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

6 Towards formalization and structural transformation: State and civil society actions

What can policymakers and civil society actors in low- and middle-income countries do to improve the conditions of work in the informal sector in the short run and promote structural change in the long run? In this section we start with short-run solutions to bring self-employed individuals into the ambit of formal laws and regulations. Next, we discuss the efforts of one of the largest unions of self-employed workers anywhere in the world, the Self Employed Women’s Association (SEWA), which was founded in the state of Gujarat in India. Finally, we will learn about what economists have to say about policies that promote structural change.

Public policy to formalize and improve self-employment incomes

How can we formalize the informal sector? As we have seen, one answer to this question is to bring economic activity into the ambit of laws and regulations. From the Lewis model perspective, however, the important thing is to expand the size of the capitalist sector. A by-product of this process is that more and more enterprises will become large enough to come under the tax net or under labour and other regulations.

The distinction between these two views is important. To understand this, let us take the recent, rapid expansion of banking and digital payments in India, which has been the result of deliberate government policy.¹ With the advent of digital payment apps such as Paytm, PhonePe, and Google Pay, coupled with quick-response (QR) codes and almost universal access to bank accounts, it has become much easier for any vendor, however small, to accept digital payments. Visit any marketplace in India, even in smaller towns, and you will find fruit sellers and fast-food stalls with their own QR code displayed to accept such payments. This means that transactions that were previously made almost exclusively in cash and were not recorded anywhere, are now passing through the banking system.

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A QR code for making digital payments at a vegetable vendor on the outskirts of Bangalore.

economies of scale

These occur when doubling all of the inputs to a production process more than doubles the output. The shape of a firm’s long-run average cost curve depends both on returns to scale in production and the effect of scale on the prices it pays for its inputs. Also known as: increasing returns to scale. See also: diseconomies of scale.

Does this mean that the street vendor now operates in the capitalist sector? In a narrow sense, yes. It is now possible for the government to track and tax their income. In fact, in January 2025, Indian social media had some fun with a story in the press about an informal vendor who sold a popular type of street food getting served a tax notice because his income had crossed a threshold amount. But in terms of the Lewis model, nothing much has changed. They are self-employed and cannot easily enjoy economies of scale, invest in new equipment, or increase labour productivity.

A second way in which public policy has been used to help self-employed individuals is via subsidized credit, more popularly known as microcredit or microfinance. Initially made popular by the Grameen Bank of Bangladesh set up by Nobel Peace Prize winner Muhammad Yunus, microfinance has emerged globally as a solution to the problem of credit market access discussed in Section 3. Self-employed individuals who have been shut out of the formal banking system and do not want to borrow at far higher interest rates from informal moneylenders have found microcredit to be a viable option for securing loans. Subsequently, governments have also entered the domain. The Government of India’s microlending programme under the Micro Units Development and Refinance Agency (MUDRA) disbursed around 40 to 50 million microloans each year between 2016 and 2024. The maximum size of the loan allowed under the programme is INR10 lakh or approximately USD12,000. But most loans are much smaller—less than USD1,000 or so.²

And there is the catch. The average loan amount tends to be very small (they are, after all, microloans). This means that such credit cannot finance a large one-time investment, say in a new machine or the down payment on a new site. As discussed in Section 3, informal enterprises are generally caught in a poverty trap. Since productivity is closely linked to scale, microenterprises which can only make use of micro loans remain as low-productivity enterprises. A systematic study of the impact of microloans on informal enterprises across six countries using randomized controlled trials finds that there are positive effects on household well-being, but no transformative effects on their enterprise.³ The economists Milford Bateman and Ha-Joon Chang offer a harsher criticism of microcredit programmes. They point out that structural change is about an expansion in the scale of production.⁴ What microfinance programmes achieve is the opposite of this—a proliferation of tiny enterprises. The Lewis model highlights why policies such as these—while they may ameliorate poverty among informal sector workers—do not promote structural change, because they do not increase accumulation in the capitalist sector.

An example of civil society action: The Self Employed Women’s Organization (SEWA)

In almost every society, women face restrictions that men do not. In the economic sphere, women’s ability to participate in employment is shaped profoundly by how much freedom they have to gain education or move outside their home. The uneven gender distribution of cooking, cleaning, and caregiving also constrains women’s mobility and increases their demand for part-time or flexible-time work. For all these reasons, self-employment is common among women. In low- and middle-income countries self-employed women typically work as street vendors, home-based workers, or domestic workers. Their earnings are very low and they face multiple disadvantages, including in the access to credit and public marketplaces, bargaining with contractors, bargaining for inputs, and gathering information on market opportunities.

