The role of informal sector: poverty alleviation and job creation.

Case of
mekelle city, Tigrai

CHAPTER ONE

INTRODUCTION

1.1. BACKGROUNG OF THE STUDY

The informal sector has long been an integral part of the culture and economy in Ethiopia.
Included in this sector are such economic activities as family farming, domestic serving, street
hustling, casual vending and drug dealing. Many participants operate within this sector because
of limited education, lack of proximity to urban areas, limited formal employment opportunities
or family requirement However, it has been found that a significant characteristic of citizens
participating in the informal economy do so in order to evade taxes and government regulations
(Andreoni et al., 1998; Feige, 1979).

The informal sector involve many disciplines and have produced a variety of names for this
sector, such as hidden, shadow, underground, unofficial, and black, amongst others. The
informal sector includes small businesses, microenterprises, self-employed individuals, and
participants in drug-trading and other illegal activities. The broad range of activities conducted in
the informal sector can be condensed to identify several common characteristics including all
employment that is not bound by contract or other legal regulations, very small scaled
operations, unregistered businesses, and all activities which generate revenue that is not reported
to tax authorities with the express purpose of evading payment of income taxes (Manning, 2008).

In the informal sector workers are most often not professionals, rather they are self-employed,
paid or unpaid help in family enterprises, or workers in domestic settings such as housekeepers
and gardeners. Finally, the informal economy includes those activities which are not reported or
underreported in national economic statistics such as the GDP (ibid).

Participants in the informal sector include individual workers such as small-farm workers, retail
salespeople, street vendors, domestic helpers, taxi drivers and owners of small businesses and
microenterprises petty traders, Home-based workers, Waste pickers, coolies and porters, and
small artisans, barbers, shoeshine boys and personal servants. The way of the activity
characterized by easy to entry mean that not need much training, education and capital, local and
low resources based; family ownership; labor -intensive with adapted technology ; skills
acquired informal processes (ILO,1972)

However, the main actors of the informal economy are paradoxically among the most
precarious and vulnerable. In fact, most of the informal actors are deprived from social
protection, faced with weak skills and credit constraints which undermine their productivity
(Traoré, 2013; Benjamin and Mbaye, 2012). Furthermore, relatively low levels of women’s
education and social norms often limit women to unpaid domestic cleaning work and small
income-generating activities at home or on streets from which they derive the most precarious
incomes (Traoré, 2013; Kuepie etal., 2009; Chen, 2001). So the informal economy is a
concern for Governments of Africa interested in alleviating poverty and inequities.

The informal economy in Africa has been considered for a long time as a range of marginal
activities doomed to disappear with an improving economic development (Schneider and
Enste, 2000). But during this last decade, the informal economy placed itself as a potential
source of incomes by providing after the agricultural sector the most number of jobs. In fact,
according to the International Labor Organization (ILO) the informal economy represents
42% of the GDP and occupies about 70% of the non-farming workforce of Sub –Saharan
countries. In urban areas of Africa, for example, the employment in informal sector is estimated
to be 60 percent (World Bank 2008); this figure is about 37 percent in Ethiopia (CSA, 2011).

In Ethiopia, people below poverty line in urban areas are estimated to be 34% for male-headed
households and 49% for female-headed households (1999/2000). This situation has made
Ethiopia one of the poorest countries in the developing world (World Bank’s World Dev. Report
2000/2001). Therefore participating in informal sector plays great role in poverty alleviation and
employment creation.

1.2. Statement of the problem

Some activities in the informal sector are deliberately concealed by businesses to avoid taxes
while others are missed because survey frames exclude small businesses or very new ones.
Hence some will remain actually unrecorded. The size and evolution of the unrecorded economy
is of great implications. The primary implication of prevalence of the underground economy is
loss of government revenue that would have been used to improve public services of broader
advantage. Stressed, the size and growth of unreported income and the implied tax gap affect
the size of government deficits, government debt and tax reform policies (Feige, 1990).

