In the developing world, most businesses aren’t registered with municipal or tax authorities. Many have argued that these “informal” firms hurt local tax revenues, cut into the customer base of “formal” firms and lead to low wages for workers. Despite a decade of reforms to make it easier for firms to register, however, the trend has barely budged.
What is going on? Why aren’t firms lining up to register after governments around the world significantly cut down on the time and cost needed to register a business? Is something other than the registration process that is holding firms back? How should we adjust our approach to the informal economy? These topics were explored July 9 at the Policy Research Talks Series, a monthly event by the World Bank’s research department that aims to foster a dialogue between researchers and operational colleagues.
“The persistence of informality suggests there may be too much focus on becoming formal but not enough focus on the costs and benefits of being formal for businesses,” said World Bank Research Director Asli Demirguc-Kunt, who chaired the event. “It’s time to rethink policy approaches to informality.”
The cost of going formal, including registration fees, tax payments and even land rights, outweighs the benefit for most informal firms, said David McKenzie, a lead economist in the research department’s finance and private sector development team, who has studied informal firms extensively. “Most firms are making what is for them the privately rational decision.”
Size is a major factor. The majority of informal firms – 90% in Sri Lanka, for example – are subsistence enterprises with no paid employees, and only a small percentage have more than five workers. Even after registration, those firms likely will pay little in taxes under a progressive income-tax system. They may not be able to compete with large, formal firms, either.