Some of these problems can be addressed through collective action, but collectivization of self-employed workers is rare. The Self Employed Women’s Association (SEWA) in India is one successful example. SEWA was started in 1972 as a wing of the Textile Labour Association, India’s oldest union of textile workers. Its founder, Ela Bhatt, was a staunch follower of Mahatma Gandhi. SEWA began with the objective of providing training in sewing, knitting, embroidery, and other activities to the wives and daughters of mill workers in the city of Ahmedabad in Gujarat.

trade union

An organization consisting predominantly of employees, the principal activities of which include the negotiation of rates of pay and conditions of employment for its members.

Over time, it began working with women head-loaders, cart-pullers, and vendors in surrounding markets. Women collectivized under the umbrella of SEWA to fight against exploitative wages and unfair practices by their contractors or moneylenders. In 1972, it formally registered as a trade union.

Interestingly, the organization faced some resistance from official authorities in its attempt to register, who asked: How can workers organize when there are no employers involved? SEWA argued that a trade union’s purpose was to take care of workers and it did not need an employer to justify its existence. This argument prevailed. Currently it is the single largest trade union in the country with a membership of over 2.5 million women. SEWA organizes across a range of women workers, such as small businesses or hawkers or vendors selling vegetables, fruit, and clothes; home-based workers including potters, weavers, incense or beedi workers, and garment workers; and manual labourers including women in construction work; and small-scale producers.

SEWA continues its original mandate of training its members. In more recent years, it has facilitated the establishment of cooperatives that have enabled women to have access to cheaper inputs. SEWA has also started a SEWA bank that facilitates saving and access to cheaper credit for its members.

One of the SEWA initiatives included the setting up of a wholesale vegetable market in its home city of Ahmedabad. Initially, the market was met with much resistance from locals and traders. ‘Go home, they said to us, this selling is not women’s work,’ said Labhuben Thakkar, one of the SEWA members who oversaw the operation. The market has been beneficial for both farmers and buyers, offering high interest rates to both. It has challenged previous gender- and caste-based hierarchies in occupations and has succeeded in maintaining a high and steady turnover.

To learn more about SEWA, read this summary article.

The organization has also been actively involved with central and state institutions to represent the interests of women workers in the informal sector. SEWA’s inputs have been incorporated into the framing of legislation and social security rules for informal workers at the central and national level, including the 2004 National Policy for Urban Street Vendors, and the 2008 Unorganized Workers Social Security Act.

There are other examples of successful collectivization of workers in the informal sector. The Union of Domestic Service Workers brings together domestic workers in Colombia to provide them skills training, knowledge of their rights, and improved bargaining power. Unisol in Brazil brought together waste pickers and recyclers with trade unionists. The Kenya National Alliance of Street Vendors and Informal Traders has worked towards the provision of cheap credit to street vendors and traders. Such collectives have successfully brought together workers who would typically not be able to organize either because of their limited identities as workers, or because they often work from the confines of their home, to further their financial and economic empowerment.

For more examples of trade unions and other support for informal sector workers, read this policy brief by the International Labour Organization.

Though we have focused on women workers in this section, other social identities also matter a great deal for employment outcomes. The next ‘Find out more’ box discusses more about caste and the capitalist sector in India.

Find out more Social identities and the capitalist sector

In the Lewis dual economy model, the capitalist sector is a single homogenous unit. In reality, it consists of a hierarchy of types of jobs. At a broad level, we have already discussed the distinction between two types of wage work: casual-wage and regular-wage. But not all regular-wage jobs are alike either. Some come with lifetime job security, retirement benefits, and other perks. Others are more precarious and do not come with benefits.

What factors determine who gets which type of job? If you thought of education or skills, then you have identified a very important determinant. You may also have thought of social networks—who you know (or who your parents know) matters a great deal in determining your job options.

