Most microenterprises in developing countries are not formally registered with the government. La Porta and Shleifer (2014) estimate that among the poorest countries (bottom quartile based on GDP per capita), the informal sector accounts for 35% to 40% of the economy, compared to less than 20% in the richest quartile of countries.[1]
One view is that small firms generally do not need or want the benefits that come with formalization, such as access to credit or to wider markets. This “dual economy” view posits that microenterprises and larger firms operate in different spheres. According to this view, informal firms tend to have low productivity, so when they skirt taxes and regulation, they do not gain an undue advantage over formal firms, as they cannot or do not compete with higher productivity formal firms. La Porta and Shleifer (2014) argue that most informal firms would not thrive in the formal sector, and so encouraging informal firms to register will not promote economic growth. Rather, they argue that the growth of formal sector firms naturally causes the informal sector to shrink over the course of economic development. Consistent with this viewpoint, Ulyssea (2018) analyzes Brazilian firms and concludes that the vast majority of informal firms are not being held back by their informality.
Another view, championed by de Soto (1989, 2000), is that informality is holding back the growth of microenterprises. With formalization, they would have better access to capital and product markets, fueling growth. In this view, firms would prefer to be formally registered, but are deterred by the financial costs and red tape of the application process or because they lack accurate information about the benefits of formalization. De Soto’s ideas have influenced many governments and aid agencies to streamline their business registration processes.
Several studies have analyzed interventions that provide assistance with the formalization process or information on the benefits of formalization.[2] Other interventions to encourage formalization that have been studied include cash incentives to formalize, threats of inspections and fines for being unregistered, and reducing the extra tax burden that a firm incurs when it becoming formal. These studies typically have a two-fold goal of first, understanding what microentrepreneurs perceive to be the costs and benefits of formalizing and, second, assessing how becoming formalized affects firm performance. The first goal is achieved by analyzing impacts on formalization, and the second goal is achieved by assessing how the impacts on formalization, in turn, influence access to capital, profits, and so forth.
While most of studies that examine efforts to assist firms with the registration process find that doing so increases formalization (Jaramillo, 2009; McKenzie and Sakho, 2010; Campos et al., 2018), in other cases assistance is ineffective (and thus there is no first stage to assess downstream impacts). For example, de Andrade et al. (2013) find that giving information and covering fees for registration does not increase registration in Brazil, and Rothenberg et al. (2016) similarly find no impact of an Indonesian initiative that set up one-stop shops for business registration. Galiani et al. (2017) report that information on registration has only a short-run impact on formalization in Bogota, Colombia, with firms letting their registration lapse after a year. One pattern that emerges across the multiple studies is that information conveyed in person through trained staff is more effective than just brochures (de Andrade et al., 2013; de Mel et al., 2013; Benhassine et al., 2018).
A few studies in this literature restrict their attention to the first goal of examining how an intervention affects firms’ likelihood of formalizing. For example, de Mel et al. (2013) trace out the demand curve for formalization in Sri Lanka among urban firms with at least one employee (and no more than 14 employees) by providing information on registration and covering the small 5 USD fee, with additional treatment arms offering cash incentives to register, set at 88, 175, or 350 USD. The highest cash incentive represents two months of profits for the average firm. While two thirds of the firms already had municipal-level registration, they lacked the division-level registration that allows a firm to sell to the government and to larger firms, and to get commercial bank loans. Providing information and covering the small registration fee did not increase formalization, but the cash incentives did prompt firms to formalize. At the two lower payment levels, about 20% of firms registered, while with the highest (350 USD) amount, 48% of firms did so.
While de Andrade et al. (2013) find no effect on formalization of providing information on the process, or of providing information combined with paying for registration fees and offering accounting services, another treatment arm in their study had inspectors visit firms, giving them 30 to 45 days to register before another visit; if the firm was not registered by this follow-up visit, it would be fined and shut down. This arm increased registration by 4 percentage points (from a baseline of 7.5% in the control group).
