What Does the Informal Sector Mean for Global Economic Growth?

The informal sector -- those businesses and entrepreneurs who work outside of the formal market economy -- is huge and largely undocumented in most developing economies.
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In December 2010, the Tunisian fruit vendor Mohamed Bouazizi self-immolated in protest of his poor treatment at the hands of the authorities. As an informal sector entrepreneur, he had been shamed and denied his basic rights. His death not only captured the world's attention, it led the way to the Arab Spring and ultimately to a transformation of the entire Middle East.

The informal sector -- those businesses and entrepreneurs who work outside of the formal market economy -- is huge and largely undocumented in most developing economies. Almost everywhere, the root cause is the same: cumbersome, unresponsive, unfair, and overwhelmingly status quo-driven bureaucracy. People simply cannot get through the wall of red tape or the maze of regulations to gain access to the formal economy. While they remain outside of the system, they lack the protections that laws and regulations afford them. This is a tragedy not only for those entrepreneurs stuck in the system but for the country as a whole, as informal assets represent an enormous pool of inaccessible capital that could be used to create jobs, stimulate investment, or pay for social services.

Hernando de Soto famously studied the informal sector in his own country of Peru and also in Egypt. His 1997 study, called "Dead Capital," found that the informal real estate and businesses owned by the poor represent a huge portion of domestic real assets. His first estimate of Egyptian real estate alone indicated that it was equivalent to $240 billion in today's dollars which was then 30 times greater than the aggregated market value of registered companies on the Cairo stock exchange. That's a staggering figure. De Soto calls these assets "dead capital" because they cannot be used to support businesses, create mortgage systems, or collateralize other properties -- all of the things that physical capital can do in more developed countries. De Soto argues that property titles are not enough; a country must develop legal, regulatory, and contracting systems that recognizes and creates the market, incentives, and security for titles. This legal and regulatory reform is hard work. It is institution building. But it can be done and it has to be done.

Around the world, some of the largest informal sectors in the world are in sub-Saharan Africa, but the Middle East and North Africa follow close behind. Friedrich Schneider, who along with his World Bank colleagues Andreas Buehn and Claudio Montenegro have published an estimate for the size of these "shadow economies" in 2007. At that time, the size of the informal sector in Egypt was equal to 33 percent of the economy. In Tunisia, the country of origin of Mohamed Bouazizi, the informal sector tallied 35.4 percent. And shockingly, over 60 percent of the total GDP of Zimbabwe is in the informal sector. By contrast, most of the developed countries do well, with the exception of Greece, Spain and Italy. Only about 12 percent of the United Kingdom's economy is in the shadows. In the United States, the figure is even lower at 8.4 percent.

Most of the countries involved in the Arab Spring do not yet have the resources available to create the jobs that they promised. They lack the money to simply build new factories, and government sector employment is no longer the solution it was during the strongman days. Governments must mobilize the informal sector and give them a voice. There are many ways to assist in the process of formalization, including regulatory reform and simplification, improvement of government services, tax reform and others.

Drawing the informal sector into the formal economy enables new entrepreneurs to create the jobs required by a growing and restive youth population. Governments must develop a mechanism that lifts this vast pool of entrepreneurs out of informality and encourages the economic future that the country needs. Government services and security must improve, bankruptcy laws must be reformed, and banking systems must allow greater access to capital. Entrepreneurs must understand how the formal system will benefit them. The street vendors of Cairo have already spoken out by partnering with the Federation of Economic Development Associations to develop a draft law and begin working toward its implementation.

At its core, the issue comes down to necessity. Many informal entrepreneurs work outside of the system because they have to. However, studies have found that when the opportunities are created, barriers are lowered, and legal rights are guaranteed, up to 25-30 percent of informal firms will move into the formal sector. When they do so, they are able to create jobs, provide income, and assist in developing a nation's economy. The message is clear, if we listen. And act!

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