Have you ever paid cash to get your lawn mowed? Or to buy fresh fruit from a street vendor? Or for someone to haul away your garage clutter? If so, you have probably participated in what economists call “the informal economy.” The informal economy, though simple and seemingly trivial in its everyday manifestations, remains one of the most complex economic and political phenomena of our time. It affects an array of budget decisions, macroeconomic policies, and the debate over the wisdom of austerity. At a time when policymaking depends increasingly on data, the informal economy makes accurate assessments of economic conditions and patterns elusive.

The phrase “informal economy” conjures up negative connotations and images of exploitation, hardship, and inequality. Most observers associate it with slow or stagnant economic growth, to be found mainly in poor or developing countries. This is misleading. The informal economy is a global phenomenon that exists in rich and poor countries alike, currently employs almost half of the world’s workers (about 1.8 billion people), and totals to economic activity of around $10 trillion.¹ If the informal economy were an independent nation, it would be the second-largest economy in the world, after the United States (at $14 trillion) and before China (at $8.2 trillion).

Defining the “invisible” is challenging and contentious. At least 45 different adjectives festoon the literature on the informal economy, the most recurrent being “cash-in-hand”, “hidden”, “shadow”, “underground” and “gray.” The most commonly accepted working definition is, however, not very user-friendly:

all market-based legal production of goods and services that are deliberately concealed from public authorities to avoid payment of income, value added or other taxes; to avoid payment of social security contributions; having to meet certain legal labor market standards, such as minimum wages, maximum working hours, safety standards, etc; and complying with certain administrative procedures, such as completing statistical questionnaires or administrative forms.²

Simply put, the informal economy includes remunerated activities that are not declared to the state for tax, social security, and labor law purposes, but that are legal in all other respects.

The intellectual history of the informal economy as a concept is somewhat clearer than its working definition. In the early 1970s, Keith Hart argued that the masses who were surplus to the requirements for wage labor in African cities were not “unemployed”, but rather were positively employed, even if often for erratic and low returns.³ He proposed that these activities be contrasted with the “formal” economy of government and organized capitalism as “informal income opportunities.” He also suggested that the relationship between “formal” and “informal” sources of employment might be of significance for economic development models in the long run. Hart derived his analysis from Weber’s theory of rationalization, arguing that the informal economy might be both a source of growth and a crucial ingredient of economic transformation.

The economic thinking behind the links between the informal and formal economy gained publicity thanks to a 1972 International Labor Organization report on income and employment in Kenya.⁴ The report described the informal sector as an important source of domestic economic development, but the ensuing debate yielded no more precise or workable definition. Some of the discussion conceptualized economic development as the growth of the manufacturing sector as it absorbed labor being freed from agriculture, the informal economy being a manifestation of that transformation. Others saw the “informal economy” as a convenient definition for an empirical phenomenon that coexists and interacts with the formal economy regardless of developmental trends. To date, debate still centers around the logic of the dualism and complementarity of the two sectors, but the distinction is commonly typological in nature, usually taken to refer to size (large/small), or productivity (high/low), or patterns of rewards (wages/self-employment), or market conditions (competitive/non-competitive).

Empirical research has shown that the complementarity of the formal and informal economies in the West manifests itself in terms of the volume of informal work, whereas in less developed countries the complementarity takes a different form. Disadvantaged populations, such as those living in deprived areas, lower-income households, and those excluded from formal employment, are more likely to work out of necessity and to engage in less rewarding forms of such work. More affluent populations, meanwhile, are more likely to undertake such work out of choice, and to engage in more rewarding endeavors. So the informal economy can be made up of both households outside the formal economy and households mainly inside it.

Since 2000, a small but important school of thought has focused on the social relations attending the informal sector.⁵ Apart from the profit motive, many people engage in informal work to help neighbors, friends, family, and acquaintances for reasons other than financial gain. These trends are more marked in Asia, southern Europe, and Africa, which suggests that the proportion of individuals involved in these more diffuse, traditional economic networks remains stable even as wealth and education levels increase. This belies the assumption that these older, more diffuse relationships would decline with economic growth and modernization.

Finally, the recent literature tends to portray the informal economy as a route to progress and development rather than a hindrance to both. Some see informal economic activity as a response to distorted markets created by rentier elites that erect high barriers to entry. As Hernando de Soto famously said, “the real problem is not so much informality but formality.” The informal economy is naturally the place for those who are prevented from competing in the formal economy by state-imposed barriers. Others think the informal economy can benefit the formal economy by incubating new businesses and enabling entrepreneurs to test the viability of their businesses informally before deciding to register and legitimize their ventures.

