Formalize or Not to Formalize: Asking the Right Questions

Abstract

The dimensions and expansion of the informal sector of developing countries have generated
a wide range of interpretations and policy prescriptions. Since much informality, however
defined, is a natural and broadly efficient result of market forces, it should not automatically
be treated as a problem to be solved. It is important to disaggregate the elements of
informality and often treat them separately, since there is no reason that the optimal level of
formality should be similar for each of the various elements involved. Some of the
undesirable features of many informal firms, like low earnings and income instability, should
for the most part be attacked directly rather than by focusing on formalization. The wide
range of views as to the desirability of formalization qua policy is the result of the
complexity of the issue together with the methodological weakness of many of the analyses,
such as the failure to analyze the quality of the informal sector together with its size, or to
treat agriculture and non-agriculture separately. The best source of understanding of both
the implications of formalization and of the policies that may contribute to its effectiveness is
the in-depth study of the process of formalization in actual cases.