The informal sector units, often operating under unscientific and unhealthy conditions, contribute
significantly in polluting the environment. But they cannot be forced or induced to internalize the
environmental costs inflicted on the society primarily due to two reasons. First, these units are
unregistered, geographically dispersed and it is quite difficult to identify them. Secondly, the
informal sector units with a nominal capital base cannot afford to pay pollution fees or install
pollution abating equipment. However, the significant amount of pollution created by them
cannot be left unattended (Biller and Quintero, 1995)

Despite the fact that informal sector has negatives consequences on the economy the urban
informal sector units mostly produce intermediate inputs for the formal manufacturing sector on
a subcontracting basis. Many of the formal sector firms delegate the production of components to
enterprises on an informal basis through subcontracting (Papola, 1981; Romatet, 1983; Joshi and
Joshi, 1976).

The informal sector has been realized as a significant socio-economic force that should be
reckoned with in the development process, particularly in poverty alleviation efforts. Informal
sector activities are part of the socio-economic environment whose services are utilized by
every member of the communities. Numerous studies have indicated the significance of the
sector in poverty alleviation and job creation (Asmamaw, 2004)

Further the informal economy, providing jobs (often self-employed) and income to most of
Africa’s poor households, has only recently gained increasing attention from policymakers
Despite large economic growth in Africa in the past decade, the informal sector remains huge.
This is often attributed to Africa’s explosive population growth (‘youth bulges’), which
cannot be absorbed by the formal sector. Youth and women are overrepresented in an
informal sector that is frequently associated with increasing poverty, irregularity, lack of
social protection and poor working conditions. Lack of prospects for large numbers of
young urban men in particular, may lead to frustrations and even social and political
instability (‘ticking time bomb’). Engaging the informal sector to achieve more inclusive growth
is, therefore, considered crucial (African Development Bank, 2015).

Mekelle, the capital city of northern tigrai region of Ethiopia is one of those cities with informal
economic activities. In 2017 mekelle had total population of 215,546. Women made up of 51.4%
of mekelle’s population and men represented 48.6%. 60% of the population in the labour force

In Ethiopia, specifically in Addis Ababa city there are studies related to cause, effect and role of
Informal Sector. Works of Etsubdink Sibhat (2009), Asmamaw Enquobahrie (2004) and Hayat
Abdulahi (2000) are some of them. So far as my knowledge is concerned, there is no research
done on the role of informal sector in poverty alleviation and employment creation in this study
area. However, there may be geographical situation, cultural, awareness level and income level
differences among the households’ of Mekelle city and Addis Ababa.

1.3. Research objectives

1.3.1. General objective

The main objective of this study is to examine the role of informal sector in poverty alleviation
and job creation in mekelle city.

1.3.2. Specific objectives

The specific objectives of the study are:

1. To examine the role of informal economy on poverty alleviation in the study area.
2. To assess the contribution of informal sector on job creation in the study area.

1.4. Research Question

 How can the informal sector alleviate poverty for poor mekelle residents?
 How can the informal sector create productive jobs to the large numbers of
mekelle’s youth?
1.5. Significance of the Study

The study is significant in the way that it initiates other interested researchers to carry out studies
in the areas. The contribution that the study will be made is in efforts to create awareness and
bring about change of attitude on the part of regional governments, federal government other
stakeholders and policy makers to show on the sector as the fundamental base for
entrepreneurship development and effective utilization of scarce resources, role in poverty
alleviation and socio-economic role.

1.6. Scope and limitation of the study

The study, which is aimed at exploring the role of informal sector on poverty alleviation and
employment creation, will be conducted in Mekelle city, Tigrai. Because of time and budget
constraints, the study uses a cross section data from a sample of only 150 informal sector
participant households of the city. Furthermore, this research employs difference in difference
model so that it is subject to all the limitations associated with the method.

1.7. Organization of the Thesis

The thesis is organized in to five chapters. The first chapter is an introductory part of the thesis.
Chapter 2 presents review of both the theoretical and empirical literatures. Chapter 3 is about
data sources and methods of data collection, theoretical framework, econometric models
and model variables. Chapter 4 provides data analysis using both descriptive statistics and
econometric methods. Finally, chapter five presents conclusions and policy implications.
 CHAPTER TWO

LITERATURE REVIEW

2.1. The Underground Economy: Definition/Understanding the Concept

Several synonymous names have been given to the underground economy. Names such as
unmeasured, hidden, informal, invisible, black, grey, shadow are but a few. By its nature,
any study which intends to measure the extent of the underground economy must first
deal with is how to define it. As the research on the issue is an old practice in the rest of the
world, one can find ample of alternative definitions to the phrase “underground
economy”. The definition differs with the objective and approach of the study and plays an
important role in determining its size. For example, Greenidge (2009) defines the
underground economy as any economic activity that does not appear in the statistics of
the national income and GDP.

