Primary Driving Forces Behind Informal Employment

By Anatoly Gaverdovskiy

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What is the Informal Employment and Why It Is Growing?

Informal (or shadow) employment is a type of employment relationship that is based on a verbal agreement between an employee and an employer without signing an employment contract. This phenomenon is widespread in countries where the shadow economy occupies a significant share of GDP. As stated by International Labour Organization (ILO) the informal employment implies working arrangements that are de facto or de jure not subject to national labor legislation, income taxation or entitlement to social protection or certain other employment benefits (e.g., advance notice of dismissal, severance pay, paid annual or sick leave).

The defining characteristics of formal and informal employment depend on the status in employment:

• Employment of employees is formal if their employers contribute to social security on their behalf or, in the absence of information about social security contributions, if they receive paid annual leave and paid sick leave. In all other cases, we consider employment as informal.
• In the case of employers, the self-employed and members of cooperatives, the formality of employment depends on the status of the economic unit (the enterprise). If the enterprise is part of the formal sector, employment for employers and the self-employed is formal. Otherwise, their employment is informal.
• The employment of contributing family workers is always informal.

International Monetary Fund (IMF) uses the following definition:

International Monetary Fund (IMF) uses the following definition: “The shadow economy includes all economic activities which are hidden from official authorities for monetary, regulatory, and institutional reasons”.[2]

• Monetary reasons include avoiding paying taxes and all social security contributions.
• Regulatory reasons include avoiding governmental bureaucracy or the burden of regulatory framework.
• Institutional reasons include corruption law, the quality of political institutions and weak rule of law.

The shadow economy is based on the concealment of the business activities and financial turnover of companies from the tax administration, which increases the share of cash in circulation in the states. Employees in the informal sectors of the economy do not officially register labour relations with the employer. They receive wages “in envelopes”, and the country’s labour and social regulations do not protect them.

There are many complex factors that contribute to the growth of the shadow economy. Several studies highlight the following key points:

• Excessive tax burden.
• Excessive regulation of business by governments.
• Poor work of the government bodies like tax, judicial police, and others.

We can also add social factors such as high unemployment, urbanization, high migration inflow, and low tax culture of the population. Sometimes, they may lead the society to the acceptance of the shadow market as a normal part of everyday life. As a result, economic actors are moving ?in the shadows?, and the informal economy and informal employment have become one of the significant problems of the world economic system.

Friedrich Schneider (IMF) introduces [3] the following major causes/indicators determining the shadow economy:

The countries with the largest share of the shadow economy are Afghanistan (72% of GDP), Zimbabwe (64,1%), Nigeria (57,7%), Haiti (55,1%) and Bolivia (54,8%) [4] .

Global events, such as the 2008 monetary crisis, the COVID-19 pandemic in 2020 and others, have devastated economies and the political situation in many countries.

This may provoke a new increase in the share of the global shadow economy and growth of informal employment because of unfavorable conditions for doing business, a significant increase in migration flows, rising unemployment, and general tensions within the countries.

Global changes in international relations, the emergence of new paradigms and values, make the vector of economic development uncertain in the long term. This affects the domestic economy of countries and makes it even more unstable.

How the Modern Technologies and Digital Economy Impact the Informal Employment

There has been a substantial shift in labor relations over the last 10 to 15 years. Employers played a critical role before the Internet and cell phones became firmly established in our lives, because they invested in every step of the customer journey—in marketing, sales, and support infrastructure. It was necessary to be a company employee to get access to this infrastructure and a large customer base.

The rapid growth of the online economy and digital platforms changes the job structure and, in the lack of government regulation, contributes to the growth of shadow labor markets. The number of freelancers providing one-time or ongoing services and performing work for legal businesses and people has increased as the Internet has grown. The number of remote employees has also risen during the COVID-19 epidemic.

Many of them work without official registration or as informal self-employed, allowing the employer to save a significant amount of money on taxes, social security, and insurance contributions. People are increasingly using local and global digital intermediaries to market their goods and services. They drive for Uber and Lyft, rent out properties on Booking.com and Airbnb, and sell goods and services on Facebook, YouTube, and TikTok.

Consumers can acquire quick help with cleaning services, website building, relocation planning, transportation of items and papers, financial and legal support, hiring a designer, and a variety of other activities through freelance markets like Fiverr, Upwork, and TaskRabbit.

