Is there a policy rationale for actively trying to encourage small firms to formalise? In the last two decades, hundreds of regulatory reforms have been implemented in countries across the world with the primary objective of making it easier to formally register a business. Bruhn and McKenzie (2016) summarise the evidence on the effect of these policy reforms and find three key results, which are briefly summarized and discussed in this article. Firstly, they find that most reforms have not been very successful at increasing the number of formal firms. In particular, the provision of information, alone or coupled with a reduction in the costs of formalization, appears particularly ineffective. Secondly, they notice that an increased enforcement of existing rules is more effective at boosting formalization rates, as is any demand of formality by consumers and suppliers. Thirdly, from the firms’ perspective, it appears that the decision to remain informal is rational and privately optimal, i.e. the costs of formalisation appear to outweigh the benefits of formalisation for most small, subsistence informal firms.
Thus, policy makers should think carefully about whether to request formality from small-scale, subsistence enterprises, and should focus their efforts on bringing larger and more profitable informal firms into the formal system. The latter ones are those that could help the most, in efforts to widen the tax base. Reducing the costs and complexities of the formalisation process is a necessary but insufficient step in this direction.
