False definition: The informal sector is “economic activity that is unrecorded (illegal/not taxed)”

The above quote is from the International Baccalauclreate’s (IB) 2015-11 S2 Markscheme (p. 11). It makes three separate claims:

The informal sector is (A) unrecorded; (B) illegal; and/or (C) not taxed.

All three claims are false:

(A) Unrecorded?

  • Joint Informal Economic Task Team (IETT, 2022):

It is a common misconception that GDP is underestimated because it does not include the production of informal businesses. Conceptually the SNA includes all productive activities irrespective of whether these activities are formal or informal.

National accountants are particularly concerned about ensuring that the whole of economic activity within the SNA production boundary is measured comprehensively. This is often referred to as the “exhaustiveness” of the coverage of the national accounts. In practice, it means ensuring that the value of production activities that are illegal or hidden (that is, the “underground economy” or the “hidden economy”) as well as those that are simply described as informal is included in the accounts.

Now, it could be that in practice, informal activities tend to be underestimated due to defects in data collection. This claim may or may not be true. It could also be in some cases that informal activities are overestimated.

But any such claims are about the accuracy and precision of estimates. These are very different from the false claim—made by many high-school teachers, the IB, Cambridge International, and others—that GDP as a concept explicitly excludes informal activities.

  • IMF (2021, bold font added by me):

Some 60 percent of the world’s population participates in the informal sector. …

about 2 billion workers, or over 60 percent of the world’s adult labor force, operate in the informal sector–at least part time.

The informal economy is a global phenomenon, but there is great variation within and across countries. On average, it represents 35 percent of GDP in low- and middle- income countries versus 15 percent in advanced economies. …

The informal economy is difficult to measure.

This is because activities within it cannot be directly observed, and for the most part, participants in the informal economy do not want to be accounted for.

But it is important to try and measure the size of the informal economy because of its significance, and also because it employs some of the world’s most vulnerable people Informality can be measured in two different ways. The direct approach is based on surveys, voluntary replies, and other compliance methods to directly measure the number of informal workers and firms.

Indirect methods focus on certain characteristics. or proxies, that can be observed and are related to informal economic activity Examples of proxies include electricity consumption, night-light satellite data, and cash in circulation. Using these methods, the share of the informal economy in total output can be measured.

There is even an Informal Economy Database that gives estimates of the size of each country’s informal economy. Again, one can argue that such estimates are imprecise, inaccurate, and incomplete. But that is very different from the false claim that such estimates are explicitly and entirely omitted from GDP.

(B) Illegal?

  • ILO Recommendation R204 (2015):

the term “informal economy” … does not cover illicit activities

  • OECD (Measuring the Non-Observed Economy: A Handbook, 2002):

Most informal sector activities provide goods and services whose production and distribution are perfectly legal. This … distinguishes them from illegal production.

(C) Not taxed?

  • OECD (2002):

a sizeable proportion of informal sector enterprises are actually registered in some way, or pay taxes

As usual, we’re free to define terms as we like. But if our definition contradicts the UN, World Bank, Eurostat, IMF, ILO, and OECD (and contains what they call a “common misconception”), then we should probably make this clear.


There Is No Simple, Precise, and Widely Agreed-Upon Definition of “Informality”

  • OECD (2002):

Since its first appearance in the early 1970s, the term informal sector has become so popular that nowadays it is used with different meanings for different purposes.

New definitions of informality compete with old definitions leading to a plethora of alternative conceptualisations. While some individual studies may apply a tight definition consistently, the literature as a whole is in a mess.

  • Medina and Schneider (2021):

an internationally accepted definition of “shadow economy” is missing

So, don’t teach students that there’s any simple and precise definition. And certainly don’t ask them to memorize and regurgitate it for exams.


Does This Mean We Can’t Teach Students about Informal Activities?

Nope. This is actually a wonderful opportunity for an open-ended discussion on

  • what the possible characteristics of informal activities are;
  • why this matters (or doesn’t);
  • what other classifications are (or could be) used;
  • what difficulties we encounter when trying to come up with a definition;
  • what the growing “gig economy” is and how it relates to informal activities;
  • whether informal activities are necessarily backward, inefficient, and undesirable.

