Category Archives: The Informal Sector



Follow this link for full essay: INFORMALITY AND DISTRIBUTIVE POLITICS(final)

Rory Creedon London School of Economics (MPA ID)


An individual’s preferences regarding taxation may be derived from a number of sources such as the distance between his income and the average income[1] or notions of social justice. A further particularly salient source is that presented by Alesina and Rodrik [2]. Individuals, they argue, are endowed with labour, capital, or most likely a mixture of the two, whilst governments make productive investments financed by a tax on capital. The basic result of their model is that an individual who derives all of his income from capital will prefer the tax rate that maximizes the economy’s growth rate, whereas anyone who earns even part of his income by selling his labour will prefer a lower tax rate and a correspondingly lower growth rate.[3] To this insight I would like to add another: that the presence of a large informal economy will affect the preferences for taxation of both capitalists and wage earners.

The directional influence that a large informal economy will have on preferences for taxation is not discernable a priori. This is because the true nature of the key mechanism by which the informal economy affects preferences for taxation, namely the interaction between the informal and formal economy, is disputed. This essay analyses two major lines of thought on how the informal economy interacts with the formal economy. Dualists argue that the informal economy is a separate marginal sector not linked to the formal sector in any significant way. Structuralists on the other hand maintain that both the informal and formal economy are part of the same capitalist spectrum.[4] This essay does not assert the primacy of either of these views. Rather, within the stylized model presented by Alesina and Rodrik with the additional assumption of a large informal economy, I seek to emphasize that preferences over taxation will vary according to whether the true nature of the informal sector is closest to the dualist or structuralist tradition, thus reaffirming the importance of the debate. Arguments and examples are drawn largely from the literature surrounding the informal economy of Latin America as the extent of the informal economy in that region is such that it is impossible to ignore in terms of policy making and preferences over policy[5]. Additionally a particularly rich vein of scholarship has emerged in relation to the Latin American informal economy.

[1] A.H. Meltzer & S.F. Richard, A Rational Theory of the Size of Government The Journal of Political Economy, Vol. 89, No. 5, (Oct., 1981)  pp.916

[2] A. Alesina & D. Rodrik, Distributive Politics and Economic Growth The Quarterly Journal of Economics, Vol. 109, No. 2, (May 1994) pp. 465-90.

[3] Ibid. pg. 466

[4] M. Carr & M.A. Chen, Globalization and the Informal Economy: How Global Trade and Investment Impact on the Working Poor, ILO Employment Sector Working Paper on the Informal Economy, No. 1, Geneva, ILO pg. 5

[5] J.R. Franks Macroeconomic Policy and the Informal Sector in C. Rakowski (ed.) Contrapunto: The Informal Sector Debate in Latin America, New York: State University of New York Press (1994)



A. Portes & K. Hoffman

Latin American Research Review, Vol. 38, No.1 (Feb., 2003)

A Summary

In a Nutshell

The size of the informal sector increased greatly during the neoliberal era of adjustment. The paper also provides interesting data on the stratification of classes within LA.

Class Structures

  1. Capitalists as owners of large scale means of production sit at the top and account for 1-2% of society. They receive profits.
  2. Senior executives are below them, running sizable organizations. They account for between 1 and 5% of society. They receive salaries and bonuses tied to profits.
  3. Next come professionals, university trained elite workers employed by private firms to positions of responsibility. They trade on their scarce expertise and account for around 5% of the population. They earn salaries based on their expertise.

Together the above three classes account for around 10% of society.

  1. Next come the “petty bourgeoisie”. These are micro-entrepreneurs who have some resources, skills and employ a small number of workers on a face-to-face basis [whatever that means]. These people have been the traditional link between the modern economy (1-3) and the mass of informal labour; they organized labour into producing low cost goods for consumers, and low cost inputs for subcontracting formal firms. During the 90s this class became a refuge for redundant civil servants and other skilled workers displaced by adjustment. Indeed, in 1998 100% of new jobs were in the micro sector.

