DOI: 10.1111/joes.

12487

ARTICLE

Theories and definitions of the informal

economy: A survey

Roberto Dell’Anno

Department of Economics and Statistics

and CELPE, University of Salerno, Abstract
Fisciano, SA, Italy This paper surveys the literature on the definitions and
Correspondence theories of the informal economy (IE). It outlines the
Roberto Dell’Anno, Department of Eco- main differences in the definitional approaches of infor-
nomics and Statistics and CELPE, Univer-
mality and proposes a definition for the IE that may
sity of Salerno, Via Giovanni Paolo II, 132,
Fisciano, SA, 84084, Italy. be consistent with measurement and policy. The litera-
Email: [email protected] ture review distinguishes three, not mutually exclusive,
approaches to the IE: the “neoclassical,” the “macro-
[Correction added on 07 May, 2022 after
first online publication: CRUI-CARE econometric,” and the “conceptual” perspectives. I con-
funding statement has been added.] clude the survey by outlining a framework that points
out the main differences and similarities among the
schools of thought on the nature of the IE. From a nor-
mative perspective, a leading recommendation emerges:
a “one-size-fits-all” policy response is inadequate to deal
with the heterogeneous nature of the IE. Policy mea-
sures should be tailored around the distinct segments of
the IE grounded in terms of characteristics, contexts, and
needs of the informal units.

KEYWORDS
informal economy, informality, informal sector, shadow economy

This is an open access article under the terms of the Creative Commons Attribution License, which permits use, distribution and reproduc-
tion in any medium, provided the original work is properly cited.
© 2021 The Authors. Journal of Economic Surveys published by John Wiley & Sons Ltd.

1610 wileyonlinelibrary.com/journal/joes J Econ Surv. 2022;36:1610–1643.

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DELL’ANNO 1611

1 INTRODUCTION

Informal economy (IE) encompasses a huge diversity of phenomena that vary in composition
and size within economies and across regions. Although estimating the size of informality is
challenging, there is a wide consensus that the IE is the most important source of employ-
ment in developing countries and it also has a significant role in providing employment and
income for marginalized people in developed economies. Specifically, according to the Interna-
tional Labour Organization (ILO, 2018a), 61.2% of global employment (about two billion people)1 is
informal.
Literature on informality dates back to the analyses of the British anthropologist Keith Hart,
who coined the term “informal sector”2 in 1971 publishing it 2 years later in his article (Hart,
1973) and in the ILO’s (1972) Report on Kenya, which contributed to the widespread use of
this “new” concept. Hart’s most important (1973: 61) contribution to this literature consisted in
showing that the economic activities of the urban Southern Ghanaian sub-proletariat were not
a passive and exploited “reserve army of urban unemployed and underemployed” but possessed
“some autonomous capacity for generating growth in the incomes of the urban (and rural) poor.”
As Clement (2015) points out, this perspective disagreed with the prevailing theory of economic
development at that time (often labeled “Modernization” theory), which regarded the “informal
sector” as a transient phase in the process of economic development. Indeed, while the “Modern-
ization” theory assumed subordination between the traditional/subsistence (i.e., informal) and
the modern/industrialized (i.e., formal) sectors, for Hart (1973) and the ILO (1972), the infor-
mal sector was too large, persistent and, in some places procyclical, to predict its natural dis-
appearing with economic development. After these seminal studies, mainstream thinking pro-
gressively moved away from the “Modernization” theory of the IE. The idea that there was only
one, inevitable trajectory of development, which corresponded to the formalization of informal
activities into the official economy, became just one of the potential theoretical views. Following
this strand of research, several scholars have classified theories on informality but, at the state of
art, these taxonomies are sometimes inconsistent with each other. For instance, we can find dif-
ferent labels for the same theoretical view as well as the same label to indicate diverse theoretical
approaches.
In this paper, I review the approaches followed in economic literature to explore the phe-
nomenon of informality and, the schools of thought proposed to capture the intrinsic nature of
the IE. As a result, I propose a unified conceptual framework of the main hypotheses behind these
theories that may be useful to further foster an interdisciplinary debate on this issue.
In general, the vast literature on IE can be divided into three major (interconnected) issues: a
definitional issue (i.e., what is “informal”); a measurement issue (i.e., “how” to estimate its size),
and a theoretical explanation of “informality” (i.e., what are its causes and consequences? Why is
it so persistent over time? What is its relationship with the formal economy?).
This paper deals with the first and third issues.3 Section 2 reviews the different definitional
approaches to IE and, by pointing out the main critical issues, proposes a definition that aims
to be consistent with statistical and economic purposes. Section 3 distinguishes three, partially
overlapping, perspectives to approach IE in literature. Moreover, it outlines a conceptual frame-
work to point out the main differences and similarities among the best-known theories of infor-
mality. The last section concludes with normative implications and some suggestions for further
research.
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1612 DELL’ANNO

2 DEFINITION(S) OF IE

Hans Singer, who led the first ILO employment mission along with Richard Jolly in Kenya in 1972,
compared the informal sector to a giraffe in that it is difficult to define by usual standards, but easy
to recognize when you meet one. Lautier (1990) replied to Singer, by saying that the metaphor of
the giraffe was inadequate. The informal sector is “a unicorn because the literature abounds with
definitions, but you will never have the opportunity to meet one, because it does not exist (Charmes,
2016, p.6). This disagreement on the best faunal metaphor for the informal sector gives us an idea
of how challenging the debate on the definition of informality is.
An important source of misunderstandings on the definition of IE consists in the divergence
of research goals among scholars from different disciplines (i.e., “statistical” vs. “economic”). For
instance, the “economic” concept of IE (or of its seeming synonyms, e.g., shadow, unofficial, hid-
den, black, underground economy) has a different meaning to the concept of informality used
by statisticians in national accounting (e.g., non-observed economy (NOE), underground pro-
duction) or by labor economists in ILO statistics (e.g., informal sector and informal productive
activities (IPA)).
Although there have been some attempts to reconcile these definitional approaches (e.g.,
Dell’Anno, 2007, 2016; Hussmanns, 2004; ILO, 2013, 2018a, 2021; OECD, 2002; Quiros-Romero
et al., 2021), a common solution is still not available. For example, according to the strand of liter-
ature that focuses on informality from an “economic” perspective, Feige (2016) proposes a taxon-
omy based on noncompliant behaviors. He points out that noncompliance and “unobservability”
are common features in all behaviors in unobserved economies. Accordingly, what distinguishes
one unobserved economy from another is a particular rule being violated. Specifically, Feige offers
the following definitions: “unreported economy” as when the noncompliance consists in the cir-
cumvention of the fiscal code by tax evasion; “unrecorded economy” as when the added informal
value added arises from violations of the rules of national income accounting; “illegal economy”
as the contravention of rules governing the production and distribution of prohibited goods and
services (e.g., drugs, prostitution); “IE” as the circumventions of labor market regulations such as
minimum wages, working conditions, social security, unemployment, and disability benefits.
Recent resolutions of the International Conference of Labour Statisticians (ICLS) of the ILO
provide a valuable contribution to matching the differences among the concepts of the informal
sector, employment, and economy. For instance, according to the ILO (2018b), the different sci-
entific aims pursued by economists and statisticians are the source of the problem for a com-
mon definitional framework of the IE. Statisticians need a definition that makes it unproblematic
to measure the phenomenon, on the other hand, economists look for a suitable definition for
both analyzing causes and effects of informality and for providing effective policy implications.
This heterogeneity of research purposes explains why, although the ILO (2015a) has proposed
an “official” definition of IE in Recommendation No. 204 – “all economic activities by workers
and economic units that are – in law or in practice – not covered or insufficiently covered by formal
arrangements” – this concept is still not adequately followed by statistics. Indeed, the ILO pub-
lishes, almost exclusively, estimates on informal employment. As the ILO (2018b, p.22) explains,
the reason is that “the IE is not a statistical concept but a concept for policy purposes that embodies
the sum of all parts of informality.”4
While an exhaustive review of all the definitions of informality in literature is out of the scope of
this article, in the following, I report the three most common sources of misinterpretations among
“economic” and “statistical” definitions of the aggregates related to informality.
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DELL’ANNO 1613

T A B L E 1 Components of the informal sector, informal employment, and employment in the informal
economy by institutional sectors in the Systems of National Accounts (SNA)

Source: (Charmes, 2016, p.13).

The first source of confusion is due to the different meanings of the concepts of “IE” (mainly
used by those who analyze informality as “informal value added”) and “informal sector” (typically
used by scholars who examine informality in terms of “involved productive units”). The 15th ICLS
resolution states that the informal sector consists of “units engaged in the production of goods or
services with the primary objective of generating employment and incomes for the persons concerned.
These units typically operate at a low level of organization, with little or no division between labor and
capital as factors of production and on a small scale” (ILO, 1993, par. 5). This concept is dissimilar to
the concept of informal employment which is, at least in developing countries, the most important
source of the IE (as defined by ILO, 2015a). Specifically, informal employment and informal sector
are conceptually different phenomena because, while informal employment refers to the charac-
teristics of the job,5 the concept of informal sector refers to characteristics of production units. As a
consequence, we can have formal employment in the informal sector (e.g., a formal job carried out
in an informal enterprise) that should not be included in the IE, and informal employment in the
formal sector (e.g., an employee of a registered enterprise whose employment relationship is not
subject to labor legislation, income taxation, social protection, etc.), which should be included in
the IE. Following Charmes (2016), Table 1 shows that: (1) the informal sector and informal employ-
ment are not mutually exclusive components of the labor force; (2) informal activities and jobs are
positioned in the various institutional sectors of the Systems of National Accounts (SNA); (3) the
informal sector and informal employment both contribute to employment in the IE.6
The second source of misunderstanding when comparing the labor-based ILO definition of IE
to the definition of informality based on national account standards concerns the treatment of
illegal activities. According to the 2015 ILO Recommendation No. 204, the IE does not cover illicit
activities.7 On the contrary, the concept of NOE – introduced by the OECD (2002) and furtherly
recalled by the 2008 SNA and European System of Accounts (ESA, 2010, par. 11.26)8 – includes
(some) illicit activities. Specifically, the NOE includes both production of legal (i.e., underground
and informal) and illegal activities, where the illegal production consists of those economic activ-
ities that fall within the national accounts production boundary, i.e., where both parties involved
in an illegal economic transaction are willing partners, such as in prostitution, drug trafficking,
and so forth.
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1614 DELL’ANNO

