CAT 2023 Slot 2 VARC: Rethinking the Informal Economy

The term "informal economy" was coined in the early 1970s by an anthropologist studying urban employment in Ghana, who noticed that a great deal of economically productive activity — street vending, small-scale repair work, unregistered transport, casual construction labour — fell entirely outside the categories that official labour statistics were built to capture. Half a century later, the term has become indispensable to development economics precisely because the phenomenon it names has refused to shrink as predicted; in much of the world it has grown, and it now accounts for a majority of employment across large parts of Africa, South Asia and Latin America.

The persistence of informality confounded an earlier generation of development theory, which had treated it as a transitional stage: as economies industrialised and formal-sector jobs multiplied, workers would migrate from informal subsistence activity into registered firms offering contracts, benefits and legal protection, much as had occurred, imperfectly but recognisably, in the industrialising economies of nineteenth-century Europe. What this model missed was that formalisation is costly to firms as well as workers — registration fees, mandated benefits, tax compliance, labour regulations — and that in economies where formal job creation lags population growth, informality functions not as a waiting room but as the default mode of economic participation, absorbing labour that the formal sector was never going to employ in the first place.

This reframing has practical consequences for policy. An older approach treated informality chiefly as a problem of enforcement: crack down on unregistered vendors, and formal employment would rise to fill the gap. Where this has been tried without complementary measures, the more common result has been not formalisation but displacement — informal workers pushed into more precarious and less visible activity, with no corresponding increase in formal jobs, since the underlying constraint on formal job creation was never addressed. A newer approach instead asks what specific barrier is binding in a given context — access to credit, the cost of registration, the absence of enforceable property rights over a market stall — and targets that barrier directly, on the observation that informal enterprises are frequently as productive, entrepreneurially, as their formal counterparts, and are held back by identifiable and fixable constraints rather than by some general deficiency.

None of this is to romanticise informality. Workers in the informal economy typically lack recourse to labour courts, unemployment insurance or enforceable safety standards, and informal firms are usually too small and too capital-constrained to invest in the productivity-raising technology that formal firms can access through credit markets closed to them. The point of the reframing is narrower: that treating informality as a deviation to be eliminated by fiat, rather than as a rational response to a specific and identifiable set of constraints, has repeatedly produced policies that punish the symptom while leaving the underlying constraint fully intact.