Informal Economy
Introduction
In many countries, not only in the poor countries throughout the world, the informal economy plays an important role. Also in the Caribbean, the informal economy provides a source of income for a great number of people. "At the same time, informality motivated by regulatory distortions, tax evasion, or in the pursuit of illegal activities can be a development trap that deprives governments of needed funds and leaves participants without legal protection". (Report on Informal economy in Jamaica, 2006). The informal sector is a large and growing portion of the Jamaican economy. In 2001, informal activities represented around 43% of official GDP and by some measures had more than doubled over the previous decade. This rapid growth contributed significantly to the decline in poverty during the decade. Activities and participants in the informal sector are diverse and differ in many important respects from their formal sector counterparts. These differences should be kept in mind in policy design. This paper is mostly based on the final report written by the researchers of the Group of Analysis for Development (GRADE, 2006). In their report they talked about the definition of informal sector, its size and its characteristics. According to their study they stated that the informal economy in Jamaica represents a large and growing share of the overall economy, measuring in the vicinity of 40 percent of total economic activity as currently measured. This growing sector represents a diverse group of enterprises and workers, ranging from local peddlers to sophisticated small entrepreneurs. This paper explores these and other characteristics of the informal sector, which should be taken into account when prescribing new policies or programs.
In this paper, some examples of the informal economic activities in the goods sector and the services sector of Jamaica will be pointed out.. This will be followed by mentioning the policies that the government should implement to deal with the informal economic activities in Jamaica.
1.Defining the Informal Economy
There is no agreement on how to define the informal economy, or even what to call it. "Underground," "shadow," "black," "unofficial," "unrecorded," "hidden," "parallel," "clandestine" and "second" economy are all used by researchers to describe roughly the same phenomenon. To a large extent, these differences in terminology and definitions reflect differences in research objectives. (See Schneider and Enste, 2000, for a more thorough treatment of definitional issues.) Gërxhani (1999). After many attempts to define the informal sector, three broad criteria were identified by authors to define the informal sector: political, economic and social. From the economic perspective, the most relevant for the current study, several sub definitions are identified:
Illegal Activities
Trade in stolen goods; drug dealing and manufacturing; prostitution; gambling; smuggling and fraud. Barter: drugs, stolen goods, smuggling, etc. Produce or growing drugs for own use. Theft for own use. Tax Evasion; Tax Avoidance
legal Activities
Unreported income from self employment; wages, salaries and assets from unreported work related to legal services and goods Employee discounts, fringe benefits Barter of legal services and goods All do it yourself work and neighbor help Source: Rolf Mirus and Roger S. Smith (1997, p.5), with additional remarks.
Informal activities in the goods sector are:
Wholesale; retail trade; agriculture(sell vegetables); sell food on the road side; sell clothing, foreign currency trading outside the market; craft work, catering.
Informal activities in the services sector are:
Security services; domestic services; religious practicing; cooking; hairdresser; barber; carwash These definitional issues have practical implications for quantifying the informal sector. What exactly are we to estimate? Some options include measuring the value of informal transactions in the labor market, the number of persons hired without any contractual and social protection, the amount of credit outside the regulated financial system, the asset value of the businesses without legal status, or the value of transactions that evade value added tax.
Despite the lack of consensus in academic literature, in this study the informal economy is classified into three categories (Dreyden and College, 1996): (1) "pure" tax evasion, (2) the irregular economy, and (3) illegal activities. Pure tax evasion occurs when individuals fail to fully report earnings from otherwise legal business activities that are properly registered and recorded in the national statistics. The irregular economy generally covers the production of legal goods and services in unregistered and, hence, largely untaxed and unrecorded small businesses. Activities in the irregular economy are an important form of underground activity. Finally, there are a number of illegal activities that conflicted with regulatory and tax laws, as well as criminal law. Because of the way official GDP estimates are calculated in Jamaica, they include some pure tax evasion and irregular economic activities, as well as some illegal activities.
