About informal sector

CHAPTER ONE

INTRODUCTION

1.1 PROBLEM STATEMENT

The informal sector makes a considerable contribution to production, consumption and income generation, particularly in developing countries. For example, it contributed about 8 percent and 68 percent to the GDP of the United States and Bolivia respectively in the years 2002 – 2003 (Schneider 2005). The sector is also a source of sustenance for the majority of the poor, unskilled and socially marginalized population, especially women. Moreover, it is a vital way of survival in an economy that suffers from deficient social safety programmers and unemployment insurance.

In developing countries the informal sector not only contributes significantly to the national output but it also serves as a source of employment for most of the unskilled population (Becker 2004). According to the estimations of the World Bank (2003) in the period from 1980 to 1990, the informal sector contributed on average 40 percent of the GNP and 50 percent of the employment in developing countries. In India, the informal sector accounts for 62 percent of the GNP, 50 percent of the gross national savings and 40 percent of the national exports and absorbs 83 percent of workforce (ILO 2002).

The contribution of the informal sector also tends to increase in many countries. On average, the informal sector contributed about 41 percent of the official GDP in 1999 – 2000, and increased to 43 percent in 2002 – 2003. For example in Colombia it increased from 39.1 percent in 1999 – 2000 to 43.4 percent in 2002 – 2003; in Moldova from about 45 percent to 49 percent; in Botswana from 33.4 percent to 34.6 percent and in South Africa from 28.4 percent to 29.5 percent (Schneider 2005). However, different methods of measurement were applied depending on the specific definition of the informal sector. This complicates any comparison.

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In Africa the informal sector is mostly composed of street vendors, retailers and in rare cases wholesalers who trade in products such as food, clothes and electronic appliances. The manufacturing and services only account for a small share of the sector (UN 1996). For instance in countries like, Angola, Botswana and Uganda, the informal sector is dominated by the retail sector. ILO (2002) demonstrates that in Sub-Saharan Africa (SSA) the majority of informal workers are self-employed and it makes up 70 percent of the total informal labor force and the remainder are hired employees. However, street vendors are much more common on the continent and according to Charmes (1998) they account for about 80 percent of the entire sector in Benin.

In recent decades there has been greater interest in getting consensus on the definition of the informal sector as well as on the measurement. It is important to have a clear understanding of its impact and contribution to the economic growth and the welfare of the society of low income countries. Therefore, most governments in developing countries took positive steps to measure the size of the sector to ensure that it is integrated as an engine of growth and development. This is important to make policies in order to support the informal sector in a sustainable manner (Tokman 2001).

The informal sector in Mozambique involves wholesalers and retailers, selling a broad range of food and non food products that are consumed not only by low income, but also medium income households (Dana & Galbraith 2006). The sector employs the majority of the labor force due to a lack of financial incentives to participate in formal activities, labor laws and complexities in the implementations of regulations. Approximately 77 percent of the labor force was involved in the informal activities in 2005 (INE 2006). Additionally, this sector accounts for 20 to 50 percent of the country’s GDP. The above mentioned factors clearly demonstrate that this sector requires legal empowerment as support for its stakeholders and enterprises (Weber, Michael & David 1992). Although the government of Mozambique designed a strategy to attract foreign investment to support and develop the linkages between the informal and formal sectors of the economy, this is not sufficient.

Also in South Africa the informal sector is making an important contribution to the problems of unemployment and absolute poverty. It also acts as support base to the rest of the economy (Braude 2005; Becker 2004). The policy of the government of South Africa is to create a supportive environment to support informal sector operators, including street vendors. Thus new laws were introduced at all levels (national, provincial and local) that provide the informal traders with rights to trade. The local authority is merely a regulatory authority (Whyte 1991). Whyte explains that the South African national strategy also promotes and assists the development of all the categories of the informal sector.

The general objective of the paper is to compare the informal sectors of Mozambique and South Africa in terms of the reasons for engaging in informal activities, relative sizes, problems and challenges. From such a comparison some lessons can be learnt, that can assist policy makers to deal with the sector in such a manner that it would develop from being a marginal to a real segment of the economy. .

1.2 SPECIFIC OBJECTIVES OF THE STUDY

• To provide the necessary theoretical framework – explaining various views on the informal sector; reasons for involvement in the sector, challenges faced by the sector and the sector’s relative economic contribution;
• To present a descriptive overview of the informal sector of Mozambique, focusing on the specific features, the relative contribution and challenges to the sector;
• To provide a descriptive overview of the informal sector of South Africa, focusing on the same issues as in the case of Mozambique;
• To compare various aspects of the informal sectors of the different countries with the objective of learning some lessons which can assist policy makers to make more appropriate policies.

