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Saturday, June 26, 2004

The hidden dangers of the informal economy via Mckinseyquarterly

Governments suppose that the gray market creates jobs and relieves social tensions. Academics think it will disappear of its own accord. Neither idea stands up to scrutiny.It's no secret that some companies operate partially or wholly outside the law by underreporting employment, avoiding taxes, ignoring product quality and safety regulations, infringing copyrights, and even failing to register as legal entities. The problem is particularly acute in developing countries, but it is widespread in some developed nations too.The World Bank estimates that this informal economy1 generates 40 percent of the GNP of low-income nations and 17 percent of the GNP of high-income ones.2 In some industries, such as retailing and construction, informality can account for as much as 80 percent of employment. Over the past ten years, MGI has studied informality within a variety of industries in a range of different countries, including Brazil, India, Poland, Portugal, Russia, and Turkey. MGI found that the substantial cost advantage that informal companies gain by avoiding taxes and regulations more than offsets their low productivity and small scale. Competition is therefore distorted because inefficient informal players stay in business and prevent more productive, formal companies from gaining market share. Any short-term employment benefits of informality are thus greatly outweighed by its long-term negative impact on economic growth and job creation.For many people, the informal economy means street vendors and tiny businesses, and it is true that informality is pervasive among small, traditional concerns with low levels of technology, scale, and standardization. But it is hardly unknown among larger, modern enterprises in developing countries, where MGI has found informal supermarket chains, auto parts suppliers, consumer electronics assemblers, and even large-scale industrial operations.Three factors contribute to informality. The most obvious is limited enforcement of legal obligations—a result of poorly staffed and organized government enforcement agencies, weak penalties for noncompliance, and ineffective judicial systems. A second factor is the cost of operating formally: red tape, high tax burdens, and costly product quality and worker-safety regulations all prompt businesses to operate in the gray market. Finally, social norms contribute to the problem. In many developing countries, there is little social pressure to comply with the law. In some, many people see evading taxes and regulations as a legitimate way for small businesses to counteract the advantages of large, modern players.Informality's deleterious effects - A.The low-productivity trap B.Curbing legitimate companies c.The social cost.Persistent myths keep developing countries from addressing the informal sector. Yet diminishing its size would, in almost every case, remove barriers to growth and development and generate sizable economic gains. Reducing the level of informality is no easy task and carries risks that are not inconsiderable. But by addressing the root causes of informality—weak enforcement, the high cost of operating formally, and injurious social norms—governments can attack the problem and reduce the possibility of further social disruption.

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