Informal Sector Employment and Economic Growth

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1		Nahid Sultana	--	2281	2022-10-19 00:31:07	\|
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This entry is adapted from the peer-reviewed paper 10.3390/su141911989

Originating in the context of third-world countries, the informal sector constitutes a dominant part of the economy and is identified as an untapped reservoir of opportunities in terms of employment and the entrepreneurial capabilities of developing countries; it is often called the subordinate zone of the overall economy that can play a significant role in the growth and socio-economic development of countries across the world. The informal sector accounts for almost half of the economic activities in developing countries. These activities were initially backed by the core assumptions of the classical theory that the informal economy would wither away after achieving persistent growth. However, the new view of the informal economy features it as contemporary growth that should proceed as a result of the changed economic context of countries. The prevalent feature of the informal economy around the globe provides support to the new view of informality, mentioned as a dichotomist’s approach, which indicates that the informal economy will not wither away; rather, it will be contested in an arrangement of interdependent coexistence with distinctively different conditions, notably in terms of employment arrangements.

informal sector informal employment economic growth macroeconomic policies

1. Introduction

The new view of informality anticipates that the internal heterogeneity of the informal economy makes it a resilient feature of modernization and economic growth ^[1]. Moreover, informal activities have the potential to affect sustainability, since they arise due to the improper functioning of the formal system ^[2]. Therefore, a comprehensive and holistic understanding of the features of the informal sector is important to pursue economic growth by avoiding the undesired effects of economic policy measures ^[3]. This provokes researchers around the globe to undertake more research on the informal economy to find the reliable and consistent drivers of the informal sector and its relation to economic growth ^[4], while economic growth itself remains a topic under investigation and debate ^[5]. The present study has contributed to this end by investigating the significance of the informal sector to the economic growth in terms of employment since informal employment constitutes a persistent structural pillar of the labor market in low-income and developing countries and is identified as a thematic area in at least two sustainable development goals (SDG-8.3 and SDG 10.2) by International Labor Organization (ILO).

In developing countries, employment in the informal sector is increasing over the years ^[6]^[7] and it is considered to be a resort against unemployment despite its significant low wage, as compared to the formal sector ^[7]^[8]. Informal employment includes the self-employed, paid workers in informal enterprises, unpaid workers in family businesses, casual workers without fixed employers, and sub-contract workers connected to both formal and informal enterprises as per the definition mentioned in the ILO guidebook (2018) which provides a detailed overview of the SDG labor market indicators pertain to Goal 8 (sustained, inclusive and sustainable economic growth, full and productive employment and decent work for all). Informal employment is also linked to some extent to the other SDG goals, such as Goals 1, 5, and 10 since a vast portion of workers are pursuing their livelihoods in conditions of informality. Informality issues are addressed in SDG target 8.3 where the promotion of development-oriented policies are suggested to support productive activities, decent job creation, creativity and innovation, and entrepreneurship, along with an encouragement to the growth and formalization of micro, small and medium-sized enterprises ^[9]. The prospect of an informal economy in productive activities with the viewpoint of economic gains, improvement of physical and human capital, and the extraction of profit from the local economy may motivate to set this target ^[10].

2. A Theoretical Background of Informal Employment: Socio-Economic Safety Mechanism or Growth Engine

The theoretical background of informal employment particularly urban informal employment, is presented in the seminal paper of Lewis (1954). Later in 1970, Harris Todaro explained the reason for urban unemployment that serves as an equilibrating force for rural urban migration and provides the foundation for the subsequent theories of informal employment. Field (1975) extended this in several directions by assuming that urban workers can choose to become informally employed rather than search for higher paying formal jobs ^[11]^[12].

Informal employment is considered to be a substitute for formal employment and is treated as a residual absorbing surplus, unskilled labor from the formal sector in the dualistic labor market approach. This group views informal employment as involuntary that utilizes traditional production technology, organizes with little to no capital, and provides a subsistence wage; it is seen to be a safety net for unemployed workers in the dualistic framework and incapable of accumulating capital for growth ^[13]. Based on this approach, poverty alleviation and providing unemployment insurance during the periods of unemployment are the most appropriate policies. However, in the context of developing countries it is hard to provide unemployment insurance or safety nets ^[14]. On the other hand, informal employment is considered as a voluntary strategy and compliment to formal employment in the neo-liberal approach; they opine that entrepreneurs are capable of establishing new firms and can avoid strenuous and costly labor regulations by adopting a cost-saving strategy. The entrepreneurs can accumulate a substantial amount of capital for their business and can be associated with formal markets through output demand and business relations with the formal firms ^[13]. In this way the informal sector becomes capable to accumulate capital and contribute to growth that creates a positive impact to the overall economy ^[15]. In such a situation entrepreneurs and business owners often enter the informal sector to escape excess labor costs that ultimately extends informal employment. Thus, this particular approach sees informal employment as a potential engine of growth ^[13]

Under such a theoretical debate, Structural Articulation approach, the third theory of informal employment is evaluated which sees the informal sector as heterogeneous and comprising of at least two distinct sub-sectors ^[16]. Entrepreneurs and small firms those attempt to grow by avoiding costly regulation are represented by one sub-sector and this sub-sector benefits the overall economy by providing lower consumer prices and labor costs since it is driven by labor demand. This is identified as a dynamic sub-sector that demonstrates pro-cyclical behavior with the overall economy. The other sub-sector argued by the Structural Articulation approach is largely detached with the formal economy and projects countercyclical behavior. This is identified as a static sub-sector that represents the involuntary subsistence strategies of surplus and unskilled workers who failed to find employment in the formal sector. As a result, growth policies and poverty alleviation strategies are required to apply discriminately to the appropriate sub-sector ^[13]. Based on the fact that, it is difficult to accurately identify each sub-sector, an integration of these two subsectors in informal employment and finds its impact on growth in order to target relevant policies suitable for both groups were considered.