Individuals from social or ethnic groups that have limited access to such networks are more likely to be concentrated in the lower end of the capitalist sector. One example is the caste system in India. The caste system is a form of social stratification characteristic of Indian society. Caste membership determines an individual’s access to education and employment.^5 6 For official purposes, the Indian government has identified four broad caste groups. The Scheduled Castes (SC), Scheduled Tribes (STs), and Other Backward Classes (OBC) have been historically economically and socially marginalized. Individuals not in any of these caste groups belong to the ‘General’ category and typically represent the dominant or privileged communities.

The Scheduled Castes (SCs), Scheduled Tribes (STs), and Other Backward Classes (OBCs) are administrative categories created by the Indian government to identify communities that have been historically, economically, and socially marginalized. SCs are members of the former so-called ‘untouchable’ castes and STs are members of indigenous tribes. OBCs are members of other caste groups who are higher than SCs but lower than upper-castes in the caste hierarchy. Affirmative action policies in the form of reservation in educational institutions and of public sector jobs are intended for these groups.

Figure 14 shows the distribution of types of wage work for three caste groups in India. General category individuals are far more likely to be in the most secure form of employment, while SCs and STs are predominantly in casual-wage work. Note that we have excluded employment in public sector enterprises since affirmative action policies in these sectors allow for a greater representation of the marginalized groups in secure salaried employment.

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https://books.core-econ.org/insights/informality-and-the-capitalist-economy/06-state-and-civil-society-actions.html#figure-14

Figure 14 Distribution of wage employment among caste groups (SC = Scheduled Castes, ST = Scheduled Tribes, OBC = Other Backward Class).

Centre for Sustainable Employment, Azim Premji University. 2023. State of Working India 2023: Social Identities and Labour Market Outcomes.

Identity-based differences are not present only in wage employment. Marginalized caste groups are also less likely to be owners of firms and they are far less likely to be owners of large firms. Figure 15 shows the representation of different social groups as owners of enterprises, differentiating by the size of the enterprise. The representation index is calculated by dividing the share of that group in the sector of interest by the share of that group in the overall workforce. So, for instance, if SCs and STs comprise 20% of the workforce but only 5% of the owners of large firms, the index will take the value 0.25.

Figure 15 shows that the SC, ST, and OBC representation indexes are always below one for all firm sizes, indicating that these groups are under-represented among firm owners. However, another important pattern is that the extent of under-representation of these marginalized groups systematically increases with the firm size (measured by the number of employees). In the larger firms that are likely to have more value added and higher profits, the representation index of SC/ST owners is about 0.2, whereas the non-marginalized privileged groups, represented by ‘General’, are over-represented by a factor of nearly 2.5.

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https://books.core-econ.org/insights/informality-and-the-capitalist-economy/06-state-and-civil-society-actions.html#figure-15

Figure 15 Representation Index of firm ownership among social groups in India, by firm size.

Rakshit, Angarika, and Amit Basole. 2024. ‘Entrepreneurship and Marginalised Social Identities in India’. Economic and Political Weekly 59(13): p. 45.

Can economic growth be expected to reduce these group-based disparities in firm ownership as well as employment in the capitalist sector? Or does it require targeted public policy measures, such as affirmative action? This is an important area of ongoing research in economics.

Policies to redeploy surplus labour and promote structural change

In the long run, the objective of public policy is not merely to improve incomes in the informal sector by a small amount, but rather to vastly reduce the informal sector’s size. This objective is desirable not only because it improves incomes and productivity for those workers who transition to the capitalist sector, but also because it has wider spillover effects.

Surplus labour means a vast mismatch between the demand for labour from the capitalist sector and the supply of labour to it. In a low- and middle-income country, where the government’s ability to enforce labour laws is weak due to poor resources, the existence of surplus labour further weakens its ability to hold employers accountable for evading laws. Thus a reduction in surplus labour not only means an improvement in incomes in the informal sector but also an improvement in the fallback position of wage workers in the capitalist sector by reducing the pool of jobseekers relative to available jobs. The improvement in the bargaining position of wage workers relative to their employers enables them to demand better implementation of existing labour laws as well as get new laws passed.

But how can public policy enable more formal job creation? Governments can act on both the supply and the demand side of the labour market. Acting on the supply side means improving the quality of education and skills of the population, and improving the quality of healthcare, childcare, and transport infrastructure. This makes individuals more employable and makes it easier for them to leave the home or move to where jobs are located.

