Dessy, Sylvain, and Stéphane Pallage, 2003, “Taxes, Inequality and the Size of the Informal Sector,” Journal of Development Economics, Vol. 70 (February), pp. 225–33.
Gatheru, Wamuyu, and Robert Shaw eds., 1998, Our Problems, Our Solutions: An Economic and Public Policy Agenda for Kenya (Nairobi: Institute of Economic Affairs).
Ihrig, Jane, and Karine S. Moe, 2000, “The Influence of Government Policies on Informal Labor: Implications for Long-Run Growth,” De Economist, Vol. 148 (September), pp. 331–43.
Olters, Jan-Peter, 2003, “The Informal Sector-Impeding Economic Development,” in Albania: Selected Issues and Statistical Appendix, IMF Staff Country Report No. 03/64, by Hossein Samiei and others (Washington: International Monetary Fund).
Saavedra, Jaime, and Alberto Chong, 1999, “Structural Reform, Institutions and Earnings: Evidence from the Formal and Informal Sectors in Urban Peru,” Journal of Development Studies, Vol. 35 (April), pp. 95–116.
Prepared by Martin Schindler.
This is mostly true for direct taxes. Informal sector activities are still subject to indirect taxes, such as VAT.
“Unregulated” production is to be distinguished from “illegal” production, which is not the focus of this section.
A recent strategy paper by the Kenyan authorities has pointed out that some small enterprises and microenterprises (SMEs) in the informal sector are, in fact, highly productive, paying higher wages than many formal-sector firms. While it is not surprising that the most productive informal sector firms surpass the least productive formal sector firms in terms of productivity, it is the differential in average productivities that is the cause of concern. Gatheru and Shaw (1998) also argue that the share of workers employed by SMEs is small. More important, even the more productive informal sector firms would likely benefit from the reforms outlined below. Finally, wages are only an imperfect measure of job quality. Jobs in the informal sector are often characterized by a lack of employment stability and health and other benefits. Consequently, even workers who find a high-wage job in the informal sector, relative to average formal sector wages, are not necessarily better off. (See also Maloney (2003)).
Although enterprises in the informal sector are generally said to have only limited access to credit, some informal businesses use “personal lines of credit” with financial institutions to finance their activities. However, the costs of these credit lines tend to be significantly higher than the costs of those available the typically larger, formal sector businesses.
A large informal sector may hide some of the aggregate impact of minimum wages as they are most strongly felt in the relatively small formal sector employment.
See Ihrig and Moe (2000) for empirical support and Olters (2003) for a discussion of some of these issues in the context of Albania. By contrast, Dessy and Pallage (2003) formulate a model in which the government uses taxes to produce public infrastructure that benefits formal sector agents more than those in the informal sector. In this environment, a lowering of tax rates does not necessarily lead to a reduction in the size of the informal sector because the associated reduction in public infrastructure expenditure also diminishes the benefits of formalizing.
As defined by the Kenyan authorities, the labor force includes all economically active individuals aged 15–64. According to the Integrated Labor Survey (ILS) 1998/99, about 22.6 percent of the total population aged 15–64 were economically inactive in 1999. Roughly two thirds of this group was accounted for by individuals aged 15–19, suggesting that schooling is an important reason for inactivity.
According to the ILS, the aggregate unemployment rate was 14.6 percent in 1999. However, interpretation of this number is made difficult because Kenya does not have an unemployment insurance system and its other types of social safety nets (the contributory social security scheme administered by the National Social Security Fund and the pension scheme administered by the Retirement Benefits Authority) are limited. In order to subsist, unemployed workers must therefore either live off their savings, engage in some type of unmeasured economic activity, or be supported by other types of social support systems (such as the family). In this environment, the distinction between concepts such as unpaid family workers, true unemployment, and underemployment becomes blurry.
By contrast, real GDP grew by an average annual rate of 2.9 percent between 1982 and 2001, and by only 1 percent between 1997 and 2001, suggesting that measured GDP growth may underestimate actual developments in aggregate production.
The active labor force is calculated assuming a constant share of the inactive population of 22.6 percent (from the 1998/99 ILS).
Over the period 1993–2001, real wages and the share of informal sector employment were almost perfectly positively correlated, with a correlation coefficient of 0.96 whereas the opposite was the case for real wages and formal sector employment, with a correlation coefficient of -0.97.
In 2001, only 43,031 employees were covered by collective wage agreements, down from 71,586 in 2000, and thus the aggregate impact of these wage increases was limited. However, collective wage agreements may have a much broader impact than these numbers suggest if spillover effects to nonunionized workers are important.
By the nature of the informal market, taxes are mostly collected in the formal sector.
Figure 9 suggests that minimum wages and taxes affect the labor market in different ways. Taxes seem to have a more immediate effect, with the correlation to informal sector employment decreasing as the number of lags increases, whereas minimum wages appear to have more lagged effects, with the correlation increasing along with the number of lags.
Employment in the informal sector was almost 2.7 times the size of formal sector employment in 2001. Even large reductions in average tax rates are therefore consistent with increased total tax revenues if they translate into a sufficiently large flow from informal to formal employment. Similar magnitudes are likely to hold for value-added tax (VAT) rates, licensing, and other fees.