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FEATURE STORY

Ecuador Fights Informality to Strengthen Small Enterprise

August 14, 2013

It has been three years since Freddy Quelal opened his auto shop. Despite his success and his compliance with monthly tax payments, his business is still considered informal.

STORY HIGHLIGHTS
  • Over 80% of micro and small enterprises in Ecuador are not completely formal, even though many of them are registered and pay taxes.
  • According to a World Bank study, consequences of informality include limited access to credit or poor credit terms.
  • Women entrepreneurs are mainly concerned with the flexibility to care for their children in the workplace and to establish a schedule that accommodates family responsibilities.

Thirty-year-old Freddy Quelal studied auto mechanics at a technical school in Quito. After working for nearly five years in an auto shop, he decided to open his own business with his brother.

Today, the three-year old garage is well-known in Quito and Quelal has a large customer base. Nevertheless, his business is still considered informal.

Freddy and his partner have a tax contribution number (RUC) and pay taxes monthly, but they still do not have the necessary operating license or other municipal permits. Their efforts to remedy this situation were in vain since they were unable to comply with all the requirements to become a legally registered firm.

 “We tried to obtain the permits but realized that it takes a lot of time. We don’t have everyone (the workers) registered with social security since most are temporary staff and it’s hard to sign them up, only to then have to give them severance pay and register new people all over again,” says Freddy.

This is a reality that occurs time and time again, especially in micro and small enterprises –those with fewer than 50 employees – in urban areas of Ecuador, and which represent 71% of the country’s business sector.

According to the World Bank study The faces of informality, more than 80% of these firms operate somewhere on the formality continuum. The vast majority of firms comply with some but not all regulations and the rates of compliance vary by type of regulation and size of the firm.

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We tried to obtain the permits but realized that it takes a lot of time. We don’t have everyone (the workers) registered with social security since most are temporary staff and it’s hard to sign them up, only to then have to give them severance pay and register new people all over again. Close Quotes

Freddy Quelal
Auto shop owner

Learning about informality in Ecuador

The study found that the level of informality remains high in Ecuador: informal enterprises employed 37% of the employed population in 2011, as compared with 42% in 2000. Moreover, Ecuador ranks fourth among the countries with the largest population without social security coverage in Latin America (62% of workers).

According to study authors Denis Medvedev and Ana María Oviedo, “many micro and small firms in Ecuador have limited growth potential due to a variety of factors, including the lack of access to and poor quality of credit.” Many of these entrepreneurs are women who value their own business not only for the income they generate but for the flexibility to care for their children in the workplace and to establish a schedule that accommodates family responsibilities.

This issue has become a priority for the Ecuadorean government. In early 2012, the Law of the Popular and Support Economy and its accompanying regulations introduced several benefits for family businesses and small firms, part of the group prioritized in this new law. These include increased access to credit, education and training, as well as tax benefits.

A key conclusion of the study, which was conducted directly with entrepreneurs and workers in the manufacturing, retail, tourism, transport and construction sectors, is that firms that are in greater compliance with laws and regulations tend to generate more benefits in the medium and long term.

According to the report, “While Ecuadorian companies show higher survival rates than in more advanced economies, other indicators of firm performance suggest that most of them are unlikely to grow and become more productive.”

Among other recommendations, the report encourages better dissemination of information on support programs for small firms, streamlining administrative procedures to promote formalization and the establishment of simplified tax regimes that combine several taxes, including social security, into a single payment.

Key findings of the Faces of Informality Study

  • Micro and small enterprises in Ecuador have limited growth potential.
  • Owners of larger firms are better educated.
  • Most credit is used to finance operating expenses instead of investment.
  • Most firms comply mainly to “follow the rules,” and those who do not comply argue that they are too small to do so and that the costs of formalizing them are too high.
  • Formalization facilitates increased profitability through increased access to formal sources of finance and the ability to generate more sales and grow the customer base by issuing tax receipts.
  • The vast majority of micro and small enterprises comply with some but not all regulations and over 80% operate somewhere on the “formality continuum.”
  • Although the vast majority of entrepreneurs believe that tax evasion is unacceptable, around 40% know of a firm that does evade taxes.
  • Inspections significantly increase the likelihood of compliance, yet the compliance rate remains substantially below 100%, even in firms where inspections are made.