Hidden Economies: Uncovering the Role of Informality in Kenya’s Business Landscape

A new report by the International Finance Corporation titled "Spatial Inequality and Informality in Kenya’s Firm Network" reveals how Kenya's formal sector data overstates urban trade while underestimating the critical role of the informal economy in rural regions and downstream sectors. This informal sector, which constitutes a significant part of Kenya's economy, is vital for connecting smaller markets and ensuring local trade flows. The report calls for a shift in policy to recognize the importance of the informal sector, which can help reduce spatial inequality and strengthen domestic supply chains.

In a country where vibrant, informal markets make up a significant portion of economic activity, Kenya’s formal trade data paints a partial, often skewed picture of the economy. A new report by the International Finance Corporation titled "Spatial Inequality and Informality in Kenya’s Firm Network" explores the gap between formal economic data and the largely overlooked informal sector, which is vital to the country’s economic well-being.

This study highlights how spatial inequality and the concentration of formal businesses in urban hubs like Nairobi and Mombasa contribute to a distorted understanding of Kenya’s domestic economy. It calls for a more nuanced view that includes informal businesses, particularly in smaller regional markets and downstream sectors. The findings present a compelling case for why Kenya, and perhaps other developing nations, should pay greater attention to the informal economy.

The Formal Sector Bias

Kenya’s economy is characterized by a stark divide between formal and informal businesses. Formal firms, which pay taxes and are subject to regulation, are heavily concentrated in urban centers, while informal businesses dominate rural areas and smaller markets. According to the report, which combines transaction-level data from formal firms with population census information on informal activity, formal businesses contribute only 36% to Kenya’s gross domestic product (GDP).

This concentration of formal businesses in metropolitan areas creates a false image of the country's economic activity. It overstates the importance of cities like Nairobi and Mombasa while downplaying the critical role that informal businesses play in connecting various regions through local trade networks. The report reveals that while formal sector data suggests trade flows are mostly between large urban areas, informal trade links, especially in smaller counties, are far more significant than previously thought.

The Role of Informality

Kenya's informal sector plays a crucial, albeit largely invisible, role in the economy. These businesses, which often operate outside of government regulations, are not evenly spread across the country. Instead, they cluster in specific sectors and regions. Informal activity is especially prevalent in downstream industries like retail, food service, and small-scale trade, often making up the last link between products and consumers.

The research found that informal firms are particularly active in rural areas, where they are more likely to operate in proximity to larger, formal firms. These informal businesses serve as distributors for goods produced by formal firms, creating a complex, symbiotic relationship between the two sectors. However, because informal firms do not file tax returns or engage in other formal business processes, much of their contribution to local and regional economies goes unnoticed.

"Informal businesses are not just marginal players; they are essential to the functioning of Kenya's domestic supply chains," says the report. By operating under the radar, these firms provide critical goods and services in areas where formal businesses rarely venture, ensuring that the benefits of Kenya’s economic growth reach more remote and underserved regions.

Economic Impacts and Policy Implications

The study’s most striking finding is how the exclusion of informal businesses from formal economic data can distort policy-making. For instance, without accounting for informality, economists and policymakers may severely underestimate the vulnerability of regional economies to domestic shocks, such as supply chain disruptions. Areas with high levels of informality are more exposed to such shocks, but this is often missed when using only formal sector data. Conversely, when it comes to international trade, relying on formal data can overestimate the economy’s dependence on imports, as informal firms tend to rely more on local suppliers.

This bias in data collection means that policies designed to address economic inequality or strengthen supply chains may miss their mark. The report urges policymakers to integrate informal sector data into their economic models to better understand how domestic and international shocks ripple through the economy. By doing so, they could design policies that are more responsive to the realities of regional economies and help reduce the disparities between urban and rural areas.

The report also suggests that stronger linkages between formal and informal sectors could enhance market resilience. Policies that encourage collaboration between these two sectors, rather than trying to regulate informal businesses out of existence, could strengthen Kenya’s economy, making it more robust in the face of both internal and external challenges.

Reframing Kenya’s Economic Future

Kenya’s informal economy is not just a collection of small, unregistered businesses; it is a key player in the country’s economic network. As the International Finance Corporation’s report makes clear, ignoring the informal sector creates an incomplete and misleading picture of the economy. The study challenges policymakers and economists to rethink their approach to data collection, trade policies, and economic development strategies.

By incorporating informal sector data into economic models, Kenya could not only better understand the dynamics of its economy but also design policies that foster more inclusive growth. The study concludes that recognizing the value of the informal economy will be essential in reducing regional inequality and ensuring that all parts of Kenya benefit from the country’s economic progress.