THE EFFECTS OF THE INFORMAL SECTOR ON
CONSTRUCTION
Carol Jewell1, Roger Flanagan1 and Keith Cattell2
ABSTRACT
Most construction sectors around the world have a high percentage of output being produced
informally. In developing countries informal construction activities can account for as much
as 80% of employment (Farrell 2004). In general, the informal sector equates to a significant
percentage of country’s GDP - 40% in developing countries and 18% in the OECD highincome countries (Schneider 2002). The informal sector in construction is not well
understood and difficult to measure and is thriving both in the developed and developing
world.
Construction industries are made up of a large number of small firms and a small number
of large firms. Many small firms are less likely to be able (or to want to) afford the
bureaucratic demands of a nation’s fiscal and legal system. This evasion means a reduction in
tax income for the government, and also leads to inaccurate estimates of the true value of
construction output. Some national statistical agencies factor in an estimate of the size of the
informal sector, but without effective measurement, there is no guarantee that the estimate is
a fair one.
The message from the paper is that the informal sector in construction is likely to grow.
We need to understand the sector and recognise its impact on construction.
KEYWORDS
Informal sector, construction, taxation
INTRODUCTION
Discuss the construction informal sector (or any of the other terms used) with anyone and
they will probably recount a job they have had done by a local builder or tradesman that was
paid for by cash. They may, or may not be, ambivalent about the fact that the work was
probably not declared to the tax man. The existence of an informal sector, especially in
construction, is a fact of life, and indeed is an important part of the sector for small
businesses and for those on a low income.
WHAT IS THE INFORMAL SECTOR?
There has been substantial research into the characteristics, causes and effects of the informal
sector, most of it within the economic community. There are many different terms used to
describe the informal sector: irregular economy (Ferman 1973), the subterranean economy
1
Carol Jewell (C.A.Jewell@reading.ac.uk) and Prof Roger Flanagan (R.Flanagan@reading.ac.uk), School of Construction
Management and Engineering, Univ. of Reading, PO Box 219, Whiteknights, Reading, RG6 6AW, UK Tel. +44 118 378 6224
2 Assoc Prof Keith Cattell, Department of Construction Economics and Management, University of Cape Town, Private Bag
Rondebosch 7701, South Africa cattellk@eng.uct.ac.za Tel: + 27 (0) 21 6897564
1
(Gutmann, 1977), the underground economy (Simon 1982; Houston 1987), the black
economy (Dilnot 1981), the shadow economy (Frey 1982) and the informal economy. Van
Eck (1987) lists nearly 30 terms that are used as synonyms for, or are closely related to, what
he called the underground economy, including: Black, Concealed, Dual, Hidden, Invisible,
Irregular, Non-observed, Parallel, Shadow, Underground and Unofficial.
There are substantial differences between the measurements undertaken by researchers
(Fleming 2000), suggesting that it is not only the definition and measurement that cause
disagreement amongst economists; it is also the terms used to describe the informal economy
and the use of any estimates in economic analysis (Battacharyya 1999).
The International Labour Office (ILO) first used the phrase “informal sector” in reports
on Ghana and Kenya in the early 1970s. Their definition of the sector “one which essentially
covers the unorganized spectrum of economic activities in commerce, agriculture,
construction, manufacturing, transportation and services” they estimate that this economy
absorbs as much as 60% of the labour force in urban areas of developing countries.
Smith (1994) defines it as “market-based production of goods and services, whether legal
or illegal, that escapes detection in the official estimates of GDP.” Bhattacharyya (1999)
argues that the hidden economy is best described as “unrecorded national income, calculated
as the difference between the potential national income for the given currency in circulation
and the recorded national income. For this paper, the commonly used definition of “all
currently unregistered economic activities which contribute to the officially calculated (or
observed) GNP” will be used. For the sake of clarity the term, “informal economy” is used
throughout (Frey & Pommerehne 1984; Feige 1994; Schneider & Enst 2000).
IS IT DAMAGING TO THE FORMAL ECONOMY?
