Informality: bigger and worse than it seems


By Armando Castelar Pinheiro - Valor Econômico (23/07/04)

It was a prediction that paid attention to the social character of informality, marked until then by the predominance among peddlers of the physically disabled, unemployed and migrants who had just arrived in the big centers. Informality was more concerned with signaling a worsening of the social situation than with its negative repercussions on national development. This has changed, and a lot, in these two decades. This is shown by McKinsey's recently released report, “Removing barriers to economic growth and the formal economy”.


The work brings a series of contributions to the understanding of this theme. One of them is to propose to define informality as “the execution of lawful activities in an irregular way, through non-compliance with regulations that imply significant cost”. It thus delimits a perimeter of the informal economy that, without including illegal activities, contains much more than just companies that disrespect the labor rights of their employees. By this definition, all companies that derive at least part of their profitability from non-compliance with burdensome regulations are informal.


This spurious competitiveness hinders growth in two main ways. First, it allows inefficient firms to maintain their “market share”, making it more difficult for more productive companies to expand, which are also those that manage to increase their productivity more quickly. Second, as informal firms are, by nature, more risky and lack incentives and means to grow, the accumulation process is compromised.


In this way, both the increase in productivity and the investment rate are sacrificed, penalizing economic growth. As informal companies come to dominate a very large part of the economy, as in Brazil, where 55% of the workforce, including the public sector, are informal, the macroeconomic implications of this process become significant . Obviously, the other side of the coin is that there is great potential to accelerate the growth of the Brazilian economy by reducing informality. McKinsey's estimates show that the Brazilian GDP could grow two percentage points more per year, reducing informality by 20%. The report leads to at least five other important conclusions:


[1] Informality has many faces. It ranges from tax and social security evasion to disrespect for property rights and non-compliance with health standards. The examples are many. This finding reinforces the conclusion that informality has long ceased to be an escape valve for unemployed workers to become a strategic option for firms in the most diverse sectors of the economy. Going informal is a business decision that weighs gains, costs and risks.


Informality has long ceased to be a disguised social policy to become an upside down industrial policy


[2] There is a vicious circle in informality. As more companies fail to pay their taxes and contributions, the more it is necessary to tax companies and formal workers to maintain the same revenue. Likewise, the spurious competitiveness obtained by informal companies forces many of their competitors to follow the same path, in order to remain viable. There is nothing to say, therefore, that the expansion of the informal economy is close to ending. On the contrary. The good news, on the other hand, is that the reduction of informality can generate a positive dynamic, if care is taken to increase the number of formal companies by reducing the tax burden on them.


[3] The fight against informality itself suffers from this vicious circle. When this assumes the magnitude it has today in Brazil, the imposition of sanctions is very difficult, as evading and circumventing the law becomes part of the daily life of a very large portion of the population. As McKinsey's report shows, there are supply chains that operate almost entirely in informality. The consumer himself, in the search for the lowest price, becomes a partner in this process.


[4] Tolerance of tax evasion and disrespect for the law has important social implications. It reduces legal certainty, facilitates money laundering, encourages corruption, in its different forms, and makes illegal activities more socially acceptable, leading to the deterioration of values ​​that helps to foment crime. Thus, if the most directly affected by informality are the State, the taxpayer and, in several cases, the consumer, indirectly this causes serious damage to the citizen in general.


[5] The fight against informality needs to be multi-faceted, requiring action in different areas. This requires strategy, government commitment and political and social support. The effective application of sanctions, which do not necessarily need to be stricter, must be combined with the reduction of taxes and corporate regulations and the granting of greater benefits to formal companies. For example, public banks may be more demanding about their clients' compliance with tax and regulatory obligations. The judiciary can also contribute to making informality less profitable for companies.


The truth is that nowadays informality does more harm than help to unemployed workers. It has long ceased to be a disguised social policy to become an upside down industrial policy, reducing economic growth, the supply of good jobs and the ability to adopt appropriate social policies. It is no longer necessary to go to Bolivia to see how much it hinders development.

Armando Castelar Pinheiro, economist at Ipea and professor at IE-UFRJ writes monthly on Fridays.

See also:

 Studies and Research: McKinsey Study