Economic Reform Toolkit: Reducing Economic Informality by Opening Access to Opportunity

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Much of the developing world has two parallel economies: the formal, or mainstream economy, and the informal or extra-legal economy. The formal sector includes firms and activities that are legally recognized, officially recorded, and that function within a framework of formal economic institutions. The informal sector “is made up of entrepreneurs who produce legitimate goods and services without proper permits and legal status because they are locked out of the formal-legal economy by a maze of regulations, excessive procedures, high tax rates, and other barriers to market entry. Both the entrepreneurs and their employees lack protection of the law, access to formal sector services such as credit, and are prey to corrupt officials.”

Informal businesses make vital contributions to their economies – accounting in some cases for as much as 60 percent of GDP – yet their potential is severely curtailed by their extra-legal status and high barriers to conducting business. Informal businesses are unable to access public services and formal sources of credit, are vulnerable to bureaucratic whims, and are limited to pursuing business opportunities that can be found within their circle of acquaintances. As a rule, informal entrepreneurs and their employees are denied significant opportunities that formal businesses enjoy. They have at times completely been left behind during waves of overall national growth.

The denial of economic opportunity to informal entrepreneurs and workers results in the political disenfranchisement of the same groups. Democracy and its benefits elude them because they are not legally counted and cannot voice their interests. An informal sector further erodes democracy by eroding the rule of law, leaving large swathes of the economy outside regulation and legal protection.

Opening routes to formality creates new opportunities for the poor to realize their potential and raise national competitiveness. Acquiring formal status allows entrepreneurs to access formal markets, invest with security, obtain new sources of credit, and uphold their interests in courts and policymaking. An effective route to formality, however, requires more than the alteration of entrepreneurs’ legal status by decrees and registration. It requires the tearing down of barriers at the origin of informality to improve the business climate for all entrepreneurs. Such reforms expand the participation of the poor in the market economy and in public life, thus bolstering the performance and legitimacy of a democratic market system.

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CIPE

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