The third source of misunderstanding in this literature concerns the treatment of tax evasion.
In economic literature, the definition of IE (or shadow economy) often includes tax evasion. For
instance, Schneider (2005, p. 600) defines shadow economy as including “all market-based legal
production of goods and services that are deliberately concealed from public authorities [. . . ] to avoid
payment of income, value added or other taxes, to avoid payment of social security contributions,
to avoid having to meet certain legal labor market standards, such as minimum wages, maximum
working hours, safety standards, and so forth, and to avoid complying with certain administrative
procedures, such as completing statistical questionnaires or other administrative forms”.9 This “eco-
nomic” definition of informality – which focuses on the agent’s aim to avoid taxes and regulations
– may diverge both from the ILO definitional approach – which focuses on the characteristics of
economic units (as for the informal sector) or formal arrangements (e.g., the informal employ-
ment in the formal sector which should be included in the IE) – and also from the definition of
informality based on national account standards – which focuses on the outcome of those activ-
ities (i.e., if they fall within the national accounts production boundary). On the latter discrep-
ancy, it is worth pointing out that the difference between Schneider’s “economic” definition and
Dell’Anno’s (2007) “NOE-based” definition of IE (see below in this section) depends on the differ-
ent productive nature that the phenomenon of “tax noncompliance” (i.e., illegal and legal meth-
ods used by people or companies to reduce the tax they pay) may have. According to the SNA,
tax evasion and tax avoidance are excluded from the NOE if they only generate a “tax-gap” (i.e.,
a difference between the total amount of tax theoretically collectible and the total amount of tax
actually collected)10 . On the contrary, if tax noncompliance behaviors consist of income or pro-
duction underreporting, in this case, value added or production of these activities is included in
the NOE as “underground production for economic reasons” because within the national accounts
production boundary.11
That of the ILO (2021) is one of the most recent attempts to find a harmonized single-definition
of informality suitable for both “statistical” and “economic” purposes. It introduces two new
concepts:12 IPA (defined as “all productive activities carried out by persons and economic units
that are – in law or in practice – not covered by formal arrangements” (ILO, 2021, p.7) and infor-
mal market economy (IME) (defined as “all productive activities, carried out by workers and eco-
nomic units for pay or profit that are – in law or in practice – not covered by formal arrangements.”
(ILO, 2021, p.11).
The concept of IPA has relevant advantages in terms of inclusiveness and flexibility with
respect to the usual definitions of informal sector and informal employment. The key criterion
to include productive activities within the aggregate of IPA is that they are not covered by for-
mal arrangements. Accordingly, it would potentially include activities carried out by workers
(independently of whether they are in an informal or formal job), (formal or informal) eco-
nomic units, or by households, making this concept particularly suitable for measurement pur-
poses. The second aggregate that the ILO (2021) suggests to include in the next ICLS resolu-
tion, i.e., the IME, consists of a subset of the IPA, as e only activities taking place in relation
to employment and enterprises producing for the market are included in the IME. According
to the ILO (2021), this restricted definition allows us to outline a statistical aggregate that is
more relevant for policy purposes (e.g., identify the size of the informal activities that can be
formalized).13
Although ILO (2021) represents a valuable advancement in meeting policy and measurement
needs, the treatment of unrecorded activities due to undeclared value added aimed to paying less
taxes is still problematic. Explicitly, ILO (2021, Table 2) excludes under-declared value added due
to tax elusion (i.e., legal methods to minimize the amount of tax) from IME, while ILO (2021,
 TA B L E 2 Matching different definitions of the informal economy
DELL’ANNO

a
Source: our elaboration based on: ILO(2021, Table 2).
b
The issue of whether or not paid domestic workers should be included in the informal sector was left by the 15th ICLS as open for determination by the countries and, if included, it should be
identified as a separate subcategory (OECD, 2002, p.168).
1615

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1616 DELL’ANNO

Non-Observed
Economy

Underground Informal Illegal

Statistical Economic T6 T7
Reasons Reasons Not registered Not registered

T1 T2 T3 T4 T5
Non response Not updated Not registered Under reporting Not registered

F I G U R E 1 ISTAT framework of non-observed economy (NOE) [Colour figure can be viewed at

wileyonlinelibrary.com]

Table 1) includes tax evasion (i.e., illegal methods to pay less taxes) due to “non-declared transac-
tions for the portion of the production declared in physical units, not just minimizing its value added”,
within IME. This partition appears irrelevant for policy purposes and impracticable for statistical
aims.
Chen and Carré (2020, p.5) point out that while the concept of informality has been criticized
by many scholars “as being too fuzzy and the formal-informal dichotomy as being too binary,” it is
unfeasible to renounce defining it. Indeed, it is unquestionable that workers and enterprises fall
on a continuum between being fully formal or fully informal, therefore the formal-informal divi-
sion is “easy to criticize.” But, as Harriss-White (2020) argues, a clear description of what should be
and what should not be included within the IE remains pivotal for positive, normative, and mea-
surement purposes. In line with Harriss-White’s (2020) argument, I consider Dell’Anno’s (2007)
definition of IE as suitable for both statistical and economic purposes. By amending the Italian
National Statistical Institute (ISTAT) analytical framework of NOE described in Calzaroni (2000)
and OECD (2002), he delineates an aggregate of productive activities that may be suitable for eco-
nomic analysis of informality. Specifically, along with the ISTAT framework, Dell’Anno (2007)
defines the IE as a subset of the NOE that includes underground production for economic reasons
(i.e., T414 and T515 ) and informal production (T6)16 . In terms of productive activities involved in
the IE, these can be (a) self-employment (including employers, own-account workers, and unpaid
family workers) in informal (i.e., unregistered) enterprises; (b) formal (i.e., registered) enterprises
that deliberately underreport their production to avoid the burden of regulation and taxation; (c)
wage employment in informal jobs (i.e., without secure contracts, worker’s benefits or social pro-
tection). Figure 1 outlines the components of NOE according to the ISTAT framework and a sub-
set of NOE (i.e., T4 + T5 + T6) that quantifies the informal value added suitable for an economic
analysis of informality.
Following ILO (2021), Table 2 outlines the differences and overlappings between the most
recent labor-based ILO (2021) definitions of informal aggregates (e.g., IPA, IME, IE, informal sec-
tor) and the concept of IE as derived by the ISTAT frameworks (i.e., informal production and
underground production for economic reasons).
In conclusion, although in the last decade important steps forward have been made on the
definitional issue, further interdisciplinary research is still needed to attain a unified definition of
IE, suitable for both economic and statistical aims.
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DELL’ANNO 1617

3 THEORIES OF INFORMALITY

The IE is a complex and heterogeneous phenomenon, in which determinants and consequences

depend on the characteristics of the involved units, and on macroeconomic and institutional fac-
tors. The multifaceted nature of IE explains the lack, in literature, of a comprehensive theory
of informality suitable both for developing and developed economies. Indeed, a theoretical view
that explains the emergence of informality as a strategy to survive in a developing country might
be inapt to grasp the prevalent nature of IE in a developed country (e.g., Goel & Nelson, 2016).
Because of that, to avoid misunderstandings among scholars, it is important to specify which type
of informality a theory aims to explain.
Specifically, on the one hand, IE can be seen as a strategy of last resort to escape unemployment
and poverty. The literature dealing with this type of informality mostly refers to it as an informal
sector, rather than IE. It focuses on productive units (e.g., as a percentage of units involved) instead
of the value added generated by these activities (e.g., as a percentage of official GDP). These infor-
mal productive units operate at a low level of organization and capital, they are geographically
concentrated in low- and middle-income countries and, due to the low level of organization, this
type of informality is strongly correlated with informal employment. According to this perspec-
tive, informality is a key topic both for labor and development economists and, given the focus on
people, it also attracts anthropologists and sociologists generally interested in understanding the
relationship between marginalization and informality (Wilson, 2010). In the wake of Hart (1973),
the theoretical literature on this type of informality goes beyond economic analysis, because it
involves research on human behavior, social exclusion, the role of social structures, and institu-
tions.
On the other hand, informality may be approached by emphasizing its deviant behavior nature.
According to this view, the IE (normally labeled in this literature as “shadow” or “undeclared”
economy) is, first and foremost, considered a rational voluntary choice to “exit” from the formal
economy to reduce taxation and regulation burden. This approach generally focuses on informal-
ity in terms of informal (or unobserved) value added (or GDP). According to this perspective,
the analysis of informality has become a relevant topic in developed countries too. Indeed, in
high-income economies, the analysis of the effects of the IE in terms of efficiency and equity
is prevalent with respect to its consequences in terms of economic growth. From this viewpoint,
research on informality mainly attracts public economists (e.g., to design effective public policies),
national accounting institutions (e.g., aiming to adjust official statistics to achieve exhaustiveness
of GDP), tax administrations, public finance researchers (e.g., to analyze tax evasion), and applied
economists (e.g., dealing with the interactions between the IE and labor aggregate, firms’ com-
petitiveness, etc.).
As for the definitional issue, where the difference between “statistical” and “economic” aims
is a source of misinterpretation for the theoretical strand of this literature too, the heterogeneity
of research goals (ranging from sociology to taxation theory) and the, at least, twofold nature of
informality, have hindered the emergence of a consensus on a “general” theory of the IE.
In the following three sections, I systematize this literature according to three (partially over-
lapping) approaches and I direct my attention especially to the third one due to the lack of surveys
in this strand.
Section 3.1 includes the literature that explores informality by analytical frameworks assum-
ing the standard hypotheses of neoclassical economics (hereinafter “neoclassical approach”).
In these theoretical models, productive units are rational agents that voluntarily choose to
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1618 DELL’ANNO

Informal economy literature

Neoclassical approach Macro-econometric approach The schools of thought

(Formalized economic models) (Econometric models) (Conceptual models)

Tax-evasion Informal product. Estimating IE Testing causal hypotheses

Modernization Dualist Structuralist Neoliberal Free-riding Two-tiered

FIGURE 2 A roadmap of the literature on informality

participate in the IE by maximizing a welfare (e.g., utility, profit) function subject to resource con-
straints. The neoclassical approach includes both microeconomic and macroeconomic formalized
theories where, in addition to the assumption of rational choice, the steady-state equilibrium that
defines the aggregate size of the IE depends on the allocation of resources among formal and
informal units in a competitive market.
Section 3.2 includes those empirical studies dealing with both measurement issues and test-
ing causal hypotheses on the determinants of the IE. These analyses are predominantly explored
by macro-econometric exercises (hereafter “macro-econometric” approach) and explore the phe-
nomenon of informality mainly in terms of value added as a percentage of official GDP.
Section 3.3 surveys the studies that systematize the theoretical approaches to the IE (hereinafter
“schools of thought”). This literature has a multidisciplinary character and pays particular atten-
tion to the relationship between informal and formal sectors.
Figure 2 summarizes the proposed structure of the literature survey.

3.1 The neoclassical approach to the theory of the IE

Under the neoclassical approach to the IE, I include those analytical microeconomic models in
which the rational agent chooses to operate informally as a result of a constrained maximiza-
tion of his/her value function and, in macroeconomic models, the equilibrium is obtained by
assuming a competitive market. These theoretical frameworks usually follow two main analyti-
cal workhorses, depending on the predominant nature of the IE under scrutiny. If the analysis
examines the IE “underground” component (i.e., underreported earnings deliberately concealed
to avoid the burden of taxation), then the mainstream framework is Allingham and Sandmo’s
(1972) model of tax evasion (e.g., see for a survey Alm, 2019; Devos, 2014). Conversely, if the focus
is on the “informal sector,” where informality is mainly related to employment, then the usual
analytical framework consists of macroeconomic two-sector search and matching models. Among
several studies proposing macroeconomic frameworks where the size of informality depends on
the allocation of the labor force between formal and informal sectors, Rauch (1991) plays a signif-
icant role. He develops a model where a firm’s decision to hire informal workers depends on the
desire to remain small to enjoy legal exemption from a mandated minimum wage policy. Ihrig
and Moe (2004) analyze the agent’s decision to accumulate capital and to work in the formal and
informal sectors using a two-sector dynamic equilibrium model. In terms of policy implications,
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DELL’ANNO 1619

the authors conclude that to reduce the informal sector the most effective policies are to cut tax
rates and increase enforcement by implementing higher tax penalties for informal agents, rather
than increasing the chances that an informal agent may be caught. Amaral and Quintin (2006)
propose a dynamic model where, in equilibrium, the characteristics of formal and informal work-
ers systematically differ, even though labor markets are perfectly competitive. This implies that
the hypothesis of formal barriers to movement between sectors is not important to explain the
emergence of informality. According to these results, Amaral and Quintin (2006, p.1552) conclude
that the “dualistic view of labor markets in developing countries should be questioned.” Similarly,
Allen et al. (2018) propose a multi-industry general equilibrium model where formal and infor-
mal firms often operate in the same markets, and the degree to which informal firms are similar to
formal firms in terms of productivity is heterogeneous across industries. In this framework, infor-
mality tends to decrease with industry productivity and establishment size. Günther and Launov
(2012) empirically test whether employment in the informal sector in a developing country (i.e.,
Côte d’Ivoire) is a workers’ voluntary choice based on utility maximization or rather a strategy of
last resort to escape unemployment. This query indirectly deals with a fundamental question in
this literature, whether “individuals are poor because they are employed in the informal sector (an
implication of a segmented labor market); or alternatively, whether they are employed in the informal
sector because they are poor(ly endowed) with characteristics that generate high returns in the for-
mal sector (an implication of a competitive labor market)” (p.88). Günther and Launov (2012) finds
that both voluntary and involuntary employment describes the empirical data. Dell’Anno (2018)
proposes a microfounded macroeconomic modeling framework, in which, other than taxes, the
worker’s choice to informally operate depends on indivisible entry costs, credit market imperfec-
tions, and, the composition of the labor force (i.e., the proportion of workers who do not have the
opportunity to work in the IE, such as employees). Ulyssea (2018) develops a competitive equi-
librium model where heterogeneous firms can exploit two margins of informality: an “extensive
margin” (when firms do not register their business); and an “intensive margin” when firms pay
workers “off the books.” According to this framework, two key factors explain the firm’s deci-
sions regarding entry, production, and compliance: the firm’s heterogeneity in terms of produc-
tivity and the entry costs into the formal sector. The main result of this research is that within
the same economy three different types of informal firms co-exist (“survival firms,” which are too
unproductive to operate formally, even if entry costs were removed; “parasite firms,” which are
productive enough to survive as formal firms once entry barriers are removed but choose to remain
informal; informal firms (“de Soto’s view”), which are kept out of formality by high entry costs, but
if these were removed, they would become formal and improve their performance). In conclusion,
I suggest Elgin and Ertuk (2019) for a recent survey of analytical models on informality.

