Rule of Law and the Informal Economy

If you have an interest in rule of law, trade liberalization, and the informal economy, you may find this dissertation interesting:

DOCTORAL DISSERTATION: Beyond the Invisible: Formalization Policies and the Rule of Law in the Informal Economy

ABSTRACT

Trade liberalization in Latin America has substantially altered business opportunities and economic development in the region. As barriers to competing inputs have come down and foreign investment in the region has gone up, small, domestic firms have struggled to stay afloat. Many small businesses have survived by skirting the legal requirements to operate a business, including registration and taxation, thereby bringing their operating costs just low enough to earn a profit. As trade liberalization continues to reduce barriers to foreign competition, and domestic firms face increasing pressure to compete, these “informal” firms have come under increasing pressure to legitimize or cease operations. With strong pressure from the tax-paying business community, international organizations, and foreign industry, many countries have increasingly begun formalization programs that target informality as a reason for slow growth in the face of open trade.

In this thesis, I pose a straightforward question—is formalization good for economic development? This question opens the door to an evaluation of the underlying cause of informality, the basis for the push for formalization, and an assessment of the likely result of such a process.

Formalization attempts to remedy the problems of low productivity and aversion to compliance with the law through economic incentives, such as tax discounts and streamlined business procedures that are intended to help firms make their way into the formal marketplace. However, in many developing countries, the informal economy is an economic consequence of trade pressures, and a legal consequence of a failed social contract between the state and its small business community.

In its current iteration, the formalization process is coupling the tools used to improve business practices and procedures with the legalization process for millions of existing informal firms. By doing so, the state is ignoring the dual legal and economic framework within which informal firms operate. Improvements in business processes are good for business and can help existing and intending formal firms succeed. But these are much less likely to overcome the deep-rooted failure of the state to address the needs of the bulk of the citizenry.

I argue that an effective formalization process must 1) address the terms of the social contract between the state and its informal economy, and; 2) make improvements in social programs to protect the health, safety and prosperity of existing informal firm operators. It is my contention that informal firms have largely rejected the state’s rule of law contract because the firms are unwilling to cede their freedom to operate an informal business in exchange for state protection of property or rights that they rarely possess. As such, in order to not only reduce the growth of the informal economy, but also to improve the rule of law, the state must take aggressive steps to reform their arrangement with the informal economy by building dynamic linkages between formal and informal legal and economic frameworks. An immediate step that states should take, I argue, is to implement programs that remove some hazards of operating an informal business by enforcing restrictions on the use of certain public space, providing safety equipment to street-based firms, and investing in improvements in the design of public space.

This modified formalization approach is not intended to rapidly eliminate the informal economy. Rather, it is aimed at improving the economic development of the state through an enabling, rather than a punitive approach. This modified approach will increase the value of the social contract and rule of law to informal firms; illuminate a pathway to voluntary legalization; protect individuals operating informal firms, and; improve access to education, training, and social services for all small firms. Capitalizing on the contributions made by the informal economy to a state’s economic development may help to turn a destructive process into a growth opportunity.


[For further information about this dissertation, please email me.]

KJF

Law and Society Meeting

I will part of an excellent panel at the Law and Society annual meeting in Chicago on May 29, coordinated by Amanda Perry-Kessaris (University of London). The panel description is below:

CRN24 Rule of Law, State Building, and Transition--Roundtable--Success in Law and Development: Evaluating the Conventional Wisdom of Using Evidence from the Field 3403

Law and development works involves Assessing existing rights and duties, Building capacity, Contesting existing and future rights and duties, Delegating the implementation of projects and Evaluating outcomes. This round table is made up of participants who have conducted extensive field work in developing and transitional economies. Drawing on their field work, each participant will give a short presentation about the extent to which a specific legal reform program has achieved its objectives. Thereafter, there will be a round table discussion covering a broader discussion on the role of legal reforms and what is working and what is not. At this point the audience will be invited to participate in the discussion.

I hope that you can attend.