It is at least as hard to measure the informal economy as it is to define it. Good information about informal economic activities on goods and labor markets remains scarce as those engaged in these activities usually do not want to be identified. Measuring multiple causes and multiple indicators over time turns out to be the best way to deal with the sizing puzzle. If we use this method, the informal economy in 2013 made up around 17 percent of the world’s GDP. Sub-Saharan Africa is highest with 38 percent of GDP, closely followed by Europe and Central Asia with 36 percent, Latin America and the Caribbean with 35 percent, the Middle East and North Africa with 27 percent, South Asia with 25 percent, and East Asia and the Pacific Islands with 18 percent. High-income OECD countries have the lowest level of informality with 13 percent, though the sheer relative size of their economies makes the actual monetary value of informality staggering. In the United States, for instance, 9 percent of GDP translates into $1.4 billion.⁶

Despite the big numbers, the informal economy has been getting smaller worldwide. Between 2003 and 2013, it decreased almost 3 percent.⁷ Economic growth and more robust employment numbers get credit for this result, but the numbers fluctuate. One might think that trends in the formal and informal economies rise and fall more or less together, but they may not. When the formal economy stalls, the informal economy often grows. Europe illustrates these trends, particularly in the aftermath of the 2008 financial crisis.

The size of the informal economy in Europe reached a ten-year low in 2013 both in terms of GDP ratio (from 22 percent in 2003 to 19 percent in 2013), and in its euro-value, which is now estimated at $3 trillion. But in 2009, the informal economy surged 0.5 percent relative to GDP worldwide. While this increase was hardly massive, it broke a steady, long-term trend in which Europe’s informal economy had been declining relative to GDP. As a result of the 2008 break in the pace of decline, the gains against the informal economy have been roughly half of those during the early 2000s.

This shows that the state of the official economy affects decisions to join the informal economy. In a booming official economy, people have many opportunities to earn a good salary. In the face of an economic crisis, with rising unemployment and lower disposable income, individuals may drift into informality to improve personal finances and compensate for missing income streams. The austerity programs implemented by many European governments since the onset of the 2008 economic crisis, which included slashed wages and pensions and budget cuts in health care and education, caused business closures and rising unemployment. The result was to incentivize informal economic activity.

Also interesting is how the informal economy is dispersed in Europe. Counterintuitively, almost two-thirds of the informal economy expressed as a percentage of GDP is concentrated in Europe’s five largest economic powers: Germany (13 percent), France (10 percent), Italy (29 percent), Spain (19 percent), and the United Kingdom (10 percent). Other countries in Europe also have sizeable informal economies: Portugal (19 percent), Sweden and Norway (14 percent each), and Greece (24 percent). This data shows an East-West as well as a North-South divide, suggesting that economies on the Eastern/Southern side are more informalized than those on the Western/Northern side.

Finally, the data also indicate that more equal societies have a lower level of informality due to greater labor market intervention, higher levels of social protection, and more effective redistribution of wealth. This can help us understand, for instance, the higher levels of informality in eastern central European countries where these conditions are lacking, and the lower levels of informality in Nordic and West European countries where those economic and social factors are robust.

So what drives informality? In Europe at least, two things that stand out are social security infrastructures and the overall tax burden. The bigger the difference between the after-tax earnings from work and the total cost of labor in the official economy, the greater the incentive to work in the shadow economy to avoid the negative economic impact of this difference. Italy suffers from both these factors.

The effect of Italy’s high taxation (44 percent, including direct and indirect taxes, compulsory social security contributions, and capital taxes) and the pressures of the informal economy (20 percent of GDP) produces an actual fiscal pressure—namely, the weight of taxation on income—of about 55 percent on individuals or firms, and so offers an excellent illustration of the combined impacts of these two drivers of informality. Italy has been battling the informal economy since the mid-1950s, and achieved a 10 percent reduction between 1966 and 1974 almost exclusively thanks to the decrease of non-specialized self-employment. However, a steady increase in taxes and mandatory social security contributions between 1975 and 2013 reversed these successes and created the conditions for Italy’s informal economy to grow, in time becoming the third largest in Europe, after those of Turkey and Greece.