The Informal Sector and Adjustment

  • The formal sector shrank during the age of ISI. But the neoliberal adjustment saw the formal sector shrink as the modern industrial sector was destroyed by cheap imports from new open market doctrine.
  • Income inequality rose greatly during the neoliberal period. Data indicate that for most LA countries, average urban incomes either stagnated or declined (with the exception of Chile in the 1990s). This was reflected in those employed in micro enterprise. Meanwhile the incomes of the top quintile grew much faster. As a result of the rise in incomes of the rich relative to the proletariat, the gulf between economic conditions and life chances was exacerbated. It is not necessary to be unemployed in LA to be poor – the vast majority of the working population receive wages that condemn them to poverty.
  • They describe the informal sector as “forced entrepreneurism”. As the contraction of the state sector and formal private employment has shrunk the subordinate classes have had to search for other economic alternatives. The liberalization regime favoured those with resources and left the rest to fend for themselves. Thus informality and to a certain extent crime, and emigration are “ADAPTIVE STATEGIES” for coping with harsh economic realities. This has happened along with a move to broad support populist parties.
  • It is strange that the poverty in the employed and informal sectors has not given rise to class based politics in the democratic era. Populism remains, but that is not identified solely with the poor [the turn left is relevant here????].
  • In this sense neoliberalism has been a success as the changes it has wrought in society have weakened the basis for organized class struggle and popular mobilization of discontent. Nevertheless, the economic hardships etc. could mean that this peace is unsustainable.



J. Franks in Contrapunto: The Informal Sector Debate in Latin America C. Rakowski (ed.)

 A Summary 

In a Nutshell

Macroeconomic policy effects the informal sector differently than it does the formal sector. Given the size of the informal sector (which he defines as economic activity which escapes traditional national income accounting excluding illegal activities) in Latin America, it should be incorporated into thinking about macroeconomic policy. Not paying it sufficient heed can lead policy to have unwanted or unforeseen consequences. Indeed, that the structural adjustment programmes of the 80s and 90s did not consider fully the informal sector in their strategies could be one explanation as to why they were not successful. Whilst many argue that it would be preferential for the entire informal workforce to be absorbed by the formal sector [J.J. Thomas], Franks makes the case that from a macro point of view (i.e. growth) there is an optimal level of informality. In other words some states could improve aggregate welfare by informalizing some of the economy.

 Effects of the Informal Sector on Macroeconomic Policy

Omitted Variable Bias

  • If the informal sector is omitted from macro models, any behavioural differences between the informal sector and the rest of the economy introduces bias into both the models and the policies the models suggest. The outcomes can thus be suboptimal.

 Currency Markets and FOREX

  • The existence of an alternative FOREX market can restric a government’s ability to maintain overvalued or multiple rates or to enforce strict controls on currency (to prevent capital flight etc).
  • Many of the goods produced in the informal sector are import substituting, and thus the sector is closely linked to the international economy, especially through tariff measures and foreign exchange policies.

 Fiscal Policy and Taxation

  • Tax structures may be a deciding factor in the decision to be formal/informal.
  • Formal firms can subcontract, meaning that higher taxes may actually lead to less revenue, [especially as corporation tax increases].
  • By reducing the tax base many governments have to rely on monetizing the deficit which leads to inflation.
  • Government spending can also reduce the size of the informal sector. To the extent that it crowds out private sector demand which will include a much higher percentage of informal sector goods than the higher government demand, jobs will be shed in the informal sector. Wages will be lower.
  • Increased taxes drive suppliers to go informal and the same taxes may reduce informal sector demand. So they pull in different directions.

 Employment Policy

  • Informality can serve as the employer of last resort.
  • Many government employment policies can have the oppopsit effect on the informal sector i.e. avoidance of wage law, social security, workplace regulation etc.
  • An increase in the minimum wage will have to be complied with by the formal sector, boosting wages but reducing demand for labour, so formal employment will fall. Firms also respond by informalizing certain of their activities. The new supply of informal workers will depress wages there, so the end effect of a wage rise in the formal sector is a wage fall in the informal sector. The same logic holds for workplace regulations.

 Disadvantages from Informality

  • Ability to evade government controls, particularly to evade taxes restricting the ability of the government to provide public services.
  • It indicates a failure at the government level for not providing sufficient formal sector work.
  • Undercuts government legitimacy.
  • Low productivity and low wages with often inferior products that will never be capable of being competitive on a grander scale or internationally. i.e. there is little export potential in the sector.

