal workers will be formalised but others will be driven to
activities beyond the reach of the state, so increasing their deprivation
In Zimbabwe in the 1990s, there was evidence that entry to the productive parts of the informal
sector was limited by lack of skills and capital. Most instances of voluntary entry were formal sector
workers who had accumulated experience, knowledge, and skills (Jenkins and Knight, 2001). It
was difficult for educated young people to set up immediately in successful self-employment: if
they could not find formal sector jobs they preferred unemployment to free-entry self-employment.
February 2007 10

Informal apprenticeships in Ghana
Skill formation in the informal sector is a potentially serious form of market failure. There is often
simply no market by which workers wanting to set up in self-employment or to establish small
businesses in the informal sector can acquire the skills they need. However, it is interesting that a
traditional and indigenous market operates in Ghana, in the form of informal apprenticeships.
Valenchik (1995) uses a survey of manufacturing enterprises in Ghana to investigate this system.
No fewer than 54% of micro-enterprises (1-4 employees), and 66% of small enterprises (5-29
employees) were owned by former apprentices, 37% and 57% of their workers respectively were
former apprentices, and 37% and 72% respectively of the firms were training apprentices. The
apprenticeships were generally in production crafts, such as baker, tailor, welder, and carpenter.
Often the apprentices came from within the same social network, so increasing trust. Workers
were either paid a low wage, determined in the largely competitive conditions by their productivity
minus their training cost
Latin America informal labour markets: dual, but predominantly voluntary
Maloney (2004) has also argued, but with respect to Latin American experience, that informal
sector workers tend to be older and to enter from the formal sector after they have accumulated
knowledge, capital and contacts. The study finds that in Brazil and Mexico 60-70% of the
informally self-employed report preferring informal self-employment for reasons of independence
and higher earnings.
Attempts to compare welfare more directly find a premium to being informally self employed in
Bolivia (Arias and Sosa, 2004), consistent with the sociological evidence from Mexico that self
employment is often considered a step up from salaried work. Women appear to find that self
employment allows a better balancing of home and work responsibility. For some workers,
informality offers more flexibility and mobility opportunities than the patronage-tenured-based
formal sector. For instance, Bolivian indigenous workers do not face earnings gaps with respect to
non-indigenous in informal jobs contrary to the formal sector (LAC Labour Team, 2004).
2.5 Linkages with the formal sector
In traditional poor economies almost every activity was informal (Lewis, 1954). It was commonly
thought that, with economic development, the formal sector would expand and the informal sector
would wither away. In many developing countries this has not happened, for two main reasons.
First, the inadequate growth of formal sector employment in countries with labour market
segmentation means that the informal sector acts as a residual sponge for the growing labour
force. Second, in some countries the informal sector is preferred, and is entered voluntarily. An
important reason for this is the complementarities that can exist between the two sectors.
Chen (2004) argues that that most informal enterprises and workers are intrinsically linked to
formal firms and describes three broad schools of thought regarding the informal sector and its
links to the formal sector:
· Dualists. Dualists subscribe to the notion that informal units and activities have few, if any,
linkages to the formal economy and operate as a distinct and separate sector. Wage
rigidities – raising wages above market-clearing levels – segment the labour market, and
informally employed workers are in the residual, disadvantaged segment of the labour
market.
February 2007 11

· Structuralists. Structuralists see the informal and formal economies as intrinsically linked.
In the interest of increasing their competitiveness, firms in the formal economy are seen to
reduce their input costs, including labour costs, by promoting informal production and
employment relationships with subordinated economic units and workers. According to
structuralists, both informal enterprises and informal wage workers are subordinated to the
interests of capitalist development.
· Legalists. Legalists focus on informal enterprises and the formal regulatory environment
rather than the informal sector labour market and its workers. While they do not focus on
the relationship between informal enterprises and formal firms, the legalists acknowledge
that capitalist interests collude with government to set the bureaucratic ‘rules of the game’
(de Soto 1989).
Given the heterogeneity of the informal economy, each of these three approaches has potential
value. Here we concentrate on the structuralist approach, following Chen (2004).
Informal enterprises and formal firms
Apart from some survival activities, few informal enterprises operate in isolation from formal firms.
Most source raw materials from or supply finished goods to formal firms either directly or through
intermediary (often informal) firms. Sourcing and supplying of goods or services can take place
through individual commercial relationships or a value chain of sub-contracted relationships. To
understand the linkages between informal enterprises and formal firms it is important to consider
the nature of the production system through which they are linked. The nature of the linkage –
specifically, the allocation of authority and risk between the informal and formal firm – varies
according to the nature of the production system. For instance, a garment maker might produce for
the open market (with some authority and all of the risk) or for a supply firm linked to a
multinational company (with little authority but much of the risk in the form of non-wage costs,
rejected goods, and delayed payments).
Informal workers and formal firms
Historically, around the world, the ‘employment relationship’ has represented the cornerstone
around which labour law and collective bargaining agreements have sought to recognise and
protect the rights of workers. Whatever its precise definition in different national contexts, it has
represented “a universal notion which creates a link between a person, called the employee
(frequently referred to as ‘the worker’) with another person, called the employer to whom she or he
provides labour or services under certain conditions in return for remuneration” (ILO 2003). The
concept of employment relationship has always excluded those workers who are self-employed.
Increasingly, some categories of wage workers have found themselves to be, in effect, without
legal recognition or protection because their employment relationship is either disguised or
ambiguous or not defined.
· Disguised: the employment relationship is deliberately disguised by giving it the
appearance of a relationship of a different legal nature. For example, the lead firm in a sub-contracting
chain may claim that it has a ‘sales-purchase’ – or commercial - relationship
with those who produce goods for it, rather than a subcontracted employment relationship.
· Ambiguous: the employment relationship is kept deliberately ambiguous to create doubt
about whether or not an employment relationship really exists. This is the case, for
instance, with street vendors who depend on a single supplier for goods or sell goods on a
commission for a distributor.
February 2007 12

