Informality Cause and Symptom of Underdevelopment Norman V. LoayzaThe World BankInformality is an essential issueIt implies that a large number of peopleand economic activities are outside thelegal-institutional frameworkThe positive side: flexibility and creativityThe negative side: inefficiency and dangerAnd informalityisrampant in thedevelopingworldInformal Production05101520253035404550OECD East Asia & PacificSouth Asia Sub-Saharan AfricaLatin America & CaribbeanEurope & Central AsiaMiddle East & North AfricaInformal Labor0102030405060708090100OECD East Asia & PacificSouth Asia Sub-Saharan AfricaLatin America & CaribbeanEurope & Central AsiaMiddle East & North AfricaInformal Production-- across countries in Latin America ComparatorCountriesLAC Countries020406080USACHLCRI ARGPRY MEX DOMECUVENJAMBRACOLNICSLVHND URY GTMHTI PERPANBOL(% of GDP)A. Schneider Shadow Economy indexInformal Labor-- across countries in Latin America ComparatorCountriesLAC Countries020406080USACHLURYCRI PANJAMBRAARG MEXECUVEN DOMPERSLVGTMHNDPRYCOLNICBOL(% of labor force)D. Non-contributor to Pension SchemeBack to basics: Definition What is informality? Informality is the collection of firms, workers, and activities that operate outside the legal and regulatory frameworks. It entails avoiding the burden of taxation and regulation but, at the same time, not fully enjoying the protection and services that the law and the state can provide. Back to basics: Measurement Although the definition of informality can be simple and precise, its measurement is not. Best described as a latent, unobserved variable. Approximated through several indicators Production Schneider index of shadow economy: DYMIMIC Heritage Foundation index of informal mkts: Perception Employment Self-employment share of labor force (ILO) Lack of pension coverage as share of labor force (WDI) Informality indicators are highly correlatedwith each otherVariable0.72*** 0.90*** 0.89*** 1.001.000.68*** 1.000.88*** 1.00Schneider Shadow Economy index(% of GDP)Heritage Foundation Informal Market index(range 1-5: higher, more informality)Self Employment (% of total employment)Non-contributor to Pension Scheme(% of labor force)0.71***Heritage Fndn.Informal MarketSchneiderShadow EconomySelfEmployment Non-contributorto Pension As with all other complex issues, informalityisbotha cause and a symptomI nformalityas a symptomInformality is a symptom of Excessive regulations in a context of insufficient supervisory capacity by thestate Defficient provision of public services such as the police and judicial system, of which formal firms participate Low productivity because of lack of education and other socio-demographic factors (youth, rural) Informality and regulations ALBARMAUSAUTAZEBDIBELBENBFA BGDBGRBIHCHECHLCHNCIVCMRCZEDEUDNKDZAEGYESPESTFINFRAGBRGEOGHAGRCHRVHUNIDNINDIRLIRNITAJORJPNKAZKENKGZKORLKALTULVAMARMDAMDGMKDMNGMOZMRTMUSMYSNGANLD NORNPLNZLPAKPHLPOLPRTROMRWASENSGPSLESVKSVNSWETGOTHATUNTURTZAUGAUKRUSAVNMZMBZWEARGBOLBRACOLCRIDOMECUGTMHNDJAMMEXNICPANPERPRYSLVURYVEN(% of labor force)0204060801003 4 5 6 7 8Business Regulatory Freedom (index: higher, less regulated)correlation: -0.70***N = 101Informality and public services ALBARMAUSAUTAZEBELBFA BGDBGRCHECHLCHNCIVCMRCZEDEU DNKDZAEGYESPESTFINFRAGABGBRGHAGINGRCHRVHUNIDNINDIRLIRNIRQITAJORJPNKAZKENKORLBNLBYLKALTULVAMARMDAMDGMNGMOZMYSNGANLD