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Links between informality and development challenges
Fourth, although informality is linked to a host of developmental challenges, formalization alone is unlikely to offer an effective path out of underdevelopment. For instance, although declines in informality were associated with poverty reduction, they were not systematically linked to declining income inequality (box 4.3). This may reflect the fact that informality itself is a symptom of underdevelopment, in line with the metaanalysis of the literature that finds that the wage penalty largely reflects the characteristics of informal workers (box 4.1).
The following section summarizes the transmission mechanisms underlying the link between informality and development challenges. Here informality is regarded as both a cause and a consequence of underdevelopment: there are reasons to expect causation potentially to run in both directions. The subsequent sections examine the economic and institutional correlates of informality, followed by sections that describe the link between informality and various SDGs. The penultimate section summarizes the finding of the BMA approach, followed by a conclusion in the final section.
EMDEs with widespread informality face relatively large development challenges. Informality may be linked with these challenges through several channels. For the purposes of the discussion here, informality refers to output informality, but the results are robust to using employment informality.
Low productivity, low incomes. Informal workers tend to be less skilled and lower paid than their formal counterparts (Loayza 2018; Perry et al. 2007; World Bank 2019). A meta-analysis of worker-level empirical studies shows that informal workers are, on average, paid 19 percent less than formal workers (figure 4.2; World Bank 2019). In part, this reflects lower productivity on account of lower skill and experience levels than formal workers have. The meta-analysis suggests that, when controlling for worker characteristics, the wage gap is no longer statistically significant (box 4.1).6 In 2020, these features made participants in the informal sector particularly vulnerable during lockdowns associated with the COVID-19 pandemic (World Bank 2020a; box 2.1).
Similarly, informal firms tend to be small, lack funds, and operate in labor-intensive sectors, and, as a result, are less productive than formal firms (figure 4.2; Fajnzylber, Maloney, and Montes-Rojas 2011; Farazi 2014; McKenzie and Sakho 2010). They tend to invest less, possibly in an effort to avoid adopting technologies that would make them more visible to tax and other authorities (Dabla-Norris, Gradstein, and Inchauste 2008; Gandelman and Rasteletti 2017). For example, in about 11,600 firms that participated in Enterprise Surveys in 18 economies during 2007-14, the fraction of formal firms that
6 This lower productivity may also account for the inability of the formal sector in cities to absorb rural migrants during the urbanization process (Fields 1975; Harris and Todaro 1970; Loayza 2016).