3.2 The macro-econometric approach to the IE

The second strand of this literature analyzes the IE by following a macro-econometric perspective.
Since their early papers, Cagan (1958), Gutmann (1977), Feige (1979), Tanzi (1980), and Gaertner
and Wenig (1985) have paid particular attention to the issues of measurement and analysis of the
IE determinants. These studies normally focus on the value added concealed from official statis-
tics rather than the number of people involved in informal activities. Accordingly, this perspective
tends to overweight the underground production (i.e., undeclared GDP due to economic reasons)
with respect to the informal production in the analysis of the IE. From a theoretical background,
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1620 DELL’ANNO

these empirical studies encompass theoretical hypotheses from economic models both on tax eva-
sion and on labor or development literature.
The macro-econometric approach has probably been the most fast-growing strand in the liter-
ature on IE in the last 20 years (e.g., Afonso et al., 2020; Dell’Anno, 2007; Elgin & Ertuk, 2019;
Feld & Schneider, 2010; Gërxhani, 2004a; Goel & Nelson, 2016; Jessen & Kluve, 2021; La Porta
& Shleifer, 2014; Loayza, 2018; Medina & Schneider, 2018; Ohnsorge & Yu, 2021; Schneider, 2011;
Schneider & Buehn, 2017; Schneider & Enste, 2000; Schneider & Williams, 2013; Ulyssea, 2020).
One of the reasons for this success is the relatively recent abundance of estimates of the size of
informal GDP. These estimates have encouraged researchers to empirically explore both the most
significant causes of informality and also the effects that IE has on other variables.
Taking into account that an exhaustive list of these studies is outside the scope of the present
survey, Dell’Anno (2021a) groups potential drivers of the IE into six categories. These categories
deal with: taxation system (e.g., measured as overall tax burden, tax mix, tax complexity, marginal
tax rate); regulatory system (e.g., overall regulatory burden, employment protection legislation);
labor force composition (e.g., self-employment rate, unemployment rate, the existence of a signif-
icant amount of illegal immigrants, unskilled workers); enforcement system (e.g., probability of
detection, fine rates, the strength of criminal penalties); tax morale and institutions (e.g., historical
roots, fairness of public policy, corruption, quality of political institutions, media and economic
freedom).17
An important issue for these empirical analyses is to determine the direction of causality
between IE and the macro-variables. Without any claim to exhaustiveness, among the studies
that focus on the relationship between IE and other economic aggregates, I quote Ferreira-Tiryaki
(2008), Granda-Carvajal (2010), and Elgin et al. (2021) on the relationship between informality
and business cycle; Afonso et al. (2020) on the link with economic growth; Bonnet and Venkatesh
(2016) on poverty; Chong and Gradstein (2007) and Dell’Anno (2021b) on inequality; Capasso &
Jappelli (2013) on financial development; Dreher and Schneider (2010) and Goel and Saunoris
(2014) on the relationship between IE and corruption.
In conclusion, although several studies agree on both the identification of potential drivers of IE
(e.g., tax policies and state regulation according to Schneider, 2019) and on the idea that the size of
their marginal effects depends on the economic development of the country (e.g., Goel & Nelson,
2016), the doubts on both the reliability of the estimates of the IE and the issue of endogeneity
leave an aura of suspicion on the consistency of these empirical findings.

3.3 The Conceptual approaches to (or “schools of thought” on) the IE

In the third strand of literature, I include those researches that, following the seminal studies of
ILO (1972) and Hart (1973), aim to explore the emergence and evolution of the IE and its relation-
ship with the formal economy. In this strand, the concept of informality is mainly focused on the
notion of the informal sector (i.e., “units typically operate at a low level of organization, with little
or no division between labor and capital as factors of production and on a small scale”, ILO, 1993,
par. 5) and, consequently, the proposed conceptual views are more suitable to explaining informal
employment than unreported value added.
The contribution of this section to the literature is twofold. First, I survey the main studies
that deal with the classification of the theoretical views on IE (e.g., Chen, 2012; Gerry, 1987;18
Chen et al., 2004; Hart, 1973; ILO, 2015b; La Porta & Schleifer, 2008; Perry et al., 2007; Tok-
man, 1978; Williams, 2008, 2015; Williams & Kedir, 2018; Williams & Nadin, 2011), by following a
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DELL’ANNO 1621

chronological order. Second, given that these studies use different labels, hypotheses, and refer-
ences, at the cost of smoothing some minor distinctions, I combine the existing theories into six
“schools of thought” in Section 3.3.1. These six conceptual approaches are defined by aggregating
the (not necessarily mutually exclusive) theoretical views of informality according to a criterion
of homogeneity in terms of causes, characteristics of informal units, and policy implications.
Bangasser (2000) considers Hart (1973) and ILO (1972) as milestones in this field of research
because they propose a new viewpoint for the informal sector that disagreed with the prevalent
“miserabilist” views of survivalist activities of working poor in urban areas. ILO (1972, p.5) high-
lighted as “far from being only marginally productive” – as supposed by the old-fashioned con-
cept of the “traditional sector” – [the informal sector] is economically efficient and profit-making,
though small in scale and limited by simple technologies, little capital, and lack of links with the
other (“formal”) sector.” Moreover, the employment in the Kenyan informal sector “has probably
increased a good deal faster in the informal than in the formal sector” (ILO, 1972, p.6). This evidence
conflicted with the first generation of development economists19 (also known as the “Modern-
ization” view) that predicted that the development of the (formal) market economy would lead
developing economies on the same successful pathway followed by Western capitalist countries
after the Second World War. Unfortunately, for developing countries, the economic growth was
lower than expected and, since the 1970s, it became clear as the theoretical prediction of a declin-
ing informal sector was destined to remain a mirage. Historically, by rejecting the hypothesis of
informality as a transitory phenomenon that would disappear with economic growth, these stud-
ies have opened the scientific debate on the theories of the IE.20
Following a chronological order, Tokman (1978) is among the first authors to review the theories
of informality by focusing on the relationship between the informal and formal sectors. He distin-
guished two main theoretical approaches to informality (i.e., a “benign” and a “subordinate” view)
and proposed a third integrated approach, which he labeled as “Heterogeneous subordination” of
informal on the formal sector. Along with the first approach, the relationship between informal
and formal sectors is “benign” because the informal sector has “the potential for a more adequate
pattern of growth with a more egalitarian distribution of income” (Tokman, 1978, p.1066). Tokman
(1978) indicated two leading hypotheses to explain the economic rationales behind the “benign”
relationship. According to the “duality sub-approach,”21 the informal sector is an autonomous
self-contained segment (i.e., without significant links to the formal sector) characterized by pro-
viding employment, goods, and services for the lower-income groups of the urban population.
It is economically efficient and has comparative advantages to similar activities operating in the
formal economy. The second hypothesis supporting the benign approach sees the informal and
formal sectors as complementary. Consistent with the “complementary sub-approach”22 , the infor-
mal sector “is highly integrated to the rest of the economy exporting three quarters of its production
and importing a similar proportion of its consumption” (Tokman, 1978, p.1067). Such integration
is “benign” since the informal sector predominantly produces distinct and specialized goods and
services, that is, labor-intensive productions that employ low-skilled workers. For this reason,
under the complementarity approach, the size of the informal sector is expected to expand with
the size of the formal sector and the presence of informal activities does not generate negative
externalities as a result of unfair market competition between the two sectors.
A second conceptualization of the relationship between the formal and informal sector is in
opposition to the “benign” relationship approach. Tokman (1978) defined this view as a "Sub-
ordination” approach. He outlined two sub-approaches to explain how a subordination of the
informal sector to the formal sector is detrimental for economic development. The “marginal-
ization” hypothesis assumes that the informal sector operates mainly through the lack of access
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1622 DELL’ANNO

to resources of production and product markets (e.g., Quijano, 1974). As Tokman (1978, p.1069)
argued, “the lack of stable access to basic resources of production, because they are monopo-
lized by the formal sector, determines that informal activities can only operate around residual
resources, being excluded from the possibility of technological improvement.” The second sub-
approach assumes an “exploitative integration” of the informal sector into the capitalist system
(e.g., Gerry, 1974). This view posits a scenario inspired by Marx’s theory on the role of the “reserve
army of labor” in capital accumulation. In this perspective, the informal sector may be seen as
the pre-capitalistic sector and the formal economy as the capitalistic sector. Consistent with the
Marxian model, informal workers constitute the “reserve army” that facilitating capital accu-
mulation by releasing cheap labor to the formal capitalist is functional to the capitalistic sys-
tem. As Mkandawire (1985) explains, the informal sector facilitates the exploitation of the work-
ing class to weaken the bargaining position of formal workers thus forcing their wages down.
Tokman pointed out an additional cause through which the informal sector favors capitalist
accumulation compared to those originally assigned by the Marxian model to the army of labor
reserve. Indeed, the informal sector also subsidizes the consumption of urban workers by provid-
ing survivalist activities. Thereby the capitalistic (formal) sector can pay lower real wages and
lower taxes to sustain and reproduce the proletariat and, consequently, capitalists earn higher
profits.
Tokman (1978) concluded his analysis by proposing a framework that is not entirely different
from the two previous approaches but has common features with both of them. Tokman (1978)
labeled it as “heterogeneous subordination” because it is much closer to the “subordination” than
to the “benign” relationship approach. Specifically, it “implies a subordinated relationship for the
sector as a whole, but resulting from different processes occurring within it” (Tokman, 1978, p.1065).
This conceptual framework considers the “informal sector neither as a completely integrated nor
as an autonomous sector, but rather as one with significant links with the rest of the economy, while
simultaneously it also presents a considerable degree of self-containment” (Tokman, 1978, p.1071).
Chen et al. (2004) outline one of the most known classifications of the theoretical approaches
to IE. In this study, the authors delineate three fundamental schools: the dualist, the structuralist,
the legalist. Chen (2012) enriches this tripartition by two additional views (i.e., the voluntarist
and the holistic models). Consequently, according to Chen’s (2012) taxonomy, we distinguish five
theoretical views.
The Dualist school, which widespread in the 1970s mainly through ILO (1972) and Hart (1973). It
considers the informal sector as an autonomous segment of the economy characterized by provid-
ing employment, goods, and services for the lower-income groups of the urban population. This
school corresponds to Tokman’s (1978) “duality sub-approach” under the “benign” view. Accord-
ingly, informal activities are autonomous, economically efficient and have comparative advan-
tages to similar activities developed in the formal sector. According to the Dualists, the links
between informal enterprises and government regulations have minor relevance because infor-
mal and formal activities operate “as a distinct separate sector of the economy” (Chen, 2012, p.5).
The macroeconomic causal root of the informal sector depends on the difference between the
growth rate of labor demand for modern (formal) jobs and the urban workforce’s faster growth
rate – enhanced in developing countries by the growing population and urban migration. This
mismatch in the labor market is intensified by the discrepancy between the excess of low-skilled
urban unemployed and the demand for modern job opportunities.
The structuralist school was popularized by Moser (1978) and Castells and Portes (1989). Accord-
ing to this approach, informal activities are subordinated economic units (micro firms) and work-
ers that serve to reduce input and labor costs and, by doing so, they increase the competitiveness
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DELL’ANNO 1623

