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Formation and Impact of the Informal Sector

What is the informal sector? Explain its formation and its persistence despite substantial economic change in cities in late industrializing countries. What would formalizing the informal sector mean in practice? What might be the role of the state? Provide evidence where formalization has/has not worked and offer some reasons why that was case.


The informal sector in majority of the developing countries represent approximately 50% of the entire economic activity. It sustains and provides livelihood to a large majority of people, notwithstanding that, the part it plays in overall economic development remains contentious (Porta and Shleifer, 2014). It is observed that although this sector is widespread in the developing countries, it has relatively low productivity compared to the formal sector, mostly concentrated with poor and less educated entrepreneurs and is largely disconnected from the formal sector. The reason why many entrepreneurs tend to set up small scale firms in the informal sector is the avoidance of taxes and regulations and because they are aware that the productivity of their firms are quite low and would not allow them to thrive in the formal sector (Porta and Shleifer, 2014).

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According to Peterson (2013), a cursory glance at the informal sector reveals that it is not problematic at all in the short run, as it tends to be the primary source of livelihood and sustenance for the poor. However, in the long run it has an adverse effect on a country’s economy and can stagnate the government’s social programs. If informal sector growth remains uncontrolled, this mean an economy that is beyond the control of the government or regulatory agency would not be able to provide the necessary protection to the workers and workers will continue to have lower standards of living compared to their counterparts in the formal sector. The reasons the workers in the informal sector continue to have low living standards are irregularity in their working days, absence or lack of minimum wage, lack of health and safety facilities, inability to enforce the contractual arrangements and absence of social protection (Peterson, 2013).

In this paper, I argue that despite the fact that the informal sector provides means of sustenance for the poor and relatively less educated it has numerous disadvantages and steps should be taken by the state towards formalization of the sector. The paper looks at the informal sector in Pakistan and why inequality persists in the opportunities for the workers in this sector. The informal sector’s growth should be curtailed in the developing countries because 1) informal sector workers have very low level of protection from the police and judiciary in case of crimes committed against their property 2) as most of the informal sector workers do not possess the capacity to enter into binding contracts, this prevents them from accessing capital markets for the purposes pertaining to finance and insurance and they are also not able to fully make use of social welfare, skill enhancement training programs and other government/public incentives (Loayza, 1999).

In this paper, I will begin with first explaining what the informal sector entails and what are its key characteristics. I will go on to discuss the emergence and persistence of this sector focusing primarily on two issues that in my view have contributed to this sector i.e. globalization/trade liberalization and poverty. I will look at the informal sectors in Pakistan and India to some extent as my case studies to explain what formalization of the informal sector means and what could be role of the state in that regard. The conclusion will reiterate that although informal sector is not entirely unfavourable for the poor, it could have negative impact on the economy in the long run.


The informal sector: what is it?

There is no definitive and conclusive single definition of the informal economy, however, the work of Hernando de Soto (1989) defines informal economy “as the set of economic units that do not comply with government imposed taxes and regulations” (Loaya, 1999:1). It appears that defining the informal sector has been a contentious and debatable issue. The consequence of the debates over the informal sector has resulted in four dominant schools of thought including the Dualist school, the Structuralist school, the Legalist schools and the Voluntarist school. According to the Dualists, the informal sector consists of marginal activities very different from the formal sector and not related to the later at all. The Dualists are of the view that the informal economy is a means of livelihood for the poor and something to fall back upon in financial upheavals (Hart 1973, ILO, 1972, Chen, 2012). The Structuralists believe that informal sector consists of micro-enterprises and workers that play a key role in reducing the input/labour costs, thus, facilitating increased competitiveness of big capitalist firms (Castells and Portes, 1989). The legalists such as DeSoto refers to informal sector consisting of micro-entrepreneurs who choose to function informally to avoid the cost and time incurred registering formally. All they require is property rights to ensure that their assets are converted to and recognized as legal assets (De Soto, 1989, 2000). The Voluntarist school tends to focus as well on the entrepreneurs striving to avoid taxes and regulation, however, compared to legalist school they do not put the blame on the burdensome procedures of registration (Chen, 2012).