1.3 METHODOLOGY

The essay presents a descriptive overview of the literature on the informal sector in various countries, but focuses on the informal sectors of Mozambique and South Africa. It is based on secondary sources including books, journal articles, online articles, research and studies done previously by various scholars, the government, the United Nations Organization, the World Bank, NGOs and donor institutions.

The essay is structured as follows: Chapter two provides a theoretical framework of the informal sector including definitions, general characteristics, various perspectives and government policies towards the informal sector. Chapter three and four focus on the informal sectors of Mozambique and in South Africa respectively. It focuses on the causes of the informal sectors in the countries, the dimension of the sectors, contributions to the poverty alleviation and economic growth and development, challenges faced by the informal sectors and conclude with a comparison between the informal sectors of the two countries.

Chapter five presents the general conclusions and recommendations with a focus on future policies and strategies to support the informal sector.

CHAPTER TWO

THEORETICAL FRAMEWORK

2.1 INTRODUCTION

This chapter focuses on providing a clear theoretical background about the informal sector and its contribution to the economy. This background exposition is based on studies done by different scholars in the field. The chapter is structured as follows: first it defines the informal sector according to various experts and organisations, secondly it focuses of explaining the most common perspectives on the sector, thirdly it provides the general characteristics, fourthly the empirical evidence on the role of the sector and, fifthly government policies to support the sector followed by a summary.

2.2 DEFINING THE INFORMAL SECTOR

The term ‘informal sector’ was introduced by the anthropologist Keith Hart in the early 1970’s, to describe the economic activities that were unregistered in the records of revenue authorities in Accra – Ghana (Hart 1973). However, he recognized that earlier studies had been done on the so called ‘economy of the street’, including studies by Mayhew (1961-2) and Whyte (1943) in London and America respectively.

Since then the informal sector has become a common concern in academic literature, even though it still does not have a precise definition. Various scholars describe the informal sector in different ways, such as ‘black economy’ (Lyssiotou, Potshards, & Stenos 2004), ‘underground economy’ (Tansy 1999), and ‘unofficial economy‘(Hobbs Jr. & Piculescu 2005). All the above-mentioned designations classify the attributes of the informal sector as transactions that are not recorded or accounted for officially (Tokman 2001).

The International Labor Organization (ILO) in its International Labor Conference (ILC) (2002) extended the concept of the informal sector to ‘informal economy’ to incorporate vulnerable workers even if they are employed in the formal sector. Moreover, the ILO definition of the informal sector is more inclusive and incorporates all informal activity in agriculture, industry, trade and labor. Therefore, the ILO defines the informal sector as “all economic activities by workers and economic units that are in law or in practice not covered or insufficiently covered by formal arrangements” (Chen 2004).

Djankov, Lieberman, Mukherjee & Enova (2002) classify the informal sector as an activity for subsistence and unofficial business enterprises struggling to be part of the formal sector. He further claims that, despite being engaged in unofficial activities with unreported employees, it has a high potential to be turned into formal and registered activity.

The informal sector is also defined as being “the sector of economy whose existence, for reasons that may be voluntary (choice approach) or involuntary (illegal), is not registered in the statistics of the national accounts, gross domestic product (GDP) or the official numbers on the national wealth” (Maurine 2007:03). The informal market is referred to as a market that emerged from the impulsive organization of people with no government intervention in terms of licensing and tax payment and a market that lacks the most basic of infrastructure such as toilets, electricity and water (Maurine 2007).

The different ways of defining the informal sector complicates the measurement of the sector as well as the effectiveness of policy measures. However, in this study the term informal sector is used to refer to any person or enterprise participating in the trading, agriculture, manufacturing and employment market without a license from the legal authority, including operating traders who even though not licensed, pay a certain fee to municipal authorities (MOA/MSU 1992).

2.3 PERSPECTIVES ON THE INFORMAL SECTOR

According to Chen, Sestet & O’Connell (1999) the informal sector emerged due to low economic growth, high rates of unemployment, rural/urban migration and structural adjustments. Thus the informality is a protection of the economic agents in response to the regulatory burden imposed on them through policy measures, such as labor law and tax and social security. Chen (2004) described three fundamental schools of thought on the informal sector, namely the dualistic, structuralism and legalist schools. In reality these three approaches cannot be easily separated and are mostly integrated.