Italy’s attempts over the past forty years to address the high level of informality have not been particularly successful. Starting in 2000, the Italian government put in place several measures to address some of the causes of the informal economy, including a national committee to improve the coordination among social partners; trade associations and tax audit authorities to monitor likely underground economic activities at the local level; an amnesty to legalize some 700,000 undeclared, non-EU workers; incentives to reduce social security contributions and tax relief for both undeclared workers and entrepreneurs who permanently leave the informal economy; and a tax amnesty for a wide range of tax-evaders who operated in the informal economy. In 2013, a review of these programs found the results to be limited, basically for two reasons. First, entrepreneurs and workers did not consider the incentives fair and equal, but rather an indiscriminate initiative that rewarded tax-cheaters and undeclared workers. Then the Italian government failed to implement structural economic reforms to simplify and add flexibility to labor market regulations. This resulted in Italy having the highest per-capita fiscal pressure among OECD countries, and one of the highest in the world.

Other European countries have been more successful in addressing the combined effects of high taxation and social security contributions. During the past decade, Bulgaria, the Czech Republic, Germany, Hungary, Romania, and Slovakia introduced flat tax rates for individuals and corporations, and reduced social security contributions to discourage participation in the informal economy. In Bulgaria, tax revenues rose 5 percent in the first year these incentives were in place. In the early 2000s in Germany, the “mini-jobs” reform removed red tape and simplified tax requirements to encourage lower-wage workers to join the official economy. Despite some initial skepticism, almost 13 percent of the German population between 16 and 64 years of age registered as “mini-jobbers.” These successes suggest that indirect measures, which “nudge” people to change their behavior, can be a powerful tool to counter the growth of the informal economy, yet they still remain less common than outright controls and penalties that punish offenders.

The intensity of labor market regulations within the European Union is also a powerful incentive for both individuals and firms to “go underground” and reduce the burden of minimum wage mandates, dismissal protections, and restrictions regarding the free movement of foreign workers. Empirical evidence suggests that countries with more regulated economies tend to have larger informal sectors, since they impose higher labor costs in the official economy. Since most of these costs usually are shifted to employees, they furnish an incentive to work in the shadow economy, where they do not apply.

To counter some of the impacts of overburdening regulations and encourage entrepreneurs to leave the informal for the formal economy, Montenegro reformed its business registration processes in 1999. In 2003, only four years later, the number of registered firms had grown to 21,724 from 6,001. In 2002, the Mexican government implemented the “Sistema de Apertura Rápida de Empresas”, which allowed small and micro-firms to complete their business registration process in just two days by reducing the number of procedures from eight to two. Registrations increased between 4 and 8 percent within the first ten months of 2002. In Uganda, the municipality of Entebbe introduced a simplified licensing process that required entrepreneurs to provide only basic information and pay a fee, after which they immediately received their license. This reduced average registration time from two days to 30 minutes, and cut the registration cost by 75 percent. Furthermore, administrative costs fell by 10 percent and staff time used in registration fell by 25 percent.⁸ Alternative legal ways were found to introduce needed reforms at the local level without changes to national legislation, which would have been too slow and difficult to achieve.

In Chile, Costa Rica, the Dominican Republic, Guatemala, Honduras, Mexico, Nicaragua, and Paraguay presumptive taxes levied on gross corporate revenues have replaced either VAT or income taxes. In Argentina, Bolivia, Brazil, and Peru, a single tax has replaced the VAT, income tax, and social security contributions. Despite the great amount of simplification, some of these systems have gone further than others. In Brazil, the “Integrated System of Taxes and Contributions for Micro and Small Enterprises” (SIMPLES), implemented in 1997, de-linked social security contributions from the number of declared workers employed or the wage bill, and made the contributions proportional to the firm’s revenues. In addition, it replaced six types of federal taxes and five types of social security contributions with a single progressive tax levied on gross revenues, and unified the collection of federal tax payments and social security contributions. The changes applied to firms with revenues below $1,000,000 in the services, trade, manufacturing, or agriculture sector, representing 75 percent of the businesses registered and 7 percent of GNI. SIMPLES has been a success because it eliminated incentives to employ workers without a contract, and increased the registration rate of firms by an estimated 10–30 percent between 1998 and 2010.⁹

“Undeclared work” and “underreporting” are by-products of intense and often intrusive economic regulations, and have become powerful drivers of the informal economy. “Undeclared work” accounts for roughly two-thirds of the value of the informal economy worldwide and is particularly widespread in construction, agriculture, and household services. In the West, 30 percent of the labor force is undeclared; 70 percent of the workforce in sub-Saharan Africa is informal; 62 percent in North Africa, 60 percent in Latin America, and 55 percent in Asia and the post-Soviet economies.¹⁰ As long as the rewards of formalizing “undeclared work” remain low, it will be more attractive to remain informal.