According to this definition, while it happens that illegal activities lie within the hidden
economy, there are many legal ones that may contribute. For example, one who gets extra
income working his spare time but does not report his income is said to participate in the
underground economy. Likewise, Schneider & Klinglmair (2004) defined the shadow
economy as all currently unregistered economic activities that contribute to the officially
calculated (or observed) Gross National Product (GDP). He considered the underground
economy as all market-oriented activities-whether legal or illegal- that escaped detection in
the official estimates of GDP. On the other hand, Schneider (2008) defined underground
economy as one that includes only all legal and market-based production of goods and services
that are deliberately concealed from governments for the following reasons:

1. To avoid payment of income, value added or other taxes,

2. To avoid payment of social security contributions,

3. To avoid having to meet certain legal labor market standards, such as minimum wages,
maximum working hours, safety standards, etc., and
4. To avoid complying with certain administrative procedures, such as completing statistical
questionnaires or other administrative forms. Despite the disagreement among the definitions
on the legality status and whether monetary transaction or not of the activities, the scholars
agree on the exclusion of do it-yourself activities. The lack of consensus in formulating a unified
theory of the shadow economy, or even a precise definition of the components that comprise it,
suggests that important questions remain unanswered (Fleming et al, 2000). However, a
useful definition of shadow economy should be one that includes all unreported incomes
from the production of legal goods and services, either from monetary or barter transactions –
and so includes all economic activities that would generally be taxable were they reported to the
state (tax) authorities (Buhn et al, 2007). The literature on the definition of underground
economy includes some or all of those entries in the table reported below.

Table 2.1: Taxonomy of types of underground economic activities

Source: Taken from Buhn et al (2007) as cited from Lippert and Walker (1995)

To summarize, it can be said that the total economy is made up of the measured
economy and the hidden economy. The measured economy comprises of the official
economy, (that which follows all laws and regulations and is recorded by national
authorities), and a fraction of the informal economy (that is not either recorded
orestimated by authorities). For example, the fiscal authority in Ethiopia (Ministry of
Finance and Economic Development-MoFED) considers some estimates of the informal
economy while computing the GDP of the country. Hence, the underground economy may be
regarded as to refer to the illegal economy, the unmeasured portion of the informal sector,
and all other economic activities that goes unrecorded. The method we will be using to
quantify the hidden economy in Ethiopia will force us limit our definition to those
unrecorded activities involving monetary transactions irrespective of legality as it is not easy to
discriminate the activities at least for now.

2.2. Main causes of the informal economy

Many factors cause or encourage informal economy depending on the country and the
historical moment of which we speak. It is important to know what may be the main
factors of the problem to adopt appropriate policies. The informal economy also has a historical
and cultural nature. There are countries where it is widespread and is not perceived as such, but
as another way of doing business, often the only one. In most cases, when the informal economy
has reached a significant size, we have a problem of poor public governance (Moore, 2007)
(OECD, 2008).

First, the form of government affects the informal economy. When there is not a strong
relationship between state and citizens, the latter seek alternative ways to operate forming what
could be defined as informal economy (this time with a wider connotation than it can be a
motivation in tax matters). An example of a form of government that can counter the rise of the
informal economy is democracy. But for good governance, you also need an appropriate
institutional apparatus on the relationship between citizen and government is founded. In these
countries, people have a particular interest to operate in the formal economy, as an
economic activity, to grow, requires public institutions and the informal economy
consequently have a reduced dimension. The literature had underline three main factors
that have a strong correlation with the informal economy. They are tax burden, intensity of
regulations, governance structure. (OECD, 2010) (Schneider & Buehn, 2009)

This vision does not want to be exhaustive, but it gives a better understanding on what we should
care about when we study how lowering informal economy. So we select the following three
factors that could have a main correlation in informal economy: fiscal burden, intensity of
the law and public service (Schneider & Buehn, 2009).