It appears that the activity-based definitions around informal economy have gained ground in the recent past. The OECD, IMF and ILO reiterates that the informal sector includes “all legal activities that are deliberately are deliberately concealed from public authorities for the following reasons: to avoid payment of income, value added or other taxes; to avoid payments to social security contributions, to avoid having to meet certain legal standards such as minimum wages, maximum hours, safety or health standards etc…” (OECD, 2000:139, Gurtoo and Williams, 2009:2).

The emergence and persistence of the informal economy


During 1950’s and 60’s it was acknowledged that there exists a dichotomy between urban economies, that is, along with the organized industries an unprotected and unorganized sector also subsists. This sector was first identified as an‘informal sector’by Hart (1971) and owing to the introduction of this sector as an informal economy the activities that were not incorporated in theoretical models of development were finally made a part of it (Chaudhuri and Mukhopadhyay, 2009). The informal sector was initiated at the launch ILO World Employment Programme and as a result of the ILO Kenya Report (1972). A major portion of ILO’s work on informality sees it as correlated to poverty. In this section I will be referring to globalization and rampant poverty being the reasons for emergence and persistence of informal economy.

Globalization and the informal economy

Chaudhuri and Mukhopadhyay (2009) state that globalization and the major forces that drive it i.e. trade liberalization are considered to be the key reasons for the large number of workers in the informal economy. The term ‘globalization’ refers to reduction in barriers to trade, liberalization of the external flows of capital and international labor migration. The literature on the informal sector depicts that the way the workforce is becoming increasingly casual in nature is to some extent owing to the liberalized regime. How? It is argued that owing to enhanced market competition and uncertainty as a result of globalization, the entrepreneurs are moving towards higher capital-intensive productions and that results in laying-off human labor force. Many people who are laid off cannot afford to remain unemployed and hence seek employment in the informal sector. Another reason why globalization perpetuates informal sector is that in order to curtail costs and remain competitive, some entrepreneurs prefer subcontracting some stages of their production process to informal sections that can assist them in minimizing training and maintenance costs of labor force (Chaudhuri and Mukhopadhyay, 2009).

It is established that the major shortcoming of globalization is that even more people are ‘self employed’ today compared to pre-globalization era. Yet, being self-employed does not depict that the workers’ conditions are ideal. In fact, a fundamental portion of the burgeoning workforce finds itself in casual, contractual, home-based, own-account and migrant work within the informal sector having no social security. Although globalization has led to the proliferation of the informal sector, with the support and help of trade unions such as Self Employed Women Association (SEWA) the women working in the heterogeneous informal sector are lent support to earn and lead better lives and become more empowered (Kapoor, 2007). The point I am trying to make here is that notwithstanding the impact of globalization on expansion of informal economy trade unions and organizations like SEWA can play a part in making globalization work for the informal sector workers. How SEWA is making globalization work for the informal female workers? The case of Puriben Ahir explains that. She is from Gujarat in India and was working as a farmer but had no means to deal with enhanced mechanization, the new yielding seeds that didn’t go along with her drough-prone farms. The irregular nature of her work and frequent migration became her way of life. She then decided to join SEWA. Upon joining it she was not only able to raise her financial status and her status in the family and the community was also elevated. Through SEWA she also gained access to the market and was able to tap the national as well as international markets. This depicts that if dealt properly informal sector emerging due to globalization can be tackled and its adverse effects could be curtailed (Kapoor, 2007).

Poverty and informality

It is argued that one of the key characteristics of the informal sector is poverty and that there is a strong nexus between poverty and informal sector participation (Mead and Morrison, 1996). In order to provide an insight to this argument I will look at the case of India. The literature on informal economy in India suggests that during the years 1999-2000 and 2004-05, the following four states had the largest share of the informal sector Bihar followed by Uttar Pardesh, Rajistan and Orissa. It is also observed that poverty is more prevalent in these four states of India compared to the others. The incident of poverty in these states is quite higher than the national average. Thus depicting that there is a positive correlation between poverty and informal sector (Naik, 2009).