NORNZLPAKPHLPOLPRTROMSDNSENSGPSLESVKSVNSWETGOTHATUNTURTZAUGAUKRUSAVNMYEMYUGZMBZWEARGBOLBRACOLCRIDOMECUGTMHNDJAMMEXNICPANPERPRYSLVURYVEN(% of labor force)0204060801001 2 3 4 5 6Law and Order (index: higher, better)correlation: -0.72***N = 99Informality and education AUSAUTBELBENBGDCHECHLCHNCMRDEUDNKDZAEGYESPFINFRAGBRGHAGRCHUNIDNINDIRLIRNIRQITAJORJPNKENKORLKAMARMOZMRTMUSMYSNLD NORNPLNZLPAKPHLPOLPRTRWASDNSENSGPSLESWETGOTHATUNTURTZAUGAUSAYEMZMBZWEARGBOLBRACOLCRIDOMECUGTMHNDJAMMEXNICPANPERPRYSLVURYVEN(% of labor force)0204060801000 1 2 3 4 5Average Years of Secondary Schoolingcorrelation: -0.84***N = 78Informality and sociodemographics ALBARMAUSAUTAZEBDIBELBENBFA BGDBGRBIHCHECHLCHNCIVCMRCZEDEU DNKDZAEGYESPESTFINFRAGABGBRGEOGHAGINGRCHRVHUNIDNINDIRLIRNIRQITAJORJPNKAZKENKGZKORLBNLKALTULVAMARMDAMDGMKDMNGMOZMRTMUSMYSNGANLD NORNPLNZLPAKPHLPOLPRTROMRWASDNSENSGPSLESVKSVNSWETGOTHATUNTURTZAUGAUKRUSAVNMWBGYEMYUGZMBZWEARGBOLBRACOLCRIDOMECUGTMHNDJAMMEXNICPANPERPRYSLVURYVEN(% of labor force)020406080100-2 -1 0 1 2Sociodemographic Factors, standardizedcorrelation: 0.87***N = 109Informality determinants (or correlates) Schneider Shadow Heritage Foundation Self Non-contributor toEconomy index Informal Market index Employment Pension SchemeExplanatory variables: (% of GDP) (1-5: higher, more) (% of total employment) (% of labor force)Average of 2000-2005 by country [1] [2] [3] [4]Law and Order -3.2360** -0.0969* -1.6925* -2.9764*(ICRG, index ranging 0-6: higher, better) -2.57 -1.76 -1.84 -1.67Business Regulatory Freedom -2.0074* -0.5333*** -2.5196** -5.8675**(The Fraser Institute, index ranging 0-10: higher, -1.80 -9.95 -2.17 -2.28 less regulated)Average Years of Secondary Schooling -1.9684* -0.1152** -2.1527** -5.8114***(Barro and Lee 2001) -1.70 -2.00 -2.25 -3.27Sociodemographic Factors 3.8438** 0.5027*** 5.9743*** 21.6130***(average of share of youth population, share of 2.00 4.99 3.77 7.31 rural population, and share of agriculture in GDP)Constant 60.3429*** 6.6326*** 54.7254*** 113.3110***10.48 31.72 14.06 11.40No. of observations 84 86 57 70Adjusted R-squared 0.57 0.89 0.78 0.88Informality measuresI nformalityisnot explainedbya single source.It is a complex phenomenon that arisesfrom the combination of several forcesActual vs. Predicted InformalityAREAUSAUTBELBGDBWACANCHECHLCHNCMRCOGDEUDNKDZAEGYESPFINFRAGBRGHAGRCHKGHUNIDNINDIRLIRNITAJORJPNKENKORKWTLKAMARMLIMOZ MWIMYSNERNLDNORNZLPAKPHLPNGPOLPRTSENSGPSLESWESYRTGOTHATUNTURTZAUGAUSAZAFZARZMBZWEARGBOLBRACOLCRIDOMECUGTMHNDHTIJAMMEXNICPANPERPRYSLVURYVENActual values(% of GDP)Predicted values(% of GDP)0102030405060700 10 20 30 40 50 60 70A. Schneider Shadow Economy indexAREAUSAUTBELBGDBWACAN CHECHLCHNCMRCOGDEUDNKDZAEGYESPFINFRAGBRGHAGRCHKGHUNIDNINDIRLIRNISLITAJORJPNKENKORKWTLKA MARMLIMOZMWIMYSNERNLD NOR NZLPAKPHLPNGPOLPRTSENSGPSLESWESYRTGOTHATTO TUNTURTZA UGAUSAZAFZMB ZWEARGBOLBRACOLCRIDOMECUGTMGUYHNDHTIJAMMEXNICPANPERPRYSLVURYVENActual values(Higher, more informality)Predicted values(Higher, more informality)123451 2 3 4 5B. Heritage Foundation Informal Market indexAUSAUTBELBGDCANCHECHLCMRDEUDNKDZAEGYESPFRAGBRGRCHKGIDNIRLIRNISLITAJPNKORLKAMARMYSNLDNORNZLPAKPHLPRTSGPSYR THATTOTUNUSAZAFZMBARGBOLBRACOLCRIDOMECUGTMHNDJAMMEXPANPERSLVURYVENActual values(% of total employment)Predicted values(% of total employment)01020304050600 10 20 30 40 50 60C. Self EmploymentAUSAUTBELBGDCHECHLCHNCMRDEU DNKDZAEGYESPFINFRAGBRGHAGRCHUNIDNINDIRLIRNITAJORJPNKENKORLKAMARMOZMYSNLD