 Benefits from Informality

  • The sector shows often admirable efficiency in its use of plant and technology.
  • Uses much lower levels of foreign inputs for the same level of output relative to the formal sector. This helps improve BOP whilst the high real price paid for FOREX by the informal sector (on the black market) promotes more efficient use of that scarce resource.
  • The sector contains a disproportionate number of the urban poor. Thus programmes to assist the informal sector could be used to alleviate poverty.
  • The is a benefit in those who would otherwise be unemployed having some form of income generating possibilities.
  • It is much more flexible than the formal economy and as such it can adjust to changes in the macro picture much more quickly than the formal sector making it more efficient in that respect.
  • There are reasons to believe that informal sector promotion could lead to dynamic growth.

 Macro Adjustment and the Informal Sector

  • The size of the sector increased with the crises of the 80s and during stabilization. Some of the stabilization policies themselves could have been more successful had they incorporated the informal sector:
    • Increased taxes may not reduce deficits if it encourages more people to move to the informal sector.
    • Informal markets reduce the benefits from trade liberalization.
    • The flexibility of the informal sector indicates it should play a crucial role in adjustment, as it is an adaptive economy so it could ameliorate the burdens of adjustment by cushioning against the shock. E.g. in Bolivia during the 1985 austerity programme – it worked on a macro level but it caused huge hardships (unemployment, poverty, growth in living standards etc.). Employment in the informal sector grew but that meant declining incomes, and it did not absorb sufficient of the redundant formal sector workers. The contraction would certainly have been more severe had the informal sector not existed.  

An Optimal Level of Informality

  • The balance between he costs and benefits from informality change with the level of the informal sector. So whilst it may be beneficial to have a small informal economy to absorb displaced formal sector workers and to boost the economy, if it becomes too large the government loses control over the economy and may not be able to provide certain public goods.
  • As the level of informality grows the two sectors move from a mostly complementary relationship to a more competitive one.
  • Historical evidence suggests that informality becomes less important as incomes increase. The opportunity cost of being informal increases as formal sector wages increase.
  • A stabilization plan that damages the informal economy could thus hurt the economy, producing less growth and more unemployment.
  • Evidence suggests that the informal sector is more than just a safety valve absorbing workers hurt by adjustment. It changes the way adjustment works and shows dynamic potential that could be tapped to restore economies hurt by decades of debt crises.



W. F. Maloney

(World Bank)

 A Summary

In a Nutshell

This paper challenges the dualistic view of the informal/formal secotr in Latin America which characterises the former inferior based on absence of benefits, irregular working conditions and low remuneration.  It proposes rather that the sector is similar to the voluntary entreprenuerial small scale sectors in thed eveloped world rather than a amrginalized residual. Undert this interpretation rational workers take stock of their levels of human captial, the opportunities available in both sectos, and the relative benefits provided and choose to enter the informal secotr. Data from Mexcio indicates that around 60% of those employed informally left their previous job and entered the informal market voluntarily as it offered them an improvement in job status. Workers are able to find replacements for the social security insitutions provided by the formal sector, or are at least willing to trade those benefits for other characteristics of the informal sector such as benefits received from being self-employed. This does not imply that those in the informal sector are not effected by poverty, merely that given their preferences and the contrainsts they face in therms of formal sector labour productivity and human capitla, being in the infomral economy can be an optimal decision.

Evidence suggests that there is late entry into ebing self-employed as people leave the formal sector with accumulated skills to start their own business. However this late entry is also consistent with people getting fired from their formal sector jobs and indeed, it seems logicval that the informal secotr does provide a safety net when there are cotnractions in the economy brough about by adjustment programmes etc. However, in Argentina it seems that 80% of informal workers are not lookinf for formal emplyment which seems to counter the idea that the informal sector is merely a holding zone whilst formal work is sought. This could be related to the perceived utility from being one’s own boss. Thus, the sector should not be treated as inherently inferior.