· Not defined: the employment relationship clearly exists but it is not specified who the
employer is, what rights the worker has, and who is responsible for securing these rights.
For example, in value chain production, it is not clear who the real employer is - the lead
firm, the supply firm, or the sub-contractor.
Similarly, in the case of temporary work, it may be unclear who the real employer is - whether it is
the agency that supplies temporary workers or the firm that hires them on a temporary basis.
Under each of these employment relationships, workers tend not to be protected under labour law
or collective bargaining agreements. By this definition, they are informally employed. In many such
cases, the employer seeks to disguise the employment relationship or avoid definition of who is
responsible; and the employer in question may well represent a formal firm, not an informal
enterprise.
Beginning in the 1980s, formal firms in developed countries began to favour flexible labour
relationships. This form of labour market segmentation took place in the interest of flexible
specialised production, not in response to rising wage rates or labour costs (Piore and Sabel,
1984). Also increasingly since the 1980s, many formal firms in developed countries have decided
to sub-contract production out to unprotected workers in developing or transition countries. There
is often further segmentation between the core semi-permanent workforce and a peripheral
temporary workforce that is mobilised during peak seasons and demobilised during slack seasons
(what has been called a ‘permanent temporary workforce’).
In summary, many formal firms prefer informal employment relationships, in order to reduce labour
costs. Formal firms choose these types of informal employment relationships as a means of
avoiding their formal obligations as employers. In such cases, it is the formal firm and not the
informal worker that chooses to operate informally and enjoys the benefits of informality. Workers
may therefore be employed in the informal sector not by choice but for the lack of formal sector
alternatives.
2.6 Informality and illegality
There has traditionally been a widespread assumption that the informal sector comprises
unregistered and unregulated enterprises whose owner-operators choose to evade registration
and, thereby, legally imposed burdens such as taxation. Lest this be regarded as convincing
argument against such informality, we should note the following:
· There is a distinction between illegal processes or arrangements and illegal goods and
services. While production or employment arrangements in the informal economy are often
semi-legal or illegal, most informal workers and enterprises produce or distribute legal
goods and services. Although the criminal sector not only operates illegally but also deals
in illegal goods and services, this is only a small part of a sector that is, for the most part,
not illegal or criminal.
· It is important to note that, in the case of informal wage work, it is not the workers but their
employers, whether in formal or informal firms, who are avoiding registration and taxation.
Many owner-operators of informal enterprises operate semi-legally or illegally because the
regulatory environment is too punitive or cumbersome. Many would be willing to pay the
costs of registration and pay taxes if they were to receive the incentives and benefits of
formality that are often enjoyed by registered businesses.
· Those who work in the informal sector involuntarily generally associate operating outside
the legal regulatory framework with costs rather than benefits. Such informal sector
February 2007 13

workers are deprived of secure work, employer-sponsored benefits, social protection, legal
protection, and representation or voice. Partly as a result of this, a much higher proportion
of people working involuntarily in the informal economy than of those working in the formal
sector are poor.
February 2007 14

