The World Bank and IMF are using flawed logic in their quest to do away with the informal sector

Many low and middle-income countries face a myriad of challenges. But policies that can address them are few and far between. The challenges include high and rising inequality, budget crises and the ongoing pandemic.

In a set of recent outputs, the World Bank and the International Monetary Fund (IMF) presented an approach that they argue can tackle all three crises at the same time: fighting informal economies.

Their arguments are premised on the claim that informality undermines efforts to both slow the spread of the pandemic and boost economic growth. They also believe that abolishing informality will lead to more tax revenues.

However, based on our organisations’ extensive research into informality and taxation we argue that their analysis is fundamentally flawed in its understanding of both the causes and consequences of informality. This is not a mere academic issue. Their reports endorse policies that will fail to deliver on their promises of higher growth and tax income. Blaming informal workers, rather than the structural conditions that leave them with no option but informal work, effectively blames the victims of global inequality while wondering why they’re not picking themselves up by their bootstraps.

In addition, what’s put forward as pro-poor interventions in the reports in fact risk actively increasing inequality and further disadvantaging vulnerable populations.

Blame the symptoms or the structures?

Recent flagship reports and accompanying commentary by both the IMF and the World Bank demonstrate a somewhat flippant approach to causality. They do this by framing informality as a cause, rather than a symptom of a weak or faltering economy.

The authors of both reports start off on safe ground. They observe that countries with high levels of income inequality also generally have high rates of informal employment (informality).

They also correctly note that they can’t demonstrate causality and that there is no ‘one size fits all’ policy approach.

But the reports then go on to abandon their own caveats when they get to the analysis or policy recommendations.

Demonstrating a similar logic, one World Bank blog, for instance, insinuates that an increase in unemployment in Peru is the result of informality, rather than the COVID pandemic.

This is not just a harmless analytical sleight of hand or benign semantic error. The result is that the bulk of the policy recommendations that stem from this analysis aim to eliminate the informal economy. They suggest that by simply removing informality, inequality would then decrease.

The World Bank’s odd approach to causality allows it to frame any policy that cracks down on informality as also addressing inequality, while largely ignoring a wider set of targeted interventions that aim to improve the livelihoods, security, stability and earnings of the most vulnerable workers.

Informality and taxes

The second fundamental flaw in the reports’ analysis relates to the assumption that eliminating informality will automatically increase tax revenues. This relies on the idea that tax evasion is “at the core of informality”. This is then baked into key concepts and measurements.

However, this simply does not match the reality of either informality or taxation in much of the Global South.

Tax evasion does indeed exist, including in a subset of the informal economy. But the analysis still mischaracterises the majority of the sector. Critically, it conflates deliberate evasion with the non-payment of taxes by workers who would typically be far below any tax thresholds.

Indeed, much employment in the informal sector is comprised of survivalist own-account operators. These are likely to be earning too little to be ‘evading’ tax in any substantial way.

In emerging and developing countries, direct measures of informal employment show that 78.1% of all economic units are own-account workers in the informal sector. This is even higher in African countries at 87.3%. By contrast, only 4.4% are informal sector employers.

As a further indication of limited tax liability, the share of the working poor in informal employment ranges from 50.4% to about 98% in developing and emerging countries (at US$3.10 PPP per capita per day).

Informal workers do pay taxes – notwithstanding these low levels of earnings. The regressive way in which the informal sector is already (over) taxed is well documented. For instance, a 2013 World Bank study of informal micro-enterprises in Uganda found that 70% were below the national business tax but still paid a substantial share of their profits to local authorities. The poorest payed the highest share of profits.

Carrot and stick

Based on their flawed premises, these analyses further assume that the informal economy can be eliminated by lowering taxes for formal enterprises (the carrot) while increasing taxes for unregistered or informal businesses (the stick).

For example, the World Bank argues that it is necessary to

streamline tax regulation to lower the cost of operating formally and increase the cost of operating informally.

But this understanding of the root causes of informality and the benefits of formalisation is ungrounded. It also leads to policies that don’t raise much tax revenue, while actively distracting from policies that can help those in informal employment.

This often happens in two ways. First, policy interventions to better ‘include informal economies in the tax net’ – or formalise them – are often sold with bold promises about the potential public revenue that they can generate. This suggests that informality is hiding a ‘gold mine’ for public coffers.

But many informal workers aren’t eligible for national taxation due to very low incomes. The risk, therefore is, that not a lot of revenue is actually brought in – all while adding further financial burdens on the poorest groups in society.

Critically, they may serve as distractions from taxing economic actors that could bring in significant revenue. These include politically connected businesses or unregistered independent professionals such as lawyers and dentists.

Second, focusing on taxation risks crowding out meaningful support that people in informal work require. There are real and complex challenges faced by people in informal economies: they range from harassment by authorities to unsafe working spaces to low incomes and a lack of access to finance or social safety nets.

Focusing primarily on eliminating informality risks creating an impression that formalisation can happen simply by getting people on tax registers or lowering the ‘costs of formality’. This ignores the question of what the benefits of formality are and how accessible they are. And it risks drawing attention away from the wide and complex set of reforms that are needed to support people both in informal work, and vulnerable work more widely.

A more productive way forward

The policy recommendations that follow from this reasoning won’t be helpful in addressing inequality. In fact, they may actually increase it by not addressing the underlying issues that lead to informality and informal employment.

Indeed, the suggestion that redistributive policies are bad for the poor in the informal economy, but that heavier taxation is good for them is a puzzling, at best, and deeply cynical, at worst, conclusion of the reports.

Rather than focusing on eliminating the informal economy, influential international actors like the World Bank and the IMF and domestic policymakers would have a greater impact on inequality by focusing on progressive taxation and the expansion of social protection for the poor, regardless of employment status.

by : Mike Rogan, Associate professor, Rhodes University

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