Economic Research Forum (ERF)

Sticks rather than carrots to expand the formal economy

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Reforms that get more firms and workers into the formal economy can come in the form of both inducements such as better information and lower costs – ‘carrots’ – and legal enforcement – ‘sticks’. This column surveys the research evidence on the potential of carrots, sticks and other development policies for promoting greater formalisation and the many benefits it can bring to the economy and wider society.

In a nutshell

Using legal enforcement, inspections and fines may be more effective at getting firms and workers to move into the formal economy than making it easier and cheaper to register.

But carrots and sticks are not mutually exclusive – and policy-makers should use an integrated approach.

Policy-makers should also follow development policies, such as upgrading skills, encouraging microfinance and reform of social security coverage, to encourage formalisation.

There are two views on informality in economic activity. One group of economists believes that the informal sector is comprised of micro-entrepreneurs who try to avoid the costs and responsibilities of formal registration. This group argues that burdensome and time-consuming regulations prevent firms from registering and thus becoming formal – and that the resulting informality results in lower productivity.

The proposed policy response is to remove burdensome regulations to increase formalisation, as recommended by international organisations like the World Bank. Over the last decade, a number of countries have followed this suggestion and introduced reforms making it easier to register a business or workers. For example, in 1996, Brazil started a process of simplified firm registration, simplified tax systems and reduced tax burdens on small firms.

A more recent alternative view of informality is proposed by neoclassical economists. They state that firms make a cost/benefit calculation in their decision on formalisation just as in any other investment decision. According to this view, informality is a choice by entrepreneurs to avoid taxes and labour market regulations.

The costs of formality may include initial registration and costs such as tax payments. The benefits of being formal may include a reduced risk of being fined, the possibility of bank financing and access to courts and government contracts and programmes. If the benefits provided by formality outweigh the costs of being formal, then the decision will be to operate informally.

Benefits and costs of formalisation

Formalisation of both firms and employment is desirable. For the government, formalisation of firms widens the tax base and brings in additional tax revenue. High levels of informality mean lower tax collection, which restricts the government’s ability to finance public services.

For the economy in general, formalisation of firms allows more efficient reallocation of resources in the economy. Formal and informal firms competing in the same industry face different production costs, such as taxes and labour costs. Furthermore, formalised firms may benefit from government programmes and bank financing possibilities, and experience higher productivity and incomes.

Formalisation of employment brings in revenue to the government from social security payments. Formalisation of employment allows social security protection of health and retirement benefits for workers as well as sanitary and decent working conditions.

From the point of view of society at large, formalisation may bring benefits, such as an orderly work and business environment, a diminished culture of informality and corruption, and increased morality and law-abiding social order. Costs for firms are the costs of registration and tax payments. Costs for the governments will include costs of information provision as well as enforcement.

Recent evidence on formalisation policies

In the fight against informality, reducing the costs of formalising is as important as increasing the costs of remaining informal. One way to raise the cost of remaining informal is to increase the enforcement of existing regulations. But there is very little research on whether enforcement efforts can induce firms to register or close down and prevent firms from starting up.

Evidence from developed countries shows that a higher likelihood of detection and enforcement leads to an increase in tax compliance. Other factors, such as a sense of moral or social obligation, are also important. Similarly, evidence from developing countries finds that the degree of enforcement matters for labour informality (Almeida and Carneiro, 2012) as well as firm informality (Andrade et al, 2016).

The former study finds that stricter enforcement in Brazil with an increase in labour inspections led to an increase in formal employment and a decrease in informal employment. Brazil implemented a new system of tax exemption and simplifi­cation for tax collection for small and micro enterprises. The latter study involved a field experiment in Brazil to find out which government actions encouraged informal firms to register.

The researchers tested several competing mechanisms for reducing informality, including: providing information about how to register; coupling this information with an exemption in registration fees and free use of mandatory accounting services for a year; and visits by randomly assigned inspectors to firms to see whether increased enforcement would encourage firms to formalise.

The results indicate that the first two mechanisms result in increased knowledge about formalisation processes but do not lead firms to formalise. In contrast, receiving a visit from an inspector does result in an increase in registration.

In Egypt, labour laws adopted in April 2003 made it easier for employers to fire workers and allowed for fixed-term employment contracts that brought more flexibility in formal employment relations. Wahba and Assaad (2015) find that this brought a certain degree of formalisation.

De Mel et al (2013) in Sri Lanka and De Giorgi and Rahman (2013) in Bangladesh find no significant impact of information alone in getting firms to register.

Conclusion

Overall, these studies imply that providing information and reducing the costs of formalising alone may not be enough to induce formalisation, and should thus be coupled with enforcement. Firms that register face costs of paying taxes as well as keeping proper accounts. These costs may prevent informal firms from wanting to formalise unless they are forced to do so. Therefore, improving enforcement is an important tool to induce formalisation.

But these mechanisms should not be considered as mutually exclusive, and implementing an appropriate combination of them could be a better strategy to increase formalisation of firms or employment. The greatest impact in inducing firms and employment to formalise may come by combining policies that involve information provision, lower time and monetary costs of formalisation and enforcement.

For policy-makers, the ultimate objective must be to support the transition to formality. Enforcement and design of the legal and institutional frameworks are prerequisites for reducing infor­mality.

The relevant legal and institutional frameworks include those that govern labour, social protection and business regulations, as well as access to financial capital and securing property rights. This requires an integrated strategy to bring informal workers and entrepreneurs into formal channels of protection, support and responsibilities with registration, while preserving their resilience and dynamic potential.

Wider development policies are also important. These could include growth-promoting policies and providing skills training programmes to upgrade the skills of workers and entrepreneurs in the informal economy. Microfinance and reforms for extension of social security coverage can also facilitate a move out of informality.

Further reading

Almeida, Rita, and Pedro Carneiro (2012) ‘Enforcement of Labor Regulation and Informality’, American Economic Journal: Applied Economics 4(3): 64-89.

Andrade, Gustavo, Miriam Bruhn and David McKenzie (2016) ‘A Helping Hand or the Long Arm of the Law? Experimental Evidence on What Governments Can Do to Formalize Firms’, World Bank Economic Review 30(1): 24-54.

De Giorgi, Giacomo, and Aminur Rahman (2013) ‘SME’s Registration: Evidence from an RCT in Bangladesh’, Economics Letters 120(3): 573-8.

De Mel, Suresh, David McKenzie and Christopher Woodruff (2013) ‘The Demand for, and Consequences of, Formalization Among Informal Firms in Sri Lanka’, American Economic Journal: Applied Economics 5(2): 122-50.

Tansel, Aysit (2016) ‘Sticks Rather than Carrots to Induce More Informality’, ERF Policy Brief No. 9.

Wahba, Jackline, and Ragui Assaad (2015) ‘Flexible Labor Regulations and Informality in Egypt’, ERF Working Paper No. 915.

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