It's no secret that some companies operate partially or wholly outside the law by underreporting employment, avoiding taxes, ignoring product quality and safety regulations, infringing copyrights, and even failing to register as legal entities. The problem is particularly acute in developing countries, but it is widespread in some developed nations too (see "Making Portugal competitive"). The World Bank estimates that this informal economy¹ generates 40 percent of the GNP of low-income nations and 17 percent of the GNP of high-income ones.² In some industries, such as retailing and construction, informality can account for as much as 80 percent of employment.

Policy makers show surprisingly little concern about this phenomenon. In emerging markets, governments frequently view it as a social issue and fail to understand its damaging effect on productivity and economic growth. The informal economy, they believe, creates jobs for unskilled workers and relieves urban employment tensions. Some academics argue that the informal economy will disappear over time as the formal manufacturing and service sectors grow and create more jobs. Well-meaning development experts believe that informal companies themselves will grow and eventually join the formal economy if they are given credit and other types of technical...