2.3.1 The dualistic school

These schools advocate that the informal sector is a distinct and separate secondary sector indirectly related to the formal sector since it provides income and security to the poor population (ILO 1972). They furthermore believe that as a result of rise in per capita income, the informal sector will eventually cease to exist, especially the segment that are peripheral to the capitalistic production system (Chen 2004). In contrast, Prate & Quentin (2006) claim that there is no evidence that the informal sector would disappear completely, because the informal output makes a significant contribution (10 to 15 percent) to the official GDP of most developed countries.

2.3.2 The structuralism school

The structuralism argue that the sector represents a subordinate economic activity of the formal economy, since the informal enterprises bring down costs for the formal enterprises and subsequently increase competitiveness (Cast ells & Ports 1989). They further consider the relationship between the informal and formal sectors as a ‘buyer-supplier relationship’ or interaction as ‘contracting out or actualization’. They claim that the informal sector not only mitigates the risk of the formal economy but that it also functions as a strategy to reduce costs. Thus, the formal sector promotes informal production and employment (Moser 1978; Cast ells et al. 1989).

2.3.3 The legalist school

This school advocates that the informal sector consists of entrepreneurs who aim to reduce operational costs related to formalization, specifically company tax and the compliance cost of labor regulations. The sector will thus continue to exist as long as the government continues with burdensome and costly regulation (De Soto 1989). This phenomenon can be found in high and middle income countries of Latin America such as Brazil. Prate & Quentin (2006) also found that high taxes, weak institutions, inefficient property rights, quality of the legal system and excess bureaucracy are key factors that explain the disparity in size of the informal sector in countries with similar levels of economic development. XXX

2.4 GENERAL CHARACTERISTICS OF THE INFORMAL ECONOMY

Type of activity: In general, the informal sector denotes all unregulated and non-formal economic activities. It is characterized by low entrance requirements in terms of capital and qualified workers, small scale operations and labor intensive methods of production. The informal sector was perceived to be populated by unpaid domestic workers and those who engage in informal activities for survival. The informal sector is also characterized by tax evasion, undeclared labor and other illegal activities. Nonetheless, it provides goods and services of which production and supply in the market are legal. Therefore, the informal sector may or may not practice illegal operations but should not be confused with criminal activities (Becker 2004).

Involvement of women: In developing countries in Africa, informal employment is characterized by a high percentage of women. In Sub-Saharan Africa 63 percent of the informal sector workers are female, in Latin America it is 58 percent and similar results were found in Asia for the period 1980 to 1990 (Hart 1973).

Wages: Wages in the informal sector are generally lower and the extent of poverty is consequently higher among employees and households who rely on this sector for income (ILO 2002). Brand (2005) confirmed that workers in the informal sector in Africa earn on average about 84 percent less than employees in the formal sector. However, the estimates do not distinguish between types of activity.

Business costs: The informal enterprises are characterized by relatively low business costs and no entry requirements with a small number of workers. Generally, the informal sector is labor intensive and requires low levels of skill. Thus, the workers can gain some skills as they engage in these activities (Becker 2004).

Physical infrastructure: The informal sector has become differentiated with those who still continue on the street corners without physical infrastructure and those who have developed established markets with a large number of traders and have consistent physical infrastructure, and have a direct link with registered wholesalers.

2.5 MEASUREMENT OF THE INFORMAL SECTOR

The measurement of the informal sector is challenging because of the different definitions. However, there are certain international standards of measurement including direct approaches, which employ planned surveys and samples based on voluntary responses, tax auditing and other accepted methods, as well as indirect approaches such as an indicator approach. These approaches generally use macroeconomic indicators that use information on the sector over time, such as the discrepancy between national expenditure and income statistics, the discrepancy between the official and actual labor force, the transactions approach, the currency demand approach, the physical input approach (electricity consumption) and the model approach. The indirect approach considers factors leading to the existence and expansion of the sector, as well as factors impacting on the sector such as a tax burden and over-regulation over time (Schneider 2005; Friedman, Johnson, Kaufmann & Zoido-Lobaton 2000).

The various ways of measuring the contribution of the informal sector complicate research. For example, the size of the informal sector in Russia in 2000/2001 was 41 percent of GDP using the physical input approach (electricity) and 45 percent using the currency demand approach. In German the size of the informal sector in the same period was determined as 12 and 16 percent of GDP, using the physical input approach (electricity) and the currency demand approach respectively (Schneider 2005).

2.6 EMPIRICAL EVIDENCE ON THE ROLE OF THE INFORMAL SECTOR

The importance and contribution of the informal sector in the country’s gross national product has been realized by various scholars, despite the fact that it is often treated as unimportant and of low productivity (ILO 1998).