of large capitalist firms (Chen et al., 2004). For the structuralists, the informal sector is inextri-
cably connected and interdependent to formal economy. This school shares several aspects with
the “exploitative integration” within the “subordination approach” proposed by Tokman (1978).
Indeed, both the views see the informal sector as highly integrated into the formal economy and,
unlike the dualists, they argue that the persistence and the growth of the informal sector depend
on “the nature of capitalist development (rather than a lack of growth)” (Chen et al., 2004, p.17).
The Legalist school, inspired by de Soto’s (1989, 2000) analysis of Latin American countries, was
very influential in the economic debate on informality in the 1980s and 1990s. Consistent with
this view, informal activities are “‘plucky’ micro-entrepreneurs who choose to operate informally in
order to avoid the costs, time, and effort of formal registration” (Chen, 2012, p.5). Unlike the dualist
and the structuralist schools, the legalists argue that informal activities were neither a function
of poverty nor a structural necessity of late capitalism. Instead, informality is a choice made by
rational actors facing a legal environment that hampers business activity (Bonnet & Venkatesh,
2016). These activities circumvent the legal system because the formal institutional framework,
taxation, and administrative costs of the formal economy are counterproductive to the growth of
small and medium-sized enterprises. According to de Soto’s perspective, informal entrepreneurs
represent efficient market forces that emerge as a reaction to over-regulation and government
oppression (Biles, 2009). As stated by Chen (2012, p.5–6), in terms of policy implications, the legal-
ist school suggests simplifying “bureaucratic procedures to encourage informal enterprises to regis-
ter and extend legal property rights for the assets held by informal operators in order to unleash their
productive potential and convert their assets into real capital.”
Chen (2012) defines a fourth approach to the informal sector labeled as Voluntarist school. It
is based on Maloney’s (2004) analysis of informality in Latin American countries and focuses on
the intentional and rational choice of informal entrepreneurs to avoid regulations and taxation.
Unlike the “legalists,” the voluntarists do not consider the size of informality as predominantly
due to cumbersome registration procedures and as a “plucky” business activity. On the contrary,
this school argues that informal enterprises create unfair competition for more efficient formal
enterprises because informal firms can gain a price advantage by not paying taxes and not com-
plying with regulations. For Maloney (2004, p.1173) “the urban informal microenterprise should be
viewed as a part of a voluntary small firm sector similar to those in advanced countries that, due to
the laxity of enforcement of labor and other codes, is able to choose the optimal degree of participation
in formal institutions”. In terms of normative implications, Chen (2012, p.6) highlights that for the
voluntarists: “informal enterprises should be brought under the formal regulatory environment in
order to increase the tax base and reduce the unfair competition to formal businesses.”
Chen (2012) proposes a fifth category of theoretical approaches to informality: the Holistic Con-
ceptual Models. These models, which focus on the heterogeneous composition of the informal sec-
tor, consider various factors driving informality. Among these integrated approaches, the author
cites the “multi-segmented model of informal employment” developed by the Women in Informal
Employment: Globalizing and Organizing (WIEGO). The WIEGO approach renounces the ambi-
tious goal to outline a general theory of informality to define informality in terms of employment
status. In particular, this definition, based on two key dimensions, that is, the economic risk (of
losing a job) and the authority (over the establishment and other workers), is functional for policy
purposes (Chen, 2012). A second holistic model of informality is based on Perry et al. (2007). In
line with this view, informality may have different forms and causes. It may be seen as an “Exit”
option for formal activities (that is, a voluntary choice to work in the IE)23 and as a result of an
“Exclusion” from the formal sector, (i.e., the poorest and most marginalized people who do not
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1624 DELL’ANNO

have access to the formal sector need to work informally as a survival strategy for them and their
families).
La Porta and Shleifer (2008) belong to a growing literature (e.g., Williams and his co-authors,
Ulyssea, 2018, 2020) that aims to determine which theoretical approaches to informality are empir-
ically supported. In particular, La Porta and Shleifer (2008) consider three alternative views to
classify informal activities (specifically, they refer to informal firms) based on characteristics of
productive units and test, which of these views better explains informality in developing countries.
The Romantic view assumes that informal firms are “extremely productive but are held back
by government taxes and regulations, as well as by lack of secure property rights and access to
finance.” (La Porta & Shleifer, 2008, p.276). The key hypothesis of the “Romantics” is inspired by
de Soto (1989) because informal firms are considered similar in terms of efficiency to formal ones
but are kept down by invasive public policy.
The other two views are more skeptical about the potential efficiency of informal firms because
they are run by entrepreneurs with lower human capital.
The Parasite view considers IE as a collection of firms that need to stay small to avoid detec-
tion and therefore they lack the necessary scale to produce efficiently (Baily et al., 2005; Farrel,
2004). According to Farrel (2004, p.28) “the cost advantage that informal companies gain by avoid-
ing taxes and regulations more than offsets their low productivity and small scale.” Thus, informal
firm “hurts growth both because their small scale makes them unproductive and because they take
away market share from bigger, more productive formal competitors” (La Porta & Shleifer, 2008,
p.277). Consistent with the Parasite view, the voluntary “exit” choice to operate informally is a
source of a negative externality, therefore it should be tackled through better enforcement by the
policymaker.
The Dual view (or Wal-Mart theory) is intimately related to the “traditional” theories of develop-
ment economics, which see IE as a transitory phase of the transition, from the rural, preindustrial
to the urban and industrial (formal) economy (e.g., Lewis, 1954; Rosenstein-Rodan, 1943; Rostow,
1960; Murphy et al., 1989). La Porta and Shleifer (2008) highlight the differences between the Wal-
Mart theory and the previous approaches: “unlike the romantic view, the dual view predicts that
informal activities are very different from the formal ones in their characteristics not affected by gov-
ernment policies (p.277) [. . . ] Unlike the parasite view, the dual view does not see the unofficial firms
as threatening the official ones, because they are hugely inefficient and hence unlikely to be able to
charge lower prices for the same products (p.278).”
La Porta and Shleifer (2008) test which of these views better explains the informality in devel-
oping countries using data from the World Bank surveys of individual firms. According to their
evidence, informal firms are small, use less capital, and are extremely unproductive, compared
even to the small formal firms. This result is consistent with the Wal-Mart view. In terms of policy
implications, the authors conclude that “one should not expect much from the unofficial economy,
with its millions of entrepreneurs, except to hope that it disappears over time” (La Porta & Shleifer,
2008, p.347). In other words, by revitalizing the basic idea of “Modernization” theories, they sus-
tain that the reduction of informality should only rely on “the hope of economic development lies
in the creation of large registered firms, run by educated managers and utilizing modern practices,
including modern technology, marketing, and finance.” (La Porta & Shleifer, 2008, p.279–280).
Ulyssea (2018) provides a unified theoretical framework to show, as La Porta and Shleifer’s
(2008) views are not alternative perspectives but coexist in IE because they reflect the heterogene-
ity in the firms’ productivity. Using the Brazilian IE as a case study, he finds that the Romantic view
explains 16.8% of all informal firms, Parasite firms correspond to 38.7%, and the remaining infor-
mal firms, too unproductive to ever become formal and are only able to survive in the informal
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DELL’ANNO 1625

sector – that is, Dual economy view, represent the majority of informal firms (44.5%). Although
Ulyssea’s empirical evidence is consistent with La Porta and Shleifer’s (2008) result that informal
firms are extremely unproductive, compared even to the small formal firms, the studies diverge
from a normative viewpoint. For La Porta and Shleifer (2008, p.279), the differences in productiv-
ity between formal and informal firms are so wide “that it is hard to believe that simply registering
unregistered firms would eliminate the gap” as well as “. . . stronger enforcement would devastate
the livelihood of millions of people surviving near subsistence.” According to the authors, informal
firms will die as the economy develops and “the formal firms created will be new firms run by new
people, not previously informal firms” (p.278). On the contrary, Ulyssea (2018, p.2045) considers
a transition to formality as possible, indeed “informality reductions can be but are not necessarily
associated to higher GDP, TFP, or welfare.”
Williams and his co-authors have proposed three comparable classifications of the conceptual
approaches to informality. Williams (2008) advised a categorization that, in the wake of Tok-
man (1978) and Chen et al. (2004), focused on the relationship between informal24 and formal
economy.25 Williams and Nadin (2011), Williams (2015), and Williams and Kedir (2018) reformu-
lated Williams’s (2008) classification by using different labels for (seemingly) similar theoretical
approaches. In the following, I match these taxonomies for the sake of brevity, in order to outline
four conceptual approaches.
The Modernization theory takes its name from traditional theories of economic development
(e.g., Geertz, 1963; Lewis, 1954; Rostow, 1960). In this view, the IE is a product of economic under-
development and, due to its transient nature, it is destined to disappear with economic growth.
The Modernization theory corresponds to the category of informality as “a residue” in Williams
(2008) and, in general, it is inspired by Tokman’s (1978) “duality sub-approach.”
The Structuralist theory26 (e.g., Castells & Portes, 1989; Davis, 2006; Portes, 1994) considers IE
as a “direct by-product of the advent of a deregulated open world economy” (Williams, 2015, p.336).
Williams and Kedir (2018, p.158) point out as informal firms are “the outcome of too little state inter-
vention in not only the economy but also social protection and social transfer systems.” Consistent
with this theory, the global economic system exploits informal workers, who are excluded from
formal jobs and welfare support and work informally as a last resort. In terms of policy impli-
cations, Williams and Kedir (2018), following Davis (2006), state that, for the structuralists, the
lack of state intervention to protect workers and citizens may explain cross-country variations in
informality.
The Neoliberal theory27 (inspired by de Soto, 1989, 2000) hypothesizes that the IE is “a populist
reaction to high taxes, a corrupt state system and too much interference in the free market, result-
ing in workers making a rational economic decision to voluntarily exit the formal economy in
order to avoid the costs, time, and effort of formal registration” (Williams, 2015, p.336). According
to this perspective, the policies to reduce informality are in contrast with the structuralists’ recom-
mendations. Specifically, for the supporters of the “neoliberal theory,” the best policies to reduce
informality consist in lowering taxes, promoting deregulation, and minimal state intervention.
The Post-structuralist approach includes different hypotheses that share a common critical posi-
tion on both the structuralist and neoliberal explanations. The post-structuralists argue that IE is
not (only) a rational choice of economic actors influenced by the cost/benefit ratios (i.e., neoliberal
theory) or an exploitative global economic system (i.e., structuralist theory), rather, it is a volun-
tary choice made by marginalized people. This “exit” option can be due to social relations, redis-
tributive reasons, or resistance practice to the exploitation of workers as well as identity reasons.28
Among the post-structuralists, Biles (2009, p.232), includes Whitson (2007) who shows as “infor-
mality not only served as a simple livelihood strategy; many men and women employed informality
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1626 DELL’ANNO

as a form of resistance in response to the exploitation of workers within Argentina’s neoliberalized

