Re-thinking the Approach to Informal Businesses IN FOCUS Typologies, Evidence and FINANCE, COMPETITIVENESS & Future Exploration INNOVATION Andreja Marusic, William Nielsen, Tania Ghossein, and Sylvia Solf INVESTMENT CLIMATE © 2020 The World Bank Group 1818 H Street NW Washington, DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org All rights reserved. This volume is a product of the staff of the World Bank Group. The World Bank Group refers to the member institutions of the World Bank Group: The World Bank (International Bank for Reconstruction and Development); International Finance Corporation (IFC); and Multilateral Investment Guarantee Agency (MIGA), which are separate and distinct legal entities each organized under its respective Articles of Agreement. We encourage use for educational and non- commercial purposes. The findings, interpretations, and conclusions expressed in this volume do not necessarily reflect the views of the Directors or Executive Directors of the respective institutions of the World Bank Group or the Governments they represent. The World Bank Group does not guarantee the accuracy of the data included in this work. Rights and Permissions The material in this publication is copyrighted. Copying and/or transmitting portions or all of this work without permission may be a violation of applicable law. The World Bank encourages dissemination of its work and will normally grant permission to reproduce portions of the work promptly. All queries on rights and licenses, including subsidiary rights, should be addressed to the Office of the Publisher, The World Bank Group, 1818 H Street NW, Washington, DC 20433, USA; fax: 202-522-2422; e-mail: pubrights@worldbank.org. Authors William Nielsen (win5@cornell.edu ) is a consultant to the World Bank Group. He conducts research and analysis in various areas of economic inclusion. Andreja Marusic (amarusic@worldbank.org ) is a Senior Private Sector Specialist in the World Bank Group’s Europe and Central Asia region. Tania Ghossein (tghossein@ifc.org ) is a Senior Private Sector Specialist in the World Bank Group’s Investment Climate Unit. Sylvia Solf (ssolf@worldbank.org ) is the Business Regulation Global Lead and a Senior Private Sector Specialist in the World Bank Group’s Investment Climate Unit. The authors are grateful for the valuable guidance and peer review comments received from Christine Zhenwei Qiang (World Bank Group Investment Climate Practice Manager), Miriam Bruhn (Senior Economist, World Bank Group), Thomas Farole (Lead Economist, World Bank Group), and Chaning Jang (Chief Executive Officer, The Busara Center for Behavioral Economics). Photo Credit: World Bank Photo Library and Shutterstock.com INTRODUCTION 3 THE CONCERN WITH INFORMALITY 4 THE MIXED RESULTS 5 RETHINKING THE FACTORS DRIVING INFORMALITY AND THE HETEROGENEITY OF INFORMAL BUSINESSES 6 BROADENING THE SCOPE OF STUDY TO UNDERSTAND MORE FACTORS OF FORMALITY 7 Informal Clusters 8 Support Without the Goal of Formalization 9 Simplified, Intermediate, and Temporary Legal/Tax Statuses 10 Behavioral Insights 10 CONCLUSION 11 BIBLIOGRAPHY 13 APPENDIX: INTERVENTIONS AND REFORMS THAT IMPACTED BUSINESS FORMALIZATION 19 FOREIGN DIRECT INVESTMENT AND PRODUCTIVITY | 1 2 | RE-THINKING THE APPROACH TO INFORMAL BUSINESSES: TYPOLOGIES, EVIDENCE AND FUTURE EXPLORATION Introduction I nterventions to incentivize business formalization over the past decades have shown mixed results (Bruhn and McKenzie, 2013; Bruhn and McKenzie, 2018; Floridi et al., 2019) and brought limited knowledge on how to address informality in a systematic way. Adding to the challenge is determining whether informality should be a direct target, or is rather something indirectly impacted through development, improved governance, better regulation and improved public services (Loayza 2016; Loayza, 2007; Perry et al., 2007; World Bank, 2009). The informal sector includes businesses, workers, informal businesses), this note will focus on the and activities operating outside the legal and research on informal businesses and the reforms regulatory systems (Loayza 2016). The scale of and interventions conducted in an effort to nudge the informal sector in emerging and developing their willingness and support their ability to move economies, which accounts for 25 to 40 percent of towards formalization. GDP and often more than 60 percent of employment (World Bank 2020), merits rethinking approaches to Based on a review of relevant literature on formalization. informality and efforts to promote formalization, this note will discuss the use of the term ‘informality’ This effort is even more relevant in the current to align with the heterogeneity that exists within context of the COVID-19 pandemic. Many formal the informal sector and identify factors that