3. Definitions and measurement of the informal sector
3.1 Definitions
The attempts at defining the informal sector provided in the introduction in Box 1 are contentious
because the definitions require interpretation in particular contexts and it begs the question as to
the reason for seeking a definition. In the case of the informal sector, it is not true that ‘one size
fits all’. There is a continuum between informality and formality, with formalisation being a gradual
process. Few firms follow all the rules governing enterprise behaviour and few follow none of
them. Entrepreneurs make repeated economic calculations of the costs and benefits of following
the rules, and embrace formality up to the point where the potential benefits outweigh the costs.
The production unit and type of employment status of those commonly described as informal are
highly diverse. They include own-account workers in survival-type activities, such as street
vendors, shoeshiners, garbage collectors and scrap- and rag-pickers; paid domestic workers
employed by households; homeworkers and workers in sweatshops who are “disguised wage
workers” in production chains; and the self-employed in micro-enterprises operating on their own
or with contributing family workers or sometimes apprentices/employees. It is important to note the
diversity of those working in the informal economy because the problems and needs are different.
For example, they differ for those engaged in survival activities, for homeworkers, whose
employment relationship with an employer is not recognised or protected, and for the self-employed
and employers, who face various barriers and constraints to setting up and operating
formal enterprises. These different groups have been termed “informal” because they share one
important characteristic: they are not recognised or protected under the legal and regulatory
frameworks. This is not, however, the only defining feature of informality.
It is relevant to ask: in what circumstances can the distinction between the formal and the informal
sectors be non-existent or irrelevant, and in what circumstances does it become important? This
inevitably directs attention to the underlying policy concerns. These are likely to include both
efficiency and equity objectives. On the efficiency side, is there inefficient resource misallocation
as a result of the distinction, in particular misallocation of labour or inadequate investment in
workers? On the equity side, does the division between formal and informal contribute to poverty in
its various dimensions, such as low income, economic inequality, economic insecurity, and bad
conditions of workers?
These considerations mean that there is no right definition of the informal sector labour market,
independent of economic and institutional context and underlying objectives. In principle, we are
looking for a sharp segmentation between groups of workers that leads to problems of equity or
efficiency. In practice, the informal sector might be defined in terms of not having a legal contract,
or not being covered by social security provisions, or being self-employed or employed by a small
firm, or not being a trade union member, or not having employment with an officially ‘registered’
establishment. Even though there is likely to be overlap, the size and composition of the informal
sector can vary greatly according to which of the available definitions is used, and so it is important
to be clear why it is that the informal sector raises policy concerns.
The availability of a rich data set makes Brazil a good case study for evaluating the definition and
measurement of the informal sector (Henley et al, 2006). The labour market is regulated by means
of a Labour Code. This mandates the official registration of all contracts of employment and
requires employers to provide each contracted employee with a signed ‘labour card’, stating the
terms of employment and conferring legal entitlement to a wide range of contract terms. There is
an incentive for employers not to register contracts and for employees to be registered. Social
February 2007 15

security (mainly in the form of pensions) is provided by the employee’s membership of a ‘social
security institute’. Thus there are three possible definitions of informality: not having a formal
contract, not having social security, and being employed in a small firm. The Brazilian household
survey permits the application of all three definitions. In 2001, 40% of the employed were informal
on all three definitions, and 36% were formal on every definition of informality. The remaining 24%
were informal on one or two of the definitions: 11% on only one and 13% on two of the three.
Which definition is the most appropriate? Although Henley et al (2006) did not analyse wages and
their relationship to informality, insofar as we are concerned about income poverty, the firm size
definition is the most appropriate because it is the one most likely to identify low-paid workers..
Insofar as we are concerned about insecurity, each the other two is very relevant. If policy-makers
want to address both poverty and insecurity, then the 40% of employees who qualify by all three
criteria can be regarded as the group most vulnerable.
The official definition of the informal employment used in Ethiopia requires that all three conditions
be met: employees are informal if the employer has no book of accounts, no official ‘license’, and
has fewer than ten employees. On that basis, 38% of urban employees were informal in 2005.
However, if domestic servants, self-employed workers, apprentices and unpaid family workers are
included – as seems appropriate if the criterion is to identify workers with low incomes - the
proportion rises to 71%.
At an operational level, the combination of proxy indicators (e.g. employment size of the enterprise,
non-wage employment, or whether the enterprise is officially registered) used in household and
establishment surveys to identify the informal sector varies from country to country. Whatever
definition is used, it is unlikely to represent the concept most useful to policy-makers in any
particular context. It may not be a good guide to identifying low-paid or insecure workers, and it
may not pick up all informal activities. For instance, labour force and household surveys typically
count only one's primary occupation, thus effectively excluding secondary activities in the informal
sector.
3.2 Scale of the informal sector
Attempts to estimate the importance of informal sector employment find vast differences across
countries in standardised measures of its size. This is partly because standardised measures are
misleading if different concepts are required, but the research also suggests that certain
characteristics increase informality on almost any measure. Countries with lower GDP per capita
tend to have larger informal sectors; when the state and its institutions impose high regulatory or
fiscal costs on formal enterprises, informality is a form of evasive action; when formality provides
access to public services and favours, informality dwindles (Loayzi and Rigolini, 2005).
Despite these measurement difficulties, it is still valid to review evidence of the scale of the
informal sector in developing countries. ILO data on informal sector employment as a percentage
of total employment is available for 42 countries. Out of these countries, 17 have more than half of
their total employment in the informal sector and only four countries have less than 10% of total
employment in the informal sector. Among the regions covered, sub-Saharan African countries
tend to have the highest proportion of informal to total employment, and the transition countries of
Central and Eastern Europe and the Commonwealth of Independent States (CIS) have the lowest
shares (see table 3.1). The table shows that there is considerable variation among countries as
regards informal employment as a percentage of total employment, from 5% to over 70%. Among
the regions, countries of West and East Africa, South Asia and the Andean region tend to have the
highest proportions of informal to total employment.
February 2007 16