3. The Informal Sector, Productivity, Output, and Growth

It wasrevealed by ^[17] that the structure, nature, and evolution pattern of the economy and structural change in the informal sector could cause a rapid growth of output in the informal sector. ^[18] observed that the informal sector lacked investment from a government that could promote direct economic growth but promoted growth in entrepreneurship in the sector and thereby spurred economic growth. It was also opined that the growth of the informal sector was required to sustain the growth of the formal sector since agriculture was a part of the informal sector and the economies experiencing economic growth with informality didn’t indicate a lack of development, rather they indicated the improved productivity of informal employment due to economic development. The productivity of output was also linked to the informal sector through the economic performances and policies of countries and thereby influenced economic growth in many ways. Productivity differences across countries were found to be important for analyzing the informal sector by ^[19]. A larger share of output from low-productivity firms of the informal sector in such countries was revealed that faced a low degree of debt enforcement and high costs of getting associated with the formal sector. The level of output i.e., GDP per capita of countries was found to be significant in the relationship between informality and growth by ^[5]. Using a novel data set of 161 countries, the size of the informal sector and the growth of real GDP per capita projected an inverted U relationship herein. It was indicated that small and large size informal economies were associated with lower growth, and medium size informal economies were linked to a higher level of growth. The decomposition of growth into growth accounts confirmed the nonlinear result by observing the negative association of labor and capital-output ratio, and the positive association of total factor productivity and the large informal economy in this study. Refs. ^[20]^[21] also found a commendable and significant impact of the informal sector on growth in Nigeria and Pakistan, respectively. This brief review reveals that there are considerable channels through which informality and productivity can be linked to the growth of countries.

4. Enforcement, Informal Employment, and Growth

The conditions of regulations and enforcement were identified as critical to determine the size of the informal sector in both developed and developing countries by ^[4] and these had an impact on informal sector employment. In the presence of informality, a theoretical relationship between enforcement and the economic growth of society was developed by ^[22] and this discussion was found to be important by the study as the employment capacity of the formal sector was declining worldwide. When the enforcement level that encompassed the level of security of property rights, the integrity of contracts and checks of corruption, affected the formal and informal activities differently and imposition of taxes reduced the formal activities only, their simultaneous choice entailed growth as well. The growth rate and welfare functions projected inverted U shapes herein that acted against the enforcement level. ^[23] found that product market deregulation reduced informality, unemployment, and wage inequality. Contrary to this finding, enhancement of enforcement level reduced informality by the study of ^[24] without increasing unemployment, allowing the reallocation of workers to more productive jobs that facilitated increases in wages and contributed to a reduction in inequality. Therefore, debate belongs to the nexus between informality, employment and enforcement level that impacts economic growth through the path of public policy and productivity.

5. Informal Employment, Income Inequality, and Economic Growth

Precarious employment and poor prospects reproduce and reinforce distinctive territorial inequalities and thus create a stern limitation for sustainable development. Observing this ^[25] has opined that for pursuing sustainable development, work arrangements have to be fair and stable. Unfortunately, these are absent in the informal sector and the inequality features are observed in informal employment. ^[6] revealed that increased employment and inequality in the informal sector due to the formal and informal wage gap had links to productivity and output. According to ^[24] low productivity was found both in the informal and formal sectors and in the transit between the two, but the informal sector paid significantly less than the formal one. The study observed that the movement of the Gini coefficient over time depended on the gap between formal and informal sector wages and therefore employment in the informal sector had the potential to contribute to improving income inequality in developing countries by improving the Gini coefficient value. The changes in the wages of the informal sector created a major impact on the Lorenz curve and the evolution of the Gini coefficient as Ref. ^[26] also observed the same while investigating the conditions under the inverted U-shaped curve of the income distribution. The study found that the expansion of the informal sector and manual labor migration to this sector were vital for reducing income inequality. Using Gini index ^[27] observed the past level of inequality as a salient feature to explain the size of the informal economy. He showed countries with larger initial inequality had larger informal economies over time and not necessarily the informal economy would naturally decline to the same steady state. Improvement in contractual and financial participation of informal firms could increase informal wages along with an expansion of the size of the informal sector according to ^[28]. These findings indicate that informal firms accessing institutional services and informal employment with a minimum wage gap have the potential to improve income inequality and foster economic growth.

6. Informality, Institutions, and Sustainable Development

Informality has been projected as a core aspect of sustainable development in ^[29] and it is established a strong association between the size of the informal sector and the socio-economic indicators. ^[30] has revealed an overall detrimental role of the informal sector in the sustainable development of developing countries while the working poor is used as a proxy for the informal sector. Acknowledging the informal economy and informal workforce as the broad base of the global economy and workforce ^[6] suggested a review of all economic and social policies in terms of their impact on the informal economy and its integral parts. The high correlation of informal activities to the level of economic development and institutional quality was revealed in ^[12]^[31] and in response to this result ^[12] pointed to the modern model of the informal sector that put emphasis on small-scale, unskilled labor-intensive, and self-financed activities with the potential to uphold the consequences of pro-growth policies accommodating a large informal sector. Considering informal labor in the form of unregulated and subcontract work ^[32] argued that decent work in the informal sector and economic growth issues should gain more focus to realize its promise.

From the above discussion, it is observed that there are several pathways through which informality is linked to formal economic processes such as employment generation, economic productivity, output growth, inequality reduction, institutional capacity, and socio-economic development. However, the dynamics of informality related to formality are yet to be understood completely compared to its wider influences on the economy and development of developing countries. Moreover, macroeconomic factors are rarely considered in this connection.

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