Innovative technologies (such as 3D printing) are allowing people to become manufacturers and produce things in their own flats or houses without having to register as a business with the tax authorities.

Marketplaces, social networks, and bulletin boards help to sell goods and services, allowing businesses to operate without utilizing formal sales channels and avoid paying taxes.

How can the state reduce the share of shadow employment considering the rapid development and progress of the digital economy?

We can learn from Australia, Japan, Austria, Switzerland, and the United States, which have the lowest percentage of the shadow economy (7-10% of GDP). The secrets to their success are low tax rates and a high degree of tax control for each local market segment.

Factors Affecting the Global Shadow Labor Market

The International Association of Accountants (ACCA) has named three key factors affecting the development of the global shadow economy: bureaucratic quality, corruption control and GDP per capita [5] .

The refusal of businesses to pay labor taxes and social contributions linked to wages is the primary reason for the growth of informal employment. Depending on the amounts paid, each country uses its own collecting techniques, tax rates, and progression, and enforces the liability for non-compliance with the law’s requirements:

• The employer acts as a tax agent and pays the employees’ taxes.
• The employees oversee their own taxes.
• The employer and the employee share responsibility for taxes and social payments.

Each government dictates how to fund the budget, but every country’s tax administration strives for the same goal: to reduce collection costs and risks. As a result, making the employer a tax agent is more beneficial to the state because the number of employers is significantly less than employees. This decision raises the tax burden on the payroll fund, giving the corporation a significant incentive to persuade employees to engage in informal relationships to save money.

Another reason for the development of informal employment is the complexity and cost of managing employees and social obligations that arise when concluding an employment contract: payment of vacation, sick leaves, and severances. That imposes a significant financial burden on the business, especially sensitive for the smaller companies, seasonal businesses, and employers of the part-time workers.

How Informal Employment Affects the Economy and Peoples’ Well-being

Informal work has several negative effects on the population’s well-being and the economy of the country. Pension and other social programs do not receive enough money to meet the state’s duties to the most disadvantaged members of society (pensioners, disabled people). When a company needs enough cash to pay “gray” employees, it encourages the development of unlawful tax avoidance strategies, which results in VAT and income tax losses.

The world’s tax administrations are working together to combat informal work, but their success hinges on their capacity to weaken the causes of informal employment because the state is frequently the principal source of this problem. Many government efforts to combat illegal employment have yielded insignificant results. Workers are more interested in the availability of jobs and the net amount of earnings they can get in their hands than in official employment and social guarantees.

As a result, involving an employee as a victim or witness is difficult. The tax authorities face a difficult and infeasible task in detecting and administering all cases of illicit employment. New digital business models and remote involvement of individuals in the online economy make the existing tax administration system outdated and inefficient. Tax administrations are presently facing the tough choice: either to adapt legal processes to new requirements or to outlaw such schemes while ignoring consumer interests.

In our next article , we will discuss how to find a balance and create a legal framework that will aid in the reduction of national informal employment.

[1] SMALL MATTERS. Global evidence on the contribution to employment by the self-employed, micro-enterprises and SMEs // International Labor Organization (ILO), 2019. URL: https://www.ilo.org/wcmsp5/groups/public/—dgreports/—dcomm/—publ/documents/publication/wcms_723282.pdf

[2] Shadow Economies Around the World: What Did We Learn Over the Last 20 Years? Leandro Medina, Friedrich Schneider // IMF Working Papers, Volume 2018 (2018), Issue 017 (Jan 2018). URL: https://www.elibrary.imf.org/view/journals/001/2018/017/001.2018.issue-017-en.xml

[3] Shadow Economies Around the World: What Did We Learn Over the Last 20 Years? Leandro Medina, Friedrich Schneider // IMF Working Papers, Volume 2018 (2018), Issue 017 (Jan 2018). URL: https://www.elibrary.imf.org/view/journals/001/2018/017/001.2018.issue-017-en.xml

[4] Quarterly Informal Economy Survey (QIES) by World Economics, London. URL: https://www.worldeconomics.com/Informal-Economy/

[5] Emerging from the shadows. The shadow economy to 2025 // ACCA (the Association of Chartered Certified Accountants). URL: https://www.accaglobal.com/in/en/technical-activities/technical-resources-search/2017/june/emerging-from-the-shadows-the-shadow-economy-to-2025.html

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