Barriers to Participation: The Informal Sector in Emerging Democracies

The recent trend towards democracy and market-based systems has improved the lives of millions across the globe. Many countries have increased political participation, achieved macroeconomic stabilization and restored growth. Despite these achievements, millions of people in emerging democracies remain excluded from the political and economic system and still live in poverty. A glaring symptom of this exclusion is the growing number of entrepreneurs who are engaged in low-income, low-growth business activities outside the formal economy. These citizens feel that democracy and marketbased economy have not brought them the expected benefits.1 As a result, an increasing number of citizens in emerging democracies and economies are disappointed and disillusioned.

In order to consolidate democratic and market-oriented transitions, it is imperative to understand why this is happening and then to devise viable solutions. The underlying reason why many citizens in emerging democratic, market systems do not participate in the political system or the formal economy is that the institutional structures or the “rules of the game” prevent them from doing so. In other words, there are barriers to participation in the formal political and economic systems.

These barriers exist in spite of democratic elections for public offices. Holding free and fair elections regularly is the essential first step towards a participatory political system. The next step, removing obstacles to routine, daily public participation in national and local decision-making— is receiving increased attention worldwide, and is essential to improving the practice of democratic governance. One series of policy recommendations for opening the governance process to democratic participation comes from the Sana’a Declaration adopted by over 30 emerging democracies.2 Until the
barriers are removed, democratic governance and economic growth will continue to be hindered.

This paper focuses on one type of barrier to political and economic participation: the cost of doing business in the formal economy and will discuss how these barriers jeopardize the consolidation of democratic and economic transitions. Examples of the costs of conducting business in the formal sector include:

  • obtaining a business license
  • acquiring land titles or leases
  • hiring employees
  • knowing and complying with applicable government laws and regulations
  • obtaining information about the price, quality and quantity of particular goods and services, about sources of goods and services, and about potential customers
  • obtaining a loan
  • buying supplies
  • hooking up and maintaining electricity and telephone services
  • paying taxes
  • enforcing contracts, and so forth.

These costs are often referred to as transaction costs.

Key determinants of transaction costs in a particular country are the institutions, i.e., the rules and regulations that affect economic activities. Well-designed institutions provide entrepreneurs with a predictable framework and necessary business information at a cost that encourages them to comply with and pay for these institutions. Poorly designed institutions require entrepreneurs to comply with burdensome rules and regulations and deal with inefficient, corrupt government agencies, and offer few benefits in return. Such institutions increase transaction costs, lower entrepreneurs’ incentives to
comply, and hinder political and economic participation.

One of the most important institutions contributing to the success of capitalism is the formal property rights system. This system provides the legal mechanisms through which assets can be converted into capital and used to create additional value, increase productivity and growth (see De Soto 2000). While virtually every country has a formal property rights system and acknowledges its importance, in developing countries the general public does not benefit from such institutions for two reasons. The first is that formal law has often been crafted by (and for) an upper-class minority and thereby does not reflect the concerns and norms of the general public. The second reason is that the
enormous costs in terms of time and money necessary to acquire formal property rights in developing countries often outweigh the benefits. Entrepreneurs of modest means without political influence simply do not have the resources or the incentives to comply with costly laws and regulations--including obtaining formal property rights, acquiring a business permit or maintaining legal accounting records. Locked out of formal, wealthcreating institutions, these entrepreneurs operate informally in small-scale, short-term, low-investment and low surplus-generating activities or they do not engage in business at all. This greatly hinders growth.

Moreover, these entrepreneurs are often excluded from policymaking or lawmaking processes. As a result, government is not held accountable to their concerns and democracy is weakened. This creates an opportunity for a small number of politically active oligarchs to control the nation’s economy through a system of politically-motivated, state-endorsed laws and regulations at the expense of the rest of the population who eke out a living in the informal sector.5 “To the extent that excessive regulations are created to benefit particular interest groups and not society in general, the
presence of the informal sector is a result of the failure of political institutions to protect and promote an efficient market economy”(Loayza 1997:2). In addition, lack of democratic and market-based institutions imperils the competitiveness of an economy and weakens its ability to take advantage of globalization.

In short, poorly designed institutions bar entrepreneurs from or discourage their participation in the political and economic system. Hence, they operate in the informal sector. This has serious implications for the future of political and economic transition in emerging democracies and economies and thus warrants attention.

For this reason, CIPE has recently devoted increased attention to reforming key political and economic institutions in order to encourage and enable informal sector entrepreneurs to participate actively in the formal market economy and policy making process of emerging democracies. To this end, CIPE sponsored a workshop on the informal sector that was part of the National Endowment for Democracy’s Second Global Assembly of the World Movement for Democracy in São Paulo, Brazil in November 2000 (see www.wmd.org). In preparation for this event, CIPE prepared an earlier version of this background paper and sent it, prior to the event, to those who had signed up for the workshop. The workshop brought together forty-one people from twenty-four countries from all regions of the world and different sectors of society including informal sector experts and representatives from civil society such as business associations, think tanks, universities, labor unions, and human rights and pro-democracy groups. (See Appendix B for a participant list.) This paper was drafted to offer overview of the challenges that a growing informal sector poses to economic and political reform in emerging democracies in order to stimulate focused workshop discussions on the specific sources of and effective strategies for removing obstacles to formality. The lively exchanges between the participants in São Paulo yielded valuable insights on the reasons for informality and produced useful suggestions, strategies and policy initiatives on how to reduce these barriers. This feedback has been incorporated into this version of the paper.

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