There are three main reasons why knowledge about the informal sector is important to the
economy 1) A large and growing informal economy will render official statistics unreliable
for such data as unemployment, workforce statistics, income and output and therefore
policies based upon inaccurate information may be ineffective (Harding 1989; Schneider
2002); 2) Tax income will be reduced by the existence of a thriving informal sector and; 3)
The informal sector provides many benefits, especially for those on low incomes.
The informal sector can be classified into three areas, home production e.g. DIY; illegal
market activities e.g. drug dealing, smuggling; and
legal market activities that are hidden in order to
avoid taxes, registration and other fiscal measures.
The third classification is the focus of this paper.
There is a close link between the informal sector of
a country and its taxation system as the next
section shows.
A growing informal sector will erode the tax
and social security bases of a country. In a
developing country, it is a thriving informal
Figure 1 The destructive circle
economy that stifles the growth of a structured tax
created by the informal sector
and social security system, but does not stunt
economic growth. Figure 1 illustrates how the
2
informal sector can create a destructive circle where growth in the sector will lead to a fall in
tax income which may lead to higher taxes and so lead to an increase in the informal sector.
Schneider (2002) noted that over 60% of the money earned in the informal sector is spent in
the formal economy, representing positive economic activity.
The Laffer curve (Figure 2)
demonstrates the effects of a tax rate rise
on tax revenue. Laffer maintained that, up
to an optimum level, any tax rise would
produce a corresponding increase in tax
income. Beyond the optimum point (T),
the tax income would reduce as either
people choose not to work so hard or they
transfer into the informal sector and at a
100% tax rate nobody would work. The
curve illustrates the synergy between
Figure 2 The Laffer curve
taxation and the informal sector.
The construction industry constitutes a high risk of tax non-compliance (Australian Tax
Office 2003), due to a number of factors: 1) The widespread use of cash payments in the
industry; 2) The high cost of labour (construction is a labour-intensive industry) leads to
some companies reducing costs in order to increase their competitiveness; 3) The change
from direct labour to indirect labour has made contractual arrangements less accountable and
in some cases, this has resulted in non-compliance; and 4) The minimisation of costs, in
particular the tax burden, in order to remain competitive.
Construction industries around the world are made up of a large number of small
companies and a small number of large companies. For example, 93% of the UK
construction industry is made up of companies that employ less than 7 people. In the USA
81% of construction companies employ 9 people or less. These small firms are less likely to
be able (or to want to) afford the bureaucratic demands of a nation’s fiscal and legal system
and so some will seek ways of avoiding tax and social security burdens.
Small firms in the sector are less likely to invest in training, research and new
technologies, all of which improve productivity. They enjoy the cost advantages of not
conforming to the legal and fiscal regulations that bind ‘legitimate’ businesses. Byggnads,
the Swedish construction industry union organisation, found that over a third of construction
sites in Skäne (Southern Sweden) were manned by informal labour with an estimated output
of US$160 million.
IS IT A GROWING SECTOR?
The transition economies, the developing world countries, and the OECD countries have all
experienced significant growth in their informal sector. In some countries it has doubled in
the 30 years between 1970 and 2000 - from 10% of GDP to 20% in Belgium, Denmark, Italy,
Norway, Spain, and Sweden. There has also been growth in those countries with a smaller
informal sector - USA doubled from 4% of GDP in 1970 to 9% in 2000. For OECD
countries, the growth has been the fastest in the 1990s (Schneider & Enst 2002) - see Table 1.