Contribution to employment

Studies conducted by Ban gasser (2000) found that the informal sector employed a large share of the labor force in developing countries. It operates as a key source of employment for most of the labor force, particularly the unskilled, women and older people. Moreover, in Sub-Saharan Africa, this sector accounts for between 60 and 80 percent of total non-agricultural employment (Charmes 2000). Recent estimates show that in India it accounts for 73.7 percent, in Indonesia 77.9 percent, in the Philippines 66.9 percent, in Thailand 51.4 percent and in Pakistan 67.1 percent of urban employment (Charmes 2000, ILO 2000). Charmes also reported that 80 percent of the informal sector workers in sub Saharan Africa are non-wage workers involved in a form of self employment. Likewise, Sethuraman (1997) asserted that most of the informal operators were either self-employed or family workers .

Contribution to output

Studies conducted by Schneider & Klinglmair (2004) found that the informal sector impacted negatively on the economic growth of developing countries, contrasting with results that were found in developed countries whereby informality impacts positively on economic growth. The same results were found by (Sartre 2000).

On the other hand, Bhattacharyya (1993), Asia (1996), Schneider & Nest (2000) found that the informal economy impacts positively on the formal economy. They advocate that the informal sector contributes to the growth of the formal sector by creating a market for its products and indirectly increasing tax revenue.

Due to scarcity of data it is difficult to estimate the contribution of the informal sector to national output, however, where estimated, evidence demonstrates that the informal sector has a significant contribution to GDP. Thus, in Sub-Saharan Africa excluding South Africa, South and Southeast Asia and Latin America the sector on average contributes 20 to 50 percent of non agricultural GDP (Charmes 2000).

Activities and enterprises

According to Tokman (1990) the informal sector is heterogeneous in terms of type of activities, i.e. it encompasses the manufacturing, construction, trade and services subsectors. The largest part of the sector is generally trade followed by services. Construction is less common. Tokman further describes the informal sector as being of a small scale and labor intensive, with low levels of technology and low capital requirements. To formulate appropriate policies, it is important to distinguish between the various types of informal activities (subsistence and those directly or indirectly related to the formal sector).

2.7 GOVERNMENT POLICY TO SUPPORT THE INFORMAL SECTOR

Effective institutions and a legal framework are important for ensuring the smooth performance of business, especially in the informal sector. In contrast, inappropriate institutions raise business costs and distort the proper functioning of the market. In general the institutional framework for informal operations has been unfriendly in most African countries (Label 1991; Schneider & Nest 2000). Policies are instruments for setting measures for provision of goods and services and to protect consumers and investors. Similarly, in the informal sector, by-laws set standards for the provision of public goods and services by the informal operators and enable local authorities to collect revenue for payments of services (Label 1991).

In most African countries, local authorities are generally the main obstacle in the expansion and development of the informal sector. They often use restrictive policies, by-laws and regulations that constrain the growth of informal enterprises. They tend to view informality as an illegal activity and as an activity responsible for making cities dirty and obstructing road traffic. Thus the policies do not often recognize the role played by the informal sector operators (Becker 2004). Some examples of policy measure to support informal sector include: Burkina Faso where the government improved the social security, health and minimum wage to safeguard informal workers. In Kenya the Government incorporated the informal sector into the national policy, assisting in getting credit as well as promotion cheaper ways of production (Becker 2004).

2.8 CONCLUSIONS

The term informal sector is used in the study to refer to any person or enterprise participating in economics activities without a license from the legal authority, including those who are not licensed, but are paying a fee to municipal authorities. It is also clear from the literature that there are different perspectives on the informal sector, i.e. dualistic, structuralism and legalist approaches.

In general the informal sector is associated with tax evasion and undeclared labor. In low income countries the informal sector has a relatively high percentage of women. Self-employment in the sector results in lower wages and longer working hours. However, the sector is differentiated in terms of economic activity, thus there are those who continue on the street corners and those who have established some physical infrastructure and have a direct link to the wholesalers.

CHAPTER THREE

THE INFORMAL SECTOR IN MOZAMBIQUE

3.1 INTRODUCTION

In Mozambique, the informal sector originated in the late 1980s when groups of small traders, mostly women, appeared on the street corners and sold small quantities of basic food products, such as tomatoes, rice, onions, etc, to casual by-passers. These small markets were illegal, molested by the police who removed them from the streets. Today the informal sector consists of wholesalers and retailers, with a broad range of food and non-food products supplied, not only by low income earners but also by a sizeable number of medium income earners (Dana & Galbraith 2006).