Table 3.1 Persons employed in the informal sector1
Number (000’s) % of Country Year total employment
Total Men Women
Women
per 100
men
Total Men Women
Latin America
Mexico 1999 9,141.6 5,693.8 3,447.7 61 31.9 32.7 30.7
Barbados2 1998 6.9 4.2 2.7 63 5.9 6.8 4.9
Peru 2,3 1999 3, 606.1 1,897.8 1,708.3 90 53.8 48.9 60.6
Brazil4 1997 18,113.3 8,652.6 9,460.6 109 34.6 28.3 43.4
Africa
Mali3,4 1996 370.6 214.3 156.3 73 71.0 n.a. n.a.
Benin3 1999 275.5 174.8 100.7 58 46.0 50.0 41.4
Botswana4 1996 60.5 21.1 39.4 187 19.3 12.3 27.6
South
1999 2, 705.0 1,162.0 1,544.0 133 26.1 19.3 35.5
Africa4
Ethiopia2,3 1999 1,149.5 485.6 663.9 137 50.6 38.9 64.8
Kenya 1999 1,881.0 1,090.4 790.6 73 36.4 43.9 29.5
Tanzania2,5 1995 345.9 221.0 124.9 57 67.0 59.7 85.3
Asia
India 2000 79,710.0 63,580.0 16,130.0 25 55.7 55.4 57.0
Nepal4 1999 1,657.0 1,052.0 605.0 58 73.3 67.4 86.5
Philippines
1995 539.3 282.8 256.5 91 17.3 15.8 19.4
2,6
Turkey 2000 10,319.5 1,183.0 136.5 12 9.9 10.6 6.2
Central and Eastern Europe
FYR
Macedonia
1999 152.0 96.0 56.0 58 27.8 n.a. n.a.
Slovakia 1999 450.0 343.5 106.5 31 23.0 30.5 12.9
Poland2,4 1998 1,166.0 817.0 349.0 43 7.5 9.5 5.0
Lithuania2,3 1997 93.0 68.3 24.7 36 8.5 11.9 4.8
Ukraine 2,3,4 1997 755.9 345.4 420.5 122 4.9 4.5 5.3
Georgia7 1999 103.3 73.6 28.6 39 6.9 10.0 3.8
Notes: 1. In the same geographic areas, branches of economic activity, age limits, etc, 2. Agriculture included, 3.Urban
areas, 4. Paid domestic workers included, 5. Dar-es-Salaam, 6. National Capital Region, 7. Agriculture included for
urban areas, n.a.: Not available.
Source: ILO Bureau of Statistics on the Basis of Official National Data
In about half of the countries included in table 3.1, the share of informal in total employment is
higher for women than for men. In some countries (Botswana, Brazil, Ethiopia, South Africa and
Ukraine), there are more women than men in informal employment, even in absolute numbers.
However, the gender bias in the informal economy is probably underestimated. Women are more
likely than men to be in those informal activities that are undercounted, such as production for own
consumption, paid domestic activities in private households and home work.
The composition of the informal sector is likely to depend on the relative importance of voluntarily
and involuntarily entered employment. In Ethiopia, where the informal employment is
predominantly involuntary, informal workers tend to be young, female, and poorly educated. Young
people entering the labour market find it difficult to compete with incumbents of formal sector jobs,
who can be protected by law or by their firm-specific human capital. Women are often at a
disadvantage as a result of societal norms, demands of the home, and their relative lack of
education. Education is more valuable in larger and technically more sophisticated economic
February 2007 17

activities than are generally found in the informal sector. Moreover, as the Chinese case study
above illustrated, the informal sector is often the natural entry point to the urban economy for
migrants from the countryside. By contrast, in Mexico, where voluntary employment is reported to
predominate, informal sector workers tend to be older, more experienced workers who have
entered from the formal sector having accumulated skills, contacts, and savings.
In surplus labour countries the distribution of residual labour between disguised unemployment in
the free-entry informal sector and open unemployment has to be explained. In South Africa, where
the informal sector employs an unusually small proportion of the labour force, Kingdon and Knight
(2007) estimate the proportion in informal employment, formal employment and (narrowly defined)
unemployment to be 24, 47 and 29% respectively in 2003. This is on the official definition of
informal employment (own-account workers plus workers whose employers are too small to be
VAT registered) plus agricultural workers. A broader definition that includes employees of
registered firms if they do not receive paid leave, pension rights or employment insurance doubles
the proportion of informal employees in non-agricultural employment, from 28 to 59%, but this
definition may be too encompassing to identify the people whom the policy-makers wish to reach.
Our account above of the barriers which restrict informal sector employment helps to explain why
South Africa is an international outlier. However, the question arises: why do the unemployed not
enter the informal sector activities which are relatively open to access, such as crafts and petty
trade? Much of the explanation has to do with the small size of this sector, given competition from
the efficient formal sector, and the consequent collapse of real incomes in those activities as the
growing residual labour force poured into them. Provided that the unemployed receive some
support from within or beyond the household, they prefer to remain outside the informal sector
(Kingdon and Knight, 2007). However, in lower income countries possessing a smaller formal
sector, unemployment is lower insofar as the poor cannot afford to be unemployed and have no
prospect of formal sector employment.
3.3 Trends
ILO (2002) describes how the bulk of new employment in recent years, particularly in developing
and transition countries, has been in the informal economy. However, the report recognises that
the term informal sector is an inadequate term to reflect various dynamic, heterogeneous and
complex aspects of the phenomenon.
One aspect is the 'flexibilisation' and 'informalisation' of production and employment relationships
in the context of global competition and information and communications technology (ICT). More
and more firms, instead of using a fulltime, regular workforce based in a single, large registered
factory or workplace, are decentralising production and reorganising work by forming more flexible
and specialised production units, some of which remain unregistered and informal. A global
variation of flexible specialisation is the rapid growth in cross-border commodity and value chains
in which the lead firm or large retailer is in an advanced industrialised country and the final
producer is an own-account worker in a micro-enterprise or a homeworker in a developing or
transition country. As part of their efforts to enhance competitiveness, firms are increasingly
operating with a small core of wage workers employed on regular terms and conditions and a
growing periphery of workers employed on different, normally inferior, in different workplaces
scattered over different locations and sometimes different countries. These measures often include
outsourcing or subcontracting arrangements and more flexible and informal employment
relationships.
It has been argued that periods of economic boom can lead to the formalisation of informal sector
workers: government is more able to enforce regulations when enterprises can afford their cost,
February 2007 18

