Wednesday, November 26, 2014

The Logic of the Informal Economy

CAMBRIDGE – A specter is haunting the world’s developing countries – the specter of the “informal” economy. For some, the informal sector includes all businesses that have not been registered with the authorities. For others, it refers to businesses that escape taxation. The International Labor Organization defines it as comprising firms that are small enough to fall outside the labor code.

Whatever the definition, what has concerned many economists and gained policymakers’ attention is that the size distribution of firms in developing countries has a long tail. Compared to developed countries, an unusually large number of small, unproductive firms coexist with a small number of large, productive firms.

According to standard economic reasoning, this is inefficient. If the small, unproductive firms closed down and the larger, more productive firms hired their workers, total output and well-being would rise. This should happen automatically through the invisible hand of competition, because the more productive firms should be able to deliver a better product at a lower price, while luring workers with higher wages.

So, why doesn’t this happen routinely in developing countries? Why do the inefficient firms survive, trapping resources in low-productivity activities? What is preventing the market from working its magic and making everyone better off?

For some, the problem is that government regulations make compliance too onerous for small firms. Others claim that tax evasion creates an unfair advantage for informal firms, or that family-wide health care gives households no incentive to have more than one member pay social-security taxes. For still others, programs that target the informal sector distort the playing field.

In an effort to address the problem, governments in Colombia, Mexico, Peru, South Africa, and elsewhere have been busy changing their tax codes, redesigning their registration systems, and exploring the potentially perverse incentive problems associated with social-welfare programs. While the jury is still out on the effectiveness of any of these initiatives, I would bet against their success.

It requires many years of training and abstract economic thinking to miss the obvious. The salient characteristic of modern production is that it mobilizes a lot of knowhow – too much to fit in the head of any single person.

Efficient production requires a division of labor among those who know about technology, marketing, finance, logistics, human-resource management, contracts, regulations, distribution, customer service, and much else. It requires manual and intellectual skills that must be used in tandem. Just think of the different specialized skills (many of them recognized by the Oscars) that must come together to make a single film.

To bring these skills together, people have to be integrated into cooperative arrangements in the same firm or within clusters of related firms. But, in order to get together to work, people have to travel from their homes to production sites. How do they do that?

In the typical developing-country city, they do so with difficulty. Daily commute times for low-income formal-sector workers often exceed three hours, and the average direct cost of transportation is equivalent to roughly two hours of work at the minimum wage. An eight-hour shift becomes an 11-hour shift for which net pay is only six hours.

This implies an effective tax rate of 45% on low-income formal-sector workers. Add to this the inconvenience of travel and the potential problems caused by being far from home in case of a family emergency. With these considerations in mind, it becomes easier to understand why people would prefer to do something useful near home rather than where modern production takes place.

But in the shantytowns where developing countries’ urban poor live, there are few varieties of skill that people can mix with their own to make things productively. As a result, the only feasible forms of production use very few low-skilled workers – and thus operate at low productivity. They specialize in food preparation, retail, construction, repairs, Internet cafes, and myriad other activities that can be carried out at home and sold to neighbors (often through a window facing the street).

Economists and policymakers have disregarded the physical aspects of urban life. Housing policy is typically discussed with blatant disregard for urban transport and the locations where industrial and business zones are authorized. When planners designed Punta Cana – the very successful tourist destination in the Dominican Republic – or the giant Fiat plant in Betim, Brazil, they forgot to plan for their workers’ housing. Not surprisingly, shantytowns quickly developed.

The informal sector is mostly a consequence of the fact that people are disconnected from modern production networks – an inefficiency that will not be resolved simply by reducing the cost of registering a business or forcing small firms to pay taxes. What is required is a redesign of urban space, including subways and dedicated bus lanes, and a more integrated approach to housing, social services, and production areas. Governments will have to start doing some good things, not just stop doing some bad ones.

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    1. CommentedLeo Arouet

      De acuerdo. Para lograr formalizar a la personas extralegales se necesita todo un conjunto de medidas de inclusión y de herramientas como las especialidades de administración, urbanización, finanzas, tecnología, etc., para que se pueda lograr una integración adecuada y productiva.

      Hernando de Soto es el peruano que más ha trabajado este tema, si bien ha formulado correctamente un parte esencial que impide formar capital a los informales como la obtención de títulos de propiedad, para convertir sus activos en capital, ha olvidado las demás cosas necesarias que usted apunta aquí...

