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Bringing businesses out of the informal sector

by Oliver Schmidt

In depth

Women are unequal to men in many places

Women are unequal to men in many places

In developing and emerging economies, governments are at pains to get enterprises to switch from the informal to the formal sector. In this context, donor agencies can have both a positive and a negative influence. That is evident in sub-Saharan Africa for example.

The informal economy does not have a good reputation in western industrialised countries like Germany. A fundamental reason is that it operates outside the realm of taxes and social-protection systems. Many critics see it as a shadow economy, with actors illegally sidestepping the paying of taxes and social security contributions. On the other hand, many informal workers view government institutions and state structures with scepticism.

In most low-income countries, state structures tend to be young and typically often go back to authoritarian colonial rule. They are widely considered to be artificial – in contrast to long-established sociocultural traditions and norms. According to the World Bank, the informal sector in emerging market and developing economies accounts for around a third of gross domestic product (GDP) and about 70 % of employment (World Bank 2021). Many of the people concerned are self-employed.  

One would intuitively expect informal employment to move in counter-cyclical ways to formal employment. When the formal economy weakens, after all, people lose their jobs and are forced to earn money informally. In an economic upswing, on the other hand, there are new opportunities to switch from the informal to the formal sector.

In reality, however, things are more complex. For example, the informal sector can provide additional growth impulses in an economic upswing. The potential differs from country to country however. Among other things, the dynamics depend on:

  • how flexible formally regulated markets are and
  • what levels of demand for informal labour are prevalent.

It is striking that, according to the International Monetary Fund (IMF) informal businesses and workers were particularly hard hit by economic downturns which the Covid-19 pandemic caused.  

Exploitation and meagre pay

Many workers in the informal sector endure poor working conditions. In some cases, they are severely exploited and may even live in slavery-like conditions. The pay gap between the formal and informal sectors is considerable. A major reason for the different pay levels is that the productivity of formal enterprises can be up to twice as high as what informal businesses achieve. This is largely due to higher levels of education, and that applies to the workforce as well as the management.

In sub-Saharan Africa, the informal economy is more pronounced than in any other region of the world, accounting for around 34 % of economic output (IMF 2020). Even people with formal jobs are often involved in some informal activities too – either personally or through family members. In Latin America and South Asia, the informal economy accounts for significant shares of GDP too. However, it has been shrinking across all regions mentioned here.

South of the Sahara, most micro-, small- and medium enterprises (MSMEs) are not formally registered; most of their workers do not have an employment contract – let alone a job description. Many are paid late or irregularly. The tasks they perform depend largely on their relationship to the owner-manager, who will often be a relative.

Enterprises often unsuccessful

Some informal entrepreneurs are quite successful – but most businesses do not last long. Statistics tend to be of dubious quality, since informal businesses neither have an official paper trail. Nonetheless, it is safe to say that most MSMEs in sub-Saharan Africa do not survive five years.

Many governments in Africa are keen on formalising informal enterprises. The reasons include that they wish to:

-     support businesses more effectively in pursuit of growth and jobs,

-     benefit from more tax revenues and

-     make production more environmentally and socially sustainable.  

To achieve such things, governments cooperate with donor agencies. In joint efforts, they support enterprises with capital grants, loans and skills training. Both the KfW Development Bank and the European Investment Bank expect every financial institution they support to set up an Environmental and Social Management System (ESMS). The idea is to channel funding to borrowers that comply with environmental and social standards.

The skills training donor institutions provide typically addresses various areas of management, including business and investment planning, financial management, human resources management as well as sales and marketing. Competencies in these areas help an enterprise to grow. Gaps regarding relevant skills often make businesses stall.

Formal business competences, moreover, are often a prerequisite to securing loans. Formalised financial institutions, after all, are accountable to regulators, so they need a clear understanding of their debtors’ situation – and only those clients’ financial reporting can provide that kind of knowledge.

Better business training needed

According to a review of the literature on the effectiveness of training efforts geared to enhancing business skills (McKenzie and Woodruff 2014), the impact tends to be rather limited. One reason is that the participants are too heterogeneous. In practice, the efforts to formalise enterprises often do not amount to much more than issuing certificates of registration. Some financial institutions, moreover, seem quite happy to refuse loans on the pretext that a business lacks formal status, for example, because they prefer to invest without risk in government bonds.

The larger the informal economy of a country is, the lower is its ratio of tax revenue to GDP. Many African governments have reformed their tax laws to address this problem. Nonetheless, many of them still hesitate to enforce fair taxation stringently. Part of the problem is that these governments find it easier to obtain donor funding than to collect taxes.

Despite all criticism, donor agencies often play a positive role in terms of enabling enterprises to obtain suitable loans. For example, they may incentivise financial institutions to accept movable assets as collateral. Furthermore, they help financial institutions extend their range of services, which is particularly helpful with regard to financial products that have proven useful for MSME promotion elsewhere. On the other hand, donor agencies also have a tendency to push financial institutions to grant loans even when they are either unwilling or strategically positioned to do so.

Ultimately, what is needed to improve the interaction of the informal and formal sectors is a sound macroeconomic policy. It should prioritise creating incentives for private-sector investments – especially in capital goods, skills training and business formalisation. Donor organisations should constantly reassess what role they are playing in this context and – whenever necessary – adjust their policies.  


IMF, 2020: What is the informal economy? https://www.imf.org/Publications/fandd/issues/2020/12/what-is-the-informal-economy-basics

World Bank, 2021: The long shadow of informality – challenges and policies. Edited by Ohnsorge, F., and Yu, S., Washington, DC. https://www.worldbank.org/en/research/publication/informal-economy

McKenzie, D., Woodruff, C., 2014: What are we learning from business training and entrepreneurship evaluations around the developing world? The World Bank Research Observer, vol. 29, no. 1.

Oliver Schmidt is a senior project manager at the Bonn-based consultancy AFC (Agriculture and Finance Consultants). AFC is the competency centre for financial sector development of the GOPA Consulting Group, which provides advice to international development agencies.

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