3
Table 1
The size of the informal economy in OECD Countries
Size of the informal economy (in average % of GDP)
using the Currency Demand and DYMIMIC Method
1989/90
1. Australia
2. Belgium
3. Canada
4. Denmark
5. Germany
6. Finland
7. France
8. Greece
9. UK
10. Ireland
11. Italy
12. Japan
13. Netherlands
14. N Zealand
15. Norway
16. Austria
17. Portugal
18. Sweden
19. Switzerland
20. Spain
21. USA
10.1
19.3
12.8
10.8
11.8
13.4
9.0
22.6
9.6
11.0
22.8
8.8
11.9
9.2
14.8
6.9
15.9
15.8
6.7
16.1
6.7
1994/95
1997/98
1999/00
2001/02
13.5
21.5
14.8
17.8
13.5
18.2
14.5
28.6
12.5
15.4
26.0
10.6
13.7
11.3
18.2
8.6
22.1
19.5
7.8
22.4
8.8
14.0
22.5
16.2
18.3
14.9
18.9
14.9
29.0
13.0
16.2
27.3
11.1
13.5
11.9
19.6
9.0
23.1
19.9
8.1
23.1
8.9
14.3
22.2
16.0
18.0
16.0
18.1
15.2
28.7
12.7
15.9
27.1
11.2
13.1
12.8
19.1
9.8
22.7
19.2
8.6
22.7
8.7
14.1
22.0
15.8
17.9
16.3
18.0
15.0
28.5
12.5
15.7
27.0
11.1
13.0
12.6
19.0
10.6
22.5
19.1
9.4
22.5
8.7
2002/03
13.8
21.5
15.4
17.5
16.8
17.6
14.8
28.3
12.3
15.5
26.2
11.0
12.8
12.4
18.7
10.8
22.3
18.7
9.5
22.3
8.6
Source: Schneider & Klingmair (2004)
Those engaged in the informal sector will not want to disclose their involvement and
income, and in most cases the records of transactions will be sparse. There are four main
methods used to measure the informal economy; these vary according to whether the
measurement is in a developed, developing or transition economy (Hanousek 2003;
Schneider & Klingmair 2004): 1) Direct approach 2) Indirect approach 3) Physical input
(electricity) and 4) Model approach
The direct approach is undertaken either through micro surveys or voluntary replies to tax
audits and has been used extensively in Norway and Denmark. The major drawback is the
robustness of the data collected as those that reply may not give accurate information, many
more may not be willing to reveal any information. Another disadvantage is that it gives a
measurement at one point in time rather than over a longer time horizon.
There are a number of indirect approaches:

The gap between income and expenditure measures. For example in national accounting
the income measure of GNP should be equal to the expenditure measure of GNP
(Schnieder 2004). However, as this approach uses national statistics that include many
omissions and errors, the result is questionable.
4

A decline in the labour participation figures is often used as an indication of an increase
in the informal economy. It is not a foolproof method as there may be other reasons for a
drop in the labour participation figures.

The transactions approach is based on the equation: M*V = p*T (where M = money, V =
velocity, p = prices, and T = total transactions) which assumes that there is a constant
relationship over time between levels of transactions and the official GNP. This approach
ignores the fact that the differences between transaction and GNP figures may not be due
solely to the informal economy.

The currency demand approach was first used in 1958 (Cagan 1958). It is based on the
premise that transactions within the informal economy are undertaken using cash
payments, therefore measuring the level of cash in the economy is an indicator of the
level of the informal economy. Certain allowances are made for other causes of cash
level increases, such as interest rates. This approach has been widely used and has been
applied to many OECD countries, but it has some criticisms: not all payments in the
informal economy are made in cash.
Kaufmann and Kaliberda (1996) made an assumption that electricity consumption is the
single best physical indicator of overall economic activity. This ‘physical input’ method has
been criticised as not all informal economy activities use large amounts of electricity.
Technical progress has produced fuel efficiency which would affect the consumption figures,
and there may be considerable differences in the elasticity of electricity/GDP.
The model approach recognises there is no single indicator of the informal economy.