2. Review of Previous Studies of the Informal Sector in Jamaica
Several studies have examined various aspects of the informal economy in Jamaica. For example, Witter and Kirton (1990) define informal activities as those that violate any aspect of the socio legal framework of the economy. They use three methods to estimate the size of the informal economy in Jamaica. The first one is Gutmann's method (1977), where excessive growth in the use of cash in the economy is an index of the growth of the informal economy. The estimates showed informal activities were generally increasing both in current Jamaican dollars and as a share of formal GDP over the 22 year period under review. The latter increased from 8% in 1962 to 24% in 1984. The study also experimented with a modified version of Gutmann's approach, where the income velocity of money in the informal sector is 10% higher than in the formal sector. This yielded estimates that were more than double those from Gutmann's approach. Using a monetary approach, Witter and Kirton estimate that between 1977 and 1984, J$20 denominated bills increased from 45% to 77% as a share of the total currency stock, and from 49% to 88% as a percentage of per capita currency holdings. In this regard, these figures indicate significant growth of informal activities in Jamaica. Yet, this rapid increase in the use of large bills could also be explained by other factors, such as high inflation rates. Lastly, Witter and Kirton turned to the labor market and examined changes in workforce participation in the official economy as an indicator of increased activity in the "shadow" economy. While not providing an estimate of the size of the informal sector, they found that men turned to informal activities and that women increased their participation in both the formal and informal economies between 1968 and 1985. They further estimate that in 1985 almost 20% of the population aged 14 and over were potential participants in the informal economy. In fact, this study understates potential informal activity because it excludes workers in the formal economy who were also working part time in the informal sector.3
A study by Tokman and Klein (1993), "Informal Sector and Regulations in Ecuador and Jamaica," assumes that the informal sector operates in a grey area between "underground" and legality. The study analyzes these countries' legal and regulatory systems, the degree to which small firms comply with these laws, the factors determining compliance and the impact of compliance on a firm's performance. It also examines the characteristics of the micro enterprises surveyed and of the entrepreneurs involved in these businesses. They found that regulations are not perceived as important constraints in the establishment or operations of such micro enterprises, though smaller firms are more likely to be unregistered. No statistical evidence was found that registration affects capacity for growth. Even though there is not a macroeconomic picture of the relative importance of the informal sector in Jamaica, it is stated that informal activities employ around 35% of the country's non agricultural workforce. Finally, "The 1996 Micro and Small Enterprise Survey of Jamaica" provides a comprehensive analysis of more than 2,000 non agricultural micro and small enterprises (each employing less than ten paid workers). The results show that the micro and small business sector in Jamaica grew at an annual rate of 0.8% between 1990 and 1996. By 1996, there were more than 93,000 non agricultural micro enterprises, most of them engaged in the wholesale and retail trade. The annual value of their sales was estimated at J$48.6 billion, or 13% of the gross output of the corresponding sectors in that year. In terms of employment, it was estimated that these firms employed around 174,000 workers, more than 18% of the workforce.
The survey also revealed the following: by 1996, three quarters of MSEs were being operated by own account and unpaid workers; a significant number of enterprises did not fulfill all the formal regulatory requirements; a great number of micro entrepreneurs decided to run their own business because they wanted to be independent; and the participation of women as working proprietors was almost equal to that of men. In particular, we focus on two aspects of the informal sector: pure tax evasion of formal firms and the legal activities of unregistered businesses. Prior research on Jamaica's informal sector is sparse, and in particular does not provide estimates for the growth of the informal sector during the 1990s. The following sections address these research gaps. IADB (1987) also estimated that almost 33% of the urban workforce (around 16% of the national workforce) was in the informal economy. Its definition of the informal sector includes the self employed (except for professionals), non remunerated household workers and domestic workers.
3. The size of Jamaica's informal economy
The size of the Jamaican informal sector is estimated around 43% of official GDP in 2001. Estimates based on electricity consumption put the informal sector at a much larger 40% of total GDP in 2000 (total GDP includes all unreported plus officially reported economic activities). Both the electricity consumption and monetary data indicate that the informal sector grew significantly faster than the formal economy during the 1990s.