and has to be more lenient when times are tough.. Moreover, informal sector employment
expands in periods when formal sector employment contracts. For instance, in the East Asian
economic crisis millions of people who lost formal jobs in the affected countries tried to find or
create jobs in the informal economy (Lee, 1998). Structural adjustment in Africa and economic
transition in the former Soviet Union and in Central and Eastern Europe were also associated with
an expansion of employment in the informal economy. Informal employment tends to expand
during periods of economic adjustment or transition because retrenched workers who cannot find
alternative formal jobs turn to the informal economy for work because they cannot afford to be
unemployed. In response to falling living standards, brought on by recession or inflation,
households may try to supplement incomes from formal jobs with informal earnings.
The ILO’s World Labour Reports show the importance of informal sector employment growth in
recent years. In Latin America, the urban informal sector was the primary job generator in the
1990s. An average of 6 out of every 10 new jobs were created by micro-enterprises, own-account
workers and domestic services. Informal sector employment grew by 3.9% per annum while formal
sector employment grew by only 2.1% in that region. In Africa, urban informal employment is
estimated to absorb 61% of the urban labour force. This sector was estimated to have generated
more than 93% of all additional jobs in the region in the 1990s.
Figure 3.1 Trends in informal sector employment as a percentage of total
employment, selected Latin American countries
Source: ILO: Key Indicators of the Labour Market 2001-2002, op. cit., table 7.
There are only 17 countries for which ILO time-series data are available that permit monitoring of
the evolution of informal employment over time. They show that in virtually all cases, the share of
informal in total employment in the corresponding branches of economic activity has increased
during the 1990s (figure 3.1 gives some examples of trends in informal employment). Where there
has been an increase in informal employment, it has grown for both men and women. In some
February 2007 19

countries, however, particularly in Latin America, women’s participation in informal employment
has risen much more rapidly than men’s.
The reasons why the informal employment has grown in importance can very from one country to
another. For instance, in South Africa the informal sector had to absorb the residual labour force
and its growth, in Brazil the explanation might be the growing attractiveness of informality, and in
China informal sector employment has increased on account of marketisation and privatisation.
More generally, however, the trend towards globalisation has also contributed, by making out-sourcing
and sub-contracting more feasible.
February 2007 20

4. Policies
4.1 Introduction
Historically, policy makers have taken differing policy stances on the informal economy: some
observers view informal workers as a nuisance to be eliminated or strictly regulated; others see
them as a vulnerable group to be assisted through social policies; still others see them as dynamic
entrepreneurs to be freed from cumbersome government regulations. Another perspective sees
the informal workforce as comprised of unprotected producers and workers who need to be
covered by labour legislation and social protection.
At the core of the policy debate on the informal economy is the oft-repeated and greatly-misunderstood
question of whether or not to ‘formalise’ the informal economy. Experience
suggests that no simple rule exists that increasing or decreasing formalisation necessarily
improves or worsens the well-being of the poor or welfare of society at large (Guha-Khasnobis et
al, undated). Policy makers must be aware of the risk that attempts at formalisation can lead to
increased levels of unemployment and poverty for those who cannot be formalised.
It is also unclear what is meant by ‘formalisation’. To many policy makers, formalisation often
means that informal enterprises should obtain a license, register their accounts, and pay taxes. But
to the self-employed, these represent the costs of entry into the formal economy. For
entrepreneurs to be willing to meet these costs, they must be offset by benefits, such as:
enforceable commercial contracts; legal ownership of the place of business and means of
production; membership in formal trade associations; and statutory social protection. To informal
wage workers, formalisation means obtaining a formal wage job – or converting their current job
into a formal job – with secure contract, worker benefits, and social protection.
4.2 Objectives and justifications for public intervention
In considering policy approaches towards informal sector labour markets, it is relevant to question
whether the issue is one of labour market inefficiency to be redressed by government or
institutional interventions, or one of labour market efficiency marred by government or institutional
interventions. The same country might harbour both: for instance, efforts to encourage the
emergence of entrepreneurs might fall into the former category, and attempts at excessive
regulation into the latter. Determining the policy stance will additionally depend on a diagnosis of
whether informal labour is voluntary or involuntary.
Even in countries where the informal sector has to absorb much surplus labour into unproductive,
poorly remunerated, wage or self-employment activities, there is nevertheless often a case for
intervention to promote productive informal sector activities. This is liable to take the form of
weakening the barriers to entry to such activities - some artificial and some having an economic
basis. These policies might include overcoming market failures in the acquisition of technical and
business skills and in the provision of credit to self-employed persons and small businesses, and in
the creation of an environment conducive to business (such as ensuring legal redress and security
of property).
In many countries, the informal sector is divided between parts which are protected by barriers to
entry and parts with relative freedom of entry. The unemployed and entrants to the labour market
find it difficult to enter the former – normally self-employment activities – because they lack the
February 2007 21

