Shadow Economies Cushion Shocks but Weaken Growth Prospects, IMF Study Shows

The new working paper, issued by the International Monetary Fund and drawing on complementary research from the International Labour Organization and the World Bank's Enterprise Surveys, challenges the prevailing narrative of informality as an unmitigated drag on development. For decades, policymakers have viewed informal economies as evidence of structural weakness, a symptom of poor governance, low productivity, and chronic revenue losses. Yet the IMF economists behind this study argue that informality also serves as a stabilizer in countries subject to recurring economic shocks. In Bolivia, where informality accounts for 85 percent of employment and contributes nearly 70 percent of the GDP, this “shadow economy” is not peripheral but central to the country's economic life. Through a dynamic stochastic general equilibrium model, the researchers show that informal labor markets and enterprises, with their inherent flexibility, cushion output and inflation against sudden downturns that might otherwise devastate livelihoods.

A Global Map of Informality

The report begins with striking contrasts. In Sub-Saharan Africa, informality dominates almost entirely: in Niger, Burundi, Chad, and the Democratic Republic of Congo, more than 90 percent of workers operate outside the formal system. South Asia mirrors this pattern, with India and Bangladesh recording overwhelming informality rates. Latin America also presents vivid examples, with Bolivia and Guatemala surpassing 80 percent. By contrast, advanced economies report negligible informality; Switzerland, Austria, and Belgium record less than 1.5 percent of their labor force in informal employment. This divergence underscores the profound institutional and structural differences between economies. But for developing countries, the dilemma is sharper: while informality is a marker of underdevelopment, it also functions as a pressure valve, enabling adaptation when formal markets seize up.

Inside the Model: Flexibility Versus Rigidity

The IMF researchers design a model that divides the economy into formal and informal spheres. Formal firms operate with wage contracts negotiated by unions, and both wages and prices are sticky, echoing the rigidities familiar in advanced economies. Informal actors, by contrast, operate without contracts, and their prices and wages adjust rapidly to market fluctuations. The government collects revenue mainly from formal firms, but loses out substantially to tax evasion in the informal sector, constraining fiscal capacity. Households are split between those with access to credit, able to smooth consumption over time, and “hand-to-mouth” households who survive period to period on disposable income. Workers can move between sectors, and this mobility is what gives informality its buffering power. In periods of stress, employment shifts into informal markets, providing a safety net that the formal system cannot deliver.

Shock Scenarios: When Informality Cushions the Blow

The simulations reveal a series of intriguing dynamics. When a negative productivity shock hits, output falls less in an economy with informality because wages and inputs in the informal sector fall quickly, encouraging production and employment to shift. Consumption also tilts away from tradable goods toward cheaper non-tradables. Inflation spikes are muted and dissipate faster compared with a purely formal economy. Fiscal consolidation, modeled as a one percent cut in government spending, produces a less severe contraction in output when informality is present, though inflation falls sharply and stays depressed longer. When foreign demand rises, informality magnifies the upside: output expands more strongly, with minimal inflationary fallout, because informal firms can ramp up supply quickly. Even in the harsh test of a 30 percent exchange rate devaluation, informality softens the blow, output shrinks less, and inflation spikes are limited to eight percentage points instead of ten. For commodity-dependent exporters like Bolivia, such margins matter significantly.

The Double-Edged Sword of Informality

The paper’s central message is paradoxical. Informality cushions the economy against shocks, making downturns shallower and recoveries smoother. It stabilizes consumption, keeps employment more resilient, and prevents inflation from spiraling. Yet this short-term benefit comes at a long-term cost. High levels of informality erode the tax base, starve governments of the revenues they need to invest in infrastructure and education, and trap economies in a low-productivity equilibrium. Policymakers therefore face a delicate balancing act: acknowledging the stabilizing function of informality while steadily pursuing reforms that expand formality, strengthen fiscal capacity, and promote inclusive growth. The authors situate their findings within a broader body of research, from Harris and Todaro’s dual-sector model to more recent work by Castillo, Montoro, and Ospina, all of which grapple with the contradictory role of informality. The conclusion is stark: no country has achieved lasting prosperity with informality rates above 80 percent. For Bolivia and peers, the challenge is to harness informality’s resilience without becoming trapped by it.