Turning to studies that also analyzed effects of formalization, Benhassine et al. (2018) provided information on a new registration status and how to apply for it in Benin. Benin was one of over a dozen African countries that jointly introduced the registration status of “entreprenant,” which was aimed at microenterprises. Unlike standard registration, there is no monetary cost to obtain this registration status and the process takes just one day, with interaction with only one government office. The new status confers many of the benefits of standard registration such as access to business banking services and eligibility for some government contracts, but excludes others such as access to large government contracts and the right to export. One arm of the Benhassine et al. (2018) study provided basic information on the registration status and process, another arm added in information on potential benefits of formalization, and a third treatment arm paired the basic information with tax compliance assistance. Registration increased by 10 percentage points in the basic information treatment, by 13 percentage points when the benefits of formalization were emphasized, and 16 percentage points when information on tax compliance was included (from a baseline that was close to 0).[3] However, formalization did not lead to any measured increases in sales, profits, or number of employees. Because the cost of formalization is over 1,000 USD, the authors estimate that it would take the government many decades to recoup its costs, even if the newly registered firms paid 100% of their tax obligation.
Campos et al. (2018) conducted a randomized evaluation among 3,000 unregistered microenterprises in urban Malawi. The main intervention was to assist with business registration by covering the monetary costs of registration and helping to reduce the non-monetary costs by filling out the paperwork and submitting the forms on the firms’ behalf. The monetary costs included a 1.3 USD registration fee, transportation costs to submit the forms, and fees to middlemen to facilitate faster processing. Among these treated firms, one subset also received assistance opening a business bank account, for which registration is a prerequisite, and another subset received assistance with tax registration. Note that in Malawi, as in many countries in Africa, business registration and tax registration are distinct processes.
When offered help with business registration only, 75% of the firms registered their business. This percentage was somewhat higher when paired with the banking session and somewhat lower when paired with tax registration assistance. Meanwhile, take-up of tax registration was only 4%. The authors find no significant impact on firm productivity from business registration alone, but when paired with banking information, it led to 20% higher sales and 15% higher profits. Consistent with the channel being access to banking services, these firms report being less credit constrained.
The take-up of business registration between male- and female-owned firms was similar. The effect on sales and profits was also similar in levels, but female-owned firms experienced a larger proportional improvement, as they had lower sales and profits under the status quo.
The quite different propensity of firms to pursue business registration and tax registration found by Campos et al. (2018) highlights a key cost and benefit of de-linking these two activities. On the one hand, allowing firms to reap the benefits of being a registered business, including business loans, without the automatic need to pay taxes reduces tax revenue. On the other hand, linking the two activities would mean that fewer firms register and enjoy the increase in profits that business registration might unleash.
Fajnzylber et al. (2011) examine whether reducing the tax burden for small firms encourages them to formalize. The study takes advantage of a 1996 policy change in Brazil that offered a simplified tax system for small firms, called SIMPLES, which lowered their tax liability by 8%. One specific component was to reduce social security payments for employees, which might have deterred hiring. The study uses an interrupted time series design around the introduction of SIMPLES, classifying firms based on their creation date. The analysis makes two fairly strong assumptions: that the composition of firms that are created is unaffected by the policy change and that there was no anticipation of the policy change (which would have shifted the creation date of firms). With that caveat, the paper finds that firms that started after SIMPLES was in place were 30% more likely to be registered, from a baseline of 11%. These firms also report higher revenues, profits, and employment levels, but these impacts might not be due just to formalization. To interpret them as due to formalization requires the exclusion restriction that firms were not affected by the policy change unless it was pivotal in their decision to formalize. However, the policy lowered firms’ tax burdens, including for firms that would have formalized without SIMPLES.
Monteiro and Assun¸c˜ao (2012) use a difference-in-differences design to analyze the SIMPLES reform, finding quite different results. Their study compares firms before and after the reform, across sectors eligible and ineligible for the reform. The study finds no overall impact on registration. Breaking down the results by sector, there is no effect in construction, manufacturing, transportation, or services, but a sizeable increase in formalization in the retail sector (13 percentage points from a baseline of 27%).