KJF

The informal economy - that is, those individuals and firms not fully complying with state registration and taxation requirements - occupies as much as 80% of developing country markets. The trade that exists within an informal economy is vast and essential to the well-being of that country's economy. But a vexing question that has avoided resolution thus far is how that domestic trade is affected by changes in international trade. Until recently, developing countries had little role to play in global trade as most trade moved between developed country markets. Today, developing countries play a significant role in trade and are likely to continue increasing their share of the global marketplace.

The International Labour Organisation has been discussing the importance of the informal economy in domestic trade since 1972. The World Trade Organisation has been harking on the importance of bringing developing countries into the world trading regime since its inception (and really even before that with the formation of UNCTAD in 1964). This year, these two organisations joined forces to explore the linkage between expanding international trade and informal economies. The report, "Globalization and Informal Jobs in Developing Countries," is a comprehensive examination of the inverse relationship of trade expansion and informal economy growth and, while not intending to put the issue to rest, it does a nice job of providing useful data on various areas of impact. It does not focus on informal firms directly (my particular area of interest) but rather on the labor market. The report echoes the assertions of authors that have broached this topic previously by concluding that more trade is usually associated with higher rates of informality, either because domestic workers are replaced by technology or foreign workers, or because foreign investments often yield short-term gains that create little lasting growth in the formal economy. Interestingly, the report highlights the vicious circle of informality and trade - high rates of informality lead to less productive investments, leading to lower wages and continued growth of informality.

The report concludes with a recommendation to continue the current trend toward increased formalization. They note the distinction between formalizing firms and workers, explaining that firms should be encouraged to formalize through reductions in the red tape of small business registration and taxation systems, whereas workers should be formalized by providing opportunities to work in more productive environments (investing in infrastructure, for instance) while at the same time providing basic social protections for those workers as this is a long-term process.

No doubt a positive recommendation following a less than positive report, there is reason to doubt the viability of these recommendations. Incentivizing firms through tax breaks and faster registration processes does nothing to address the root cause of their informality. Economic incentives are insufficient to address the needs of informal firms in most developing countries today. Workers that benefit from the informal economy job opportunities may hesitate to leave behind that income for an uncertain future in the formal economy. The history of volatile labor markets encourages an atmosphere of distrust that the state, or the private sector, can provide stability in the formal labor market, making the informal economy, with its flexibility and availability in times of crisis, a reasonable alternative.

The report is available here:

http://www.ilo.org/global/What_we_do/Publications/Newreleases/lang--en/docName--WCMS_115087/index.htm

KJF

New Informal Economy article

A new article on the Informal Economy by Rafael la Porta (Dartmouth) and Andres Shleifer (Harvard) was recently released (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1304760). The paper does a nice job summarizing a few of the key theories of informal economy and economic development, including the work of Victor Tokman and Hernando de Soto. It does not, however, give due credit to more recent work by Alejandro Portes, Martha Chen, and others that have categorized the informal economy as a dynamic, heterogenous sector of the economy. Instead, the paper concludes that the firms found in the informal economy are largely run by uneducated individuals and operate unproductively. Accordingly, they should be formalized, and following Tokman's model of modernization, they will formalize when the economy grows. This theory takes us back in time to the early studies on development take-offs and assumes that informality is a relic of the traditional economy and nothing more. Based on the fact that the I.E. is growing and becoming a more essential part of overall economic growth, perceiving it as a stagnant and unproductive environment limits resolutions to increased enforcement and formalization, which may not be the best solution to this phenomenon.

KJF

Capitalism Under Fire - Again

Capitalism Under Fire – Again

Strikes in France this week centered on the major American company, Caterpillar, which is threatening to cut a substantial number of workers from its workforce in France despite earning more than $3.5 billion in profits in 2008. The French workers are rightfully upset at the company for reducing their workforce in the face of such gains, but in the company’s defense, they are acting rationally in the capitalist model. 2009 began with major losses for the construction industry worldwide, meaning demand for the heavy machinery that Caterpillar provides will likely slow down substantially this year. To prevent a loss, the company is streamlining its workforce, especially in areas where labor costs are high, like France. The company did offer to compromise with the workers if they agreed to work more hours in the workweek, but as might be expected from previous negotiations with French workers, their union refused. Thus, the dilemma in the French town of échirolles is a reflection of what is happening in many parts of the world – capitalist-driven companies are taking cover from a worsening global economy, and workers are grasping for help as their downfall becomes imminent. What will be interesting to see in this case is how well the French social system will cushion the fall for the workers.

