How do we measure the informal economy? There are two approaches in the literature in attempting to respond this question. The first focuses on measures of hidden income, while the second on the size of informal employment. The size of the informal economy can differ considerably depending on which measurement we use.

Examples of the first approach include Schneider  and Chaudari et al. who define informal all unregistered economic activities, which contributes to the officially calculated GNP. This strand of literature focuses on all the portion of income from legal activities not considered by the standard measurement procedures used for the compilation of national income accounts. A broader view includes illegal activities and the informal household economy, but a stricter definition looks mainly at all legal activities that would generally be taxable. Those activities are unreported mainly for tax evasion and to avoid social security contributions and other labour market regulations.

The National Commission for Enterprises in the Unorganized Sector (NCEUS from now on) reports on Definitional and Statistical Issues relating to the Informal Economy in India is an example of the second approach. According to this report, the informal (or unorganized) economy is given by the informal (or unorganized) sector and its workers plus the informal workers in the formal sector, where the unorganized (informal) sector is defined as all incorporated private enterprises owned by individuals/households with less than 10 workers. Also the report defines unorganized (informal) workers, as workers in the unorganized sector, households, excluding regular workers with social security benefits, plus workers in the formal sector without any social security benefit.

From a methodological point of view, the size of the informal economy has been estimated directly and indirectly. The direct method relies on surveys or samples, while the latter uses macroeconomic indicators with information on informal activities. The main drawbacks of direct methods as survey or tax-auditing are that the information collected is often incomplete, samples can be biased, and also they refer to one point in time, lacking information on the development of the phenomenon over a period of time.

There are a variety of indirect methods to quantify the extent of informality. Schneider  describes five of the most used methods. Schneider, for example, opts for the currency demand and the DYMIMIC (dynamic-multiple indicators multiple-causes) methods. The former of these is based on the assumption that cash payments is used for hidden transactions so an increase in the demand of currency should reflect, separating all other possible causes, an increase in the number of hidden transactions. The latter of these, which is an evolution from the MIMIC or unobserved/latent variables approach is based on the critique that the shadow economy has an impact not only on money market, but also on production and labour markets. The size of the hidden economy (unobserved variable) is influenced by a set of (measurable) indicators/causes such as the burden of taxes and regulation as well as tax morality, and change in labour force participation. Based on the statistical theory of unobserved variables, the unknown coefficients are simultaneously estimated in a set of structural equations typically by maximum likelyhood. The indicator variables are used to capture the effect of the unobserved variables indirectly. Different combinations of causes and indicators can then be used to provide different estimates (Chaudari et al. (2006)). This method provides a time-series index for latent variables, an ordinal index which is then converted into a cardinal series of values of size by scaling up ordinal values to cardinal values previously obtained through other indirect methods (i.e., currency-demand approach). One of the main criticism of this method is the lack of a theoretical link of causes and indicators with informality being the only unobserved variables linking them (Perry et al. (2007)).

In response to some of the criticisms of the MIMIC approach, Solomon (2008) uses a RBC model as a theoretical framework for choosing causes and indicators used in the estimation of the size of the informal economy.