The Informal Economy
This informal-formal business divide generates questions for policymakers, particularly with governments around the world actively trying to induce firms to enter the formal sector, often by eliminating red tape. Why don’t informal firms take the steps to become formal businesses? What steps can provide the incentives to lead them toward a transition? And, if these informal operations become formal ones, do profits improve? Do tax receipts rise?
These questions underlie the research two colleagues and I conducted in what is the first field experiment of its kind, offering inducements for informal firms to register as formal businesses. The experiment allowed us to analyse the demand for and consequences of formalization. It offered a test of two competing economic views: Do businesses remain informal largely due to actual or perceived costs of registering, or do they make rational decisions not to pursue formal registration because the actual or perceived benefits are not worth it.
We conducted our research in Sri Lanka, which is representative of many developing countries in that only one-fifth of firms operating without paid workers are registered with any government agency. Even among firms employing paid workers, the majority are unregistered with one or more pertinent agencies.
We worked with informal firms that had one to 14 paid employees. We randomly divided the sample into four experimental groups and one control group. The first group received information about the costs and benefits of, and procedures for, registering their firms with the Divisional Secretariat (DS) – the relevant registration for tax purposes. They were also reimbursed for the modest, direct cost of registration. The second, third, and fourth experimental groups received the same information and were offered payments of varying amounts, representing up to two months’ profit for the median firm – an amount roughly equal to $350. Three follow-up surveys of these same firms were conducted 15, 22 and 31 months after the intervention, enabling us to examine whether and how the firms benefited from formalization.
Prior to the intervention, owners of unregistered firms were either ignorant of or vastly overestimated registration costs. We might therefore have expected that simply informing firms about registration costs would be sufficient to induce registration. But, in fact, it did not. Instead, registration was spurred only when the information was combined with incentive payments. A payment of two months’ profit was sufficient to lead half of the firms to register.
The businesses’ decisions to remain as informal operations, even when the direct costs of registering would have been reimbursed, suggests these firms are not being excluded from the formal sector by high registration costs. The willingness of firms to register for a modest payment suggests that they perceive modest costs but even more modest benefits from establishing themselves as formal operations. It provides support for the view that firms are making rational benefit-cost decisions in this regard.
The experiment shed light on the nature of barriers to formal registration. more than half those offered the largest incentive payment did register. These firms operated with informal leases or agreements—ironically, often on governmentowned land—and hence were unable to provide authorities with the required proof of ownership of the land on which the firm operated.
The firms that did formalize saw larger increases in profits, our follow-up surveys found, although this impact seems largely due to the experiences of a few firms experiencing substantial growth. In looking at the channels through which businesses might have benefitted, we found increased advertising and use of receipt books, but no increases in receipt of government contracts, use of bank accounts or loans, or participation in government programmes.
Our findings offer important insights on a variety of policy fronts. First, while governments clearly should not mimic our experiment with a policy of direct payments, the results do suggest that modest increases in the perceived benefits of operating as a formal business could be expected to dramatically increase demand among informal firms for registration. At the same time, however, no evidence emerged of a pent-up demand to conduct business in formal channels among existing, informal firms.
Whether tax collections increase enough to pay for any increased benefits (or, alternatively, to pay for increased enforcement efforts) is beyond the scope of our research project. our data do suggest, however, that given the current tax code, the additional tax collections would not be large among this sample of firms. This, combined with the fact that the spillovers to growth are modest suggests that near-term gains to the government of increased formality are limited.
At the same time, our results do hold some potential for governments to think about how formalization can affect trust and attitudes toward government. Leaders of the firms that formalized were more likely to trust local government and to agree that paying taxes is a civic duty. At the same time, one must note, they were also more likely to agree that small businesses are taxed too much.
About the authors
Christopher Woodruff is a professor in the Department of Economics at the University of Warwick, and a fellow of the Centre for Competitive Advantage in the Global Economy. He is a leading expert on enterprises in developing countries and a pioneer in the use of field experiments to understand enterprise dynamics in the developing world. Professor Woodruff also directs the Private Enterprise Development in Low-Income Countries, a joint research initiative of the UK Department for International Development and the Centre for Economic Policy Research.
Suresh de Mel is a Senior Lecturer at the University of Peradeniya.
David McKenzie is lead economist of the Development Research Group at the World Bank.
This article is based on the academic paper, “The Demand for, and Consequences of, Formalization Among Informal Firms in Sri Lanka”, forthcoming in the American Economic Journal: Applied Economics. A draft is available here.