factors of production which must accompany labour or they face high transaction costs. Thus, it is
necessary for them to obtain capital or skills – both of which might require access to credit - or to
build up social networks. An important role for government is to assist people to overcome such
barriers, and thus contribute to a reduction in labour market segmentation. In some cases it is
relatively easy to assess what should be done. For instance, artificial restrictions imposed by
incumbents to exclude newcomers should be outlawed, artificial constraints on access to
workplaces should be removed, and it is the responsibility of government to ensure that firms are
free from harassment and crime. In other cases policy-making is more difficult. Private credit
markets tend to fail and official micro-credit schemes typically run into a series of problems, such
as the difficulty and cost of assessing applications, the politicisation of lending, and the hazard of
bad debts. Training schemes can suffer from inadequate official information about skill needs and
poor choice of workers to be trained.
There is scope for government to provide or fund training, credit, and other business development
services to firms and would-be entrepreneurs, but only if evaluations demonstrate that they have
positive results. There is need for an evidence-based approach to such interventions.
Nevertheless, the overcoming of barriers to entry to self-employment activities and for small
businesses is one of the clearest examples of market failure in developing countries which require
government intervention to improve on the market outcomes.
The formal and informal sectors generally compete with each other in product markets, although
sometimes their relationship is complementary, e.g. through sub-contracting. It is an important
issue whether such competition is ‘fair’ or ‘distorted’, e.g. through government favouring of the
formal sector. These product market issues have implications for informal sector employment and
therefore require policy attention.
It is well established that there is a strong positive relationship between firm size and benefits to
workers (in the forms of e.g. wages, conditions, unionisation, pension schemes, and training). This
can be the result of official intervention and regulation but often it is what large firms would choose
to do anyway, for ‘efficiency wage’ reasons or because they can afford it. Often small and micro
enterprises struggle to compete with larger enterprises, and yet they have the social advantage, in
countries with surplus labour, that they employ more labour-intensive methods. It is a debateable
question - and one which would normally require examination of particular cases - whether in such
circumstances the state and its institutions should extend to the small-scale sector regulations
relating to e.g. minimum wages, labour contracts, social security coverage, and training. There is
a risk that such an extension could reduce the competitiveness (and hence viability) of small-scale
labour intensive enterprises, which is partly based on relatively lower wages and greater flexibility.
The following sections consider specific policy areas in more detail, including the regulatory and
institutional framework, social protection, minimum wage legislation and trade unions.
4.3 Regulatory and institutional framework
Where informality is voluntary, the decision by workers to comply with formal sector regulations is
based on weighing the value of social benefits relative to what arrangements can be made
informally, against the tax, implicit or explicit, that being a registered employee implies. High levels
of voluntary informality is often blamed on excessive regulations that create barriers and costs to
working formally. Ulyssea (undated) finds for Latin America that reducing formal sector’s entry
costs significantly reduces informal employment and increases the formal employment and overall
labour market performance. Moreover, reducing entry costs generates an improvement in most
labour market indicators: the formal-informal wage differential is significantly reduced, exit
probabilities out of unemployment increase - which causes a reduction in the unemployment rate -
February 2007 22

and there is an increase in average labour productivity. Strengthening enforcement of labour
regulations is also very effective in reducing the size of the informal sector, but it also significantly
increases unemployment and reduces the aggregate product and average productivity. Overall,
the results from this study indicate that the best option to reduce labour market segmentation and
improve performance is to reduce the costs of entry into the formal sector instead of intensifying
punishment and auditing of informal activities.
Three types of legislation and regulations are important:
1. Commercial or business regulations governing the establishment and operation of enterprises.
2. The laws pertaining to property rights, which could affect the ability to transform assets into
productive capital.
3. Labour legislation governing employment relationships and the rights and protection of
workers.
What needs to be understood is whether existing laws and institutions are poorly or well designed
in terms of their influence on the costs and benefits to enterprises and workers of becoming and
staying formal or informal. Where such rules and regulations are cost effective, are predictable
and provide the requisite business information, people are more likely to conform to and pay for
them. Rules which are poorly designed, are burdensome and involve dealing with corrupt and
inefficient bureaucracies increase transaction costs, discourage compliance, impede economic
participation and encourage endemic corruption, thus enhancing segmentation between the formal
and informal economies.
Improving the legal framework does not necessarily mean deregulation. It is important to
remember that laws do not only constrain entrepreneurship and formalisation, they can also play a
facilitating or enabling role and serve to enforce fundamental principles and rights. An enabling
legal system can offer security, incentives, safeguards and protections. Reforms should focus on
the most binding constraints and consider the interactions between labour regulations and other
aspects of the investment climate affecting the incentives to become formal. Good practice in
reducing segmentation between the formal and informal sectors will in most cases include the
following measures:
· Support broad programmes of regulatory reform.
· Design measures to create a business friendly culture in government and to improve
service provision.
· Simplify official administration for business.
· Simplify tax administration.
· Rationalise business registration and licensing regimes.
· Limit licensing to those activities where it is justified.
· Reduce registration fees and statutory requirements.
· Promote labour law reform which, whilst protecting essential rights, makes it easier to hire
and fire workers and to employ people on flexible contracts.
4.4 Social protection
The term social protection is usually used to describe arrangements made for those people and
communities who encounter adverse contingencies. These arrangements aim to provide some
form of maintenance of income and services to these people to ensure that they are catered for in
February 2007 23