Some will object that such an open-ended discussion can’t be easily tested on an exam.

I agree it can’t be easily tested.

But since I don’t believe exams are all-important, I disagree that such discussions should therefore be omitted. Still more do I disagree with the idea that high-school students are too stupid to understand any of the above and that all they’re capable of is memorizing and regurgitating a false and falsely precise definition on exams.


Towards the SNA 2025—and Hopefully Some Generally Agreed-Upon Definitions

The next (sixth) version of the System of National Accounts is scheduled for publication in 2025. One of the task teams is the Joint Informal Economy Task Team (IETT), which in February 2022 released its first consultation (IETT, 2022) and made these suggestions:

Informal productive activities … are defined as all productive activities … not covered by formal arrangements. …

informal economy is defined as constituting of all informal productive activities …

Economic units that are not formally recognized are in the informal sector if their production is mainly intended for the market. …

It should be noted that the framework clearly distinguishes the term informal sector from the term informal economy which have often been used ambiguously in the past.

In particular, All production within the informal sector is part of the informal economy.

But, Formal economic units can, however, use informal labour inputs for their production.

Hopefully when the SNA2025 is published, we will have greater clarity on what the terms informal sector and informal economy mean. Perhaps thereafter, education systems will also have some clear and widely agreed-upon definitions that they can force students to memorize and regurgitate.

But right now, they don’t.


“Definitions” by IB, Cambridge International, Textbooks, and Singapore JCs

IB:

  • Economic teacher support material (2022, p. 73): The activities of the informal economy are not included in a country’s national income figures.
  • 2012-11 S2 Markscheme (p. 8) defines an informal market as a market where economic activity is not recorded by government and/or is not included in the calculation of GDP.
  • 2012-05 H3 Markscheme (p. 18) defines informal market as markets in which economic activity is not officially measured/recorded.
  • 2007-05 H3 Markscheme (p. 18) defines informal markets as markets in which economic activity is not officially measured/recorded.

Cambridge International 9708:

  • 2007-11 9708/04 (p. 2): the informal sector, where income is not recorded
  • 2017-03 9708/42 Mark Scheme (p. 9): real GDP per capita … omits social issues – education, health, sanitation, working hours – doesn’t include unpaid work, informal economy (repeated verbatim in 2017-05 9708/42 and 9708/43 Mark Schemes)
  • 2017-03 9708/42 Principal Examiner Report for Teachers (p. 10): GDP per capita also doesn’t account for unpaid work, the informal economy
  • 2017-06 9708/43 Principal Examiner Report for Teachers (p. 30): Neither does it [real GDP per capita] include unpaid work, the informal economy
  • 2019-11 9708/41 Principal Examiner Report for Teachers (p. 24): GDP … omitted the informal economy.

Textbooks:

  • William McEachern (2014): The underground economy describes all market activity that goes unreported either to evade taxes or because the activity itself if illegal. … The underground economy is known by a variety of other names in different countries, including the shady economy, informal economy, second economy, cash economy, hidden economy, unrecorded economy, parallel economy, off-the-books economy, and black economy.
  • Sloman, Garratt, and Guest (Economics, 10e, 2018, p. 20): Informal sector The parts of the economy that involve production and/or exchange, but where there are no money payments.
  • Case, Fair, and Oster (Principles of Economics, 12e, 2017, p. 470): The part of the economy that should be counted in GDP but is not is sometimes called the informal economy.

Singapore Junior Colleges (JCs):

  • Anglo-Chinese JC 2016 H2 Prelims Suggested Answers Q5a: informal sector (the part of the economy which is not taxed, monitored by any form of government or included in the measurement of GDP)
  • Innova JC 2017 H2 Prelims answers Q4b: When an activity takes place in the hidden economy/informal economy, wages are being paid to those working and hence they may enjoy a reasonably high material standard of living, which is not accounted for in GDP statistics.

(2022-02-09: First posted. 2022-02-12: Some edits.)