There are three generally accepted methods for estimating the size of the informal economy : direct approaches that employ household surveys or audit tax returns to extrapolate data relating to informal sector activities; (2) indirect, or discrepancy, methods that use available economic data to estimate changes in the size of the shadow economy over time; and (3) modeling approaches, which examine the causes and effects of informal activities to estimate the size of the informal sector. In this section, to estimate the size of Jamaica's informal economy for different time periods four indirect methods are used. The researchers utilized indirect methods because they permit analysis of changes in the size of the informal economy relative to the formal, or official, economy over time and because they are less data intensive than modeling approaches. Multiple indirect methods are used because each has its own benefits and drawbacks, and comparing the results of multiple approaches provides a better picture of the true size of the informal economy. Two of the approaches can be thought of as macroeconomic approaches: the monetary, or currency demand approach, and the electricity consumption method. These are based on observed economy wide variables, money supply and energy usage respectively. On the other hand, the other two approaches — the consumption function expenditure approach, and the method of additions — are microeconomic in nature, based on extrapolations of individual or household behavior. A brief description of each approach is followed by empirical findings related to each. These authors, using Gutmann's monetary approach, found the size of the informal economy in Jamaica (as a percentage of total GDP) showed an upward trend from 9% in 1966 to 19% in 1984.
4. Characteristics of the informal sector
This section describes the characteristics of agents involved in the informal sector in Jamaica. Generally, every economic transaction may be evaluated depending on whether agents attend to all or some of the legal regulations attached to that transaction. Here the focus is on micro and small enterprises (MSEs), generally regarded as "informal intensive," as well as individual own account, or self employed, workers. The research done by the Group of Analysis for development, GRADE (2006), showed that it was necessary to examine micro and small enterprises (MSEs) to understand the characteristics of the informal sector.. Looking at MSEs has its limitations and is used here as a practical response to the well known difficulties of accessing information on the informal economy. It overlooks, for example, informal activities of medium and larger enterprises while incorporating the formal operations of smaller entities. Nevertheless, as our results illustrate, informality is dominant among MSEs and therefore they provide a useful point of departure for understanding the informal sector as a whole.
MSEs are a segment that is heavily engaged in informal activities and they differ in important ways from their larger, more formal counterparts. Likewise, work in the informal economy differs from work in the formal economy. Salient differences include: • Enterprises in the informal sector are concentrated in low productivity, labor intensive activities. Nearly 60% of Jamaicans in the informal sector work in the wholesale/retail trade or agriculture. Manufacturing is a distant third most important activity, involving only 9%.
5. MSEs and Informality
In order to evaluate the level of informality among MSEs, the researchers analyzed their compliance with the regulations of the existing legal system. They consider informality as a continuum and that in many instances MSEs may satisfy some requirements but not others. By comparing the legal requirements with those with which an MSE actually complies, we are able to develop an index for formality. For this, they take into account the following legal demands:
• Licenses and Registrations
• Licenses and Registrations
Every firm should have:
Those who import goods and services should have a tax compliance certificate
Units with two or more employees should keep a payroll.
• Tax Compliance
Every firm should:
Firms with a payroll equal to or higher than J$14,444
Using these criteria, they constructed a simple index of formality ranging from 0 to 100, with firms that satisfy all of these requirements awarded 100 points.13 The result is that the average MSE in our survey met 36% of all the requirements demanded by the legal system, supporting the idea that the MSE sector is characterized by a high degree of informal transactions. Therefore, they observed that a significant share of economic activity in the MSE sector is a subset of the country's aggregate informal economy. Not surprisingly, they also witnessed important differences as to the level of informality within the MSE sector. First, there is a clear positive relationship between firm size and the legal index. The larger the firm, the better its compliance with legal requirements. Among small firms, the overall index is 68%, while among own account entrepreneurs it is only 20%. These results hold even when the index to reflect possession of licenses and registers and the payment of taxes is decomposed. The results suggested that informality is, to a large extent, standard operating procedure among Jamaican MSEs. MSEs engage in informal activities because of the benefits and costs of decisions. On the one hand, it is typically assumed that not complying with regulations helps firms reduce their expenses. On the other, there are significant financial and legal penalties if a firm gets caught engaging in informal activities. Additionally, participating in the informal sector may impose certain business restrictions: exclusion from the formal sector, limited access to public services and/or goods, and the need to maintain a low "legal" profile. In order to assess these issues, research was done on the most important disadvantages associated with not complying with legal requirements. Most responses highlight that being part of the informal sector restricts firms' decisions, forcing them to take actions that will keep them invisible to the legal system. Advertising problems, restrictions on the size of the establishment and a limited number of customers are among the most cited disadvantages. Clearly, all these factors can limit performance. Also firms didn't have some of the required registrations because of ignorance and high bureaucracy. This finding implies that there is still work to be done in order to simplify the legal system.
