VII. Does formalisation cause firms to grow?

In the previous sections, we considered the extent to which business regulations appear to be barriers to firms becoming formal and whether efforts to make it easier for firms to formalise, or more difficult for firms to remain informal, have succeeded in bringing small-scale enterprises into the formal sector. In this section, we examine the extent to which being formal benefits these types of firms. As illustrated in Box 1, the potential benefits of formalisation include “operating out of the shadows”, which allows firms to market themselves widely without fear of attracting the attention of the law. As a result, one of the possible channels through which formalising may help firms is by allowing them to expand their customer base. In Bolivia, McKenzie and Sakho (2010) find that firms that become formal as a result of being located slightly clos­­er to the tax office do issue more tax receipts and have greater sales. In Brazil, Fajnzylber, Maloney, and Montes-Rojas (2011) find that firms that opened just after the introduction of the program that simplified business registration were more likely to operate in a permanent location, although this finding could reflect a change in the types of individuals that decide to open firms after the reform rather than a causal impact of formalising. In Sri Lanka, de Mel, McKenzie and Woodruff (2013) find that firms that formalise are 26 percentage points more likely to advertise.

Formalisation is often hypothesised to benefit firms by improving access to financial services and to government benefits. However, the literature has found mixed evidence for this. In Sri Lanka, de Mel, McKenzie and Woodruff (2013) find that firms that formalise are not more likely to obtain a business bank account or business loan, make sales to the government, or participate in a government program. In Bolivia, McKenzie and Sakho (2010) find no impact on the likelihood of a bank loan or of sales to the government. One possible explanation for this is that informal firms for whom registration was the only barrier preventing them from obtaining credit may have already chosen to become formal, with a similar potential explanation for government contracting (which is unlikely for small firms in any case). In Malawi, Campos, Goldstein, and McKenzie (2018) find that  combining assistance in obtaining a business registration certificate with an information session with a private bank has much larger effects. Randomly selected firms assigned both these treatment, which culminated in the opportunity to open a business bank account, experienced large increases in both formality and use of banking services: the majority of the firms (over 75%) formally registered their business, and a large share (43 percent, compared with only 4 percent in the control group) also opened a business account. This combination, in turn, helped firms grow their sales by 20 percent and profits by 15 percent (US$ 27 per month). A key point of these results is that the benefits of formalisation may not come automatically -- firms may need additional assistance in realising the benefits from their new formal status.

Consistent with the view that most firms rationally choose whether to formalise by comparing the expected benefits to the costs, many studies have found that informal firms that were induced to become formal through subsidised costs have experienced little benefit from doing so, on average. Alcázar, Andrade, and Jaramillo (2010) find a significant impact of obtaining a municipal license on firm profits and revenue in Peru. McKenzie and Sakho (2010) find that Bolivian firms that would formalise if they were slightly closer to the tax registration office would appear to increase profits by doing so, but the average informal firm wold not. In Sri Lanka, de Mel, McKenzie and Woodruff (2013) find a significant increase in average profitability, but they show that this average is driven by a handful of firms that grew substantially after formalisation, whereas most firms showed no improvement. In Benin, Benhassine, McKenzie, Pouliquen, and Santini (2018) find no significant impact of formalising on any measures of business performance: sales, profits, or number of employees. The authors calculate that the additional tax revenue the government would collect from these firms over their lifetime is unlikely to cover the cost of inducing them to formalize.

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