VI. Sticks, not carrots? The effect of greater enforcement on formalisation

If making business registration easier has a limited effect on formalisation rates, what have we learned about the effect of stricter enforcement of existing regulations? Overall, the evidence suggests that stricter enforcement is much more effective in increasing formality.

Alcázar, Andrade, and Jaramillo (2010) use a randomised experiment where 577 firms were visited by municipal inspection officers and find that – although it is very difficult to locate some informal firms – there is a large potential impact on formalisation: approximately a quarter of firms that received an inspection as a result of their intervention registered with the municipality. In Brazil, Andrade, Bruhn, and McKenzie (2014) also randomly assigned municipal inspectors to firms. They find that the inspectors are unable to find many firms they are assigned to visit, but that the impact of a realized visit by an inspector visit was a 21 to 27 percentage point increase in registration.

In practice, even after firms formally register, they face a number of other regulations and can choose the extent to which they comply with these regulations. For example, Ulyssea (2018) defines two margins of informality that a firm can exploit: (i) the “extensive margin” (not registering the business); and (ii) a subtler “intensive margin” (e.g. hiring workers “off the books”).  Formally registered firms may be partly informal with regard to their compliance with labour and tax regulations, and several studies examine the role of enforcement in increasing formality along these dimensions.

Pomeranz (2015) examines the effect of increasing auditing in the VAT system in Chile. She finds that a letter sent by the tax authority to generate a perceived increase in audit probability to randomly selected firms led to an increase of 12 percent in median declared income, with this effect concentrated in firms that sell to final consumers (because the letter is likely to have less of an effect on firms that already faced enforcement through the VAT paper trail). The effect was also larger for smaller firms, which is consistent with the idea that larger firms are less likely to evade taxes.

A complementary approach is to establish incentives for customers to demand that firms become formal. Several countries have implemented a system in which tax receipts count as lottery tickets, creating an incentive for customers to ask for receipts. This system has been implemented in Taiwan, Korea, China, Brazil, and Puerto Rico. Wan (2010) finds that the introduction of this system in China increased sales tax revenue by 17 percent in districts that implemented the reform. Naritomi (2013) finds that the effect on tax revenue in Brazil was an increase of 23 percent.

Almeida and Carneiro (2012) study the impact of greater enforcement of labour regulations in Brazil and find that an increase in the enforcement of mandated benefits in the formal sector led to a reduction in formal wages and an increase in formal sector employment. However, since they have data on workers and not firms, they are not able to determine how much of this impact comes from firms from hiring new workers and how much comes from firms registering previously-informal workers.  Kumler, Verhoogen, and Frías (2013) examine the dimension of labour informality in which firms register workers but underreport the wages they pay them, in order to reduce their payroll tax burden. They find that a social security reform that gave workers incentives to monitor what firms reported led to less evasion among firms reporting the wages of affected workers.

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