2.3. Importance of informal sector in the economy

The main importance of informal sector is the sector as source of innovation, creativity,
Capital saving and growing production. (Younus, 1977) The informal sector represents an
important part of the economy and certainly of the labour market in many countries especially
developing countries, and thus plays a major role in employment creation, production and
income generation. In countries with high rates of population growth and/or urbanization,
the informal sector tends to absorb most of the growing labour force in the urban areas
(Hussmanns and Farhad, undated).

Informal sector is capable of absorbing large proportion of the new entrants into the
laborforce that the formal sector is unable to cope with the increasing numbers of the
poor, unskilled, and illiterate. The majority of survival needs drivers such majority to
create employment or self-employment and generate income in the informal sector. The
sector provides employment more over necessary goods and services for the lower income
groups (ILO, 1972). The informal economy comprises half to three-quarters of all non-
agricultural employment in developing countries and 41.4% in
Ethiopia.http://www.ilo.org/global/topics/employment-promotion/informal-economy/lang--en/
index.htm

It operates as a means to access paid work where this might be difficult in the formal sphere, a
situation that affects diverse groups such as people with poor educational or vocational
qualifications, those who have been out of work for a period of time. Informal paid work can
have a positive role in peoples’ lives, keeping them from poverty, and the development
of confidence and skills, and building social capital (Travers, 2000).The sector plays important
role of income distribution, make active competition, exploit market functions, improve
productivity and technical change and finally creates economic development.

According to Llanes M and Barbour A, Hatcher M, (2007),Copisarow R and Barbour A,

(2004), Neale, E. and Wickramage A,(2006). The positive consequences of the informal
economy are that it: Increases income and Increases self-confidence, Improves skills, Expand
work experience, Develops the habit of work, Leads to minimize cost of product, sustain
economic activity, provides employment, Offers flexible working hours and conditions, Has
reduced barriers to entry, promotes entrepreneurial spirit, Supports the formal
economy.http://www.wikipreneurship.eu/index.php5?title=Informal_economyIt minimizes costs
of customers due to minimize their cost by absence of taxes, social security contribution, and
obligatory deduction and work regulations. (Maliyamkono and Bagachwa,1986).cited in Sisay
Seifu, (2005).The importance of informal sector is providing income and employment many of
who cannot get employment in the formal sector. The urban informal sector plays greater
role in the economies of developing countries. In developing countries, an half to three
quarter of the non-agricultural labour force is in the informal sector and street vending
share a significant portion of that work force. (Chen and Carr, 2001). The average size of the
informal economy, as a percent of official GNI in the year 2000, in developing countries
is 41%, in transition countries 38% and in OECD countries 18%. In Ethiopia informal economy
percent of GNP in1999 -2000 was 40.3 http://en.wikipedia.org/wiki/Informal_sector

The informal sector is a persistent economic feature of most developing economies,

contributing significantly means of employment, production, and income generation.
Recently, in developing countries estimates of the size of the informal sector in terms of its
share of non-agricultural employment range is roughly between one-fifth and four-fifths and in
terms of its contribution to GDP, 25% and 40% of annual http://web.worldbank.org/The other
study shows the informal sector in makes a big contribution to sub-Saharan African economies
that increased economic growth and employment opportunities. The sector contributes nearly
55% of the sub continent's GDP and a staggering 77% of non-agricultural
employment.http://ledna.org/documents/importance-informal-economy-local–economic
development-led-Africa even if little attention has been paid to the role of informal sector in
development growth and creating jobs, the sector contributes about 55 per cent of Sub-Saharan
Africa's GDP and 80 per cent of the labor force. 90 % rural and urban workers have
informal job in Africa and most of them are women and youth.

