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Informality and the capitalist economy: A perspective from the Global South

2 Defining the informal sector

So far, we have used the terms ‘self-employment’ and ‘informal sector’ interchangeably to refer to the non-capitalist part of a dual economy. However, in public policy, the terms ‘informal sector’ or ‘informal economy’ are often used in a broader sense to include parts of the capitalist sector where wage workers do not have formal written contracts or legal protection. Read the ‘Find out more’ box to learn more about how the International Labour Organization, an international body working on labour rights, defines these terms.

The International Labour Organization (ILO) is a United Nations body that brings together governments, employers, and workers of almost all the countries in the world to promote better working conditions, enforce labour standards, and devise policies and programmes for job creation. The informal economy is an important subject area for the ILO. According to the ILO:

The informal economy refers to all economic activities, excluding illicit activities, by workers and economic units that are, in law or in practice, not covered or insufficiently covered by formal arrangements.

The ILO’s definition includes both informal enterprises (what they refer to as ‘economic units’) as well as informal employment. Wage workers who do not have formal written contracts or do not receive social security benefits are included in the category of informal employment. So, capitalist firms that are not formally incorporated or registered with relevant national authorities are considered part of the informal sector.

This approach to the informal economy has resulted in an expanded definition of informal employment used in public policy, bringing together features of the enterprise, on the one hand, and the type of employment arrangement, on the other (Figure 2).

Sector
Formal
(enterprises registered with the government)		 Informal
(unregistered enterprises)
Employment type Formal
(employment with written contracts and benefits)		 Regular-wage employment with job security and benefits in registered firms N/A
Informal
(employment without written contracts or benefits)		 Casual-wage or regular-wage employment without job security or benefits in registered firms Casual-wage, regular-wage without contracts or benefits, and self-employment in unregistered enterprises

Figure 2 Informal enterprise and informal employment.

Adapted from Centre for Sustainable Employment, Azim Premji University. 2018. State of Working India.

The bottom row of Figure 2 defines informal employment or the informal economy. The informal economy consists of all forms of informal employment—that is, employment unprotected by labour law and bereft of social protection—both inside and outside the informal sector.

Why do some capitalist firms register with relevant authorities, while others do not? The decision to register a business with the relevant authorities is the result of a conscious calculation by the owner. Formal recognition comes with its own costs and benefits. Benefits can include access to cheaper credit, government incentives, better-quality workers, less harassment from officials, and so on. Costs include compliance (which has many sub-parts such as paying for an accountant to review company accounts, a lawyer to ensure labour law compliance, workplace facilities for workers) and, of course, taxes. Some researchers argue that individuals may choose to participate in the informal economy (or opt out of the capitalist sector) to avoid such costs.1 2 3 4 Similarly, employers may choose to hire workers via third-party contractors instead of on their own books to avoid costs associated with labour law compliance. In this perspective, labour regulations and costly procedures in the capitalist sector result in the creation of an informal sector.

But being excluded from or opting out of the formal regulatory system does not mean a ‘free-for-all’ situation. Casual observers of a street informal economy often do not appreciate the complex, yet unwritten, rules behind the apparent chaos. An elaborate system of bribes and unofficial payments exists to secure rights to space, utilities and, not least, protection from the law, since in a technical sense such activity may be illegal—for example, operating an industrial workshop in a residential community or vending in a zone restricted for pedestrians. This system allows informal firms to operate in exchange for unofficial payments. The policy challenge is how to change incentives to encourage the shift of activities to the capitalist sector.

In this Insight, we use a narrow definition of the informal sector, excluding all capitalist firms from our definition. Since all types of wage workers, whether they work on oral contracts or written ones, are part of the capitalist production process with resulting implications for technological change and labour productivity, we consider them to be part of a single economy.

Figure 3 shows the difference between our definition of the informal sector and the broader concept of the informal economy.

The labour force is split between the capitalist sector (wage employment) and the non-capitalist sector (self-employment). Within self-employment, ‘own account workers’ are individuals running their own enterprises without any other person. Think of a fruit-seller who sits with a mobile cart on a busy streetside. The second kind of self-employment is the family worker (also referred to as contributing family workers or unpaid family workers). They assist in the family farm or non-farm enterprise. However, they do not directly receive compensation for their work but instead benefit from the shared earnings of the enterprise, either in cash or in kind.

There are two broad types of wage employment. Casual-wage workers are individuals who work on short-period oral contracts, such as one day or one week. Regular-wage workers typically get paid on a bi-weekly or monthly basis and have longer-term contracts. But they may or may not have a formal written contract with their employer specifying the conditions of employment. And they may or may not receive benefits such as paid leave, pensions, or other forms of social security. Regular-wage employment with a formal, written contract only accounts for a minor part of the workforce in India. This is generally true of other countries with similar levels of GDP per capita . You can verify this for yourself with data from the World Development Indicators database of the World Bank (Exercise 1).

This flowchart classifies types of employment into self-employment and wage employment. Self-employment is divided into own account and family work. Wage employment is divided into casual and regular employment. Regular-wage employment is further divided into no written contracts or benefits, and formal contracts with benefits. An arrow under self-employment is labelled ‘Our definition of informal sector’. A longer red arrow under all categories except ‘Formal contracts with benefits’ is labelled ‘ILO’s definition of informal economy’.
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https://books.core-econ.org/insights/informality-and-the-capitalist-economy/02-defining-the-informal-sector.html#figure-3

Figure 3 Principal types of employment in a dual economy.

Exercise 1 Comparing wage employment across countries

First, follow the steps to download data on wage and salaried employment.

  1. Go to the World Bank’s World Development Indicators database.
  2. In the ‘Variables’ menu, for the ‘Country’ option, select all countries by clicking the tick box above the country names.
  3. For the ‘Series’ option, select ‘Wage and salaried workers, total (% of total employment) (Modelled ILO estimate)’ (you can search for ‘wage’ to narrow down the list).
  4. For the ‘Time’ option, select all years by clicking the tick box above the list of years.
  5. Click on ‘Apply Changes’ in the box appearing in the centre of the page.
  6. In the ‘Download options’ (top right of the webpage), select ‘Excel’ to download the selected data as an Excel spreadsheet.

Then, use the data you have downloaded to answer the following questions.

  1. Choose three countries at different levels of income (excluding India). You can identify countries from different income groups by going to the ‘Country’ option and choosing High income/Middle income/Low income and viewing the metadata to see the list of countries. Compare the share of wage and salaried workers between the three countries you have chosen. Suggest some reasons for the differences you observe.
  2. Make a line chart showing how the share of wage and salaried workers has changed over time for your chosen countries (include all available years in your chart). Comment on similarities and differences between the countries.

  1. Bhattacharya, Prabir. 1996. ‘The Role of the Informal Sector in Structural Transformation: Some Indian Evidence’. Journal of International Development 8(1): pp. 83–94. ↩

  2. De Soto, Hernando. 2000. The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else. New York: Basic Books. ↩

  3. Maloney, William F. 2004. ‘Informality Revisited’. World Development 32(7): pp. 1159–1178. ↩

  4. Ulyssea, Gabriel. 2018. ‘Firms, Informality, and Development: Theory and Evidence from Brazil’. American Economic Review 108(8): pp. 2015–2047. ↩