Wages in the Informal Sector

  • Data from Mexico indicates not only that informal workers enter voluntarily, but that they often earn more than their formal sector coutnerparts. However, this could be overstated as there are many other benefits from formal work.
  • Pensions, helath care, housing subsidies etc. are provided to formal sector workers so ina market free of distortions the informal earnigns should be hgiher to compensate for the lack of protections. Thus higher earnings do not necessarily indicate a better job. On the other hand, formal sector workers cannot avoid being taxed, and so they do in effect pay for the protections they receive. This would seem to indicate that they should receive higher remuneration as compensation for the tax they cannot avoid paying.
  • Informal salaried workers are found to earn less and there is no convincing explanation regarding benefits they receive that can explain why.
  • Informal worker generally are drawn from the ranks of the poor however it is not easy to argue that they are poor because of their job rather than they have their job becasuye they are poor. It seems plausible that the opportunity cost of low human captila workers working in the informal sector as oppsoed to a blue collar job are low. As human capitla etc. increases the opportunity cost of remaining informal increases and so workers shouyld be less willing to work in the informal economy.
  • This argument does not say that workers in the informal economy are well off or happy, just that they may not be better off in another industry.
  • Social benefits that form remuneration are not free – they must be paid by taxes and as such if alternatives exist that better suit the worker they may choose informality. E.g. in Mex, only one of the family need be in formal employment in order to obtain health benefits for the whole family, so there is little incentive for a secodn member to enter the formal economy. The trade off may be even less sharp when we consider that service provision in many developing countries is poor meaning that formal sector workers see mandatory contorbutions to benefits programmes to be a disadavatage of formal salried work.
  • Those contemplating openign their own firms may survey the array of avaiabl;e social protection mechanisms, both formal and informal and then, comparing the utilty of the portfoliothey can cobble together in the two sectors, mnake the decision to open an informal business and leave formal protections.”

Informal to Formal

  • There are significant compliance costs associated with being a formal enterprise. However, as firms grow they increasignly need to secure proterty rights or get formal contractual protections to pool risk, get credit etc. In Peru, de Soto noted that some street vendors would pay their taxes in order to ensure that they could maintain the location of their particular pitch.
  • Thus frims do become more formal with size and age. They may wish to have access to training etc. provided by government to formal enterprises and to do so they must becoem formal.
  • Seen thus, the informal sector could be a stepping stone which is used by entreprenuers to start a small business. The nature of such businesses is that they are very risky and often fail. Thus the costs of formality would be unwelcome in the formative stages of company development, and they would only be undertaken once the firm is of a certain size and the risk of failure is somewhat diminished.

Labour Market Distortions

  • The dualistic view that informal workers are queueing for formal jobs implies large rigidities in the formal labour market that create distoritions. It does not seem plausible that poorer countries have signifiactnly more extreme rigisidites than developed economies.
  • As countries devlop (inreases in salaried wgaes) the demand curve for formal workers shifts out, the opportunity cost of being self-employed rises, and it is no longer profitable to have your small newspaper stand. Workers ared rawn to the formal sector and share of informal emplyment falls. This implies increaseing productivity in the informal sector but critically it must rise less than the formal sector or there would be a counterveiling force attrracting people back to the informal sector. This seems plausible as much of th einformal economy is serivce based. [This seems to ignore the human capital problems associated with moving into the formal economy, and also that there is little pressure for formal sector wage rises given the huge reserve of labour, lack of union activity on wages in LA and the fact that the iformal sectror is subsidizing the wage bill of the formal sector by providing cheap inputs to the formal workforce – see J.J. Thomas summary.] If this were to happen, then the informal sector would benefit from the icnreased productivity of the formal sector, as the opportunity cost of being informal has now risen so they can command higher remuneration for their services.


  1. If it is not the case that all informal workers are forced into the sector and are not disadvantaged relative to the formal sector workers then any policy that seeks to improve the welfare of those workers could make informality more attractive.
  2. If workers choose betweent the sectors, social planning needs to be done taking into accoutn the whole of the labour force, and not treat the informal sector as a residual to be dealt with by later expansion of policy.
  3. As workers pay for benefits through tax, if the benefits are of a low serive quality this gives an incentive to evade taxes by becoming an informal sector worker particularly where there are alternative informal insdituttions to deal with insurance etc. thus imporving medixcal benefits and provision will increase supply of labour to the formal sector.