economic system”.
Williams and Kedir (2018) propose an Institutional approach, which replaces Williams
and Nadin’s (2011) Post-structuralist approach. As the Post-structuralist view, the Institutional
approach, despite including heterogeneous hypotheses on the causes of informality, shares the
disagreement with the neoliberal and structuralist views. For the institutionalists, IE is a conse-
quence of the discrepancy between formal and informal institutions (e.g., Feige, 1997; Godfrey,
2015; Webb et al., 2014; Williams et al., 2015). The basic idea of the institutionalists is inspired
by Feige’s (1997, p.22) conclusion that “when formal and informal institutions clash, noncompliant
behaviors proliferate, forming various underground economies.” As Williams and Kedir (2018) point
out, informal activities sit outside the formal framework, because they distrust formal institutions,
but within the norms, values, and beliefs of informal institutions. Consequently, “the greater the
incongruence between formal and informal institutions, the greater is the likelihood of businesses
being unregistered” (Williams & Kedir, 2018, p.158).
Williams and Kedir (2018) test the relevance of these approaches to explain cross-country varia-
tions in the level of nonregistration at start-up in 142 countries. They conclude that Modernization,
Political economy, and Institutional approaches may explain differences in informality but not the
Neoliberal theory.
Another strand of literature classifies the informality conceptual frameworks by focusing on
the drivers of the decision to participate in the IE (e.g., Perry et al., 2007). One of the most influen-
tial documents in terms of normative implications, ILO’s (2015b) guide on national employment
policies, follows this approach. It provides the theoretical ground for policy recommendations and
describes four main theoretical approaches to informality.
The first view sees informality as “exclusion.” According to this perspective “informal workers
and firms would like to operate in the formal economy, they do not have the opportunity to do so
and stay in the IE to make a living” (ILO, 2015b, p.7). For the supporters of the “exclusion” view,
IE originates from a lack of demand in the formal labor markets and it increases with poverty,
lack of education, and gender-based constraints.
As opposed to the exclusion view, informality may be seen as a voluntary choice to “exit” from
the legal framework. The exit option is based on a rational choice: workers weigh the benefits
of working formally against those of working informally, selecting the form of employment with
the greatest net benefits (e.g., Maloney, 2004). Following Loayza and Rigolini (2011), the choice to
operate in the IE is determined by the opportunity costs of formality (in terms of regulatory and tax
burden, quality of public services) and the distribution of the workers’ skills. From a normative
viewpoint, under the theoretical umbrella of the “exit” option, there are both scholars who see
informal firms as “parasitic”29 – calling for strict enforcement of regulation – and researchers
who consider IE “as a way to avoid high entry costs, suggesting that strict enforcement may hold
back a dynamic part of the economy”30 (ILO, 2015b, p.7).
A third view sees informality as “driven by market competition.” Consistently with this perspec-
tive, the main determinant of informality is the need to lower labor costs and protect profitability
in a competitive global economy as supposed by Castells and Portes (1989). Unlike the “exclusion”
standpoint, the market view hypothesizes that IE is due to an existent demand for informal labor
rather than a lack of demand in the formal labor market. The key hypothesis of this approach
largely agrees with the Structuralist view (Chen, 2012) or the Political economy theory (Williams,
2015).
ILO (2015b) defines a fourth view of the IE, the “Two-tiered” approach to informality (Fields,
1990; Perry et al., 2007). In line with Chen’s (2012) Holistic approach or Williams and Nadin’s
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DELL’ANNO 1627

(2011) Post-structuralist approach, this perspective is an attempt to gather the “exclusion” and vol-
untary “exit” views into a single approach. Fields (1990) underlined as two qualitatively distinctive
branches co-exist in the informal labor market economy: a lower-tier, characterized by easy entry
and low-wage unorganized and unprotected work (i.e., the marginal activities due to “exclusion”);
and an upper-tier of the labor market, with restricted entry to self-employment activities, where
we find people who voluntarily choose to exit from the formal economy. These two segments of
the labor market differ in terms of rationales. On the one hand, people in lower-tier activities
seek to get out of them, aspiring to engage in the upper-tier segment of the self-employed. On
the other hand, the upper-tier segment of the IE is largely related to tax and regulatory evasion
and, as Field (1990, p.65) remarks, “given the constrained choices available to them, a great many of
informal sector workers are in that sector voluntarily.”
Several empirical analyses test the prevalence of “exclusion” or “exit” choice in informality
across countries (e.g., Gërxhani, 2004b; Maloney, 2004; Oviedo et al., 2009). They find that the
“exclusion” hypothesis is more relevant in developing countries while the “exit” in developed
economies. Perry et al. (2007) affirm that the “exclusion” and “exit” hypotheses coexist in the econ-
omy, but the former is more applicable to waged informal employment, while the “exit” option
more accurately characterizes own-account informal workers (i.e., self-employed with no employ-
ees). Chen (2012, p.11) concludes her overview of the theoretical approaches to IE, pointing out
that “most causal theories are valid – but only for certain segments of informal employment; and
no single causal theory can explain each segment of informal employment.” Similarly, Williams
(2008) concluded his review of the literature with two main deductions: “there is no one universal
relationship between formal and informal work but instead, many different relationships existing in
various parts of the picture” (p.117); “we cannot simplistically attribute one form of work with posi-
tive attributes [i.e., formal] and the other [i.e., informal] with negative attributes, and nor can one
treat them as discrete and separate forms of work.” (p.119). Williams et al. (2015, p.297), rather than
describing informal workers “as either universally exit- or exclusion-driven, as is the case in these
two conventional approaches, a second wave of thought has adopted a more nuanced understanding.
This evaluates the ratio of exit-driven to exclusion-driven informal workers.”
To conclude this review, at the state of art, there is not a universally applicable theory of the
IE. We have several, but not mutually exclusive explanations with diverse causal hypotheses. In
terms of normative implications, it implies that effective policies have to be tailored to the country-
specific composition and nature of the IE.

3.3.1 A conceptual framework of the “schools of thought” on the IE

This section aims to contribute to the literature by outlining a conceptual framework able to
encapsulate into six approaches the main features of the schools of thought on the IE exposed
in Section 3.3.31 Tables 3 and 4 reports the differences among these approaches according to eight
dimensions: the key idea of the theory (“General view”); the main characteristics of informal activ-
ities (“Types of activities”); the principal rationales to operate informally (“Causal roots”) and the
forced or voluntary nature of choice (“Nature of choice”); the “Policy implications”; and what the
theory hypothesizes (if it does) on the relationship between formal and informal economies (“link
to the formal economy”)32 ; in what type of countries the approach is mostly used (“Prevalent in”);
the authors who have developed the theoretical approach (“Proposer(s) of the theory”).
In our view, although this synopsis omits some details of the original classifications, it provides
a unified conceptual framework useful to move among different scholars’ classifications. The last
 TA B L E 3 Conceptual framework of the “Modernization”, “Dualist” and “Structuralist“ approaches on the informal economy (IE)
1628

Modernization Dualist Structuralist

General view The informal sector is seen as a stage The informal sector is a premodern, distinct The IE is a structural feature of
of the evolutionary process of the and persistent sector acting as an modern capitalist development.
market economy. The informal intermediate space between the Capitalist firms attempting, acting
activities will disappear as a result of mainstream (modern) formal system and with the complicity of the state, to
economic progress in developing complete unemployment. reduce wages, labor safety standards
countries. and enhance flexibility by exploiting
unprotected informal workers.
Types of Workers with lower human capital Survivalist activities by the working poor Vulnerable workers, such as women,
activities work in informal and smaller firms with few (if any) links with the formal youth, immigrants, and unskilled
and receive lower wages, whereas economy. are exploited by formal firms.
those with higher human capital are
allocated to the larger and more
productive firms and receive higher
wages.
Causal roots The informal sector is due to the excess Informal workers are excluded from modern The IE is a side-effect of capital
of labor supply (unskilled rural economic opportunities. The informality accumulation and globalization.
migrants). These “excluded” is due to the mismatch between people’s It is not a stage in the transition
informal workers will find a job in skills and the structure of modern from a traditional to modern society.
the formal economy with the economic opportunities (Chen, 2012). It does not depend on the inability of
modernization of the economy. Especially in developing countries, the formal economy to absorb
informality is enlarged by imbalances workers, or on some voluntary
between the growth rates of the urban decision of self-employed.
population and formal labor demand.
Nature of Exclusion-driven Exclusion-driven Exclusion-driven
choice
Policy Depending on the specific theories of More job opportunities, better credit and More regulation of commercial and
implications economic development. In general, business development services to informal employment relationships between
it is sufficient to develop the formal operators, enhanced infrastructure and the informal and formal economies
economy (e.g., by a “Big push,” social services to families of informal in order to address unequal
higher capital accumulation and workers. relationships between “big business”
saving rates, more international and subordinate producers.
trade, etc.)
DELL’ANNO

(Continues)

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 DELL’ANNO

TA B L E 3 (Continued)
Modernization Dualist Structuralist
Link to the Counter-cyclical relationship. Undetermined.According to Hart (1973: 87) Pro-cyclical relationship.
formal The informal sector declines with “the possibility that the informal economy Informal and formal modes of
economy the growth of the formal sector. [. . . ] may be developing at a rate faster than production are inextricably linked
Informal workers will be absorbed other sectors of the national economy, [. . . ] within the same economic system
by the formal economy with cannot be dismissed on a priori ground.” (Chen et al., 2004).
economic development.
Prevalent in Developing countries Developing countries Developed countries
Proposer(s) of Lewis (1954), Rostow (1960), Harris Hart (1973), ILO (1972). Moser (1978), Castells and Portes
the theory and Todaro (1970), Rauch (1991). (1989), Portes (1994), Thomas (1995).
Different Subordination due to marginalization Duality-benign (Tokman, 1978), dualist Subordination due to exploitation
labels used (Tokman, 1978), dual view (La Porta (Chen, 2012), complement (Williams, (Tokman, 1978), by-product
for & Schleifer, 2008), 2008), exclusion (ILO, 2015b), (Williams, 2008), political economy
comparable residual (Williams, 2008), exclusion alternative-neoliberal (Williams, 2008). (Williams & Kedir, 2018), driven by
theoretical (ILO, 2015b). market competition (ILO, 2015b).
view
1629

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 1630

TA B L E 4 Conceptual framework of the “Neoliberal”, “Free-Riding” and “Two-tiered” approaches on the informal economy (IE)
Neoliberal Free-riding Two-tiered approach
General view The IE is a market-led response The IE is a result of firms and workers who choose to Different factors drive different segments of the IE, that
by entrepreneurs to excessive operate informally after weighing the costs and is, exclusion of firms and people from state benefits
state regulation (as opposed to benefits of informality versus formality. or to voluntary exit decisions resulting from private
a temporary condition of cost-benefit calculations.
excess labor supply).
Types of “Plucky” micro-entrepreneurial Opportunistic informal firms who choose to operate High level of heterogeneity in terms of rationales and
activities activity. Informal firms are informally are constrained to operate below a certain demographic characteristics between informal
innovators and rational actors. detection threshold, therefore, lack the necessary salaried and self-employed.
They are similar to official scale to produce efficiently. According to Levenson
ones but are kept down by and Maloney (1998), informal firms in developing
excessive taxes and countries behave similarly to those in industrialized
regulations. countries.
Causal roots Informal entrepreneurs represent The rational choice to operate informally depends on Two main groups of informal workers with different
efficient market forces that lack of enforcement, negligible economies of scale, motivations (on average):informal self-employed
emerge as a populist reaction and benefits associated with formality. opt-out of formality after implicitly making a
to over-regulation and According to Farrell (2004: 28) “substantial cost cost–benefit analysis. They choose their occupations
government oppression advantage that informal companies gain by avoiding according to their individual needs (especially their
(Williams, 2015). taxes and regulations more than offsets their low desire for flexibility and autonomy) and
productivity and small scale.” abilities.Informal salaried workers are not choosing
to opt-out of the formal economy. For them, exclusion
rather than exit from formality appears to be the
driving force behind their present informal status.
(Continues)
DELL’ANNO

