Summary: Many countries have expressed an interest in the size, performance and motivation of the informal sector, especially where the informal sector provides the livelihood and employment for a critical segment of the population. This essay reviews recent literature, methodologies, and relevant Bank studies as a way to share information with country teams interested in expanding their knowledge of the informal sector and related policy debates. Research in a number of regions points to four main areas where development policy can be improved by taking the informal sector into account. First, improvements should be made along a continuum; the heterogeneity among informal firms points to different policy approaches for different types of firms. Second, there should be public-private collaboration on mutual reforms. Many efforts to improve firm performance focus on elements of the production function (labor skills, credit) while treating government mainly as a cost (taxes, cost of compliance with regulations). Yet research reveals that many characteristics of the public regime strongly influence the decisions of firms regarding informality. Third, research indicates a strong relation between basic skills and labor outcomes, particularly in the informal sector, despite the sector's lower average returns. Research also indicates the benefits of targeted training programs. Business services programs have a decidedly mixed record, yet ongoing research is refining results on what works best. Fourth, informal trade is pervasive in developing countries and the networks developed in informal trade -- wholesalers, credit suppliers and money-changers, transporters -- are a strong presence in the informal sector. Yet these kinds of complex and nontransparent trading systems can be discouraging to foreign investors and can otherwise undermine trade policy and the international competitiveness of developing countries. The paper concludes with recommendations.
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