Production, labour and money markets can all be used to measure the informal economy. The
multiple indicator and multiple causal (MIMIC) model, or dynamic multiple-indicator and
multiple-causal model (DYMIMIC), uses information contained within relevant indicator and
causal variables to estimate a time-path of the size of the hidden economy. The model
identifies the multiple causes and effects of the informal economy, rather than using a single
measure. The large body of literature on the subject identifies three causes and three
indicators (Thomas 1992; Schneider 1994; Pozo 1996; Johnson & Zoido-Lobatón 1998;
Giles & Tedds 2002; Del’ Anno 2003): the burden of regulation, direct and indirect taxation
(causes); and the development of monetary indicators, the production market and the labour
market (indicators).
Table 2 shows a comparison of the different approaches to measuring the informal sector
and the deviation in the results.
Table 2: A comparison of the different methods for calculating the informal sector
Mean value* of informal
sector (% of GNP)
Methods
Discrepancy between actual & official labour force.
Transactions approach (Feige)
Cash-deposit ration (Gutmann)
Physical input (electricity) approach
Currency demand approach
24.4
21.9
15.5
12.7
8.9
5
Model approach (Frey/Weck-Hanneman)
Discrepancy between expenditure and income
Tax auditing
Survey method
Source: Schneider 1998
7.9
6.4
6.1
3.1
* Over 5 countries: Canada, Germany, Great Britain, Italy, USA (1970-90).
An increase in the size of the informal sector is linked to a rise in a nation’s tax and social
security burden Schneider (1998, 2000). The correlation between the size of the informal
sector and three other variables - the level of bureaucracy3 (number of, and time spent on,
procedures) and the corruption index4 was tested. There was significant correlation between
all of the data as Figure 3 shows.
Figure 3 Graphs showing the correlation between the informal sector and three vaiables
WHAT TYPE OF CONSTRUCTION WORK IS UNDERTAKEN BY THE
INFORMAL SECTOR AND HOW IS IT ORGANISED?
Repair, maintenance and improvement (RMI) is a growing area. Estimates of the size of the
RMI informal sector in the UK range from between 10% and 60% of the value of the work
done formally in the RMI sector (Capital Economics, 2003). Many small firms that work in
this part of the industry also undertake small housebuilding work and extensions to property.
3
4
Red tape ranking - Centre for International Private Enterprise (CIPE)
Corruption index 2004; Transparency International
6
There is little evidence of a large informal sector in the design consultancy and civil
engineering works. Entry into design consultancy has many liability issues that require
insurances and safety checks, hence it is better to operate in the formal sector. Civil
engineering work has a high material and plant component, with work mainly undertaken for
the public sector, resulting in less opportunity for informal work.
The image of the informal sector organisation is a small group of individuals who are
self-employed and working primarily on a cash basis. In reality, there are many types of
organisation in construction that operate on an informal basis. For example, there are
companies that use overseas labour, paid for on a daily basis, using an intermediary who
distributes the payments. There are companies that are formally registered that choose to
have some of their income in cash payments, without the appropriate record keeping.
HOW DOES THE INFORMAL SECTOR AFFECT CONSTRUCTION?
There are different views of the informal economy in the construction sector, some see it as
acceptable/inevitable, others view it as a social rather than an economic issue, whilst others
see it as having a bad effect on the economy and the industry. Table 4 show the advantages
and disadvantages of the informal sector.
Table 4: The advantages and disadvantages of the informal sector in construction
Disadvantages
Advantages
 Less tax income
 Regulation non-compliance
 Unfair competition - difference in costs (e.g. labour, regulation)
between firms in the informal and formal sectors
 Short termism - less strategic planning and no investment in
R&D
 Non-conformity and negative state morality (people’s attitude to
the state)
 Lack of adequate insurances
 Less employee protection - employment regulations not adhered
to and no union representation to deal with grievance procedures
and working conditions
 Lower safety and health standards because of non-conformity
/cost
 Lack of skills training and its effect on the industry skill base
 Little after-sales care
 Policies based on inaccurate information eg. unemployment
statistics exaggerated
 Likely to have little capital which means more regular payments
from the client
 Delivery of the product at a lower cost
to the client
 Maintains economic activity
 A large percentage of informal sector
income is spent in the formal sector
 A positive effect on income
distribution with many low income
jobs being provided by the informal
sector
 Provides employment for the sector of
the labour market that might otherwise
have difficulty maintaining
employment
 Encourages creativity and
entrepreneurial spirit (which might
eventually be used in the formal
sector)
 No barriers to entry
 Flexible working hours and conditions
 Reduced bureaucracy/red tape/
unnecessary paperwork adding to the
cost of the work
Construction companies operating in the informal sector do not (or cannot) use traditional
financing options as they are tax/regulation evaders. This lack of access reduces their capital
intensity of production and they operate over shorter time horizons; a characteristic that will
7
inevitably have an effect on long-term economic growth (Eilat & Zinnes 2000). The decision
to operate in the informal sector may be a response to wasteful government spending, or
particular policy decisions. This first step into this kind of ‘anarchy’ is often followed by
further avoidance of the regulations and legislation that exist in the formal sector.
