Most countries strive to increase entrepreneurship, thinking that doing so will help to drive the economy forward. Much of this effort understandably focuses on formal entrepreneurship, but recent research highlights the jobs that are created by informal firms that typically operate under the radar.

The researchers propose a new way to categorize startups, adding more depth to the classic “dual economy” model. Instead of just two types, they suggest four, aiming to better reflect the reasons people start businesses and the structures they choose, especially in developing economies.

The first two types follow the standard model. Type 1 firms, or “informal-necessity” startups, are small businesses set up by people with lower income or education who need to make ends meet. These are usually low-productivity operations. Type 2 firms, called “formal-opportunity” businesses, are started by higher-income, educated individuals who seek growth. These tend to benefit economic development more.

The next two types are new additions. Type 3, or “informal-opportunity” startups, are launched by people with higher incomes who use informality as a low-cost way to test business ideas before fully committing. Lastly, Type 4, or “formal-necessity” firms, are set up by higher-income individuals who still feel compelled by necessity but choose the formal route for its potential advantages.

Capturing the nuance

This new framework captures a broader range of reasons for starting businesses and has implications for how policymakers can support entrepreneurs in different situations.

The researchers find that higher-income people tend to go for either the formal/necessity path or the informal/opportunity path, which is largely consistent with the perspective espoused by the dual economy. This isn’t the case for lower-income individuals, however, who are more likely to pursue informal/necessity routes to entrepreneurship.

The informal sector, often seen as a temporary stop for entrepreneurs, could be a bigger part of the economy if policies encouraged it to go formal. Instead of just allowing informal businesses to operate in the shadows, policymakers should aim to bring them into the fold by lowering the barriers of formal registration. A gradual approach—where formality is required only after certain revenue levels—could ease this transition.

Involving local communities

Local communities should also have a say in the registration and taxation of new businesses. For instance, if an ethnic minority group is given the authority to set its own registration criteria, then revenue should stay within the community, fostering trust and local growth.

Too many rules and bureaucratic steps only keep businesses in the informal sector. People often trust local authorities more than distant government offices. Giving local communities more control and tailoring policies to local needs would help people see the benefits of formality.

Simpler tax codes, low tax rates, and minimal payroll obligations could help. So would creating social protections that support people as they move out of the informal economy. Benefits should be phased out slowly as incomes grow, preventing sudden income drops. And, allowing temporary tax breaks based on individual or household income could prevent repeated registration and encourage genuine entrepreneurship.

Several structural reforms would make this shift sustainable. These focus areas are key:

• Education: Make sure everyone has access to basic and vocational education to build a skilled workforce.
• Financial Inclusion: Improve access to banking and loans for minority groups to help businesses grow and reduce informality.
• Labour Market Access: Lower barriers to entry for informal workers, creating a more flexible, inclusive workforce.
• Digital Access: Use digital platforms and innovation to boost financial empowerment, which helps small businesses grow and stay in the formal sector.
• Crisis Preparedness: The COVID-19 pandemic showed the importance of quick, flexible crisis responses. Planning for future crises is essential to keep businesses afloat and compliant.

Importantly, the government isn’t the only force for change. Socially conscious entrepreneurs play a role by sharing knowledge and making financial education more accessible.

With these changes, a steady shift from informality to formality would fuel sustainable and inclusive growth, making businesses more competitive and economies stronger.