Mead and Morrison (1996) state that despite the belief that a strong relation exists between poverty and informal sector there is a contrary view stating that there does not exist any data set that allows anyone to make the assumption around poverty-informal economy nexus. According to Cartaya (1994) while studying the levels of income for informal workers in Venezuela the association between informal sector and poverty is not definite and conclusive. She argues that there are many poor households with downtrodden workers not a part of the informal sector. Simultaneously there are numerous people in the informal sector who are not poor. In a nutshell it will be misleading to see poverty as a defining feature of the informal sector although some level of association do exist between poverty and informality (Cartaya, 1994).

The informal sector and the role of the state: the case of Lahore, Pakistan

In this section, I will be analyzing the informal sector in Lahore, Pakistan. My analysis will be based on the research study commissioned by WIEGO and Inclusive Cities project in which I was involved being an employee and a part of the “Informal Economy Budget Analysis” project in Shirkat Gah, a leading women rights organization in Pakistan. I will study how the informal sector workers located in Shahdara, Ravi Town in Lahore operated under informality and if the working conditions were too precarious. I will look at whether Pakistan’s government is able to lend protection to the workers in this sector primarily to the waste pickers and the home-based workers. Finally I will delve in to why the state has not been successful in affording protection to these workers and what prevents formalization from taking place in the country.

Overview of informal sector in Lahore, Pakistan

In Lahore, a majority of urban workforce is informal. Notwithstanding that, it is observed that in many cities in Asia, Lahore being one of them, the informal sector and their livelihood are overlooked or at times totally ignored in city planning and economic development at the local level. The major dilemma for the informal sector workers in Pakistan is their exclusion from economic policies and city/urban planning. The urban informal workforce and the working poor in Lahore are often not recognized and supported by the city authorities and ignored when the city is developing economic land allocation and zoning plans. In Lahore, many informal sector workers toil for hours in deplorable working conditions and exploitative practices (Lean Lim, 2015).

The profile of Shahdara, Lahore

Ravi town is among the nine towns in Lahore. Shahdara is a huge and busy Union Council located close to a huge waste dump in Lahore. The town recently experienced urbanization as a result many migrant from rural areas of Pakistan had settled down there (Budlender, 2009).

Informal sector workers in Shahdara, Lahore

The research conducted in Shahdara by Shirkat Gah employees through dialogues and engagement with random homes-based workers and waste pickers depicted the following trends. It was revealed that waste-picking was mostly undertaken by the families of Afghan refugees who migrated to Pakistan as a result of being displaced during the Afghan war. The refugees were residing in the slums near Lahore and in their waste picking work both their children and wives were involved. The reported family income of these waste pickers is between Rs. 6000-8000 per month not enough to sustain the families (Budlender, 2009).

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Moreover, the home-based workers in Shahdara were mostly found to be women. Most of these women do not have attained high levels of education (studied only up to grade 5) and usually work on piece-rates receiving abysmally low wages and sporadic incomes. Most of the female home-based workers interviewed in Shahdara were engaged in sewing, embroidery, carpet weaving, making henna cones and cooking. The sewers who work as part-time employees in people’s home have irregular flow of income as their orders reach their peak during Eid and wedding season and slow down during other days (Mumtaz et.al, 2009). The home-based workers are predominantly females, 65% of women are in this sector as apposed to 4% of men. Within Lahore, a stark inequality and disparity was observed between the women and men in the informal sector. The female home-based workers were subjected to increased inequality compared to their male counterparts as they were required to work for much longer hours for a reasonable amount of income. Moreover due to the patriarchal society of Pakistan most women had no control over spending the wages they had earned and at times were abused and exploited by their male employers or men in their family (Mumtaz et al, 2009). Hence (Chen et al; 2004) believes that if women in the informal sector are given due support by the state or steps are taken to formalize the informal nature of their work it would result in ameliorating poverty and gender inequality.