The opportunity of informal sector in Africa is mostly for the poorest, women and
youth.http://www.afdb.org/en/blogs/afdb-championing-inclusivegrowth-across-africa/post/
recognizing-africas-informal -sector-11645/
 The informal sector importance particularly in Ethiopia is the same as formal sector by
labor absorptive capacity(50.6 percent of urban employed was in the informal
sector). (CSA, 2003)
 The annual average growth rate of the labour force between 1995 and 1990 was 2.3% and
2.4% between 1991 and 2000. While the rates of population growth during the same
periods were 3% and 3.3% respectively. Therefore we can understand easily a gap
between the demand and supply of labour. on the other hand the rate of urban
unemployment in the country, it was 8% in 1984 and 21.2% in 1992 and about 23 %
by 2004, three times that of the 1984 (CSA, 198 4 and 2004). The formal sector
cannot solve this unprecedented unemployment problem. In contrast, the informal
sector has become by far the largest employer in urban center. The labour
absorptive capacity of the sector has been over 50% of the total employment (CSA, 2004
and 2004b) (Habtamu, 2012)
 CHAPTER THREE

RESEARCH METHODOLOGY

3.1. Description of the study area

Mekelle is the capital city in the northern Tigrai region of Ethiopia. It is located around 780
kilometers north of the Ethiopian capital Addis Ababa, at a latitude and longitude of 13 O 29’N
39O28’E with an elevation of 2084 meters above sea level. The 2017 census results show that the
total population of is 215,546 people. Women made up 51.4 percent of mekelle’s population and
men represented 48.6 percent. Administratively, mekelle is considered a special zone, which is
divided in to seven sub cities. These are Addi Haki, Ayder, Haddinet, Hawelti, Qedamay
Weyyane, Kwiha and Semien.
3.2. Data source and type

To conduct this study, the researcher will use both primary and secondary data. The primary data
includes socio-economic characteristics of the respondents. Thus, the study has mostly used
primary cross-sectional data for the time period of 2017/2018 that will obtained from sample
respondents. The secondary data relevant for this analysis will obtained from the Ministry of
trade and custom authority mekelle branch, the Web site, and other relevant sources.

3.3. Sampling Design and Procedure

Mekelle city has 7 sub cities and 33 keblles under subcities. Since the informal sector
participants of the city are not homogeneous across kebelles, the sample for the study was drawn
proportionally from all kebelles of the Town. 150 households will be randomly selected by using
multistage stratified sampling and face to face personal interview was implemented to elicit their
socio economic and demographic characteristics.

3.4. Methods of data analysis

For the analysis of the data collected from the sample respondents both descriptive statistics and
econometric analysis methods will be used. Descriptive statistical tools such as percentages,
tables and figures were employed to summarize the informal economic activities in the region
the analytical approach that is commonly used in participation is difference in difference method.
Therefore, this study used difference in difference method (DID) to analyze the role of informal
sector on poverty alleviation and job creation.

3.5. Econometrics Model

3.5.1. Difference in Difference Model

In order to estimate the role of informal sector participation on poverty alleviation and job
creation the Differences-in-Differences (DID) method will be implemented. DID method is
suitable for identifying the effects of policy intervention or program in which information on
the variables of interest exists before and after the introduction of the intervention. Such
intervention typically targets a certain group of individuals (treated group) who are the
participants while the remaining group of individuals (control group) is not exposed to the
participation (Wooldridge, 2002). In this case the approach measures the role of informal sector
participation on poverty alleviation and job creation households in non-participants (control
group) however, DID approach could be potentially invalidated by the presence of unobservable
time-variant differences. The hypothesized relationship between informal sector with poverty
alleviation and employment creation will be represented by equation (1)

Pr (Rit =1) = α0 + α1pi + α2Tt + α3pi*Tt + α4Xit+ αi + εit

Where, Rit is a dependent variable which is income by household i at time, t. p i is a dummy

variable identifying whether or not the Respondent household is participant in informal
sector. Tt represents a time dummy equal to one for the post- participation period and zero
otherwise. The Pi* Tt coefficient of the interaction variable thus captures the role of informal
sector participation. Finally, Xit is a vector of other control variables including education, age
and sex. αi represents time-invariant household specific characteristics like managerial ability,
credit access, that affect production on all household equally and the error term is denoted by
εit.

The parameters of interest in equation (1) are α 1, α2 and α3.α1 represents pre-existing differences
in income/ day and job offer between the participant and non-participant while α 2 represents the
change in income/ day and job offer after the participation. the major parameter of interest is
α3, which captures by how much the participation changed in the participant as compared to
the non-participant the same method will be implemented for the rest variable interests.
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