NORNZLPAKPHLPOLPRTSENSGPSLESWETGOTHATUNTURTZAUGAUSAZMBZWEARGBOLBRACOLCRIDOMECUGTM HNDJAMMEXNICPANPERPRYSLVURYVENActual values(% of labor force)Predicted values(% of labor force)0204060801000 20 40 60 80 100D. Non-contributor to Pension Scheme Note: In each graph, a 45-degree line is drawn to show a distance between predicted and actual levels. DecomposingI nformality--country bycountryPredicted differences in informality w.r.t. benchmarkARGBOLBRACOLCRIDOMECUGTMGUYHNDHTIJAMMEXNICPANPERPRYSLVURYVEN102030405060CHLMinMax(% of GDP)A. Schneider Shadow Economy indexARGBOLBRACOLCRIDOMECUGTMGUYHNDHTIJAMMEXNICPANPERPRYSLVURYVEN123456CHLMinMax(Higher,more informality)B. Heritage Foundation Informal Market indexARGBOLBRACOLCRIDOMECUGTMGUYHNDHTIJAMMEXNICPANPERPRYSLVURYVEN1020304050CHLMinMax(% of total employment)C. Self EmploymentARGBOLBRACOLCRIDOMECUGTMGUYHNDHTIJAMMEXNICPANPERPRYSLVURYVEN020406080100120CHLMinMax(% of labor force)D. Non-contributor to Pension Scheme Note: Presented are all predicted levels, which may be above/below the actual max/min values. Law and Order Regulatory FreedomEducation Sociodemographic Factors0204060020406002040600204060% %% %Argentina BoliviaBrazil El SalvadorDecomposing informal productionLaw and Order Regulatory FreedomEducation Sociodemographic Factors020406080020406080020406080020406080% %% %Argentina BoliviaBrazil El SalvadorDecomposing informal laborPolicyimplications1. Policy evaluation: Does this promote informality?PERU -- POLICYMEASURES GRADE Law of Positive Administrative Silence Municipal procedure facilitation, Tramifcil Special financial transaction tax Law of Promotion of Small Enterprises Increase in minimum wage Requirement of periodic testing of teachers Port concessions 2. Mechanism:How to formalize? The objective should be to formalize, but not at allcosts ! If policies are focused on punishment, Unemployment will increase Policies should focus on making formality attractive, Streamlining regulations Improving public services Then, efficiency, employment, and growth are likely toimproveThanksI nformalityas a causeInformality implies A trap of marginalization and exclusion which worsens and is worsened by poverty Distortions in the use of private and public resources which lowers economic growthHow does informality affect growth?Informal firms In order to evade, do not reach their optimal size and technology use irregular procurement and distribution channels waste resources in bribes Use inefficient mechanisms to replace the police and judicial system Do not contribute to the renewal and improvement of public infrastructureEffect of informality onper capita GDP growth, 1985-2004 [1] [2] [3] [4] [5] [6] [7] [8]Initial GDP per capita -0.1966 -0.3519 -0.3498* -0.6910* -0.6976*** -0.7684*** -1.2819*** -1.7200***(2000 US$, 1985, in logs) 1.29 1.54 1.88 1.98 3.06 2.83 2.69 2.95Schneider Shadow Economy -0.0747*** -0.1479***(% of GDP) 3.87 4.39Heritage Foundation Informal Market -0.8009** -1.3294***(ranging 1-5: higher, more informality) 2.41 4.05Self Employment -0.0657*** -0.1775***(% of total employment) 3.11 3.21Non-contributor to Pension Scheme -0.0423*** -0.0872***(% of labor force) 2.80 3.39Constant 5.4231*** 6.9131** 6.6475*** 9.2161** 11.8634*** 11.7604*** 17.1971*** 19.8890***3.15 2.57 3.35 2.59 4.29 3.80 3.18 3.33No. of observations 119 127 72 91 84 87 59 68R-squared 0.20 0.08 0.13 0.11 - - - -Hansen J Statistic (P-value) - - - - 0.48 0.21 0.30 0.70OLS IV