The power of informality

The informal sector is an untapped reservoir of entrepreneurship that can accelerate the pace of economic growth, job creation and poverty reduction in developing countries

Informal firms account for up to half of economic activity in the developing world. Contrary to conventional wisdom, their importance has not declined over the last several decades. The persistence of the informal sector has gone hand in hand with a faster pace of structural transformation and pro-poor economic growth.  

India is no exception to these global trends. India’s informal sector accounts for over 80 per cent of jobs and 99 per cent of entrepreneurs in the manufacturing sector.

Even in highly industrialised states like Gujarat, jobs are expanding in the informal sector. India’s young demographics, and limited employment generated by the formal sector, has increased the future importance of the informal sector. Its flexibility has enabled millions more women to find jobs and better-manage work-life balance. 

Despite its huge size and importance, the role of the informal sector in economic development remains controversial. Some view it as the enemy of the formal sector, and as a parasite competing unfairly with law-abiding formal firms. Others say formal and informal firms are fundamentally different and cater to different markets. And optimists view the informal sector as an untapped reservoir of entrepreneurship that can further accelerate the pace of economic growth, job creation and poverty reduction.  

We examined these trends in India using plant-level data for formal and informal enterprises in some 500 districts (see Ghani, Ejaz; O’Connell, Stephen D.; Sharma, Gunjan. Friend or Foe or Family? A Tale of Formal and Informal Plants in India. Policy Research Working Paper No. 6588. World Bank, Washington, DC. ©World Bank).  

Friends not foes

Empirical evidence shows that there are huge horizontal and vertical linkages between formal and informal firms. Informal firms are important suppliers of inputs to formal firms. Employment and output have increased in the formal sector in those states in India that also have a greater presence of informal firms. Conversely, informal employment and output are greater in those states that have a greater presence of formal buyers of inputs. Formal enterprises are more competitive in the presence of informal firms, as they change their product mix, adapt to new technology, and outsource more labour-intensive tasks to informal firms. The input-output linkages between formal and informal firms are very strong.

A 10-per cent increase in employment and output in the informal sector is associated with a 16 per cent increase in employment in the formal sector

 

A 10 per cent increase in employment and output in the informal sector is associated with a 16 per cent increase in employment in the formal sector and increase in output by 12.6 per cent. As formal enterprises become more productive, they demand better inputs from informal enterprises, and strengthen the forward spillovers. The backward spillovers are also strong, as informal enterprises purchasing from formal enterprises induce greater output in the formal enterprises. Although the productivity of the informal sector is more important for the formal sector, than vice versa, the two sectors act like friends and family members supporting each other. These linkages generate huge spillovers by working together.

New forms of globalisation 

Much of the manufacturing sector's employment growth has come in the form of informal establishments in the tradable sector. The exceptional increase of employment in the informal tradable sector in India exceeded 10 million jobs, equivalent to the entire net growth of the manufacturing sector. This rise in the informal tradable employment coincided with a strong decline in the non-tradable sector. The concentration of informality in the tradable sector suggests that the growth in traded industries is not due to plants achieving larger economies of scale and shipping goods at a distance, as might have initially been imagined, but an important role played by the informal sector. Informal firms in the tradable sector provide an opportunity to leapfrog the development process, by connecting to global value chains, resulting in greater opportunities for domestic suppliers, increased exports, and higher productivity.

What led to the expansion of informal enterprises in the tradable sector? The key driver is the rapid pace of urbanisation. This connects strongly with the broader spatial development trend of   informal sector concentrating in the cities. Other factors like the rapid expansion of female business ownership, subcontracting, and “push” entrepreneurship (entrepreneurs who start businesses out of necessity rather than growth desires) played a smaller role in the rise of informality. 

Emerging pro-poor growth agenda

The vast informal sector affects everything from structural transformation, the allocation of activity in the economy, job creation and poverty reduction. Conventional wisdom has focused on the formalisation of the informal sector, but this has not been very successful in most countries. It drives informal establishments out of business, leading to destitution of informal workers and entrepreneurs. Shifting the focus towards strengthening the linkages between formal and informal firms needs more attention. Economic growth is the cure for informality, and the policy focus should be on boosting the informal sector, strengthening their linkages (product, input, financial and technological) with formal firms, and unleashing the untapped reservoir of entrepreneurship. 

The role of urbanisation in strengthening the dynamism of small firms deserves more attention. Cities generate huge agglomeration economies and externalities, and this is greater in the informal compared to formal sectors, which makes a strong case for informal development being an integral part of the urbanisation strategy. Urban planners need to find ways to ensure that informal enterprises are integrated into urban plans, they participate in government procurement schemes, and their concerns are reflected in policy-making processes on land allocation, zoning regulation, and urban infrastructure services. The more the city mayors recognise the influx of the informal sector in cities, and design appropriate policies and investments to support it, the more effective pro-poor growth policy interventions will be. 

Industrial and trade policies too should not be targeted just on formal enterprises. Friendships and linkages between formal and informal firms can open new doors for economic growth, job creation, and gender inclusion. Policies are needed to improve access of informal sector to finance, training, technology, quality and productivity, which can induce the formal sector to outsource more higher-end tasks to the informal sector.

The informal economy has played the biggest role in reducing extreme poverty, but this is not enough. The rise of the informal sector is also associated with the rise in the number of people living with no social safety nets. Informal workers may not be poor today, but they can easily fall back into extreme poverty, due to economic shocks.    

The writer is lead economist, World Bank