For example, the social protection benefits offered by formal job contracts might not provide services good enough to be worth the contributions. This is particularly relevant for people who live in remote areas where infrastructure and public service provision is poor. For these people, formal jobs may offer virtually no advantages; informal protection networks substitute for the state, with lower transaction costs and better efficiency in reducing the impact of income shocks. Obviously, then, the quality of government, not the size of government, is a key factor in how people decide whether to formalize their economic behavior. Governments that provide high-quality and reliable services are bound to achieve lower levels of informality in the economy.

There are many reasons why some governments are better than others at providing high-quality services, and it is not easy to imitate them quickly. As a consequence, many countries have introduced reforms to their taxation systems as a means of generating a transition from informality to formality. In Belgium, Bulgaria, France, Hungary, the Netherlands, and Sweden reforms have mostly targeted undeclared work and include, for example, reduced tax rates for low-wage earners, and tax exemptions and reductions in sectors that rely heavily on undeclared work. Finally, “underreporting” accounts for around 25–35 percent of the informal economy worldwide, and it is typical of businesses that deal heavily in cash, such as retail, food and beverages, and transportation.

To some extent, incentives to remain in the informal economy, all else equal, depend on the government’s capacity to penalize that choice. All around the world, some governments are better at collecting taxes than others, just as some provide higher-quality services than others. If the benefits of formalization are modest and the liabilities of informality are modest too, most people will lack good reasons to change their behavior.

There is no doubt that the informal economy allows many of the “officially jobless” to earn a living. So, if those in need win from informality, who loses from it? Many studies have tried to answer this question in an effort to shine a light on the conditions that determine whether reducing or expanding the informal sector will benefit the economy as a whole. A common view argues that those in the formal economy end up bearing the burden of those who evade their share of taxes through informality. But that assumes that those in the informal sector would work in the formal economy if informality were closed to them. That is not necessarily the case. So if informal economic activity links to and feeds formal economic activity, then shutting it down could hurt economic activity rather than help it.

For others, the formalization of the informal sector bears more aggregate advantages than disadvantages. McKinsey Global Institute, among many others, argues that the price of a large informal sector can be lower productivity, and estimates that formalizing the informal sector could add around 1 percent to Portugal’s productivity growth, and 1.5 percent to Turkey’s and Brazil’s.¹¹ The argument is that informal firms tend to be small and want to stay that way so as not to attract the attention of the authorities, which limits their ability to take advantage of new technologies and business practices and to invest in human capital.

Slightly less negative views of the informal economy maintain that the possible advantages of the informal economy could be temporary. The informal economy might boost overall employment but at the same time create unfair competition and skew incentives for innovation. Since hidden entrepreneurs do not pay taxes or comply with costly regulations, their costs of production are lower and therefore their goods and services are likely to be cheaper, thus drawing customers away from formal firms. In this way, the informal economy acts as both a free rider and a drag on the productivity and growth of the formal economy. Low-productivity firms and unprotected workers seem unlikely to foster sustained economic growth and development. It is not clear, however, whether formalization alone can significantly boost productivity, as some have claimed.

In recent years, the informal economy has come to be viewed as an alternative route to progress. Those of this view argue that “informal” does not mean that there are no rules or norms regulating the activities of workers or enterprises. People engaged in informal activities have their own “political economy”, their own informal or group rules, arrangements, institutions, and structures for mutual help and trust. These informal arrangements can include providing loans, organizing training, transferring technology and skills, trading and market access, and enforcing obligations. Moreover, some claim that the informal economy promotes small business, reduces unemployment, and offers incomes that are often comparable with those of the formal sector. Obviously, the extent to which such claims could be justified depends on the degree of institutionalization of the formal economy and, again, on the quality of government.

A burgeoning literature also argues that the informal economy acts as an incubator for enterprise creation. Unregistered entrepreneurs are depicted as testing the viability of their enterprises in the informal economy before deciding to register and legitimize their ventures. Based on this theory and the limited existing empirical findings, a few EU countries have begun to alter their approach toward tackling the informal economy. They have moved away from deterrence approaches to avoid damaging the entrepreneurship and enterprise culture that other parts of government are seeking to nurture. To date it is unclear how many start-up businesses are unregistered and trading informally, and how many of these do so in order to test their viability.

