Making it easier to formally register a business has been one of the most popular areas of business regulatory change over the last two decades, with the World Bank’s Doing Business project identifying 558 reforms taking place in 171 economies between 2006 and 2016 (World Bank, 2017).

However, the majority of self-employed individuals and firms with only one or two workers remain informal in many developing countries. As described in this report, studies that investigate the provision of information and lower cost of formalization have found at best modest effects on formalization. The evidence that increased enforcement leads informal firms to register is more compelling. A key issue for policymakers is whether there is a public rationale for attempting to formalize small-scale firms.

The research discussed in this report presents clear evidence that, despite significant efforts to lower the cost and complexity of business registration, most small-scale enterprises in developing countries continue to operate informally. This suggests that these firms typically view the benefits of formalization as smaller than the costs, and that their decision not to formalize is a privately optimal one. There is therefore no clear policy rationale for attempting to bring most of these small-scale firms into the formal sector. This does not imply that there is no cost of inefficient and costly regulations; efforts to simplify regulations will clearly benefit those firms that choose to go through the registration process.

There are several compelling reasons to attempt to bring larger and more profitable informal firms into the formal system. For example, in many developing countries there is a need to widen the tax base, and there are potential benefits from collecting taxes from relatively well-off owners of informal firms. Andrade, Bruhn, and McKenzie (2014) suggest that inspecting informal firms in Brazil that earn an average of USD 1,000 a month in profits would formalize more than enough firms to pay for the costs of such enforcement. Furthermore, these relatively successful informal firms are more likely to be the ones competing with formal firms for customers, so ensuring that they become formal also has benefits in terms of reducing unfair competition that prevents more efficient formal firms from growing. The evidence discussed in this report suggests that reducing the cost and complexity of formalization is a necessary but insufficient step to encouraging such firms to formalize, and that policymakers also need to increase enforcement of rules and investigate innovative approaches to encouraging suppliers and customers to demand formality.

As for very small-scale subsistence enterprises, the evidence suggests that such firms see no benefit from formalizing and would typically contribute very little to taxes if they did formalize. In the absence of other job opportunities for such individuals, it may be optimal for the government to leave them alone rather than closing them down. Another rationale for the government to encourage formalization is in order to obtain basic data on firms in the economy, which can then be used for better targeting of programs. As shown by Campos, Goldstein, and McKenzie (2018), the government can achieve this by separating business registration (for which demand can be high) from tax registration (which most firms many not want to do), and thereby allowing partial formalization in order to benefit from the data that firms provide on their business registration form (such as location and sector).

Governments may also attempt to bring firms into the formal sector for fear the presence of a large number of informal firms may send a message to the public that it is not necessary to obey the law, which may dissuade more profitable informal firms from formalizing, as discussed in the "broken windows" theory of crime (Keizer, Lindenberg, and Steg, 2008). An alternative approach would be to structure the law in a way that does not require firms with income below a certain threshold to register, making them in compliance with the law. However, unless such a threshold is set very high, it is still likely that many firms above the threshold will choose not to register.

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