McKinsey in the News
> Tackling the Informal Economy
May 8, 2006
McKinsey's Diana Farrell says companies operating in the gray zone sap economic
growth in the developing world. Here's what governments should do
What do Japan, Singapore, South Korea, and Taiwan have in common? Obviously, they are
Asian nations that joined the ranks of the wealthy during the second half of the 20th century. But
a less well-known shared feature is that none of them have much of an informal economy.
Research on economic development from the McKinsey Global Institute (MGI) and others shows
consistently that these two facts are closely related. Sadly, the converse is also true: When large
numbers of businesses fail to register, ignore labor laws, flout regulations, and evade taxes, they
hinder the expansion of more productive, modern companies.
That puts a powerful brake on a country's growth rate, locking it into a condition
of "emerging but never quite making it," and condemning those living and working in the gray
economy to a lifetime of insecurity and poor living standards. For Asian nations with large
informal economies — the Philippines, Indonesia, Thailand, India, and Vietnam among them —
this is bad news indeed.
This view, however, is not accepted by many policymakers and development economists. Two
myths prevail. The first is that unlicensed activities by unregistered businesses paying little or no
tax do not threaten the growth of the formal, modern economy. Many believe that informal
operators are mostly tiny street traders, too small to prosecute for tax evasion, and any that grow
bigger will naturally choose to "go straight" as they expand.
The second myth is that for a country experiencing mass rural-urban migration, a growing
informal sector is a godsend because it will create jobs much faster than the formal economy
INCENTIVE TO HIDE.