      El Misterio del Capital es un libro revelador sobre la informalidad en los países en desarrollo, pero es muy capitalista y quiere llevar sus recetas hacia todas partes como se recetan las reformas estructurales del FMI. Ha olvidado que la titulación supuestamente para convertir los activos en capital, digno de otorgar y facilitar a las personas a acceder a créditos, prestamos y arriendos, no posible ni aplicable en la Amazonía peruana. Y es que en Perú todavía en muchas partes todavía no llega el Estado, y si llega, lo hace deficientemente.

    2. CommentedJose araujo

      I'm Portuguese, and we have been experiencing the end of informal economy, through legislation and better fiscalization, the problem is that by killing informal economy you also kill the entrepreneur spirit. Traditionally entrepreneurs start in the informal economy, started their own businesses and then legalized them, once a certain level was reached. Now the cost of doing business has arise to a point that nobody starts any business, hence the economy has stalled.

      This to say that a fine balance must be reached, informal is not bad, and developing economies need it. Parallel economies is a hole different matter, and must be eliminated, but hard working, pro-active people should be allowed to start their own business and worry about the legalities and bureaucracies latter

    3. CommentedProcyon Mukherjee

      The rules of the game must be same for both the productive formal and unproductive informal, which needs to be so orchestrated by the regulatory regime and government that the incentives or subsidies do not benefit either the less-advantaged or come in the way of development for the more advantaged; the affairs of the invisible hand should not be such that it is partially evasive of the perils of fractured networking that breeds inefficiency while it improves the prospects through rent seeking of the efficient ones, where efficiency is itself derived by the vestige of seeking favors.

      By allowing low-cost housing in satellite towns it is the organized and efficient firms who have benefited more as it augured well for outsourcing till better substitutes evolved elsewhere.

    4. CommentedJorge Simao

      This article needs to be refactored to consider tele-commuting (e.g. internet/web based) ...without discussion this point, it could have been written 30 year it now, the arguments are incomplete and no solid conclusion can be taken out of it for what is going to happen next. Please review the article...

        CommentedSegun Zack

        With context of the article focused on developing countries, telecommuting may be far-fetched as access to internet and even computing devices is limited in those regions. It is also important to note that most of the examples given in the article did not focus on knowledge work. This is the reality in the developing world. However, the conclusion that informal economy results from disconnectedness from modern production center is arguable especially for developing countries like Nigeria where organised production activities do not have the capacity to absorb the large chunk of its economically active population. The causal factors for "informal" economy, I believe, is multifaceted and will require consideration of multiple, interwoven factors to address

    5. CommentedGonzalo Vargas

      If the informal economy were a function of congestion then, other things equal, its (relative) size would be smaller in small towns than in large cities, right? I beg to differ. Informality thrives in small communities and also in the area that surrounds the downtown of most large cities.

    6. Commenteddonna jorgo

      urbanistice is important for one state .
      differences btw rich zone and cheap zone make problems .
      why in rich zone doesn't have (action industry)?
      why they have difference pay tax ?for everything..

    7. CommentedAdam Harper

      Prof Hausmann makes decent points, but if the "close to home" workforce isn't subsidized by these poor policy choices, and they face long arduous commutes to the productive regions, then they will simply move closer to the efficient businesses. It happened in the US in the early 20th century. Naturally, the government could smooth the process by building decent roads, but it is not an absolute necessity to achieve the objective of moving the workforce from the non productive businesses to the productive ones.

        CommentedAdam Harper

        I believe I understand now, thanks. But why then hasn't some opportunistic developer recognized this demand for low income housing and built stacked apartments increasing the volume of potential residents in order to make up for the lost opportunity of "regular" housing? I'm pretty young and certainly naive so I apologize if this sounds ridiculous or just plain infeasible. Are the incomes even at these productive firms so low that this wouldn't work? with shantytowns sprouting up everywhere the demand is obvious.

        Portrait of Ricardo Hausmann

        CommentedRicardo Hausmann

        You miss the point. There is fierce competition for urban space and the people with higher incomes price out the lower income people from the better connected places. That is why lower-income people tend to invade illegally the better located spaces and establish there their shantytowns. Nevertheless, in the end, the bulk of low income people are far (in time and money) from the places where modern employment takes place. This is like a huge tax on participating in the modern economy. Many of them do, but the bulk of employment remains in these small unproductive units near their homes.

