An Introduction to the Shadow Economy: What Exactly is it?

By Ness Kotecha

India has one of the world’s largest shadow economies, with over 90% of its workforce being directly involved with informal agreements and deals. During my vacations visiting family in Mumbai, I see how informality is fused into the daily lives of the whole country. There are so many occupations that are completely integrated with the country’s culture: domestic workers, including housemaids and cooks, street vendors, drivers, etc. These jobs are essential, composing the livelihoods of millions of workers and enhancing the quality of life of the general population. 

You’ve probably heard the statistic that over 60% of the global population is in some way part of the informal economy. More commonly known as the informal sector, this unregulated side of the economy is mostly misunderstood and frowned upon by many economic regulators. There are many disadvantages to informality, including dampening the potential for GDP growth and increasing inequality. However, the so-called “shadow” economy does provide notable benefits as well, driving entrepreneurship and providing additional employment opportunities for low-income households. In this first part of a two-part series, I discuss the negative aspects of the informal market and how it can dampen economic prosperity. 

Defining Informality

As always, let’s first define informality and the different things the shadow economy encompasses. There isn’t a complete consensus regarding the meaning of the “informal economy” as economic experts often disagree on whether the term includes illegal activities as well. 

For this article, we’re going to separate illegal activities from informal ones, as not all informal work is illegal. For example, non-contract employment like household cooking for an hourly wage doesn’t break any regulations. However, all illegal activities are informal, as they are outside of governmental regulation. There is a large grey area between the terms; street vendors who sell goods without a permit are partaking in unlawful activities, but they are informal and not necessarily criminals. For simplicity’s sake, we will take the International Monetary Fund (IMF)’s definition of the informal market: “activities that have market value and would add to tax revenue and GDP if they were recorded.” This definition encompasses the various aspects of the shadow economy and highlights the most fundamental aspect of the informal economy–how it’s outside the regulatory domain.

Now, let’s dive into why the shadow economy is so controversial and the various negative impacts on economic development because of it.

Impact on Tax Revenue

One of the largest consequences of an informal sector on a country’s economy is the impact on tax revenue for the government. As individuals and businesses in the informal sector don’t (fully) report their income and expenditures, there is a large gap in the potential taxable amount. For countries with massive informal sectors like China, India, and the United States, the accumulation of many small unreported returns does create a sizeable difference for government revenue, especially in the long term. This has a direct impact on the amount available for the government to spend on public infrastructure and social programs that would benefit the entire population. 

It is imperative to point out, however, that not all informal activities can/should be reported and taxed. Taxing many informal jobs, especially those that involve households creating their own goods and services for self-consumption, may indirectly target specific groups of people and disproportionately impact low-income households. An example of this is small-scale farmers producing and consuming their own crops. The negative impact of administering additional taxes that target the food they consume offsets the governmental social benefits due to the extra tax revenue. Furthermore, if governments were able to gain complete access to records for illegal activities, administering taxes would not be the main priority. Logically, criminal activity like drug trafficking and child labour would be shut down instead. 

Informal Workers’ Protection

The lack of social security and regulatory protection is a key characteristic of informal economies and can have serious consequences for informal workers. Without formal agreements between employers and employees, standard workforce regulations don’t have to be adhered to, including but not limited to minimum wage, working hours, and health insurance. During times of crisis, when people need regulatory and governmental support the most, it’s not available, and employers aren’t legally bound to help to the same extent as with a formal contract. 

COVID-19, for example, disproportionately impacted informal workers to a much higher extent compared to those working within the formal economy. Without workers’ protection rights or remote working options that formal contracts provide, informal workers suffered the greatest loss of income. In fact, a report by Azim Premji University in 2021 shows that most of the 230 million Indians who went below the minimum income during the first wave of the pandemic are of the informal sector, including street vendors, house maids, and some rickshaw drivers. These groups suddenly lost their only sources of income but still had to pay their bills and survive without the same help as their formal counterparts. Due to informality, providing monetary relief post the initial pandemic wave was also more difficult, as many governments worldwide didn’t have a fully extensive database for their country’s informal workers.

The Positive Side?

As discussed in the article, the informal economy has many disadvantages, affecting both long-term economic growth by hampering tax collection and putting a large part of the population, informal workers, at risk. Many economic agencies are constantly trying to tackle these issues deriving from informality, administering different types of policies, which will be explored in detail in the second part of the series. The main focus, however, of the next article is regarding the often overlooked positive parts of the shadow economy. Get ready, because we'll be diving into how informality drives entrepreneurship, creates opportunities, and tackles important issues in ways its formal counterpart can’t.

Also, make sure to follow @businessbeyondblog on Instagram and sign up for the newsletter so you never miss one of our fresh posts!