drive businesses worldwide, hit hard by the pandemic’s formality. It aims to motivate the testing of new economic effects, are likely to be forced to pursue approaches to informality hinged on a deepening income sources through unregistered economic of our understanding of the needs of informal activities, increasing the scale of the informal sector businesses. despite its deficiencies as a safety net. Furthermore, both formal MSMEs that fall into informality and To support greater rates of formalization, this note already informal businesses have limited access proposes four specific areas for further research and to government support, increasing their instability pilot interventions: 1) supporting informal clusters, and risk of closure. COVID-related growth in the 2) providing support to informal businesses without informal sector accentuates the need for appropriate a target of formalization, 3) simplified, intermediate and strategic policy responses. and temporary legal statuses of informal businesses to better align with business needs and government Although the informal sector consists of both goals, and 4) understanding behavioral insights informal businesses and informal workers that influence businesses’ decisions to inform (with informal workers being a characteristic of policymaking. RE-THINKING THE APPROACH TO INFORMAL BUSINESSES: TYPOLOGIES, EVIDENCE AND FUTURE EXPLORATION | 3 The Concern with Informality include targeting those firms most likely to formalize and/or with the lowest opportunity cost to formalize. The term ‘informal business’ can encompass many different profiles and different degrees of The informal sector is substantial in many countries, informality, namely: Legal, Fiscal, and Labor. and in some cases dominates the economy (figure Legal informality often refers to whether the 1). In some low-income African countries such as business is registered or not; fiscal informality to the Malawi an estimated 93 percent of businesses have extent the businesses pay taxes, have bank accounts not registered with the government (Campos et al., and maintain bookkeeping; and labor informality 2018). This is a concern because informal businesses reflects the use of contracts and benefits made tend to be less productive and pay workers less than available to employees. These are not exclusive of their formal counterparts (Hartia and Shamruk, 2013), each other and businesses may be informal across while also being perceived as unfair competition to any or all of these dimensions. formal businesses (Gonzalez and Lamanna, 2007; Friesen and Wacker, 2013). The informal sector also Pro-formalization interventions (informative or disproportionately includes women and minorities deregulatory) have had limited effect and one of the who have less access to social protection such as key reasons appears to be inappropriate segmenting health care, labor rights, and insurance (Chant and and targeting. More differentiated approaches may Pedwell, 2008). Many governments are interested be needed. For example, regulatory simplification in ways to “jump-start” the formalization process of business registration alone may not be attractive for informal businesses. Their motivations include enough for the smallest subsistence/household broadening the tax base and helping businesses businesses where the costs of formalization much access the formal economy so that they might access outweigh the benefits. An intermediate legal status markets and grow more. They also have indirect to support formalization of the status quo could objectives of strengthening the rule of law and potentially be a beneficial first step. Larger, more gaining information on the structure of the economy dynamic and growth-oriented informal businesses to better inform future policy development (Campos might be better targeted through strategic public et al., 2018). support addressing the specific obstacles limiting their pursuit of formalization, rather than indirect Figure 1 notes the scale of informality as a percent universalistic support based on deregulation. This can of regional GDP and shows that the transition of Figure 1. Average Informality Rates by Region as a percent of GDP 45 40 35 30 25 20 15 10 5 0 Sub-Saharan Latin America South Asia Middle East and East Asia Europe OECD Africa North Africa 1991-99 2000-09 2010-17 Source: Medina and Schneider, 2019 4 | RE-THINKING THE APPROACH TO INFORMAL BUSINESSES: TYPOLOGIES, EVIDENCE AND FUTURE EXPLORATION the economy to become formal is slow. Medina and These views may be complementary and tend to Schneider (2019) measured average informality rates exist within the two previously mentioned root by region over three time periods (Figure 1). The causes of informality: 1) lack of development and consistent decline in the