    8. CommentedZsolt Hermann

      I am not sure what the article tries to achieve, even if the final argument is true.
      "Informal" economy, or black market economy is prevalent not only in the countries mentioned, but also in Eastern Europe, Asia and many other places, on many occasion actually keeping the specific country floating above collapse.
      But even if such "informal", or "black" economies costs large sums of money to the actual countries in tax or productivity, we could be quite certain that government corruption, high level tax evasion, offshore accounts, or the "legal" tax breaks, tax evasions of companies like Apple, Starbucks, Google just to mention a few dwarfs the real life effects of the small firms in those "shady" economies.
      We are trying to find logic in a system that is illogical.
      The whole socio-economic system is built on the artificial, illogical foundation of "maximum profit with minimal investment", "I feel better if I win over you, if I have more than you, if I can sue you to oblivion, and so on..."
      This has become most obvious lately when humanity evolved into today's global and integral network, where unbreakable interconnections and interdependency exists in between nations and individuals.
      In today's system operating on the previous self-centered, exploitative, ruthlessly competitive manner makes us similar to cancer in a living body. This is the reason we are sinking deeper and deeper into the unsolvable crisis.
      Thus it is not better infrastructure, better tax system what we need, it is a different human nature, and different human interrelationships what is needed.
      Only changed human beings, adapted to the integral reality, operating in a mutually complementing fashion can build a new human system that is sustainable, and one that is logical, that makes sense as it is natural.

        CommentedAdam Harper

        Mr. Ponderer, I didn't mean to imply that I agreed with Mr. Herman's negative view of self interest. What I found "inspiring" was his understanding of how black market economies can prop up a failing "command-and-control" economy. He's very much correct about that. But he fails to recognize that self interest is undeniably the catalyst for such black market economies. I hope that clarifies my position.

        CommentedEdward Ponderer

        Though I understand the surface complaint of Mr. Harper concerning Mr. Hermann's comment -- I am amazed at the deeper paradox in it.

        To be inspired by the general flow of what Mr. Hermann says means to feel the correctness of the analysis leading to the present cancer in the body Humanity. Then to say that human self interest can't be overcome and thus there is no realistic hope here -- I stand amazed!

        Overcome human self-interest? Quite the contrary, intelligent human self-interest is our best friend! Can one think of a greater intelligent self-interest than living and prospering as opposed to undergoing an agonizing death from cancer!

        Do we all remember the famous lip-service of "enlightened self-interest?" Well the matter is now quite real. And like a person with diabetes learns to overcome the lust for sugar, and the Olympic runner overcomes his desire to just drop into a hammock and have a lemonade, Humanity can do this.

        The self-help tools exists, just as they do for Alcoholics or Overeaters Anonymous.

        (1) Admit you have a problem and understand it deeply, the advantage of overcoming it, and a basic understanding of what that will take.

        (2) Creating the group psychological environment that will change values (not changing self-interest -- but what that self-interest values). Self-help, voluntary propaganda, and God bless it!

        (3) Have continuous feedback about the goal and methods, and individual needs.

        In close analogy, only now the group is a fractal organization of families, communities physical & virtual, nations and corporate entities, upwards across the globe, we have our task before us.

        (1)Integral Education -- understanding the reality of the growing global interdependence in terms of the socio-economic and Nature. Deeply understand what can be done, how it can be done, and why it needs to be done.

        (2) Use the powerful tools of mass media which has so successfully been used to promote the dangerous, artificial values of consumerism, and for once use it for the good -- neigh the very survival -- of all (not a minority or even a majority -- but All!) Promote a society where benefitting the social good bring more social and self-esteem than owning expensive paintings, being a rock or sports star, or being the fashionable toast of Hollywood.

        (3) Finally, there is the formation of a fractal continuum of round tables -- we are in constant contact at all level, feeling each others concerns and ideas in common weighing in of these.

        Now if all this fractal interaction talk sounds strange -- it shouldn't. It is exactly how every natural community from bacteria, to insects, to routing plant communities, to higher animals, turn self-interest, through altruistic-form, into a higher self-interest of a new, higher entity. Such fractal interaction leads to static balance through dynamic homeostasis. In other words the strong coupling of interdependence across a living community and environmental pressure bring on a crisis threatening death through the chaos of Murphy's Law. This is then transformed into the healthy servo-systems of higher biological life.

        The only added problem for humans, who are also part of nature, is our combination of ego, freewill, and intelligence. So we have to use them backwards -- intelligence, freewill, and ego -- to put us back on track. And what is that track? The emergence of Humanity from the midst of 7 billion humans.

        Unified megacolonies of typically 70 billion bacteria from from individuals everyday, with incredible capabilities of coordination, and creative problem solving -- if by a natural artificial intelligence.

        Cannot 7 billion humans accomplish the same by force of will? And if so, do we even begin to imagine how "clever" this unified being will be?

        CommentedAdam Harper

        "we need a different human nature"....let that sink in.
        Your comment was inspiring until you divorced yourself from reality and started talking dramatically altering millions of years of evolutionary outcome in 7 billion souls.
        Self universal. No matter how virtuous and charitable one is, those acts are propelled by self interest. It simply cannot be changed.