The Mozambican economy is directly and indirectly linked to the informal sector because it assists in the country’s main development goals through job creation and income generation. Consequently the sector is becoming more important because it absorbs a large number of the population with no other means to survive, and it accounts for a large share of the country’s GNP (Weber, Michael & David 1992).

The aim of the chapter is to provide a clear understanding of the nature of the informal sector in Mozambique, of its size, the reasons for its prevalence, its characteristics, the challenges faced by the sector and its relative contribution to the economy. The chapter finally presents a brief overview of public policies toward the informal sector.

3.2 SIZE OF THE INFORMAL SECTOR

In Mozambique it is difficult to establish the size of the informal sector, given that new businesses start up almost every day while others close down. Empirical evidence does not contain enough information regarding the size of the informal sector. However, Charmes (2000) estimated that it accounted for as much as 20 to 50 percent of non-agricultural GDP. According to a national survey in 2005, the informal sector employs about 70 percent of the total labor force (7.7 million) (INE 2006). Research conducted by Saba, Horn & Motile (2002), using income and expenditure survey, found that 71.3 percent of the informal sector in Mozambique consisted of women-headed households, living in absolute poverty.

According to Charmes (1998), the women are mostly involved in the non-agricultural informal sector and trade. However, in the industry and services segments of the sector, the share of women reaches 40 percent of the total number of workers. Charmes therefore stated that the aggregate output of the informal sector was largely contributed by women.

Table 1: Population of 7 years of age and older per workforce and per gender by geographical region (absolute values in thousands)

Source: INE outputs from the First National Survey (2005)

The table above shows the economically active workforce, with women making up the largest number of informal sector operators in all regions of the country. Since the majority of poor households are headed by females with lower levels of education and skills, they rely mostly only on self-employment to make a living (UN 1995). Furthermore, the formal labor market, which itself has insufficient capacity, has absorbed more men than women, thereby placing women at a double disadvantage. Women’s role in managing everyday family life has led them to become the most active members of all informal economic activity in Mozambique.

3.3 REASONS OF THE INFORMAL SECTOR

The following are

3.3.1 High levels of poverty

According to ILO (2007) poverty is the main reason for the existence of the informal sector. In their view, participating in informal activity is an alternative to unemployment since the government does not provide adequate social security benefits to unemployed. However, informal activity is considered marginal and vulnerable, since it is not protected by labor regulation (Souza & Tokman 1976). Rakowski (1994) emphasized that macroeconomic policy should be the major tool to poverty alleviation and the distribution of employment and income, inclusive of informal sector operations. This view conforms to the dualist school of thought (See Section 2.3.1) according to which informality is a result of underdevelopment that will disappear as the country develops according to the capitalism production system.

3.3.2 Increase in taxes and excess regulation

De Soto (1989) highlighted that the informal sector was made up of prospective enterprises that were forced to run their business illegally due to increases in tax, flaws in tax systems, or excess regulation, such as licensing requirement and ineffective bureaucracy. Informality is consequently a reaction to legal barriers. Thus informality is no longer seen as a problem of development only but as a response to economic crisis and lack of institutional capacity (Rakowski 1994). Therefore, it conforms to the legalist school (see section 2.3.3) which defend that the informal sector is comprised of individuals who avoid the cost of formalization, specifically labor regulations and taxes.

3.3.3 Decline in economic growth

Due to the decline of the economic growth rate of a country, firms tend to reduce size, retrenching workers in order to reduce their costs of operation (Rains & Stewart 1999). Consequently, retrenched workers seek for alternative sources of income for survival and in most cases it turns out to be in the informal sector (Tokman 2001). The growth of the informal sector and the decline in the employment rate are associated with lower economic growth (ILO 2004). All the above mentioned factors together with the high population growth rate of Mozambique result in the rapid expansion of the sector. However, a raise in the economic growth rate does not automatically shift the informal sector to a formal one (ILO 2004, UNDP 2001).

3.3.4 Rural- Urban Migration

Until the 1980s the majority of the population of Mozambique was employed in the agricultural sector. However, because of the civil war and the decline in agricultural output due to natural disasters such as drought, people migrated from rural to urban areas seeking for protection and alternative sources of income (Charmes 2000). Consequently the urban areas became over populated with unemployed and low skilled labor. It challenged the absorptive capacity of the formal sector to hire more workers but also lead to the growth of informal activity in urban areas. In addition, the demand for goods and services in rural areas decreased, because most of the residents did not have sufficient income, thereby increasing the flow