Why are Brazil's economic-growth prospects just 3 to 4 percent a year despite the country's improved monetary and fiscal stability, while fellow emerging giants China and India are increasing their GDPs by 7 to 10 percent? A major but often overlooked reason is Brazil's huge informal economy, which restrains productivity and discourages business investment. This gray market limits the effectiveness of otherwise sound macroeconomic measures and reduces the potential for economic growth. In fact, a study¹ shows that Brazil's economy could grow by an additional 1.5 percent a year if the government emulated the successful efforts of other countries and launched a comprehensive program to fight informality.

The informal economy accounts for about 40 percent of Brazil's gross national income—a much bigger share than it claims in China and India (Exhibit 1). It consists of companies that operate partially or wholly outside the law by avoiding taxes, ignoring product-quality and -safety regulations, infringing copyrights, and sometimes even failing to register as legal entities. In this way, these companies gain a cost advantage and thus compete successfully with their law-abiding counterparts, though on average they achieve...