The original use of the term 'informal sector' is attributed to the economic development model put forward by W. Arthur Lewis, used to describe employment or livelihood generation primarily within the developing world. It was used to describe a type of employment that was viewed as falling outside of the modern industrial sector. An alternative definition uses job security as the measure of formality, defining participants in the informal economy as those "who do not have employment security, work security and social security". While both of these definitions imply a lack of choice or agency in involvement with the informal economy, participation may also be driven by a wish to avoid regulation or taxation. This may manifest as unreported employment, hidden from the state for tax, social security or labour law purposes, but legal in all other aspects. Edgar L. Feige has proposed a taxonomy for describing unobserved economies including the informal economy as being characterized by some form of non-compliant behavior with an institutional set of rules. Feige argues that circumvention of labor market regulations specifying minimum wages, working conditions, social security, and unemployment and disability benefits gives rise to an informal economy that deprives some workers of deserved benefits while conveying undeserved benefits to others.

The term is also useful in describing and accounting for forms of shelter or living arrangements that are similarly unlawful, unregulated, or not afforded protection of the state. 'Informal economy' is increasingly replacing 'informal sector' as the preferred descriptor for this activity.