Is the informal economy part of market capitalism?

Expressions like informal sector or informal economy and many similar expressions (e.g. underground, black market, shadow economy, under the table, "off the books", "working for cash" or moonlighting) are used to describe all activities that typically are undeclared for one (or all) of the following intents: payment of taxes, law and regulation or statistical reporting. Such activities are often paid in cash and are estimated to represent about 20 to 40% of GDP in developed economies and less developed economies, respectively (the percentages in terms of employment are higher).

Since they involve mostly self-employed, small businesses and part-timers one would imagine that they are part of the competitive market sector. Indeed, some even think of them as the best entrepreneurial antidote to the entry barriers often found in the formal sector. However, this would extend its rationale too far, because the informal economy includes activities that in terms of amounts and moral values are substantially different. We can appreciate that by classifying some of those activities in six groups defined on the basis of the amounts transacted and the legality of the activities as shown in the following table.

The colouring used highlights the degree to which the various activities are similar to formal and open competitive markets. Potentially only the yellow and orange activities may be included in the market capitalism sector, because free and competitive markets demand equal opportunities in the face of the law. There is obviously scope to transfer through legislation some activities from the red coloured areas into less serious offense categories. For instance, some governments may legalise and regulate the sex and soft drugs trade. Indeed, in some countries the tax authorities sometimes advocate such policies to raise tax revenue.

However, in itself this does not guarantee that they may be added to the market capitalism sector because many cannot be carried out in an open and competitive manner. In fact, this problem also affects many of the activities in the orange group because of problems of information asymmetry. For example, if someone discovers a loophole in the tax code he or she cannot advertise it otherwise the tax authorities will move to close it.

To simplify, we will assume that only activities that fit in the yellow group are part of market capitalism. And, because there are so many activities in this category we assume that they will add up to a substantial part of the market economy. So, let´s examine what drives the growth of this sector.

The economic rationale for those involved in these activities is basically two-fold: economies of scale and abnormal profits. Economies of scale usually derive from two situations – either the participants are too poor to pay the minimum “overhead” imposed by the formal sector or their demand is insufficient to cover such costs. In most advanced economies the “overhead” costs typically include sales taxes, personal and corporate income taxes, compulsory employee insurance, accounting and administrative requirements that easily cost as much as the net salary of those employed in the formal sector.

For example, those on low income often are forced into inefficient household production of junk food at a cost of $4 because they cannot afford the $5 price of a burger at the local McDonald. However, they would be better off by paying $2.5 at the street corner from someone working in the informal economy. Likewise, imagine a middle class neighbourhood where every resident has a small garden that only requires 4 hours of work per month. So, a full-time gardener would need to sign in 40 residents. What if there are only 20 residents? Well, he could still live as a part-time gardener in the informal economy with a net income equal to what he would earn net in the formal economy working for 40 residents.

Without exception, governments fail to appreciate the relevance of an adequate balance between activities carried out in the household sector, the informal sector and the formal sector using two contradictory arguments – the need to promote a level playing field (the informal sector is a source of unfair competition for the formal economy) and the need for social policies to protect the weak working in the informal sector and the low paid sectors in the formal economy. The policies used to squeeze the informal sector include both a stick (persecution, fines and taxes) and a carrot (fixing a minimum wage or granting a minimum income for the unemployed on condition that they do not carry out any paid activity).

Such policies are often ineffective, contradictory and very costly. Yet, a common sense policy would simply aim at reducing the formal economy “overhead” on both sides. That is, creating a semi-formal sector with a small overhead (e.g. 25%) and reducing the current overhead costs of the formal sector by another 25%.

Unfortunately, the current level of sales taxation is high and rising creating a strong incentive for those seeking abnormal profits in the informal sector to risk a lose-lose war with the tax authorities. Nevertheless, there is much to gain from a quasi-formal sector by empowering the poor to rely on their own initiative and entrepreneurship rather than on government hand-outs. Therefore, creating such sector is also part of the fight to promote market capitalism as a pillar of human well-being.

Left and Right today

Now that capitalism is almost the only economic system worldwide (with a few bizarre exceptions in North Korea and Cuba) does it still makes sense to talk about left and right? Can we distinguish the various types of capitalism using the left and right categorization?

If one uses the left and right categorization to depict a spectrum of opinions that we may represent through a statistical distribution then it still makes sense to talk about the left and right tails of such distribution.

However, we should recall that this categorization originated during the French Revolution to designate where the pro-monarchy (right) and anti-monarchy (left) seated in the French National Assembly (parliament). Later this designation was generalized to other divisions over single issues. In particular, it was extended to describe those in favour of the status quo (conservatives) and those in favour of moderate/drastic reforms (progressives/ radicals).

Historically, the most important split in the XIX century was over the emerging economic system of capitalism. Since this new system affected most aspects of society, it no longer represented a single issue divide. It became a split over a portfolio of visions usually designated as ideologies until the collapse of communism in 1989.

Yet, once a portfolio of visions becomes too diversified, it loses its internal coherence and no longer can be represented by a single distribution with a left and right tail. If I pick a number of divisive issues in economics, politics or moral I may end up sometimes on the right and others on the left.

For example, one of the current raging debates in economics is over the question of government economic stimulus. Typically, the supporters of the status quo sit on the right and the interventionists sit on the left. However, the interventionists are also divided into two opposing camps over the use of pro-cyclical (fiscal austerity) and anti-cyclical (fiscal expansion) policies. Can we split these into left and right?

As an economist, I believe that government intervention must be always counter-cyclical, but should be used only to smooth extreme volatilities in the business cycle. So, with unemployment above 15%, when looking at the labour market, I find myself on the left side. But, with interest rates close to zero, when looking at the bond market, I find myself on the right side against further monetary easing. So, should I average these two distributions and become a centrist? Not really, because these two visions are not necessarily incompatible.

Likewise, I am a strong supporter of market capitalism as the main driver of progress. But it does not mean that I do not accept a limited role to other forms of capitalism like managerial capitalism or state capitalism. Can I grade their relative roles in terms of left and right? Clearly not.

In conclusion, in general terms, in the absence of a coherent portfolio of ideologies we no longer should characterize ourselves as leaning towards the left or the right. But, over single issue divisions one should not be afraid to sit on the tail of the distribution. Under this eclectic approach, do we risk becoming a weathercock turning opportunistically with the prevailing wind? Yes, but it is a risk that should be mitigated by a scrupulous respect for our values and it is a risk worth taking to enjoy the greater benefits of freedom and variety.