A specter is haunting the world’s developing countries –the specter of the “informal” economy. For some, the informal sector includesall businesses that have not been registered with the authorities. For others,it refers to businesses that escape taxation. The International LaborOrganization defines it as comprising firms that are small enough to falloutside the labor code.

Whatever the definition, what hasconcerned many economists and gained policymakers’ attention is that the size distribution of firms in developing countries has along tail. Compared to developed countries, an unusually largenumber of small, unproductive firms coexist with a small number of large,productive firms.

According to standardeconomic reasoning, this is inefficient. If the small, unproductive firmsclosed down and the larger, more productive firms hired their workers, totaloutput and well-being would rise. This should happen automatically through theinvisible hand of competition, because the more productive firms should be ableto deliver a better product at a lower price, while luring workers with higherwages.

So, why doesn’t this happenroutinely in developing countries? Why do the inefficient firms survive,trapping resources in low-productivity activities? What is preventing themarket from working its magic and making everyone better off?

For some, the problemis that government regulations make compliance too onerous for small firms. Others claim that tax evasion creates an unfair advantage forinformal firms, or that family-wide health care gives households no incentive to havemore than one member pay social-security taxes. For still others, programs that target the informal sector distort the playingfield.

In an effort toaddress the problem, governments in Colombia, Mexico, Peru, South Africa, and elsewhere have been busy changing theirtax codes, redesigning their registration systems, and exploring thepotentially perverseincentive problems associated with social-welfare programs. While the jury isstill out on the effectiveness of any of these initiatives, I would bet against theirsuccess.

It requires manyyears of training and abstract economic thinking to miss the obvious. The salientcharacteristic of modern production is that it mobilizes a lot of knowhow – too much to fitin the head of any single person.

Efficient productionrequires a division of labor amongthose who know about technology, marketing, finance, logistics, human-resourcemanagement, contracts, regulations, distribution, customer service, and muchelse. It requires manualand intellectual skills that must be used in tandem. Just think of thedifferent specialized skills (many of them recognized by the Oscars) that mustcome together to make a single film.

To bring these skillstogether, people have to be integrated into cooperative arrangements in thesame firm or within clusters of related firms. But, in order to get together towork, people have to travel from their homes to production sites. How do theydo that?

In the typicaldeveloping-country city, they do so with difficulty. Daily commute times forlow-income formal-sector workers often exceed three hours, and the averagedirect cost of transportation is equivalent to roughly two hours of work at theminimum wage. An eight-hour shift becomes an 11-hour shift for which net pay isonly six hours.

This implies aneffective tax rate of 45% on low-income formal-sector workers. Add to this theinconvenience of travel and the potential problems caused by being far fromhome in case of a family emergency. With these considerations in mind, itbecomes easier to understand why people would prefer to do something usefulnear home rather than where modern production takes place.

But in the shantytowns wheredeveloping countries’ urban poor live, there are few varieties of skill thatpeople can mix with their own to make things productively. As a result, theonly feasible forms of production use very few low-skilled workers – and thusoperate at low productivity. They specialize in food preparation, retail,construction, repairs, Internet cafes, and myriad other activities that can be carried out athome and sold to neighbors (often through a window facing the street).

Economists andpolicymakers have disregarded the physical aspects of urban life. Housing policy is typicallydiscussed with blatantdisregard for urban transport and the locations where industrial and businesszones are authorized. When planners designed Punta Cana – the very successfultourist destination in the Dominican Republic – or the giant Fiat plant inBetim, Brazil, they forgotto plan for their workers’ housing. Not surprisingly, shantytowns quicklydeveloped.

The informal sectoris mostly a consequence of the fact that people are disconnected from modernproduction networks – an inefficiency that will not be resolved simply byreducing the cost of registering a business or forcing small firms to paytaxes. What is required is a redesign of urban space, including subways anddedicated bus lanes, and a more integrated approach to housing, socialservices, and production areas. Governments will have to start doing some goodthings, not just stop doing some bad ones.