It's the informal economy, stupid!

Last year, I read some books and articles on the mystery of the informal economy, where products are being sold and/or traded outside of the (formal) economy. During my stay here in Mozambique, this whole concept has become clearer to me, being confronted with it and dealing with it on a daily basis. The informal economy in Mozambique is responsible for a large share of the total value of transactions of goods and products; in fact, it is safe to say that a large chunk of the population depends on this informal economy.

But what is it exactly? The most obvious aspect is that it is ‘not formal’. Contrary to the formal economy, the informal economy consists of transactions performed and products sold by non-registered and non-licensed actors. These actors are running non-registered shops, and are therefore not paying the taxes that their registered counterparts are. Prices in the informal economy are therefore often lower (compare the registered supermarket, with prices on the market or in the stalls) if competition allows for it. On the other hand, when competition is lacking, margins are often several times higher than on the formal economy where some form of social and governmental monitoring exists – e.g. you will not find high margins on the sale of tomatoes, as competition is high for this product, whereas lending capital is a transaction where competition is often absent, so that margins can skyrocket.

Informal vs formal?Because prices are lower in the informal market, demand for these products is relatively high, resulting in an increased motivation for actors to either stay informal, or become informal. At first glance, there doesn’t seem to be much that would advocate a switch towards becoming formal. Still, being/becoming formal has its advantages: you can set up a registered business, and consequently own the land on which your shop is situated, which is then protected under the rules and laws of the nation; as you own property, you can bring it in as collateral when applying for a loan (this applies to regular bank loans; microfinance institutions work differently); as you pay taxes, you can subsequently benefit from tax benefits, social infrastructure (registered shops are on the main street, informal shops are more often located on markets or street corners), and some form of protection – at least everybody plays by the same rules.

It looks simple: a general switch form informal to formal economy would boost government revenue from taxes, which could then result in higher public spending and more investments in science and technology. In the end, the actor benefits from better infrastructure and better long term prospects.Clearly, this reasoning is flawed, or at least missing some aspects. For starters, in the short run there are definitely significant margins to be made and profits to be reaped in the informal market. Moreover, a lack of confidence in a governments ability (capacity) or willingness (corruption) to increase public spending when tax income increases, provides a further stumbling block on the path to formality. Thirdly, overly bureaucratic systems tend to make it very difficult for actors to become and then stay formal, as Hernando de Soto clearly points out in his book ‘The mystery of Capital’ by labeling the assets the poor possess “dead capital”. (Dead, because their assets are worthless, as they are not valued on the market (e.g. a shop built on land that is not owned, so that they cannot bring it in as collateral for a loan, and moreover that they could get kicked of that piece of land basically overnight) Finally, and crucially, the actors in the informal economy often do not have the same capacity as the formal actors in similar transactions. Forcing them into formality would therefore result in them being completely outcompeted by the more experienced and better trained formal competitors.

The informal economy has often been linked with (relatively) poor quality, and because customers knew this, they bought goods on the informal market while accepting a poorer quality for a cheaper price. Bigger investments such as TVs and solar panels were then bought in licensed and trusted shops, where warranty and after-sales service influence the decision making process. Over the last few years, however, the informal market has gradually expanded its reach into these somewhat bigger types of investments. It is therefore not surprising nowadays on the markets and in the bancas/barracas/stalls to find TVs, solar panels, and car parts on sale.

All in all, you would want a country’s informal market to decrease relatively compared to its formal counterpart, combined with a government that is both capable and willing to maximize the potential of the added (tax) revenue. However, the divide between informal and formal is becoming more and more unclear.

To be continued.

p.s. While I do not fully agree with the views of de Soto, his book ‘The Mystery of Capital’ does provide for a very interesting read.