68268 Finance & PSD Impact MARCH 2012 The Lessons from DECFP Impact Evaluations ISSUE 17 Our latest impact note looks at the demand for, and consequences of, formalizing among informal firms in Sri Lanka. Do informal firms want to formalize and does it help them if they do? Suresh de Mel, David McKenzie and Christopher Woodruff Most firms in developing countries (approximately US$88, $175 and $350 are informal. Does it make sense for them to respectively) to register. formalize? Hernando de Soto has famously argued that informal firms would like to be Results formal, only that burdensome entry barriers Figure 1 shows the impact on the likelihood prevent them. The result, spurred by the of a firm registering. Information and paying efforts of Doing Business and investment the registration cost had no impact on climate reform efforts has been efforts registration. 17-22 percent of eligible firms around the world to streamline the entry register when offered 10,000 or 20,000 process. LKR, just under half a month’s and one However, a countervailing view of month’s profits for the median firm informality views informal firm owners as respectively, and 48 percent register when rationally weighing up the costs and benefits offered 40,000 LKR. of formalizing, and rationally choosing only to become formal when they grow large Figure 1: Treatment effect on registration 0.5 enough to benefit from the formal institutions of society. In this view, smaller, less productive firms don’t see any gain to 0.4 formalizing, so choose not to. 0.3 An experiment in Sri Lanka 0.2 We conducted a field experiment in Sri Lanka which reduces the information 0.1 costs and increases the monetary benefits of formalizing in order to measure the latent 0 demand for formalization, and the Information 10,000 Rs 20,000 Rs 40,000 Rs consequences that formalizing has on -0.1 informal firms. We divided a sample of TOT informal firms with 1 to 14 paid employees into four treatment groups and a control The main reasons for not formalizing when group. The first treatment group was given offered incentives included issues related to information about the costs and benefits of, ownership of land and concerns about facing and procedures for, registering their firm for labor taxes in the future. The degree of tax purposes, and offered reimbursement for bureaucracy in the registration process also the cost of registering. The second, third, seems to matter for those with the incentive and fourth treatment groups were provided to register, with response to the incentives the same information and also offered a higher in Colombo, where the registration payment of 10,000 Sri Lankan Rupees process was easier, than in Kandy. (LKR), 20,000 LKR and 40,000 LKR Do you have a project you want evaluated? DECRG-FP researchers are always looking for opportunities to work with colleagues in the Bank and IFC. If you would like to ask our experts for advice or to collaborate on an evaluation, contact us care of the Impact editor, David McKenzie (dmckenzie@worldbank.org) What does formalizing do for firms? financial sector – applying for business or personal loans or having We conducted three rounds of follow-up a business bank account; or on surveys at 15, 22 and 31 months after the relationships with the government – start of the intervention in order to measure what impact, if any, formalizing was having having an electricity connection in on the firms. the business name, applying for a government contract, making sales to the government. participating in any government SME program.  We do find formalizing causes firms to be more likely to use receipt books and to do more advertising.  Firms which formalize also say they feel their businesses are more legitimate, and trust in local government increases. Would formalizing help this firm? Policy Implications Our results suggest that most firms are rationally refraining from formalizing, We find: since they see few benefits from doing so –  A positive mean effect on firm while a few firms seem to be suboptimally profits, which seems to be driven by informal. Nevertheless, our results do the experience of just a few firms, suggest that a relatively modest increase in which experienced large profit the net benefits to firms of formalizing could increases after formalizing; most dramatically increase the rate of firms saw no increase in profits (or formalization. sales or employment) after Moreover, our results cannot speak to whether simplifying registration has more formalizing. benefits at the extensive margin (by  Detailed case analysis reveals that encouraging more firms to enter), or has these large changes in the tail were spillover benefits on other firms (by genuine, rather than measurement reducing a potential cost advantage informal error. firms may have against them). Measuring  We find no significant effect of these types of impacts is a key area for future research. formalizing on relationships with the For further reading see: Suresh de Mel, David McKenzie and Christopher Woodruff “The demand for, and consequences of, formalization among informal firms in Sri Lanka�, World Bank Policy Research Working Paper no. 5991. Recent impact notes are available on our website: http://econ.worldbank.org/programs/finance/impact