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 TA B L E 4 (Continued)
Neoliberal Free-riding Two-tiered approach
Nature of Exit-driven due to excessive state Exit-driven due to opportunistic behavior Exclusion-driven and exit-driven
DELL’ANNO

choice regulation
Policy Less state regulation and more Access to mechanisms that ensure property rights. No “one-size-fits-all” solution.
implications free-market policies can To improve law enforcement because it increases the The policies should be tailored to the diverse
enable/unlock the growth benefits of formality. characteristics, circumstances, and needs of the
potential of informal To increase enforcement of government regulations workers and economic units concerned. Perry et al.
entrepreneurs (particularly and taxation because it raises the costs of informality. (2017) suggest actions to: increase the aggregate
through the legalization of Bringing informal activities into the formal productivity in the economy; raise human capital
informal property rights). regulatory environment increases the tax base and levels (especially for the poor); reduce the costs and
reduces unfair competition to formal businesses. increase the benefits of formalization; enhanced
enforcement of laws and regulations; improve the
quality and fairness of state institutions and policies.
Link to the In the short run, the IE consists In the short run, the IE consists of firms “exit” from the Undetermined.It depends on the composition of the IE
formal of firms “exit” from the formal formal economy (i.e., negative correlation). (e.g., the relative size of informal salaried workers
economy economy (i.e., negative In the long run, this negative effect is reinforced and self-employed).
correlation). because informal activities are detrimental to the
In the long run, it may have a overall economic growth because this unfair
positive effect if the state competition reduces market efficiency.
reduces overburden to
promote formalization.
Prevalent in Developed countries Developed countries Coexist with different intensity in developing and
developed countries.
Proposer(s) of de Soto (1989). Levenson and Maloney (1998), Maloney (2004), Farrell Fields (1990), Feige (1997), Jacob (2003),
the theory (2004), Baily et al. (2005). Perry et al. (2007).
Different Complementarity-Benigna Voluntarist (Chen, 2012), Parasite (La Porta and Heterogeneous subordination (Tokman, 1978); Holistic,
labels used (Tokman, 1978), Legalist Schleifer, 2008), Exit (ILO, 2015b). Multi-segmented, Exit-Exclusion (Chen, 2012);
for (Chen, 2012), Romantic (La Post-structuralist (Williams & Nadir, 2011);
comparable Porta & Schleifer, 2008), Exit Institutional (Williams & Kedir, 2018); Two-tiered
theoretical (ILO, 2015b). informality (ILO, 2015b).
view
a
Note: The inclusion of Tokman’s (1978) “complementarity sub-approach” together with the “neoliberal” view inspired by de Soto (1989), is not consistent with the authentic authors’ views.
Indeed, if for both Tokman (1978) and de Soto (1989), informality may be seen as beneficial for overall economic development and (at least, in the long-run) as complementary phenomena, the
1631

rationales behind their hypotheses are different.

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1632 DELL’ANNO

row of Tables 3 and 4 (“Different labels used for (comparable) theoretical view”) assists the reader to
match the different labels used in the literature (e.g., in Section 3.3) to the six proposed theoretical
approaches.
In the last column of Table 4 – labeled as “Two-tiered approach to informality” following ILO
(2015b) – I include all those theories33 that, despite having different (sometimes contrasting)
hypotheses on the nature and causes of IE, they share the same key idea: informal activities are
so heterogeneous in motivations, characteristics, and relationship to the formal economy that
a one-dimensional explanation of this phenomenon is an unsuitable approach. This theoretical
approach, inspired by Fields (1990) and Perry et al. (2007), is the most utilized conceptual model
for policy purposes due to its flexibility and comprehensiveness.34

4 A THEORETICAL FRAMEWORK OF INDIVIDUAL CHOICE TO

OPERATE INFORMALLY

In this section, I propose a theoretical framework of individual choice to operate informally by

combining the three main approaches of informality. Following the “neoclassical approach,” I
define an analytical framework where the IE emerges as a voluntary choice of rational agents
who maximize their welfare (utility or profit) function. According to the “macro-econometric
approach,” I consider a broad set of institutional and socio-economic variables to outline the
costs and benefits of the status of informal, formal, or a not-productive unit. Although the model
assumes a voluntary choice, following some of the theories of the informal sectors surveyed in
Section 3.3 (e.g., “Modernization,” “Dualist,” “Structuralist”), the proposed theoretical frame-
work does not exclude that the participation in the IE may be driven by necessity (e.g., lack
of employment opportunities in the formal economy, insufficient public subsidies for poor and
unemployed).
The agent’s decision rule includes the variables that, according to the literature, may affect
his/her welfare function in three alternative productive status: formal, informal, and nonproduc-
tive activity.
The proposed framework aims to be sufficiently flexible to account for a decision to operate
informally both as a result of a “voluntary choice” of opportunistic firms/workers aiming to escape
from taxation and regulatory burden, and a “forced option” for poor and marginalized people
living in a deprived socio-economic context.
In general, I assume that a productive unit chooses to operate out of formal arrangements if
his/her welfare the (profit/utility) function is associated with a net benefit of being a formal opera-
tor ( 𝑊𝑖𝐹 = 𝐵𝑖𝐹 − 𝐶𝑖𝐹 ) exceeding (or equalizing to) the expected net benefit of being both informal (
𝑊𝑖𝐼𝐹 = 𝐵𝑖𝐼𝐹 − 𝐶𝑖𝐼𝐹 ) and unemployed or inactive ( 𝑊𝑖𝑈𝐼 = 𝐵𝑖𝑈𝐼 − 𝐶𝑖𝑈𝐼 ). Welfare functions linked to
these three statuses depend on a combination of demographic, institutional, and socio-economic
factors.
The proposed model follows the “Two-tiered approach” to the IE as inspired by Fields (1990) and
Perry et al. (2007) by assuming that IE depends on multiple causes and it involves heterogeneous
agents in terms of characteristics and needs. In analytical terms, the decision rule consists in
maximizing the welfare function of ith economic unit in three possible status: formal, informal,
 14676419, 2022, 5, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/joes.12487 by Anna University, Wiley Online Library on [30/01/2025]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
DELL’ANNO 1633

and unemployed-inactive.35

𝑊𝑒𝑙𝑓𝑎𝑟𝑒 𝑓𝑢𝑛𝑐𝑡𝑖𝑜𝑛 𝑖𝑛 𝑡ℎ𝑒 𝐹𝑜𝑟𝑚𝑎𝑙 𝐸𝑐𝑜𝑛𝑜𝑚𝑦

≥
𝑊𝑖𝐹 (𝐵𝑖𝐹 [𝑌𝑖𝐹 [𝑆𝑘𝑖 ,𝐷𝑐 ],𝑆𝑜𝑐𝐼𝑛𝑠𝑐 ,𝐿𝑒𝑔𝑃𝑐 ,𝐹𝑚𝑐 ,𝐴𝑐𝑐𝑆𝑘𝑖 ]−𝐶𝑖𝐹 [𝑇𝑎𝑥𝐵𝑐 ,𝑅𝑒𝑔𝐵𝑐 ])
𝑊𝑖𝐼𝐹 (𝐵𝑖𝐼𝐹 [𝑌𝑖𝐼𝐹 [𝑆𝑘𝑖 , 𝐷𝑐 ],𝑆𝑜𝑐𝐴𝑠𝑠𝑐 ,(1−𝑝)(𝐶𝑖𝐹 ),𝐴𝑐𝑐𝑆𝑘𝑖 ]−𝐶𝑖𝐼𝐹 [𝐿𝑒𝑔𝑃𝑐 ,𝐹𝑚𝑐 ,𝑝(𝑆𝑎𝑛𝑐𝑡𝑐 ), 𝑅𝑒𝑝𝐶𝑐 ])
≥ (1)
𝑤𝑒𝑙𝑓𝑎𝑟𝑒 𝑓𝑢𝑛𝑐𝑡𝑖𝑜𝑛 𝑖𝑛 𝑡ℎ𝑒 𝐼𝑛𝑓𝑜𝑟𝑚𝑎𝑙 𝐸𝑐𝑜𝑛𝑜𝑚𝑦
𝑊𝑖𝑈𝐼 (𝐵𝑖𝑈𝐼 [𝑆𝑜𝑐𝐴𝑠𝑠𝑐 ,𝐿𝑒𝑖𝑠𝑢𝑟𝑒𝑇𝑖 ]−𝐶𝑖𝑈𝐼 [𝛼(𝑅𝑒𝑝𝐶𝑐 )])
𝑤𝑒𝑙𝑓𝑎𝑟𝑒 𝑓𝑢𝑛𝑐𝑡𝑖𝑜𝑛 𝑓𝑜𝑟 𝑢𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑 𝑜𝑟 𝑖𝑛𝑎𝑐𝑡𝑖𝑣𝑒 𝑝𝑒𝑜𝑝𝑙𝑒

Specifically, as the formal operator concerns, agent ith receives the following “benefits” (𝐵𝑖𝐹 ):
𝑌𝑖𝐹 earnings of productive activity. These profits/wages depend on both individual (e.g., skills,
education, socio-demographic) characteristics of enterprise/worker (𝑆𝑘𝑖 ) with 𝜕𝑌𝑖𝐹 ∕𝜕𝑆𝑘𝑖 > 0 and
macroeconomic factors related to aggregate demand of formal economy in country cth (𝐷𝑐 –
e.g., due to business cycle fluctuations, labor market, agent’s socio-economic context36 – with
𝜕𝑌𝑖𝐹 ∕𝜕𝐷𝑐 > 0. Benefits in formal economy also come from the access to public services acces-
sible only to formal activities such as: the social welfare system (𝑆𝑜𝑐𝐼𝑛𝑠𝑐 ), for example, social
protection schemes based on employment-related benefits, membership with trade union associ-
ations, access to better health insurance; the judiciary system for legal protection and enforceable
commercial contracts (𝐿𝑒𝑔𝑃𝑐 ); the financial system and public subsidies for business investment
(𝐹𝑚𝑐 ). Moreover, work experiences in the formal economy increase human capital and people’s
skills that, in turn, positively affect the long-run profitability and employability of the economic
units (𝐴𝑐𝑐𝑆𝑘𝑖 ).
The main costs to operate formally (𝐶𝑖𝐹 ) consist of tax and social security burden (𝑇𝑎𝑥𝐵𝑐 ) and
administrative costs to comply with regulations (𝑅𝑒𝑔𝐵𝑐 ).
As the welfare function of informal operator concerns, the benefits of being informal con-
sist of earnings/profits for units operating in the IE (𝑌𝑖𝐼𝐹 ). Alike formal units, these earnings
depend on both individual characteristics of productive units (𝜕𝑌𝑖𝐼𝐹 ∕𝜕𝑆𝑘𝑖 > 0) and aggregate
demand (e.g., employment or business opportunities within the (formal and informal) econ-
omy 𝜕𝑌𝑖𝐼𝐹 ∕𝜕𝐷𝑐 ⋚ 0).37 A second benefit of being informal, with respect to the formal activity,
is that informal units may also illegitimately benefit from cash transfers, in-kind provisions, sub-
sidies, (non-contributory) pensions, and public works programs. Accordingly, the more generous
are social assistance programs (𝑆𝑜𝑐𝐴𝑠𝑠𝑐 ) targeted to unemployment status or poverty based on
declared income, the strongest is the incentive to remain informal, other things being equal. A
third benefit of being informal is that these units may produce goods or services more cheaply
than their (formal) competitors by evading taxes, social contributions (−𝑇𝑎𝑥𝐵𝑐 ) and administra-
tive costs to comply with regulations (−𝑅𝑒𝑔𝐵𝑐 ). However, this competitive advantage is uncertain
because it depends on the probability of being detected (p), that is, they have to pay evaded taxes
and contributions to regularize their status. Consequently, informal competitors enjoy relative
cost advantages that allow them to undervalue their products provided that they are not discov-
ered, that is, (1 − 𝑝)(𝐶𝑖𝐹 ). A fourth benefit of being informal is that, likewise formal units, also
informal activities contribute to improving job opportunities and business prospects by increas-
ing know-how and building business networks of economic units (𝐴𝑐𝑐𝑆𝑘𝑖 ).
I outline three main types of costs to being informal (𝐶𝑖𝐼𝐹 ): the (opportunity) costs related to
the constraints to access to public services for individuals and firms operating in the IE. These
costs are proportional to the quality and quantity of public services and constitute competitive
disadvantages with respect to formal productive units 𝐶𝑖𝐼𝐹 = 𝐵𝑖𝐹 (𝐿𝑒𝑔𝑃𝑐 , 𝐹𝑚𝑐 ) (i.e., these costs
increase as better the judiciary system for legal protection and enforceable commercial contracts
and financial system and public subsidies for business investment are). A second (expected) mon-
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1634 DELL’ANNO

