11/29/2012 07:21 am ET Updated Jan 29, 2013

Working in the Shadows: What Have We Learned About Informality?

In the average developing country, most people work outside the law -- they have no contract, are not registered, carry no license, pay no tax or make no pension contribution. They get no social benefits or labor protection either. They are "informal."

Think of the small farmer toiling on her tiny plot, the neighborhood's handyman working out of his toolbox, the lady cleaning houses for cash, the youngster peddling fake watches at the traffic light, the sweatshop operating in a basement and the contractor that, literally, picks up day-laborers on the street corner. These kinds of micro and small "enterprises" actually provide most of the world's employment. No wonder they have been the object of much attention by politicians, academics, multilaterals, NGOs and virtually everyone else who has an interest in economic development.

Until very recently, our understanding of informality went more or less like this. To escape poverty, an individual starts a business. Happy with the initial results, she hires a helper or two. But soon she is faced with the government's taxmen, registrars and inspectors. To her eyes, they want a piece of her income, in the form of taxes, fees and bribes. To hide from them, she keeps her trade minute, deals only in cash and serves the kind of clients who don't ask for receipts. With those credentials, no bank wants to lend to her and no big company wants to train her as a supplier -- she is cut off from both finance and technology. This forever condemns her to smallness, low-productivity and, very likely, poverty. The remedy? Lighten her tax burden, make registration and licensing painless, give her basic training and help her access "micro-credit." For decades, this formula has been followed by policy-makers and charities alike to usher people out of informality.

Well, over the past five years or so, new data and new research have shown that reality is a lot more nuanced. To start with, evidence from Latin America suggests that a great deal of informality is voluntary -- people are opting out of formality, rather than being "excluded" from it. That may be because they don't value the benefits that the government gives them once they register. [If you earn barely enough to eat, how inclined would you be to make pension contributions? And what about contributions to the public health system, especially if public hospitals don't charge for their services?] Or they may think that the tax inspector is too incompetent to find them -- "weak enforcement capacity," in economist jargon -- or can be easily bribed if he does. Or the chances for expanding the business may be slim to start with -- the client base may be as poor as the business owner. Or they may simply like the flexibility and independence of being their own boss. Whatever the reason, they choose to be informal, and the usual public policies and charitable programs can't really change that. Interestingly, in some Latin American countries (among them, Brazil and Mexico), that choice seems to be related to age: the younger you are, the more likely it is that you will work informally for someone else (presumably, while you wait for a real job). As you grow older, chances rise that you quit your formal job to go solo and informal. Sounds sensible, doesn't it?

Second, the idea that informal firms are always less productive than formal ones has been proven wrong in, of all places, Africa. A 2012 study of 900 firms operating in three West-African capitals detected large enterprises that dominate entire markets -- say, grain imports -- but operate as family businesses that meet few, if any, legal requirements. [NB: just gathering so much enterprise information for that part of the world is a major achievement in itself.] It turns out that these "large informals" can be as productive as their law-abiding competitors. How so? One of a large array of reasons is that big, informal entrepreneurs may find it easier to bribe their way to the top of the waiting list for public services -- like electricity and water -- which are essential to gain market share.

Third, credit is less of a problem for the informal than previously thought. True, banks rarely lend to people who cannot show proper books or titles to their properties -- so the informal are still easy prey for loan-sharks. But new data from some 26,000 South Asian firms hinted that, for those working outside the law, logistics can be more of a problem than finance. In that region, things like electricity, transport and access to land top the wish-list of those working informally -- getting rid of crooked public officials come a close second.

Fourth, in some parts of the world (the Middle East is a case in point) informality may have less to do with economics than with politics. The real dichotomy is not between formal and informal or big and small, but between "connected" and "not connected" to political power. What really matters is knowing the "right people." Those that lack connections tend to remain small and informal -- in the periphery and "under the radar." Whether the recent wave of democratization -- the "Arab Springs" -- breaks that mold, is yet to be seen.

Finally, informality is no longer considered a white-or-black phenomenon. Today, individuals and firms may abide by some laws and ignore others; they may pay taxes but skip on social security; have titles to their land but no operating license; they may have contracts for some workers but not for all. Even government-owned enterprises and institutions may qualify as "somewhat informal" -- believe it or not, they are not always up to date on their pension contributions. Formality now has degrees; it has become a "continuum."

So, how will informality evolve over the next ten years? Nobody knows. But keep your eyes on three things: gender, aging and technology. As more women enter the labor force, many of them will initially take the informal route, especially in developing countries. At the other end, as people live longer, they will retire from nine-to-five jobs only to join the ranks of the self-employed, where they will be more likely to work in the shadows. And new technologies are already altering the value of size: while manufacturing is going for smaller, more efficient factories, dot-coms thrive in ever-expanding networks. There was no way Facebook could operate informally out of a college dorm for too long.