times of need. Social protection includes public social security schemes and also private or non-statutory
schemes. Workers in the informal economy generally have little or no social protection
and receive little or no social security, either from their employer or from government.
Social protection is an area in which there is likely to be market failure. In a developing country
there can be a dearth of private insurance providers, and in any case poor, often myopic, workers
are generally reluctant themselves to pay for insurance. Thus the state may need to take the
initiative, and to design and implement the scheme. This makes it likely that the arrangements will
be suited to formal sector employees and not to informal sector workers. Governments often
require the employer to pay the costs of the scheme on behalf of the employees, or at least to
contribute to the costs. This raises the question of the ultimate incidence of the charge: economic
theory predicts that in market equilibrium the costs will be shared between employers and
employees according to the elasticities of supply and demand. Nevertheless, the initial incidence is
clear, and this might persuade firms to be informal in order to escape these costs.
The lack of social protection is a key defining characteristic of the informal economy. ILO (2002)
estimates that only 20% of the world’s workers have what they describe as “truly adequate social
protection” and more than half of the world’s workers and their dependants are excluded from any
type of formal social security protection. In sub-Saharan Africa and South Asia, formal social
security personal coverage is estimated at 5 to 10% of the working population, and in some cases
is decreasing.
We would expect to find informality falling when the level, and thus the cost, of social insurance
that must be provided by employers falls, by making the employer’s decision to hire an additional
worker more affordable. By contrast, an improvement in the administration of social insurance,
such as the government simplifying the process for employers in the event of a claim, could reduce
informality by encouraging more employers to enter the formal sector.
With social protection being increasingly considered as a right of workers, the informal economy
poses a difficulty for policy-makers. The irregularity of informal employment makes it unreliable as
a source of income for social insurance contributions. Moreover, informal workers normally do not
have other sources of income to contribute to compulsory social insurance schemes. For workers
in disguised employment relationships, it is difficult to get the ultimate employer (or lead firm in a
global chain) to assume responsibility for protecting these workers’ rights, including the right to
basic social protection, especially as there are definite financial and legal implications.
As argued in Canagarajah & Sethuraman (2001), attempts to extend orthodox social protection
measures to those in the informal sector in developing countries are therefore unlikely to succeed
in providing effective protection. In response to this problem, increasing emphasis is being placed
on organisations of workers (or small producers) in the informal economy in order to pool risks,
and thereby lower the cost of insurance, e.g., group insurance schemes. Such informal
mechanisms are still in an experimental stage; despite innovations and adaptations few schemes
seem to reach workers in the informal sector. They also face considerable challenges relating to
problems of 'scaling up' and doubtful financial sustainability, quite apart from the problems of
institutional capacity and governance.
4.5 Minimum wage legislation
The impact of minimum wage legislation on informality appears to be mixed. As we saw in Section
2.2.2, minimum wages can make small – often informal sector – firms less able to compete. They
can also displace workers from the formal sector. Jones (1998) shows that Ghana’s minimum
wage policies during the 1970s and 1980s led to a reduction of formal sector jobs and an increase
February 2007 24

in informal sector jobs. The study also provides some evidence that a large proportion of the
displaced workers from the formal sector ended up working in the informal sector, and that there
was a corresponding reduction in the wages of those in the informal sector. However evidence
from Latin America (e.g. Maloney & Nunez Mendez, 2004 & Cunningham et al, 2004) suggests
that the minimum wage is often as binding in the informal as in the formal sector. This adds
support to the idea that in these countries, the informal sector is not completely unprotected by
social norms, but in fact is covered by notions of fair wages.
4.6 Trade unions
Trade unions are generally associated with the formal economy and tend to exclude informal
workers. However in many developing countries, a more ‘informal’ labour movement is
developing, particularly championing the rights of poor women workers. By securing better
conditions for their members, trade unions can help to tackle poor labour conditions – by promoting
human rights, core labour standards, and social responsibility in business, consumption and
investment.
In each developing country there is a particular relationship between government and the trade
unions. For instance, they are subordinated in China, suppressed in Zimbabwe, and taken into an
alliance in South Africa. This underlying political economy determines the role that trade unions
can and do play. Where they are important in wage determination, they tend to segment the urban
labour market between unionised and non-unionised segments.
Considerable care must be taken in regard to policies affecting trade unions and the informal
sector. As described earlier, in the case of South Africa, trade unions and collective bargaining
can have a significant impact on formal sector wage premiums. Such premiums can create an
incentive for enterprises to reduce their employment and to engage workers on a casual basis,
both effects being to increase the size of the informal labour force. The extent to which this is
likely to happen will depend on individual country conditions; it is most likely to represent a problem
where there is considerable involuntary informality.
February 2007 25