What can public policy do to help firms create jobs? Over the decades, governments have evolved many ways to enable firms to expand, thereby creating jobs, as well as to nudge them towards preferring labour over capital at the margin. There are two broad sets of policies that governments use to achieve this aim:

• policies that focus on enabling firm growth
• policies that focus on reducing the cost of hiring labour at the margin.

Enabling firm growth

The first set of policies—enabling firm growth—can be divided broadly into policies that improve the chances of growth for all firms in the economy (‘horizontal policies’) and policies that target a specific industry (‘vertical policies’). An example of the former is expanding the production and distribution of electricity such that the lack of power does not constrain a firm’s output. Since power is an input into every industry, such a policy helps firms everywhere in the economy. Other basic infrastructure such as water supply, roads, railways, ports, and internet services are in the same category. Similarly, a set of policies known together as the Ease of Doing Business try to simplify paperwork and regulations that employers need to do to run their businesses legally.

Industry- or sector-specific policies are often clubbed under the title ‘trade and industrial policy’. An example of an industrial policy is a recent programme by the Government of India, called Production Linked Incentives (PLI). The PLI scheme provides subsidies to firms in 14 industries (mobile phone manufacture, pharmaceuticals, automobiles, food, and textiles among others), conditional on their meeting pre-set production targets. This lowers the costs of production for firms in these industries.

import substitution policies

Trade policies that attempt to substitute imported goods with domestic ones by offering tariff or quota-based protection to domestic producers.

tariff

A tax on a good imported into a country.

Trade policy, as the name suggests, targets the flow of goods and services across the country’s border. The best-known examples are import substitution policies that protect domestic firms by placing tariffs on imported goods. The mechanism of the tariff is the opposite of the subsidy—while the latter lowers production costs for domestic producers, the former makes the goods of their foreign competitors more expensive.

To learn more about how governments are using industrial policies today, read this article in the Harvard Business Review. To learn more about the role of tariffs and other trade policies in promoting economic growth, read Section 18.10 of The Economy 1.0.

Industrial and trade policies have been used in almost every country, regardless of income level, at some time or other in their history.⁷ However, only a few countries have been successful in promoting structural change and industrialization using such policies. Once again, the stand-out cases are from East Asia: Japan, South Korea, Taiwan, and China. The work of Alice Amsden and Robert Wade has shown that appropriate conditionalities such as insisting on export targets in exchange for subsidies, as well as promoting competition among domestic firms were crucial in ensuring that such policies achieved the desired results.^8 9 More recently, Mushtaq Khan has made the same point in the case of Bangladesh. In recent years, such policies have seen a resurgence in all parts of the world, in countries of all income levels.

Reducing the cost of hiring labour at the margin

The second broad set of policies available to governments that want to promote job creation in the capitalist sector focus on reducing the cost of hiring labour at the margin. One way this can be done is by making it easier for employers to hire and fire workers by simplifying the laws governing such activities (resulting in less paperwork). There is overlap here with the Ease of Doing Business approach. Another approach, exemplified by a recent Government of India initiative called Employment Linked Incentives (ELI), is where firms are offered wage subsidies that reduce the cost of hiring new workers. Typically, such subsidies last for a brief period, for example, a few months to a few years, during which the government pays social security benefits for new workers instead of the employer bearing the cost. At the time this Insight was written, there had not been any studies on whether these policies have succeeded.

Despite the wide variety of policy options described above, governments have generally had a poor track record of promoting rapid job creation in the capitalist sector (though once again, the East Asian economies are exceptions). However, the lack of adequate counterfactuals (what would have happened instead if a policy was not implemented) also impedes our ability to draw lessons from the experience of successes or failures. This is an important area of ongoing research that you may want to take up if you pursue a career in economics.

Exercise 5 Institutions and policies for the informal sector and structural change

Choose one of the institutions and policies mentioned in this section (for example, trade unions, civil society action, horizontal policies, vertical policies, industrial policies, trade policies, or policies that reduce the cost of hiring labour).

1. Research two examples (in different countries from the ones mentioned in this section) of countries that have implemented these institutions or policies, either now or in the past. Provide a brief description of how these institutions or policies were implemented (for example, which industry or industries were involved, and how many workers did it cover?)

2. What were the outcomes of these institutions and policies? In your answer, try to include research on how different economic actors (informal or capitalist sector workers, employers, other parts of the economy) were impacted.