I agree with 1, 3, and 4 as advantages of being legit. The advantages of being big (termed increasing returns to scale in the post), being able to advertise widely (asymmetric information), and having access to the legal system must be pretty substantial to outweigh the costs of being legit.

Number 2 is an empirical question.

The line of thinking here gives several reasons for differences in the size of the informal economy: the importance of broad-based versus local clientele; the level to which the legal system and the insurance system is developed and hence how useful it is to have access to it; the actual costs of being formal; the degree of informal monitoring, i.e. the degree to which there are social norms that increase the chance of detection if you are informal; etc.

Nice of you to visit my archives!

1. Insurance/liability concerns – fix a roof for cash and fall off it, what happens then. Being formal provides access to a legal process.

2. The cost is often not that high for small business.

3. How would you advertise your informal business?

4. All large businesses need to be formal.

I find the more interesting question is what circumstances lead to big differences in the size of the informal economy in different countries.

agreed on all your points. There does seem to be some sliding scale of business that are partially formal and partially informal, mainly with low-scale activities where the productivity ratio between formal and informal is probably quite a bit lower than 1 to 3 because the business is not entirely formal to begin with (and is grudgingly allowed to be semi-informal by the authorities).

doctorpat,

your examples seem perfectly plausible to me. As to the true size of the informal economy, I confess I am not an expert in the measurement of the informal economy and have taken the best numbers I could find, where I hide behind the back of Trevor in his criticisms of the high numbers derived by Schneider. Whenever I think of the estimates around i always think of the 100 and one ways in which they can be higher than estimated too.

James,
your point is well-taken, but I am essentially agnostic as to how to label it. Increasing-returns-to-scale are now and then classified as a market failure in the sence that they violate the conditions under which you can get perfect competition, now and then not. Here I took the short-cut to label it as a market failure in the sense that it in itself does not lead to an efficient allocation of goods and services because of the market power that it engenders. If you wish to say that a large part of the story is increasing-returns-to-scale then the thrust of my point remains that the modern economy would need a deviation from the conditions of perfect competition to arise.

Like Don, I think most informal work is done in the framework of a formal business. (This allows them to claim tax deductions on supplies and overhead, even that used for tax free informal work.) So our measures of energy use and the like are based on the figures from an economy, that contains an unknown amount of informal economy.

I would also say that the sort of work that would tend towards the informal, is exactly the sort of personal service type jobs that don’t use much external resources that can be tracked.

Let’s look at a hairdresser that just pockets the receipts of everyone who has the right change (so the cash register isn’t needed). How will that show up anywhere? Well if she banks the cash… but she won’t do that, she’ll be scared of the ATO.

So she’ll spend it, on the sort of personal services (roofing, getting the house painted, a girls night out at the local massage centre) that are also hiding some large fraction of the income. Or she’ll invest it, but because of the ATO, that investment should be an apartment in Greece or India or somewhere, not showing in the Australian numbers.

You say that “The dangers of a free-lancing informal provider of some non-illegal good (like roof repairs) to be found out and seriously fined are not all that great.”

So the advantages of being informal would be greater for activities without large economies of scale? I’m guessing it would be hard to avoid the authorities if you were operating a aluminum smelter or building oil tankers.

Access to credit would be another benefit of being formal — not just borrowing for the business but also for family housing. So, as you say, asymmetric information plays a role.

But I wonder whether you overstate the costs of going formal if you’re a small business.

It may be that many formal businesses aren’t actually complying with all of the costly rules and regulations they’re formally required to do. As you suggest, it’s easier for roof repairer to avoid sanctions than for a large bureaucratic organisation like a university.

Perhaps the penalty for being formal isn’t all that great for many owner-operated (zero employee) businesses. If it was possible to structure the business in a way that limited tax liability maybe the cost is low.

I’m assuming that a lot of people who engage in informal activity work out of businesses that are formally established. They do some jobs on the books and some jobs off the books. As a result, their informal activities piggy back off the advertising and other open activities of the formal business.

On the psychic cost, yes, the implicit ‘classic economic’ presumption employed above on the social acceptability of the informal economy is that such consideration are unlikely to be important at the margin: once one is in an equilibrium where the majority sees it in their best interest to behave a certain way then social norms start to solidify it but before that moment it has to make productive sense to do so and there’s only so much deviation possible from what is in people’s material self-interest. This is of course debatable, but you can for instance note that social stigma does not prevent 20% of our population to be on income support suggesting social stigma’s dont stand against material self-interest in the long-run.

On taxes and the ability of the tax authorities to spot all this: as I understand it, monitoring rates and fines for tax-evasion are very low in Western countries. The dangers of a free-lancing informal provider of some non-illegal good (like roof repairs) to be found out and seriously fined are not all that great.

As to illegal goods: sure, but we’re talking about the question why the 90% doesnt join the 10%, where the 90% does not consist of illegal activities.