Entrepreneurship, Inequality, and the Informal Sector

Those in the field of international economic development often take the benefits of boosting entrepreneurship for granted. Helping people to grow their own businesses and find their own path to economic empowerment must be good, right? Not necessarily, according to some new research.

Two recent articles published in Economic Research and the Journal of Business Venturing find that richer, better-connected entrepreneurs cluster in the formal sector. Those in the informal sector are not typically elite and thus have fewer resources. They usually lack access to bank credit, venture capital, links to global markets, and other advantages that formal sector enterprises have.

The result is a growing economic gap. This gap is particularly wide in developing countries, where most people work in the informal sector (ILO, 2018). Thus, helping informal enterprises in these markets may be especially effective in decreasing inequality.

Promoting greater inclusion and equity in economic development takes on special importance and urgency considering recent research showing that economic inequality has accelerated in recent decades.

Entrenched inequality is especially bad in developing countries. There, the people who most need it often cannot access formal education, infrastructure, and health care. The result is that over time, social inequality increases further (United Nations, 2020).

Research suggests two possible approaches to boosting entrepreneurs in the informal sector.

Promoting Informal Enterprises

One approach is to help people already operating in the sector to start and grow their businesses. Encouraging participation in informal groups like rotating credit associations, which rely on personal trust and reputation among members, is an example. This can help people without access to formal credit raise capital for their businesses. When small-scale entrepreneurs start or expand businesses in the informal sector, they have an alternative to casual labor that can lift them out of extreme poverty and narrow national economic gaps. These efforts are, however, not likely to create many well-paying jobs or change the basic power and social dynamics of the informal economy.

Moving Businesses into the Formal Sector

A second option is to help entrepreneurs move from the informal sector into the formal economy. This can help them break free of traditional constraints and informal institutions that may limit participation based on ethnicity, gender, and other factors that can maintain inequality. The paper in the Journal of Business Venturing suggests that formal sector social enterprises backed by venture capital funding can help mobilize diverse stakeholders, break down social boundaries, and overcome norms that would otherwise exclude marginalized entrepreneurs.

Other initiatives to help entrepreneurs transition to the formal sector already exist in micro-, small, and medium-sized enterprises (MSMEs) development programs. Microcredit schemes, for example, can help MSMEs build credit and, with time, get larger bank loans. Value chain projects can link small informal producers to big buyers who are part of global markets. Small-scale entrepreneurs who organize into formal groups like Farmer Producer Organizations (FPOs) and business associations can better advocate for their interests and access public and private resources that they could not get on their own.

Changes in government policy can also lower the barriers to entry into the formal sector. Economist Hernando de Soto, in his book The Other Path, has shown how helping poor people get legal rights to real property and business assets can help them climb the economic ladder. His Institute for Liberty and Democracy (ILD) works with developing countries to implement property and business rights reforms. These reforms give citizens the tools to participate in the formal sector.

Among other projects, ILD is trying to use Blockchain, the technology behind Bitcoin’s digital currency, to help the world’s 5 billion people whose property is not legally documented. ILD wants to use the transparency and simple security features of Blockchain to allow them to get formal ownership of their property so they can legally transfer it and use it to qualify for bank loans. In Peru, for example, ILD is working with partners to use Blockchain to create a public ledger to help neglected farmers and artisanal miners get formal land and water rights vis-à-vis multinational mining companies.

Advantages to Informal Sector Firms

This work is promising, but we cannot assume that entrepreneurs always prefer to operate in the formal sector if given the chance. Businesspeople resist involvement in the formal sector for many reasons. Some stay out of the formal economy because they are involved in illegal activities, but many avoid it to evade taxes, heavy regulation, and troublesome officials.

I saw this pattern in my own research on small-scale textile enterprises in western India. There is an Indian saying: “Never stand behind a horse or in front of a government official,” and this reflects the thinking of most of these businesspeople. To avoid increased regulation under India’s Factory Act, those who owned growing businesses would split their operations into nominally separate enterprises under different roofs.

Partly by ducking regulations intended for larger manufacturers, entrepreneurs in India’s decentralized textile sector have been able to grow much faster than the formal mill sector in recent decades. It is now the second largest source of employment in India after agriculture (Swami and Padma, 2015).

But the situation in India’s informal sector is not entirely positive. Because the economy is partly rooted in institutions such as caste, religious community, and the patriarchal family firm, women and people from outside groups are often excluded from opportunities. And while the economy is creating many employment opportunities, most of these jobs do not offer income or benefits to match those of the formal sector. Thus, the net economic advantages to the nation and the impacts on inequality are debatable.

Context is Key

The best approach to helping promote informal sector entrepreneurship will depend on the local context. Cultural norms, industry type, and existing institutions are only a few of the factors that shape the informal economy in different countries.

Unfortunately, it is not always easy for people in the development field to observe and understand the informal sector in developing economies. They tend to be closely linked to formal institutions like universities, NGOs, government agencies and international donors.

People in the informal sector often speak different languages, move in different social networks, and follow different norms than the global elites who seek to work with them. This makes them hard to reach.

Another problem is that informal enterprises may not be listed in any directory, and their activities may not be accurately reflected in official reports. As a result, desk research yields little information about these firms, and the people who run them may not be comfortable opening up to outsiders.

Considering the breadth of the topic and the obstacles to investigating it, exploring the links among entrepreneurship, the informal sector, and inequality in emerging markets is very hard. People in the field of development need to be careful to promote entrepreneurship that not only increases economic equity, but also inclusion. We are starting to grasp the nature of the problem, but the hardest work — putting programs and policies in place to solve it — still lies ahead.