etary cost of being informal is that if these activities are detected by the enforcement system, they
have to pay administrative sanctions, that is, 𝐶𝑖𝐼𝐹 = 𝑓(𝑝(𝑆𝑎𝑛𝑐𝑡𝑐 )). As the third cost of informal
status concerns, I include psychic and reputational costs (𝑅𝑒𝑝𝐶𝑐 ) usually associated with deviant
behavior. In particular, I assume that (nonpecuniary) reputational costs depend on socio-cultural
factors of people’s (e.g., gender, age, social status) or enterprise’s (e.g., size and type of business
activity) context.
This theoretical framework includes a third possibility for the economic agent, he/she may
voluntarily choose not to operate either in the formal or IE, that is, being inactive or unemployed.
In this case, the agent’s welfare function 𝑊𝑖𝑈𝐼 depends on the generosity of the social assistance
programs and free time from child care and housework 𝐵𝑖𝑈𝐼 [𝑆𝑜𝑐𝐴𝑠𝑠𝑐 , 𝐿𝑒𝑖𝑠𝑢𝑟𝑒𝑇𝑖 ]. An additional
factor that may assume both positive (i.e., included in the 𝐵𝑖𝑈𝐼 ) and negative effects (i.e., 𝐶𝑖𝑈𝐼 )
on the agent’s welfare is the social evaluation (𝛼) of being inactive or unemployed. In particular,
by using reputational costs (𝑅𝑒𝑝𝐶𝑐 ) of informal status as a benchmark, I define this factor as
𝛼(𝑅𝑒𝑝𝐶𝑐 ). According to this parametrization, this component represents a cost for being inactive,
as in [1], if 𝛼 ≥ 038 while it increases the welfare if 𝛼 < 0.39
Consistent with this theoretical framework, also the decision to work informally as a survival
strategy is a “voluntary” rational choice. Indeed, let us assume that; (a) there are no chances to
operate formally because of barriers of entry (e.g., due to financial constraints, the status of an
illegal immigrant, minor) or a lack of capacity of the labor market to absorb the labor force, (i.e.,
𝑊𝑖𝐹 = 0)40 ; (b) informal workers receive the social subsidy targeted to (formal) unemployed and
inactive people (i.e., 𝐵𝑖𝐼𝐹 [𝑆𝑜𝑐𝐴𝑠𝑠𝑐 ] = 𝐵𝑖𝑈𝐼 [𝑆𝑜𝑐𝐴𝑠𝑠𝑐 ]). As a result, any economic agent rationally
accepts to operate informally if being informal has larger benefits than being (formally) unem-
ployed or inactive people. In analytic terms, the decision rule to operate informally becomes:
[ ( ) ]
𝑌𝑖𝐼𝐹 [𝑆𝑘𝑖 , 𝐷𝑐 ] + 𝐵𝑖𝐼𝐹 𝐴𝑐𝑐𝑆𝑘𝑖 , (1 − 𝑝) 𝐶𝑖𝐹 , > 𝐶𝑖𝐼𝐹 [𝐿𝑒𝑔𝑃𝑐 , 𝐹𝑚𝑐 , 𝑝 (𝑆𝑎𝑛𝑐𝑡𝑐 ) , (𝛼 − 1) 𝑅𝑒𝑝𝐶𝑐 ]
(2)
This theoretical framework explains the larger size of the IE in developing countries compared
to developed economies by combining individual and macroeconomic causes.
As unemployed and inactive people concern, in developing countries, we usually observe: (a)
negligible social assistance programs due to lack of public resources (𝑆𝑜𝑐𝐴𝑠𝑠𝑐 ≈ 0); (b) insignifi-
cant psychic, moral, and social stigma costs (𝑅𝑒𝑝𝐶𝑐 ≈ 0). Indeed, in these countries, people tend
to justify their participation in the IE by a lack of choice (e.g., Pardo, 1995; Gërxhani, 2004b). In
conclusion, in developing countries, the benefits for nonproductive units only consists of their
leisure time: 𝑊𝑖𝑈𝐼 = 𝐵𝑖𝑈𝐼 [𝐿𝑒𝑖𝑠𝑢𝑟𝑒𝑇𝑖 ].
As informal units concern, developing countries provide: (a) low-quality social protection
schemes based on employment-related benefits, judiciary, financial systems, and public subsi-
dies for (formal) business investment (i.e., 𝐵𝑖𝐹 [𝑆𝑜𝑐𝐼𝑛𝑠𝑐 ≈ 0; 𝐿𝑒𝑔𝑃𝑐 ≈ 0, 𝐹𝑚𝑐 ≈ 0]); (b) the sur-
vival nature of informality leads to “legitimize” deviant behavior from a social perspective (i.e.,
𝑅𝑒𝑝𝐶𝑐 ≈ 0); (c) ineffective enforcement policies to fight these activities by sanctions (e.g., because
informal operators do not have sufficient economic resources to pay them or alternative source
of income to survive (i.e., 𝑝(𝑆𝑎𝑛𝑐𝑡𝑐 ) ≈ 0); (d) negligible social assistance programs due to lack of
public resources (𝑆𝑜𝑐𝐴𝑠𝑠𝑐 ≈ 0). According to this scenario, the choice among formal, informal, or
unemployed-inactive status in a developing country may be represented by
( [ ] ) ( [ ])
𝑊𝑖𝐹 𝐵𝑖𝐹 𝑌𝑖𝐹 − 𝐶𝑖𝐹 [𝑇𝑎𝑥𝐵𝑐 , 𝑅𝑒𝑔𝐵𝑐 ] ≥ 𝑊𝑖𝐼𝐹 𝐵𝑖𝐼𝐹 𝑌𝑖𝐼𝐹 ≥ 𝑊𝑖𝑈𝐼 (𝐿𝑒𝑖𝑠𝑢𝑟𝑒𝑇𝑐 ) (3)
 14676419, 2022, 5, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/joes.12487 by Anna University, Wiley Online Library on [30/01/2025]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
DELL’ANNO 1635

This decision rule may be furtherly simplified in developing countries by considering two addi-
tional reasonable assumptions: (e) leisure time is a normal good – that is, the demand for it
increases as income increases, therefore if you are “poor,” being inactive or unemployed is a forced
status (i.e., 𝑈𝑖𝑈𝐼 (𝐿𝑒𝑖𝑠𝑢𝑟𝑒𝑇𝑖 ) ≈ 0); (f) markets are competitive therefore earnings (𝑌𝑖 ) only depend
on units’ productivities, then agent’s choice to operate formally can be further simplified as

Δ𝑌𝑖𝐹−𝐼𝐹 ≥ 𝐶𝑖𝐹 [𝑇𝑎𝑥𝐵𝑐 , 𝑅𝑒𝑔𝐵𝑐 ] (4)

Where Δ𝑌𝑖𝐹−𝐼𝐹 = (𝑌𝑖𝐹 − 𝑌𝑖𝐼𝐹 ) indicates the gap between formal and informal earnings.
Equation (4) allows to explain the (apparent) paradox of the “Neoliberal theory” for large size
of informality in countries with limited taxation and regulatory burden (i.e., 𝐶𝑖𝐹 [𝑇𝑎𝑥𝐵𝑐 , 𝑅𝑒𝑔𝐵𝑐 ] →
0+ ). Specifically, the decision rule (Equation (4)) typically does not hold (i.e., unit opts to operate
informally) because for the predominant sectors in developing economies (e.g., agriculture, retail,
construction, and services) the difference in productivity between informal and formal firms is
negligible due to the low optimal level of organization and limited physical capital (i.e., their
remunerations are comparable Δ𝑌𝑖𝐹−𝐼𝐹 ≈ 0).41
In conclusion, the proposed theoretical model, following the neoclassical approach, proposes
a simplified analytical framework that deals with the issue of informality as a consequence of
rational choices for welfare-maximizing agents. In line with the macro-econometric approach, it
takes into account several institutional, social, cultural, macroeconomic factors as well as indi-
vidual characteristics of (potentially) productive units. According to the “Two-tiered approach” to
informality, it aims to be sufficiently flexible to be applied for policy purposes in both developing
and developed economies.

5 CONCLUSION

This article surveys the main definitional and theoretical approaches to informality proposed in
the literature. At the state of art, we do not have a definition for “IE” that meets with both sta-
tistical standards of consistency, measurability, harmonization, and economic requirements to
outline a meaningful concept of informality suitable for positive and normative economic anal-
yses. Following Dell’Anno (2007), we can amend the ISTAT analytical framework of the NOE to
obtain a definition for the IE consistent with both statistical and economic purposes. This def-
inition includes two, of the four, components of the NOE, that is, the underground production
for economic reasons and the informal production, while it excludes phenomena such as under-
ground production for statistical reasons and illegal production that are not related to the usual
aims pursued by the economic analysis of informality. Moreover, this definition attempts to meet
the measurement purposes with the economic research that points out some structural differences
between “underground” economy and “informal” production. Indeed, in line with the Two-tiered
approach to informality, while informal production (i.e., where unregistered units with little or
no division between labor and capital and on a small-scale as casual self-employment and infor-
mal salaried workers operate) is a typical consequence of “exclusion,” underground production
for economic reasons (e.g., where self-employed, freelances, second workers, business activities
that deliberately hide their earnings to reduce tax or regulatory burden operate), is a usual (but
not exclusive) result of a voluntary “exit” choice. The proposed definition may also be sufficiently
flexible for cross-countries analyses. For instance, we expect to find a predominant share of under-
 14676419, 2022, 5, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/joes.12487 by Anna University, Wiley Online Library on [30/01/2025]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
1636 DELL’ANNO

ground production for economic reasons in developed countries while the relative size of informal
production is expected to be prevalent in developing countries.
The second aim of this research is to survey the literature on the theories of informality. I dis-
tinguish three, not mutually exclusive, approaches: the neoclassical, the macro-econometric, and
the conceptual perspectives. Given the partially overlapping classifications and theories, I pro-
pose a theoretical framework able to incorporate the main schools of thought on IE by outlining
six main theoretical views.
The survey concludes by proposing a unified analytical framework where the multifaceted phe-
nomenon of IE emerges as a result of the agent’s rational choice.
From a normative viewpoint, I have highlighted as different schools of thought endorse diverse
policy measures. However, according to the prevalent literature, the most useful approach for pol-
icy purposes should focus on two main dimensions: the nature of the choice (voluntary/forced)
to operate informally (i.e., Perry et al., 2007) and the heterogeneous features of informal work-
ers and firms. This view, known as the Two-tiered approach to informality, is consistent with the
evidence that several causes of informality coexist in the same economy and, within the same
country, across different sectors. In particular, the literature has pointed out that qualitative dif-
ferences exist in the composition of IE across developed and developing nations, with the informal
determinants of developed countries different compared to those of developing economies (e.g.,
Goel & Nelson, 2016).42 The normative implication of this result is that public policies, to be effec-
tive, have to take into account both the heterogeneous nature of informal firms and agents and
their relative size in the national economy. In conclusion, I agree with the ILO’s (2015) policy
guidelines, that it is wrong to look for a “one-size-fits-all” policy response to the IE valid across
countries or even across different components of the IE within a country. The design of policy
interventions depends on the understanding of the people’s reasons to work informally in a given
context. For that reason, the assessment of the socio-economic characteristics and needs of activ-
ities that choose to operate informally, compared to those in which the informality is a result of
the “exclusion” from the formal sector, becomes pivotal for the success of whatever formalization
strategy.
As a final point, I believe that the IE represents a research field with significant opportunities
for future research. Several questions and debates remain on the table and, as this article has
attempted to do, only by increasing the collaboration between statisticians and economists, we
could find both a definition of informality and a general theory of the IE suitable for explanatory,
policy, and measurement purposes.