Contrary to evidence described above that many firms avoid tax registration, McKenzie and Sakho (2010) find that registering with the tax authority seems to increase small firms’ profits in Bolivia. Their analysis uses distance to the tax authority as an instrumental variable for tax registration. The reasoning behind the instrument is that closeness to the office increases the firms’ knowledge of the tax office (and thus how to register) and increases tax officials’ likelihood of inspecting the firm. Distance is indeed negatively correlated with tax registration among small firms. The second-stage results suggest that tax registration leads to 88% higher profits, driven by firms with 2-5 workers, with no such benefits and perhaps lower profits for firms with fewer than 2 or more than 5 employees. The authors argue that smaller firms do not have the capacity to expand to wider markets, which is the main advantage of tax registration, while larger firms have higher-quality management and can do so even without registration.
Demenet et al. (2016) use panel data collected in 2007 and 2009 in Vietnam to examine the impacts of formalization. The identification comes from comparing the 147 initially informal firms who became formal over the two-year window between survey waves to the 1,317 firms that remained informal. That is, the study examines the effect of formalization, controlling for firm and time fixed effects. The decision to become formal could be endogenous to expansion plans and expected profits - the correlation with observables indicates that the decision is not random - so to improve the identification, the analysis uses matching techniques to make the treated and control firms more similar on observables. The study finds that becoming formal is associated with a 20% increase in value added. Other measures of performance such as profits show positive impacts when the sample is restricted to firms with at least one employee.
A closely related study is Rand and Torm (2012), which uses the same panel data. They find that becoming formal is associated with a 9% increase in profits. In addition, formalization is associated with increased investment, improved access to credit, and a decrease in the share of casual workers.
Gender
Gender differences is not a major theme in the literature on formalization, but some studies find heterogeneous effects by gender. Benhassine et al. (2018) find that female-owned firms in Benin are less responsive to interventions that encourage registration. As reported by Demenet et al. (2016), the rate of formalization in Vietnam is lower for female-owned firms. An open question is whether the differences are due to firm characteristics that are correlated with gender, such as female-owned firms being smaller, or to factors more deeply intertwined with gender norms, such as aspirations to grow. For example, in a descriptive study of 141 microentrepreneurs in Indonesia, Babbitt et al. (2015) speculate that cultural norms restrict how female owners can interact with business associations, and family obligations constrain some of their business activities. An interesting direction for future research would be to explore how these norms affect female microentrepreneurs’ ambitions and whether a gender gap in the desire to expand the firm leads to lower demand to formalize for female microentrepreneurs.
Recap
Overall, the evidence from studies that encouraged firms to formalize does not provide much support for the optimistic view that formalization unleashes growth for microenterprises. Most randomized evaluations do not find impacts of formalization on firm profits. Quasi-experimental studies tend to find larger impacts; while these estimates should be interpreted with caution due to potential omitted variable bias, they suggest that more work is needed to settle the debate on how much, and for which types of firms, formalization improves business performance.
Another area where more evidence is needed is on which specific benefits of formalization, such as access to wider markets or access to finance, convince firms to formalize and help their performance. Such evidence would help policymakers as they decide which rights and opportunities to withhold from informal firms. Similarly, governments have latitude to decide which obligations are tied to registration. Some consequences of formalizing, such as greater tax liability and regulatory scrutiny, are downsides from the firm’s perspective but upsides from other perspectives. How much effort to put into encouraging formalization and whether to remove some of its obligations depend on the relative importance of helping small firms versus of raising tax revenue and of other societal goals such as ensuring labor standards are met.
For policymakers that want to encourage formalization, there is extensive research on which interventions are effective in doing so. Besides the levers of changing the rights and obligations of formalization, assistance with the application process and cash incentives have been shown to increase formalization, for example. Help with the application process, in particular, seems like a win-win opportunity: Some firms want to formalize but are deterred by the complicated process. However, the most effective type of help is high-touch and therefore expensive, while the proportion of firms that want to formalize is modest. Thus, successfully identifying and targeting the subset of firms who would formalize but for the hassle costs is key to making this type of intervention more cost effective. How to identify such firms warrants further work.
[1] These statistics include agriculture, but the pattern of more informality in poor than rich countries holds for non-agricultural sectors too.
[2] See Bruhn (2014) for a review of the literature on formalization of firms in developing countries.
[3] Impacts on formalization were smaller for female-owned firms (63% of the sample), which could be due to these firms being smaller rather than female-owned per se.
