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The role of the informal sector in economic development: evidence from developed, developing and underdeveloped economies

Reetika Dadheech

Published 2026 in International journal of sociology and social policy

ABSTRACT

This study investigates the relationship between informal employment (IE) and economic growth (EG) across countries at different stages of development. Specifically, it examines whether IE promotes or constrains EG, and whether institutional factors such as economic freedom (EF) and government expenditure (GE) moderate this relationship. The study employs a balanced panel dataset of 161 countries from 2011 to 2019. Long-run econometric estimators including fixed effects, fully modified ordinary least squares and dynamic ordinary least squares are applied to address endogeneity, serial correlation and unobserved heterogeneity. IE is treated as the key independent variable, while per capita income, GE, EF and unemployment are included as control variables. A quadratic specification is incorporated to capture non-linear threshold effects. The results confirm a statistically significant inverted U-shaped relationship between informality and EG. Moderate levels of IE initially support growth, but excessive informality inhibits gross domestic product (GDP) per capita growth. EF and GE exert significant positive effects on growth. Unemployment exhibits an indirect short-run positive effect by pushing workers into informal activities that sustain consumption and productivity. The positive growth effect of informality is strongest in emerging economies and weakest in high-income countries. This study reinforces the need to incorporate IE into mainstream economic development models rather than treating it as a residual labour category. The findings confirm that the relationship between informality and growth is non-linear and income-dependent, suggesting that future research should examine threshold levels of informality across different institutional settings and sectors. The results also highlight the importance of accounting for unpaid and informal work in national accounts, labour-market modelling, and development theory. Scholars may further extend this research by exploring how digitalisation, automation, and financial inclusion influence the transition from informal to formal employment. The results show that the informal sector (IS) is a major source of jobs and economic stability, especially in emerging economies. Policies should not try to remove informality suddenly but should improve working conditions and support a gradual shift toward formality. Measures such as skills development, entrepreneurship support, financial inclusion, and digital access can increase income and productivity. Policy design should differ across income groups and sectors because the impact of informality on growth is not uniform. The IS plays a central role in reducing poverty by offering work to low income and vulnerable groups. Expanding access to microfinance, social protection, and skill building can improve income security and reduce inequality. Supporting informal workers can contribute to more inclusive growth where formal jobs are limited. This study is one of the few that analyses the nonlinear link between IE and EG across many countries while combining dual sector theory, the Kuznets curve, and institutional perspectives. It offers evidence for designing development policies that support inclusive and sustainable growth.

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