AC K N OW L E D G E M E N T S
I would like to thank the anonymous reviewer and the associate editor for their insightful sugges-
tions.
Open Access Funding provided by Universita degli Studi di Salerno within the CRUI-CARE
Agreement.

ORCID
Roberto Dell’Anno https://orcid.org/0000-0001-7441-8328

ENDNOTES
1
Precisely, ILO (2018a, p.15) reports that in emerging and developing countries, the share of informal employment
is 69.6% of the employed population while in developed countries, the informal employment is equal to 18.3%.
2
See Section 2 for a discussion of the different meanings of the concepts of “informal sector” and “IE.”
 14676419, 2022, 5, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/joes.12487 by Anna University, Wiley Online Library on [30/01/2025]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
DELL’ANNO 1637

3
For the measurement issue, OECD (2002) distinguishes two main approaches to estimate the IE: the econometric
methods and the National Accounting Approach. The former includes the “direct methods” (i.e., based on direct
information about informal activities as tax returns, administrative data, questionnaire surveys, or experimen-
tal data), the “indirect methods,” that is, measuring the “traces” that the IE leaves in official macroeconomic
data and the Multiple Indicators and Multiple Causes approach, that is, based on the statistical approach of the
Structural Equation Modeling. See for a review of this literature: Schneider and Enste (2000), OECD (2002),
Schneider (2005), ILO (2013), Dell’Anno and Davidescu (2019), Elgin and Erturk (2019), Bashlakova and Bash-
lakov (2021).
4
Specifically, the statistical manual to measuring informality of ILO (2013, p.44) reports that “while other ILO
publications and some documents published by other organizations use the term ‘IE,’ this manual prefers to use the
terms “informal sector” and “informal employment.”
5
According to the 17th ICLS (ILO, 2003, p.5), informal employment includes “the total number of informal jobs,
whether carried out in formal sector enterprises, informal sector enterprises, or households, during a given reference
period.”
6
It is important to point out that ILO’s splitting of productive activities between informal and formal sectors does
not perfectly match with the SNA. According to SNA (2008, p.477) units that are not informal are not necessarily
defined as formal in the SNA. This occurs for households with unincorporated enterprises not included in the
informal sector that are divided between those that are treated as formal (because of size or registration) and the
rest that are not treated as informal but are left simply in a group called households.”. Further difference exists on
ILO concepts of “sector” and “market production” that do not conform to the SNA. As the latter concerns, “the
ILO treats an enterprise as a market producer if any of the output is sold whereas the SNA requires that most or all
of the output be sold.” (SNA 2008, p.478)
7
Here the term “illicit” stands for “criminal activities.” Therefore the provision of services or the production, sale,
possession or use of goods forbidden by law (e.g., production and trafficking of drugs, firearms trafficking) are
excluded but noncompliance behaviors, such as selling in a street without a license, are included in the IE.
8
According to ESA (2010), the NOE encompasses “value of production activities that are not directly observed are,
in principle, included within the national accounts production boundary.”
9
The reasons to conceal “shadow” productions are inspired by SNA (2008, par. 6.40).
10
Indeed, in this case, these activities are not productive because they only modify the income distribution between
taxpayers and the public sector.
11
Specifically, OECD (2002, p.13) defines underground production for economic reasons as “those activities that
are productive and legal but are deliberately concealed from the public authorities to avoid payment of taxes or
complying with regulations.”
12
This resolution will be presented for consideration at the 21st ICLS, which is expected to take place in 2023.
13
In particular, the IME does not include those IPA that are carried out for an economic unit that is not producing
for the market for pay or profit – such as own-use production work, volunteer work, or unpaid trainee work – nor
illegal production – that is, illegal activities where the parties are willing partners in an economic transaction
forbidden by law or that are unlawful when carried out by unauthorized units – or under declared market value
transactions that affect the amount of value added of market transactions.
14
Economic underground due to underreporting, that is, production/value added may be understated in order to
avoid taxes, social charges, and so forth.
15
Economic underground due to not registered units, that is, enterprises may be missing because the owners have
deliberately avoided the obligations to register in order to avoid additional costs of various kinds such as value
added taxes, social security contributions, costs related to the compliance with health and safety standards, and
so forth.
16
Informal sector: units not registered, that is, non-registration can be a criterion for defining the informal sector
and enterprises may be missing simply because they are not required to register by any kind of legislation.
17
As the effects of the IE concern, see Elgin and Ertuk (2019) for a recent survey on the literature that analyzes
the consequences of IE on the economic system.
18
Gerry (1987) provides an interesting contextualization of the nature and role of the IE as closely connected to
the theories of socio-economic development. For the sake of brevity, we do not report this classification.
 14676419, 2022, 5, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/joes.12487 by Anna University, Wiley Online Library on [30/01/2025]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
1638 DELL’ANNO

19
For example, Lewis’s (1954) dual-sector model; Rosenstein-Rodan’s (1943) external economies and “big push”;
Rostow’s (1960) “stages of economic growth.” Meier (2000) defines this “school” as the first generation of devel-
opment economists that considered the state as the major agent of change.
20
For instance, ILO (1991, p.63) explicates the novelty of this new perspective on the informal sector arguing that:
“Contrary to earlier beliefs, the informal sector is not going to disappear spontaneously with economic growth. It is,
on the contrary, likely to grow in the years to come, and with it the problems of urban poverty and congestion will
also grow.” Hart (1973, pp.88–89) concluded his analysis by suggesting more empirical investigation to determine
which theory best explains the persistence of the informal sector. He considered two alternative perspectives:
the “Socialists [who] argue that foreign capitalist dominance [. . . ] condemns the majority of the urban population
to deprivation and exploitation” and “More optimistic liberals [who see] in informal activities [. . . ] the possibility of
a dramatic “bootstrap” operation, lifting the underdeveloped economies through their own indigenous enterprise.”
21
For example, ILO (1972).
22
For example, McGee (1973).
23
A link between Hirschman’s (1970) “exit” and “voice” options and the individual’s decision to work informally
has also been proposed by Schneider and Enste (2000). However, as Perry et al. (2007) point out, Schneider and
Enste’s emphasis was on the reaction of individuals who feel overburdened by the state, while Perry et al. deal
with the perceived inadequacy of the benefits that formality entails.
24
Williams’s analysis refers to “informal work” rather than “IE.” However, his interpretations can be generalized
to the IE.
25
He outlined four perspectives, informality “as a residue,”, “as a by-product,” “as a complement,” and “as an
alternative” to the formal economy.
26
Williams and his co-authors use different labels for this theory, that is, “as a by-product” in Williams (2008),
Structuralist theory in Williams and Nadin (2011) and Political economy theory in Williams (2015) and Williams
and Kedir (2018). Other scholars label this approach as Neo-Marxist (e.g., Biles, 2009).
27
Williams (2008) includes this theory as one of the “alternative approaches” to informality, specifically, the
“neoliberalism” view.
28
See Williams and Nadin (2011) for this literature.
29
It corresponds to the “Parasite” view in La Porta and Shleifer (2008).
30
It corresponds to the “Romantic” view in La Porta and Shleifer (2008).
31
The idea of a conceptual framework follows Brown and McGranahan (2016). They provide a similar table to
summarize Chen’s (2012) classification of the theories on the IE.
32
If the sign of the relationship between formal and IE is not clearly indicated by the schools of thought, we infer
the “school” by the authors’ arguments. For a general discussion on this topic, see, among the others, Gërxhani
(2004b), Schneider (2005), Dell’Anno (2008), and Elgin et al. (2021).
33
For example, Heterogeneous subordination proposed by Tokman (1978); Holistic, Multi-segmented, Exit-Exclusion
(Chen, 2012); Post-structuralist (Williams and Nadir, 2011); Institutional (Williams and Kedir 2018); Two-tiered
informality proposed by ILO (2015b) and inspired to Fields (1990) and Perry et al. (2007).
34
Indeed, ILO’s (2015b) guide for national employment policies applies this theoretical ground for policy responses
to the IE.
35
We could also include agent’s welfare associated with the choice to be a criminal by adding (𝑌𝑖𝐶𝑟 +
𝐵𝑖𝐶𝑟 [𝑆𝑜𝑐𝐴𝑠𝑠𝑐 ] − 𝐶𝑖𝐶𝑟 [𝛽(𝐶𝑟𝑖𝑚𝑆𝑎𝑛𝑐𝑡𝑐 ), 𝛾(𝑅𝑒𝑝𝐶𝑐 )]) where: 𝛽 denotes the probability of arrest and conviction for
criminal activity in the country c; 𝐶𝑟𝑖𝑚𝑆𝑎𝑛𝑐𝑡𝑐 the severity of the sentence; 𝑅𝑒𝑝𝐶𝑐 accounts for social stigma
and psychic costs, and 𝛾 > 𝛼 > 1 (see footnote 38 for details on 𝛼). However, we exclude this status from the
theoretical framework because out of the scope of this research.
36
With “socio-economic context” we mean that the aggregate demand that faces the productive unit may depend
on several factors, such as the degree of economic development (e.g., developing vs. developed economy), the
geographic area (rural vs. urban).
37
The sign of the relationship between formal and IE is debatable and it depends on the business cycle as well.
See Elgin et al. (2021) for an empirical analysis of this topic.
38
Specifically, 𝛼 = 0 means no social stigma and psychic costs for inactive and unemployed, 𝛼 = 1 indicates that
this type of nonmonetary costs is equal between informal operators and unemployed or inactive people and
𝛼 > 1 implies that for the agent’s social context being inactive or unemployed is worse than operating in the IE
in terms of social stigma.
 14676419, 2022, 5, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/joes.12487 by Anna University, Wiley Online Library on [30/01/2025]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
DELL’ANNO 1639

39
For example, this may be the case of disapproving wisdom towards woman participation in the (formal or infor-
mal) labor force present in some cultures.
40
For example, because of a lack of human and/or physical capital to enter in the formal economy. This lack of
the agent’s endowment may be due to both “micro” characteristics as inadequate education achievement (𝑆𝑘𝑖 )
and macro factors 𝐷𝑐 (e.g., related to economic recession, sectoral change in production, deindustrialization)
41
The standard hypothesis is that the informal unit productivity is lower than the formal one because the former
has lower human and physical capital endowments, restricted access to public services, or other benefits from
regulation than formal units (Loayza & Rigolini 2011). Consequently, for those activities with a fairly small opti-
mal levels of inputs endowment and/or where the access to public services is unimportant, operating formally
does not provide effective advantages in terms of efficiency compared to informal ones.
42
For instance, while factors like inflation and tax complexity promote informal activities in both cases, other
regulatory barriers (e.g., business startup procedures) incentive informality only in developing countries.

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How to cite this article: Dell’Anno, R. (2022). Theories and definitions of the informal
economy: A survey. Journal of Economic Surveys, 36, 1610–1643.
https://doi.org/10.1111/joes.12487