Even experts and social commentators who see the informal economy as a potential hotbed of entrepreneurialism recognize that using it as an incubator can be a long and arduous road. Business registration often spurs a new phase in business development, suggesting that informal entrepreneurs do benefit from some features of formality, including having legal ownership of their place of business, enforceable commercial contracts, and access to new sources of capital. For these reasons, governments should reconsider whether to accommodate the informal economy as a legitimate, albeit temporary, state for entrepreneurs to operate within. This accommodation is difficult to achieve in practice because the right policy requires not only regulatory reforms that facilitate the formalization process, but, more importantly, a wider culture of compliance. Since informality takes so many forms, and since the reservoirs of social trust are shaped differently from country to country, policies that succeed in one place may very well fail elsewhere.

That said, recent evidence suggests that governments can facilitate the transition of firms and individuals from informality to formality. Policy packages that contain both carrots and sticks rather than isolated, one-off reforms, have proven more successful in creating the appropriate incentives to increase formality in the long run. The “carrot” elements reduce the costs of formality; the “sticks” can include toughening the enforcement process, from increased collaboration between government agencies to share information about non-compliers, to higher penalties for offenders. In some countries, regulatory reform might be more relevant, while in others it could be regulation enforcement and administrative reforms to strengthen information flows among enforcing agencies.

Moreover, given the costs and benefits of increased enforcement, optimal policies do not necessarily involve reaching full compliance; the target should rather be to make formality desirable and accessible. Above all, policies need to take into account the level of trust of informal actors in their institutions, and ensure that they are being included in the policy design process.

In Europe, some of the more effective policy results have emerged from government efforts to foster financial inclusion that tends to displace the cash economy. The Netherlands, for example, changed existing rules to allow access to basic accounts for people with structural debt problems. Portugal allowed people with poor credit scores or credit problems (such as bankruptcy) to convert standard banking accounts into basic accounts at any time, and Ireland introduced a national financial inclusion strategy. In 2012, Italy introduced one of the strictest rules, a decree supported by an agreement between public authorities, the Italian Banking Association, the Italian Postal Service, and the Italian Association of Payment Institutions that requires banks, post offices, and payment institutions to provide basic accounts to consumers.

Obviously, cash is one of the informal economy’s key enablers. After barter, it is the most elementary means of transferring value. Initiatives to displace cash remain complex, since they involve changing habits and coordination among many stakeholders: governments, banks, payment providers and merchants, to name only the main ones. Successful policy measures include putting limits on cash transactions and favoring electronic payments. Belgium and France have placed limits on cash transactions for years, and more countries added them during the economic crisis. While measures vary in scope, limits have generally dropped significantly. In the past decade, for example, Italy’s government lowered the ceiling for cash payments from $15,000 to $5,000 to $3,000 and then, in 2011, to $1,200. Further decreases may be coming.

While European legislation has encouraged EU member states to adopt stricter regulations to reduce the prevalence of large cash payments, these measures remain hard to enforce. As for favoring electronic payments, most EU governments are not only using electronic payments for all transactions they initiate, but are also providing opportunities for citizens and businesses to pay bills with means other than cash. This is a particularly important topic in eastern Europe. Romania, for instance, has established a national system for tax payment via bankcard and managed to raise tax payments by card by 34 percent year on year.

Formalization remains a gradual journey, which means accepting informality as a legitimate state of affairs for many entrepreneurs. Growing empirical evidence indicates that the informal economy can constitute a protective environment that many fledgling micro entrepreneurs need as they move from unemployment to the formal sphere. Robert Neuwirth’s Stealth of Nations (2011) enthusiastically supports these views, challenges conventional ideas about the informal economy, and depicts the informal economy as an economic system where the ability to think fast, adapt, and improvise are keys to success. He offers a wealth of examples of informal practices from around the world to illustrate the strength of informality as an economic engine, and to underline that, despite being essential in employment creation, the informal sector continues to operate with little support from governments.

The “informal” sector is the fastest-growing part of the world economy, and we need to understand better what it means for business and society. The shadow economy’s effects on the official economy, and especially on macroeconomic policy decisions and budget allocations, remain mostly opaque. Because of this ambiguity, governments around the world are shifting their focus from mostly punitive measures to reforms aimed at building an economic framework that incorporates the informal economy as a virtual space through which individuals flow, from job-seeker all the way to compliant entrepreneur, and that allows the global economy to realize the potential of the 17 percent of world GDP that is currently informal.