Rethinking Informality: What is Keeping Firms from Going Formal?

In the developing world, most businesses aren’t registered with municipal or tax authorities. Many have argued that these “informal” firms hurt local tax revenues, cut into the customer base of “formal” firms and lead to low wages for workers. Despite a decade of reforms to make it easier for firms to register, however, the trend has barely budged.

What is going on? Why aren’t firms lining up to register after governments around the world significantly cut down on the time and cost needed to register a business? Is something other than the registration process that is holding firms back? How should we adjust our approach to the informal economy? These topics were explored July 9 at the Policy Research Talks Series, a monthly event by the World Bank’s research department that aims to foster a dialogue between researchers and operational colleagues.

“The persistence of informality suggests there may be too much focus on becoming formal but not enough focus on the costs and benefits of being formal for businesses,” said World Bank Research Director Asli Demirguc-Kunt, who chaired the event. “It’s time to rethink policy approaches to informality.”

The cost of going formal, including registration fees, tax payments and even land rights, outweighs the benefit for most informal firms, said David McKenzie, a lead economist in the research department’s finance and private sector development team, who has studied informal firms extensively. “Most firms are making what is for them the privately rational decision.”
 
Size is a major factor. The majority of informal firms – 90% in Sri Lanka, for example – are subsistence enterprises with no paid employees, and only a small percentage have more than five workers. Even after registration, those firms likely will pay little in taxes under a progressive income-tax system. They may not be able to compete with large, formal firms, either.

When the informal firms grow to 10 employees or more, however, they will often register with municipal, tax and labor authorities, which makes it easier for them to run advertisements and secure permanent locations for their business.

Business registration reforms advocated by the World Bank’s Doing Business project, such as simplifying tax systems and creating one-stop-shop, cut down on the time and cost of opening a business, but that alone isn’t enough to create a net benefit for informal businesses.

That’s why, McKenzie said, 72 percent of all firms remained informal after such reforms in Brazil’s Minas Gerais state. In Mexico, which reduced the time needed to start a business from 30 days to one day, business registration rose 5 percent. Even so, most of them were new businesses.

To address the problem, McKenzie suggested that governments make “sensible” laws that, for example, would make it voluntary for subsistence firms to register. They can also encourage firms to register by lowering fees even further, and beefing up inspections and other enforcement measures. The use of a tax-invoice lottery, among other creative ways, has proven to be effective in China, Korea and Puerto Rico.

Marialisa Motta, director of the Financial and Private Sector Development network in the Latin America and Caribbean Region and the FPD Investment Climate Global Practice, said McKenzie’s research findings uncover important traits of informal businesses. “We should continue on this path, and learn more about these firms,” she said. “For example, which sectors do informal businesses belong to? In which client segments do informal firms compete with formal firms?”

It’s also important to better understand which policies can make a difference for small and large firms that have the potential to grow and employ the owners of subsistence informal firms, she said. “An informal street vendor in India has a better chance of getting a job with Tata Motors, Lipton Tea or Unilever Cosmetics than turning her business into a Whole Foods.”