CONCLUSIONS
This study sought to indicate the informal economic activities in the goods and services sector in Jamaica. In order to do that, it was important to define the informal economy Research of the GRADE, showed that the informal economy (encompassing pure tax evasion, the irregular economy and illegal activities) represented a large and growing share of the overall economy during the decade. According to the authors of the GRADE, the informal economy nearly doubled in size, reaching just over 40% of official GDP in 2001. This growth contributed significantly to the decline in poverty during the decade. This growing sector represents a diverse group of enterprises and workers, ranging from local peddlers to relatively sophisticated small entrepreneurs. With respect to pure tax evasion, it is clear that tax evaders reduce revenue the Jamaican tax system would otherwise receive. Tax evasion therefore contributes to lower levels of government services, higher taxes on the rest of the economy and larger government deficits. Therefore, decreasing tax evasion in Jamaica is socially desirable.
I agree with the authors of the GRADE that to achieve this goal, tax simplification and increased information reporting must be implemented, coupled with a modernization of systems under a cost benefit criteria. Like them I do not believe that it is cost beneficial to uncover and punish all tax evasion. Irregular economic activity is the least virulent portion of the informal economy, and even has beneficial aspects. Irregular activity generates goods, services and jobs that might otherwise be unavailable. Nevertheless, these goods, services and jobs tend to be of highly variable quality and they are certainly no better than they would have been if the same activity were formalized. The government may be able to combat the attractiveness of the irregular economy by providing alternative opportunities to new entrants in the labor market. In addition, the government may want to consider reducing regulation and increasing incentives for participation in the formal economy (for example, better access to credit or training programs within targeted sectors). Given that the irregular economy is essentially composed of non agricultural and agricultural MSEs, according to the researchers another possible solution is to determine eligibility for exemption by administrative action, which has the merit of flexibility and the application of different standards across various fields, but it is open to corruption and arbitrary action. On the other hand, one of the most serious problems consists in passing tax paid on inputs. Allowing small registered firms to file and pay over longer intervals. The illegal economy is the most problematic of the informal sector's activities. The operations of the illegal economy are very costly to citizens in terms of lifestyle, antitheft devices and fear. Goods generally lose value as a result of illegal transfers. While illegal goods and services often provide net benefits to the purchaser, such benefits may be short lived and may come at substantial costs to the general public. Effective policy to combat the illegal economy may combine legalization of some goods and services (e.g. gambling) with stricter enforcement of others. To carry out the above mentioned policies, it is essential to look closely at areas of rapid growth in the informal economy so that these areas can be targeted and inefficient rules can be corrected. This implies an ongoing monitoring and evaluation program that will allow policymakers, to clearly identify the impact of corrective policies and to determine when corrective measures are necessary.
VI. REFERENCES
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Gërxhani, K. (1999), "Informal Sector in Developed and Less Developed Countries: A Literature Survey", Tinbergen Institute and University of Amsterdam.
Gutmann, P. (1977), "The Subterranean Economy", Financial Analysts Journal, Vol. 33, pp. 26 27.
Mirus, R. and R. Smith (1997), "Canada's Underground Economy: Measurement and Implications", in O. Lippert and M. Walker (eds.), The Underground Economy: Global Evidence of its Size and Impact.
Research Group of Analysis for Development (GRADE), 2006. Thomas Desmond, IADB, "The Informal Sector in Jamaica", Inter American development Bank.
Schneider, F. and D. Enste (2000), "Shadow Economies: Size, Causes, and Consequences", Journal of Economic Literature, Vol. XXXVIII, pp. 77 114.
Tokman, V. and E. Klein (1993), "Informal Sector and Regulations in Ecuador and Jamaica", Technical Paper No. 86, OECD Development Centre.
Witter, M. and C. Kirton (1990), "The Informal Economy in Jamaica, Some Empirical Exercises", WP 36, Institute of Social and Economic Research, University of West Indies.