[I am pretty skpetical about this paper. It may well be the case that given human capital levels, education, and employment opportunities, a worker may prefer to be in the informal sector. However, this does not mean that he could actually exist in the formal sector even if he chose to. Additionally, those qualities are not a given. Education and human capital levels are at least in part determined by education provision policies. Opportunities in the formal sector may be driven by indistirualization policy, but stimulating domestic demand for manufactures, by, export promotion etc. Human capital is in part dependent on training opporunities provided. Thus in the long term the argument presented does not quite wash as if all of those variables could be imporved vis-à-vis the individual worker then his choice portfolio would seem to be rather different.]



J. J. Thomas

Chapters 2.1-2.2 and Chapter 4

A Summary

Chapter 2

Conceptualizing the Informal Sector

[This is very brief summary as fuller information available in the Portes piece summarized this week]

  • Keith Hart – basic distinction between wage income opportunities and legitimate/illegitimate wage opportunities, hence including criminal activities.
  • ILO – focus on enterprises
  • PREALC – excess supply, low productivity alternative to open unemployment. Associated with poverty.
  • A rejection of dualism – heterogeneity within both sectors. Williams and Mutebile argue [as does Portes; see summary from this week] that both sectors are part of the overall system of capitalism in LA. The informal sector, or petty commodity producers to use their term, provide cheap food and good which lowers wages in the formal sector whilst maintaining a large reserve of labour that keeps wages low and limits the strength of union power. So the informal sector is essential to the formal sector profitability.
  • De Soto – the informal sector is a way of maneuvering around the excessive regulations created to try to block the success of migrants to urban centers which would have threatened the position of the ruling elites. He saw a huge amount of potential in the sector and it was thus part of the solution to development. [Yet during the neoliberal adjustments which were consistent with the de-regulation that de Soto advocated there was an increase in both poverty and the size of the informal sector. See the Portes/Hoffman summary from this week and also the J. Franks piece that argues that adjustment programmes were not sufficiently sensitive to the existence of the informal sector].
  • Political motivations – some argue that political undercurrents drive the definitions of formal/informal sectors. Seen thus the dialogue is just another way to debate the neoliberal/strong state struggle.
  • All arguments suffer from the “missing piece” strategy i.e. oversimplification that leads to the suggestion of once key policy that will solve the problem.

Chapter 4

Supply Side Measures

Education and Training

  • Informal sector workers have less education than those in the formal sector. Many poor children are only able to attend school part time if at all and education quality is poor. Workers in the informal sector are not vocal in calling for better education systems [perhaps due to lack of education themselves, plus economic needs of the family] meaning that the calls from the middle classes for more university/secondary education etc. are better represented at policy levels [see Lloyd Gruber’s theory about “tertiary tilt” education spending].
  • Better education outcomes could better prepare people to enter the formal market, as well as improve the productivity of the informal sector which could lead to enough critical mass for certain enterprises to turn formal in order to access the benefits of formality provided by the state.
  • Colombia set up a national apprentice scheme which recognized the benefits of education.

Savings and Credit

  • Informal sector workers have limited access to credit, reducing productivity and profits as they cannot purchase wholesale etc.
  • The main cause of this is a lack of contact with the commercial banking sector meaning there is no pre-existing relationship of trust, an absence of collateral etc. which would mean a project evaluation would be necessary by the bank and given the small amounts involved the cost-benefit would not make a credit arrangement worthwhile.
  • Micro-credit based on pooled lending can go some way to address this failure.
  • Increased credit could allow microenterprises to expand toward formality.
  • The inability to pool credit to micro enterprises (as opposed to groups of individuals) means that this constraint is not easily overcome.


  • Some credit providers also offer training or make it compulsory part of the loan process such as the IDESI programme in Peru.
  • After learning basic bookkeeping and stock control etc. individuals are better at managing their businesses.

Demand Measures

How can demand for the output of the informal sector be increased?