Dilemmas of the informal sector workers in Shahdara, Lahore (Chen and Sindha, 2016)

  • Evictions and relocation of homes away from contractors, markets and customers. This could be addressed by upgrading informal housing and settlements
  • Many home-based workers who work from home lack quality and spacious housing. As many of them live in small houses, they are unable to take orders in bulk owing to a lack of storage space. The space they live in has completing needs of other activities and members of house. Some houses not built with high quality face rooftop leaks during monsoon rain that hampers and impedes the working and productivity of these workers.
  • Some workers are faced with the dilemma of high rents and scarcity of affordable housing
  • Right to basic infrastructure: Consistent power failure in Lahore and high cost of electricity. Power outages are a major worry for the home-based workers engaged in sewing clothes as they rely on electrical sewing machines. Lack of water and sanitation issues in Shahdara.
  • Inadequate public transport: At times home-based workers have to leave their homes for work and thus complain about high cost and lack of round the clock availability of public transport in Lahore
  • Lack of secure a secure and transparent contracts
  • Occupational, health and safety issues such as being exposed to toxic substances and long hours with very little rest time

The formalization debate: Has formalization been achieved in Lahore and what role has the government played in achieving that?


Pakistan is increasingly faced with the challenge to manage its informal sector, as this sector is draining the country’s formal economy. The Center for International Private Enterprises (CIPE) and the Lahore Chamber of Commerce is taking the initiative to encourage informal workers to become a part of the formal sector (Dawn, 2011). At this point it is pertinent to explain what formalization is all about. The process of formalization refers to shifting informal workers to formal wage jobs and this could be made possible when the government of Pakistan is able to create more jobs and do away with the phenomenon of ‘jobless growth’. However, there is no precise definition of formalization and for some the term simply means ensuring registration of informal enterprises and taxing them (Chen, 2012).

The need of the hour for the government of Punjab to address the issue of burgeoning informal sector is to ensure that it registers and taxes formalized enterprises, provides homes-based workers and waste pickers with access to legal and social protection. In the case of home-based workers, it would be ideal if technical and vocational training institutes could impart trainings to home-based workers and build their capacities. Moreover, the government of Punjab needs to ensure that they are represented in the relevant collective bargaining process and policy making.

Practical steps that the government of Punjab could adopt for formalization of some of the informal workforce (Williams and Lansky, 2013)

  • Advertise and impose penalties for informal sector workers
  • Simplify compliance rules for entering formal sector
  • Promote benefits of formal work and educate the workers in the informal sector
  • Ensure tax fairness
  • Ensure principles of equality and non-discrimination
  • Enhance social protection measures
  • Lower cost to access the formal sector
  • Create more jobs in the formal sector
  • Ensure access to basic infrastructure
  • Do away with biases against labor, biases that privilege capital (Carr and Chen, 2004)

     Biases against the informal workforce

     Biases against women favoring men

Has formalization completely failed in Pakistan?


In my view, despite the prevalent informal economy, the process of formalization is not an utter failure in Pakistan. According to the Dawn (2011), the State Bank of Pakistan introduced the Credit Guarantee Scheme for commercial banks to ensure coverage of default risk of borrowing businessmen and that includes the informal sector-to 60% of first loss. Moreover, informal enterprises in the manufacturing sector are encouraged to use the testing, standardization and quality assurance facilities of the government in order to enhance the capacity of product and market development. The attempt towards formalization in Pakistan especially Punjab is not an utter disappointment and this could be gauged by the fact that newspaper deliverers in Pakistan have organized themselves i.e. previously they were a part of the unorganized sector (Dawn, 2011).



The discussion in this paper highlights that the two leading factors of emergence and persistence of the informal sector in Pakistan are globalization/trade liberalization and poverty. Although it is also argued that it will be wrong to believe that all worker sin this sector are poor or that poor workers are only found in this sector. However, we have also seen that in Shahdara the majority of the home based workers were females from low economic standing that is why they were forced to work and earn wages through piece rate.

The informal sector is not an utter disaster as it does provide means of livelihood and sustenance to the people belonging to impoverished backgrounds, however in the long run it could strain the formal economy as well and hence steps should be taken by the governments of the developing countries towards formalization. In my view, although the state of Pakistan is working towards formalizing its informal sector, it still has a really long way to go. It needs to focus on the persistent inequalities that exist between women and men and different economic classes within the informal sector and ensure that its policies and law take into account the contributions made by the workers in the unorganized sector.




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