Although tax evasion is often cited as the main reason for entering the informal sector,
many construction organisations have chosen this route because of the cost of excessive
bureaucracy, such as employment and safety and health regulations. Regulations generally
are a fixed cost to the company, affecting smaller firms the most. The use of unregistered
(cheaper) casual labour is possible in the informal sector and reduces costs. However,
returning to the formal economy can be very expensive with tax repayments and any
penalties; this creates a barrier to entry for firms in the informal sector.
Resources and production factors are not used in the most efficient way in the informal
sector and so can affect the competitiveness of the industry. A growing informal sector may
attract domestic and foreign workers away from ‘official’ firms, creating greater competition.
Competitiveness is not just about price, its about creating competitive advantage through
both quantitative and qualitative factors. A small firm could undercut a larger firm by
avoiding tax and social security commitments, but that may be at the expense of its
employees’ rights, health and safety.
The UK Inland Revenue (IR) Office claims huge successes from the Construction
Industry Scheme which is identifying workers who have not previously declared their
earnings to the IR. “Over 100,000 construction workers are paying tax for the first time on
their income. Over £1 billion has been deducted from subcontractors in the first year of the
scheme” (Inland Revenue Press Release 6, 2000).
WHAT ARE THE ISSUES THAT NEED TO BE CONSIDERED?
Reducing the informal economy would have the benefit of clamping down on “cowboy
builders”, and encouraging better quality in the industry, by reducing the extent to which
informal economy firms undercut formal economy ones. A smaller price differential between
formal and informal economy prices, for example through a tax cut, may mean that
households decide the saving made by using an informal economy firm is too small to be
worth sacrificing the guarantee of quality got from a formal economy firm.
In summary, the issues for the industry are safety, health, insurances, liability, training,
investment in the future. Clients want certainty and to minimise their risk. When things go
wrong there needs to be somebody to take responsibility. Firms in the informal sector are
unlikely to have the resources to cope with a claim.
CONCLUSIONS
The construction sector has a high percentage of informality, particularly in developing
countries. This paper has shown the advantages and disadvantages of the informal sector.
The sector is growing in both the developed and developing worlds. In the developed world
there is increasing concern about the effect of the sector on economic growth, tax revenue
and the effects on industry competitiveness. The sector is viewed differently in the
developing world where there are different social and economic pressures.
8
Work undertaken on a cash basis is easy to hide from the authorities and has the benefit
of being cheaper for both the customer and the builder/tradesman. Small firms are
entrepreneurial and provide valuable employment opportunities, but they are unable to
finance the risks when things go wrong. Furthermore, with the lack of training provided by
the informal sector there is no legacy for the future. The debate on the informal sector has
centred on tax evasion and regulation avoidance, whereas business has changed, we have a
more litigious society and a ‘blame culture’. Companies that cannot demonstrate proper
insurance and safety compliance are placing the risk with the client who is often taking on
liabilities. However, it should be recognised that the informal sector contributes to the formal
sector; it maintains economic activity and provides low income jobs and a better distribution
of wealth. The existence of the informal sector is not the problem; it is ignorance of its size
and socio economic impact.
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