  1. Positive Discrimination: consumer financing for informal products (e.g. wheelchairs in Colombia [surely a tiny market of informally produced goods that would need consumer finance]. Microenterprises can form trade associations to increase awareness of their products, improve marketing etc. Lastly, local governments could procure goods from the informal sector.
  2. Sub-Contracting: increase sub-contracting to the informal sector at private/government level. Is this exploitation? This policy would only have a +ve net impact if demand in the formal sector is increasing otherwise with static demand such a policy would mean the loss of formal sector jobs to the informal sector. The workers may be forced to enter the informal sector.

Removing Bureaucracy 

Removing bureaucracy etc. could potentially encourage firms to “go formal”. However, given the extent of labour legislation, social security costs etc. and given that many such policies could not reversed (from a political feasibility point of view), it may be that a firm would have to increase hugely in size in order to cover the costs of becoming formal. In other words, the gap between the ceiling of effectiveness in the informal economy, and the first level of being on the formal economy may be too wide for firms to jump on a consistent basis.

If in order to compete as a formal firm, the informal firm would have to dramatically increase size/change technology etc. then this is a barrier to the change occurring.

There is little data about the conversion rates.


ISI did not generate enough jobs, so the urban labour force created their own.

The informal sector can be  thought of a pyramid with successful enterprises at the top, and at the base a huge number of subsistence operations that could not under any conceivable economic conditions become viable businesses. In Venezuela it was thought by Marquez that only 16% of total informal sector employment was generated at the top of the pyramid with the bulk being generated by the base.

This is a picture of survival rather than a sector full of entrepreneurial talent.



A. Portes & R. Schauffler

Population and Development Review, Vol. 19, No.1 (Mar., 1993)

A Summary

In a Nutshell

The article presents different interpretations of the informal sector in Latin America. The main strains of thought are summarized below but the critical point is that how one thinks of the informal sector has implications for the policies that should be considered. If employment in the informal sector is driven by lack of demand in the formal sector then policies to expand formal employment should be pursued. If it is rather driven by rigidities in the law that exclude the masses (cost of formality), then de-regulation is needed. These are both demand side solutions. [Not actively contemplated in this article, but of importance are supply side solutions. For example if workers enter the informal sector voluntarily as it is the best alternative given their human capital levels etc. then policies to increase human capital to ensure that people can interact with the formal economy are needed. See summaries of Maloney and J.J. Thomas also in this week’s reading.]

[It seems to me that solutions can either be top down (employment policy, macro policy, de-regulation) or bottom up (education, credit policy, training) in order to convert informal enterprise to formal.]


There have been several major interpretative lines of thought regarding the informal sector in Latin America (LA). Early ideas described the sector in terms of marginalized workers. LA experienced high labour force growth rates post WWII due to high fertility and longer life expectancy due to improved sanitation etc. At the same time there was rapid urbanization driven by the Import Substitution Industrialization (ISI) model which had a strong urban bias in promoting manufactures over agriculture. Thus there was a huge influx of economic migrants to the urban areas which were already experiencing a large growth in available labour. The opportunities that awaited those migrants were not in any regards commensurate with their economic expectations as although ISI did generate significant demand for labour it was simply dwarfed by the number of migrants. Thus there was a huge excess supply of labour. Thus these workers formed the “margins” that were excluded from the modern urban economy.

Keith Hart

This interpretation neglected the extent to which this mass of people would adapt to their economic predicament. It did not however escape Keith Hart who coined the term “informal sector” and defined it as levels of economic activity with low barriers to entry in terms of skills and capital, a family owned dynamic, small scale, and labour-intensive.

This went well beyond the traditional concept of such workers as shoe-shiners, and presented a more dynamic view of popular entrepreneurship.


The ILO PREALC programme in some ways regressed toward the marginalization interpretation. They presented informality in terms of a rational response to a critical situation, namely long-term unemployment. Like Hart they emphasized the duality of the urban labour markets in terms of formal and informal. The latter was driven by a motive of profit maximization, whereas the former was thought to be driven by a need to survive i.e. provide employment. The sector was thus synonymous with poverty.

