Random odd thoughts I: why is the informal economy so small?

Some things seem to need no explanation, but are not obvious at all on reflection and, if you wonder about them, suggest something of interest about the economic system. Consider the question of why the informal economy is so small, leading to the question of how much more productive the formal economy must be than the informal economy to make sense of how little informal economic activityy there is. See over the fold for the full argument.

A typical example of the informal economy is someone who gets paid to repairs roofs for others but doesnt pay GST or taxes on these activities. Informal activities can however also include the small-scale production of alcohol, medicine, health services, childcare, financial advice, transport services, etc. In essence, informal activities are merely small-scale activities that usually have large-scale formal counterparts.

Estimates of the informal economy, which basically includes activities that have a counterpart in the formal economy but that are untaxed, hover around 6 to 20% for OECD countries. The OECD puts the informal economy in OECD countries at 15% to 18%. These numbers mainly seem to derive from the work of Friederich Schneider and his co-authors, who estimates the informal economy by looking at the volume and speed of money (or electricity) and working out which bit of the wear and tear of dollar bills (or use of energy) is not due to the formal economy (see article from The Economist).

Trevor Breusch has expressed his dissatisfaction with this technique, essentially arguing it overstates the level of the informal economy, so the true number in developed economies is probably closer to 10%.
To see why it is so informative that there is so little informal economy, reflect on the hassle formal companies have to go through in order to be formal: their workers have to pay about 30% income tax. The company profits are taxed by roughly 50% whilst the interest rate payments are taxed elsewhere. On top of this is the 10% GST, as well as a whole host of small official taxes, like garbage collection and vehicle duties. As a rough rule of thumb, it immediately costs about 40% of total revenue to be formal merely in taxes .

Then consider the administrative costs of being formal. Being formal means having to comply with thousands of pages of income tax regulation, health and safety regulations, labour regulations, etc. Authoritative numbers on just how much time in total is spent on regulations one wouldnt have to adhere to in the informal sector do not exist, but we can generate a wild guess by looking at our own backyard. Universities are a classic case in point of just how much admin is concerned with complying with government regulation of one type of another. If we put in the conservative guesstimate that half the university administrators spend their time complying with legislation (including central HR, payroll, health officers, etc.), then about 1 in 3 employees at universities are busy keeping the university formal (the ratio of admin to academics is about 2 in some Australian universities), another 33% of total activities (the admin are not paid less than the academics!). For other organisations, it is hard to say how much of their total activity goes into complying with government regulation, but a third sounds about right (for a litany of some of the burdens of compliance, see Chamber of Commerce and Industry Queensland or Productivity Commission).

What do these numbers mean? If we add to the above calculations the fact that being in the informal sector also brings with it some access to the welfare system, then in order to make economic sense those who work productively in the formal sector (the non-rule compliers) must be about three times more productive in the formal economy than they would be in the informal economy. And this is only the ratio that is needed at the margin, i.e. the ratio of 1 to 3 needs to hold for the 90th% percentile of those working in the total working economy (formal plus informal). For the vast majority of productive workers, the ratio is therefore probably quite a bit higher. Perhaps the true ration is thus even 1 to 4 or higher, but whatever it is, were a long way off 1 to 1.

Why is this so interesting? This basic factoid tells us that big is indeed beautiful. There must be all kinds of increasing returns to scale advantages to being formal that are not open to those who are informal. What are these advantages of being formal? They include formal channels of advertising, the ability to combine with many others in recognisable dwellings, the ability to trade in bulk, the ability to credibly offer long-term contracts, the ability to generate reputation, etc. The astounding thing is that these advantages are not only worth some 70% of total sold production to manufacturing firms for which one would easily accept this, but the advantages must also be worth this amount to medium sized service companies and even to most small-scale entrepreneurs.

How can we interpret these advantages? Many of these advantages are essentially solutions to market failures, like a non-zero cost of information, increasing-returns-to-scale technology, and the notion of asymmetric information. We can then conclude that the organisation of our modern economy is only possible because of market failures rather than in spite of them! We thus have come full-circle in the sense that the usual economic argument (we should get rid of all market failures) is turned on its head; in that we wouldnt be able to sustain the present tax and regulation system if we indeed managed to eliminate market failures everywhere. We need market failures for our way of life throughout the whole economy, so that their solution within the visible regulated sector makes the informal economy an inferior choice! For theory, this musing also means that any perfect-market constant-returns to scale technology at the micro-level is essentially incompatible with the small size of the informal economy.

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Bruce Bradbury
Bruce Bradbury(@bruce-bradbury)
12 years ago

Most informal economy activities are also illegal, or at least subject to substantial tax penalties. This introduces a cost for the informal sector not born by the formal sector. So two other possible explanations for the small informal sector are
1) People consider these to be substantial potential financial costs
2) There is a psychic cost to not conforming to the socially accepted organisation of production.

Don Arthur
Don Arthur
12 years ago

Fascinating post!

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.

doctorpat
doctorpat
12 years ago

What of the possibility that the informal economy is just better at hiding than researchers think?

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.

Joshua Gans
Joshua Gans(@joshua-gans)
12 years ago

Paul, why do you classify increasing-returns-to-scale technology as market failure? Scale economies create market power, but you obviously don’t mean that; also some non-regulatory solutions to market failure might take advantage of scale economies, but that’s not the saem thing either. If it’s possible that the answer to your paradox is just plain old technological scale economies that have nothing to do with market failure, isn’t it a bit of a fudge to argue as you’ve done in the last paragraph? Shouldn’t we at least quantify the relative importance of the two explanations for suppliers’ wanting to be big? Otherwise we don’t know if they want to be big because that makes them visible, or big despite the fact that it makes them visible.

Cameron Murray
10 years ago

There are lots of reasons

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.

Paul Bamford
Paul Bamford
10 years ago

I’m with doctorpat @ 4: the informal economy is very good at hiding itself. Anyone with a tradie or two in the family will know how much skilled labour gets bartered in that particular sector of the informal economy.

Paul Frijters
Paul Frijters
10 years ago

Cameron,

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!