5. Conclusions
This paper has introduced several, often contrasting, case studies to show how, if we are to
understand informal sector employment issues, we need to study the economic circumstances and
institutions of particular countries and of the contexts in which policy objectives are pursued. It is
certainly not the case that the formal sector is necessarily good and the informal sector necessarily
bad. It has not been possible to make other than broad generalisations. We have argued that
policies towards the informal sector would be generally be better if they attempted to reduce labour
market segmentation rather than reduce informality.
It is also clear that where there is market failure, there is a case for intervention to prevent it; and
where there is government failure, there is a case to remedy the inefficient intervention. Examples
of the former argument are the inadequacy of skill formation in the informal sector and the failure of
markets for social protection to develop. It is renewed emphasis on the latter argument that
explains the recent prevailing tendency among developing nations towards labour market
liberalisation or deregulation.
Two conflicts have emerged from differing views of the informal sector:
· Improving livelihoods within the informal economy while encouraging formalisation.
Some researchers and donor programmes view the informal economy as a long-term structural
feature of modern economic development. Given this, some interventions are aimed at
improving the welfare of people who find themselves in the informal economy, rather than
helping them to formalise. Other donor interventions consider formalised economic growth to
be a central goal of development and a primary driver of poverty reduction. These are
accordingly focused on encouraging formal economy growth. In between these two views is a
place for interventions that help actors in the informal economy to take gradual steps in the
formalisation process, for instance by creating associations with a formal status to facilitate
access to such services as micro-credit, insurance, land tenure and physical market places.
The challenge is to determine how interventions can be devised that improve the livelihoods of
the poor while not removing incentives to formalisation.
· Improving employment conditions for informal sector workers versus increasing
competitiveness of the private sector. Some approaches look for ways to improve labour
market conditions in the informal sector. This approach has the potential to conflict with
approaches that emphasise the competitiveness of informal economy enterprises, the need to
ensure workforce flexibility so as to maintain competitive advantage and the need to keep
employment law compliance burdens to a sensible minimum.
To ensure that appropriate policies are put in place, the informal workforce needs to be recognised
and understood by policy makers. To ensure that the policy approach is well-informed, it needs to
be evidence-based. The availability of periodic and labour force surveys has improved greatly in
recent years in many developing countries. Yet there is still limited information on the informal
sector, in the sort of detail that is required for policy-making.. Greater priority needs to be given to
the collection of data on informal employment, which is a relatively new topic in labour statistics.
Before arriving at appropriate policy for the informal sector in any particular country, it is necessary
to classify it by a set of diagnostic criteria. We set these out below, and indicate the sorts of
information and data required for this purposes. The following diagnostic tests might be applied.
· The labour market institutions – such as regulations about minimum wages and conditions,
employment protection, social protection, and differential treatment of rural-urban migrants,
February 2007 26

and the coverage of such regulations – would help to identify the likely dividing line
between the formal and informal sectors.
· The division between the formal and informal sectors that is suggested by the institutional
information should be compared with the actual division that is available from official or
other statistical sources: discrepancies might distort the analysis.
· The underlying political economy that often produces segmentation between formal and
informal sectors is relevant to understanding government policies and the feasibility of any
proposals for policy change.
· A rigorous test of the degree of segmentation between the formal and informal sectors
could be obtained from a labour force1 or household survey providing information on
individual workers. The criterion is whether there is sharp wage or other segmentation
between the two sectors, after standardising for the other determinants of the dependent
variable and correcting for any bias arising from unobserved selection into the two sectors.
A less rigorous test would simply compare average earnings in the two sectors.
· A similar test could be conducted on workers within the informal sector to decide whether
they can be divided into an upper tier and a lower tier, distinguished by a difference in
income. Such a division would probably be based on the extent of barriers to entry.
Evidence on the extent and nature of barriers to entry could be helpful in making this
distinction.
· The composition of workers in the informal sector – both absolutely and relative to the
formal sector – could provide pointers as to whether it has been voluntarily or involuntarily
entered, or whether the informal sector itself is divided between a voluntarily entered and
an imposed sub-sector. The relevant characteristics of workers might include age,
education, training, vocational skills, gender, previous activity and income, and migrant
status.
· Evidence on the level and nature of unemployment in a country can help to indicate the
state of the labour market, and thus whether informal employment is of a voluntary or
involuntary character.
These diagnostics are summarised in the table below.
Diagnostic Information source
Segmentation between
formal and informal
sectors
· labour market regulations and their coverage
· labour force or household surveys (wage
divergences?)
Segmentation within
informal sector
· labour force surveys (wage dispersion within informal
sector)
· extent of barriers to entry
Extent to which
informality is voluntary or
involuntary
· labour force surveys (characteristics of workers
might include age, education, training, vocational
skills, gender, previous activity and income, nature
and level of unemployment and migrant status)
1 For a list of labour force surveys available online, see http://www.ilo.org/dyn/lfsurvey/lfsurvey.home
February 2007 27

It is not possible to provide simple formulae for the task of understanding the informal sector in any
particular economy. Rather, that task requires a combination of the sort of evidence indicated
above, a knowledge of the policy-makers’ underlying value judgements about efficiency and equity,
and the application of the analyst’s own judgement.
February 2007 28

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