This loses Hart’s dynamism, and focuses on excess supply of labour. Thus those in the informal sector are underemployed or low-productivity workers. Yet several researchers have found a considerable degree of heterogeneity in the informal sector, with some entrepreneurs consistently earning more than their formal sector counterparts. Often formal sector workers leave their jobs with accumulated training related skills, and use the severance pay to which they are entitled to start up an informal business. Thus we should distinguish between capitalized and under-capitalized microenterprises.

Additionally this interpretation leaves little room for analysis of interactions between the two sectors i.e. it is strongly dualistic. Recent research however indicates that much of the informal sector is technologically advanced (repair shops etc.) and have dynamic links with larger formal sector firms. One way in which this manifests itself is in the practice of formal firms outsourcing certain work to the informal sector to save on regulatory costs etc.

The identification of informality with poverty is unhelpful as is discourages complex analysis of the sector. [Whilst this may be true, if on empirical investigation the informal sector is highly correlated with poverty, then this may be of importance, as policies to support the informal sector could have positive effects on poverty (see summary of J Franks also in this week’s reading).]

De Soto

De Soto saw efficient production and enterprise in the informal sector defined as “illegal operations pursuing legal objectives”. He argued it is driven not by excess supply but rather by excess regulation. The LA state is “mercantilist” i.e. it grants the privileges of employment to a narrow elite, and informality is the popular response that breaks down this barrier. During the period of migration economic elites felt threatened by the increasing labour competition, so they erected barriers to participation. The natural solution then was to de-regulate the economy in order to unlock the potential contained within the informal sector. This line of thought was very popular with neo-liberal thinkers as during the age of adjustment a priority was to shrink the size of state interference.

If the origins really are to be found in the regulation of the economy then this would suggest that Northern Europe etc. would have a large informal economy. Similarly if all regulation were to be removed this would lead to economic anarchy. Markets etc. are highly regulated institutions [although this does not mean that those of LA in the period were not over-regulated].

Alternative Approach: Structural Articulation

This approach does not focus on duality, but sees the two concepts as a related continuum of capitalism. Hence the informal sector is income-earning activities unregulated by the state in contexts where similar activities are so regulated. The excess supply of labour has important consequences beyond merely the survival of the poor at the economic margin:

  1. The Functions of the Informal Economy: informal activities are closely related to formal activities. They supply all sorts of important goods to formal sector workers, but at a better price than their formal equivalents. Thus the sector is a subsidy to the formal sector as the consumption yield of formal wages is increased which lowers labour costs for employers below what they would be if no informal economy existed. Thus the informal economy provides support to profits in the formal sector by keeping wages low.  Additionally large firms reach down into the pool of informal labour to avoid regulations thus further decreasing costs to improve profits. E.g. clothing assembly in Guatemala.
  2. Heterogeneity of Class Positions: The informal sector is internally heterogeneous regarding earnings, productivity and profitability.


  • PREALC: as the informal economy is a problem of labour supply, the appropriate response is to rapidly expand employment in the formal sector. This is achieved through investments in industry either by the state or by private firms [could involve some sort of industrial policy, tariff protection etc.].
  • De Soto: Informal sector is not a problem of underdevelopment, but part of the solution. To harness the sector is the challenge, and this is done by de-regulation. This has a close affinity with the IMF/World Bank programmes enacted in the 80s.
  • Structuralist: survival type activities can be reduced by employment expansion, but rigidities in the labour markets also need to be addressed to make employment more attractive to employers. This implies a relaxation of laws in order to induce greater flexibility although certain key policies should be maintained such as health benefits, training etc. otherwise individuals may prefer the potentially higher pay of the informal sector to the poor conditions in the formal sector. In other words, key benefits in the formal sector can encourage people to work in larger firms [although one wonders how relevant this is in a situation of large excess supply]. Removal of all regulation a la de Soto would not help the informal sector as part of their advantage is built upon their ability to evade regulation.


The final word seems to be that complete absorption of the informal sector would be desirable [see opposing opinion in J. Franks] but this will not happen in the context of rigid labour laws. [Mexico presents a special case as the minimum wage etc. has been ignored there for a long time and other labour restrictions not enforced and yet a large informal sector was maintained – see Maloney].