http://www.nytimes.com/2009/04/17/world/europe/17strike.html?_r=1&ref=world

Kevin Fandl

According to a recent article from the Economist, the informal economy in developed countries (and likely in developing countries as well) may be one of the only sectors that is growing. This makes sense as people are relocated from their formal jobs to alternative mechanisms of income-generating activity. With a small informal economy in most developed countries, the increase may be negligible and largely ignored by policymakers. But this may be indicative of what we are likely to see in developing countries, where informal economies reach as high as 80% of the entire active workforce. Weak regulation and enforcement may lead an even larger number of workers to seek shelter in informal activity, despite its often lower wages, riskier working conditions, lack of stability, and inability to secure state benefits. This will be a more serious problem worth examining.

[From the Economist, April 5, 2009]

At least one part of the economy is growing. Sadly it is the wrong
part.

"WE USED to be recession-proof. No more. You
can't blame it all on the Justice Department," laments Uncle Junior in "The
Sopranos". Life may be hard for fictitious television mobsters such as Tony
Soprano, a self-styled "waste-management consultant", but in other parts of the
black economy, business is alive and well. As pressures bear down on profits,
restaurateurs become street vendors, shopkeepers become stallholders, and as for
work permits at the building site,
fuhgedaboudit!

The shadow economy is just about
the only part of the economy that may be growing. According to Friedrich
Schneider, a professor at the Johannes Kepler University of Linz and one of the
world's experts on the topic, that would mark a turnaround in its fortunes after
nearly a decade of decline. He has estimated the value-added of the shadow
economy in 21 of the 30 OECD countries. On average, it was equivalent to 16.8%
of GDP in 1999. By 2008 that figure had fallen to 13.3%. This year he forecasts
it will rise to 13.8%. Mr Schneider's calculations do not include activities
which are illegal in themselves.

In spite of its
size, the shadow economy's elusive character frustrates easy attempts to measure
it. Simply asking people has obvious shortcomings.
Tax-compliance data can be
used and discrepancies in national income and expenditure accounts give a sense
of what is going on in between the formal and informal sectors. Sometimes
employment data can be revealing. Last month, registered unemployment in Poland
was reported to have risen from 9.5% in December to 10.5% in January, but a
survey found that actual unemployment, excluding workers in the grey economy,
had only edged higher. A week later Polish labour unions decried the continued
influx of cheap unregulated labour from farther
east.

Yet another way to gauge its size is to
look at electricity demand, which moves roughly in step with economic activity.
If it is high and official GDP low, the informal economy is probably
flourishing. Most experts, however, use a mixture of more advanced methods.
Since cash is the lifeblood of the informal economy, it is possible to look at
cash demand in bank data and tease out the proportion of cash holdings which
cannot be explained by other factors.

According to Mr Schneider, who uses a combination of two even more complicated statistical methods, the size of the underground economy is equivalent to less than 8% of GDP in the United States, whereas in Greece it reaches 25% and in Italy 22%. In Italy, of course, the Mafia still makes out handsomely. That's one firm that
doesn't have a cash problem.

Kevin Fandl

Is China the Ultimate Capitalist Country?

Is China an imperial empire? Or perhaps just the best model of capitalism to date. A recent Newsweek article discussing China as a country with significant excess supply looking for markets to receive their exports focused on this issue(http://www.newsweek.com/id/186971).

Recall that Marx proffered the idea that capitalists would always try to pursue profits through overproduction through efficient production, pushing other producers out of the market, and gaining as much rent as possible from the production of goods by maintaining low labor and input costs. Eventually, the domestic market runs out of buyers. Thus, new markets (or goods) need to be found. Marx said, “the tendency to create the world market is directly given in the concept of capital itself. Every limit appears as a barrier to be overcome.” Exports appear in the world economy to be the best avenue for relieving domestic pressure from overproduction.

Is China pursuing a similar policy today as it continues to overproduce and export its goods to markets in Africa and Latin America, where cheap import-hungry citizens long for lower-priced consumer goods? Is China, in a sense, becoming the ultimate example of capitalist development?

KJF