proportion of informality 2) bad governance. relative to GDP is likely a result of economic growth (La Porta and Shleifer, 2014) but this transition is The Mixed Results slowed with larger growth in the workforce. Costs and benefits of formalization are numerous and Theories of and Approaches to Informal variable in scale. Benefits realized by formalized Businesses businesses may include higher profits and greater value added through increased productivity (Boly, Why does informality occur? Some of the leading 2018; Medvedev and Oviedo, 2015). Financially theories include: intangible benefits are important to many firms as well. The desire to be in compliance with registration Exclusion view: Businesses are ‘excluded’ from regulations (Gatti et al., 2014; World Bank, 2007) is the formal economy due to high entry costs. This linked to feeling more secure and protected, building encompasses the legalist view as well, which notes trust with customers, and having good publicity (De that high costs of registration, regulatory and tax Mel et al., 2013). However, the perceived costs compliance lead to businesses being excluded from and obstacles of registration, taxation, licensing, the formal economy (De Soto 2003; Friedman et al. insurance, land rights, among others, often look 2000; Floridi et al., 2016). A sub-set of this view is greater than the potential benefits, particularly since the ‘parasite view’ whereby businesses intentionally those benefits such as larger customers and sales in stay small and informal to avoid detection by foreign markets take years to accrue (Gatti et al., authorities (Porta and Schleifer, 2008). 2014; World Bank, 2007; De Mel et al., 2013). Exit view: Businesses ‘exit’ the formal economy These costs and benefits have informed the after assessing costs and benefits of formalization. development of interventions to address informality. This may also be termed the voluntarist view, which But, the current approaches to informality have not notes that businesses voluntarily choose to be led to the desired changes in rates of formalization informal (Maloney 2004). (Bruhn and McKenzie, 2018) and brought limited Dual Economy / Dualist view: This view states that knowledge of how to address informality beyond there are not enough jobs in the formal economy, recognition of strong correlations with factors so the informal economy is a necessary space for such as a better business environment. Existing overflow workers and their small businesses (Porta studies are geographically focused on countries in and Shleifer 2008; USAID 2005). This is also Latin America, South Asia and Sub-Saharan Africa termed the survivalist view. (Gatti et al., 2014), often start with targeting legal informality (e.g. registration) or fiscal informality Structuralist view: A cross-cutting view, the (e.g. increased tax compliance), and have typically structuralists consider the informal economy to be covered the following four approaches1 (Floridi et a subordinate complement to the formal economy al., 2019): (Portes and Haller 2010; Basile and Cecchi 2001; Portes and Schauffler 1993). The informal economy • Reducing the financial and transaction costs provides the formal economy low-cost inputs and of registration, the number of procedures and flexibility from operating unregulated. minimum capital requirements (Branstetter et See appendix for details on each of these five interventions. 1 RE-THINKING THE APPROACH TO INFORMAL BUSINESSES: TYPOLOGIES, EVIDENCE AND FUTURE EXPLORATION | 5 al., 2013; de Andrade et al. 2013; de Mel et al., working with a formal business, such as accessing 2013; Galiani et al., 2015; Bettcher et al., 2009). new customers, working with new suppliers, bidding This may be done by establishing one-stop shops for and receiving government contracts, obtaining (Bruhn, 2011, 2013; Rothenberg et al., 2015). government incentives, etc. Providing information on procedures and benefits • of becoming a formal business (e.g. cash incentive) Re-Thinking the Factors Driving and entrepreneur training (e.g. on filling forms) Informality and the Heterogeneity (de Andrade et al., 2013; Benhassine et al., 2016; of Informal Businesses Campos et al., 2015, 2018; de Mel et al., 2013; There are many factors that influence a business’ Galiani et al., 2015). decision to formalize. These range from business Increasing enforcement (de Andrade et al., 2013; • culture, individual business characteristics, De Giorgio et al., 2015; Almeida and Carneiro, institutional structure, market conditions, costs of 2005; USAID, 2017). doing business, labor skills, etc. Gaps in the available literature and data for many of these factors results • Reducing the tax burden and providing tax in limited understanding of where the prominent incentives (Bruhn and Loeprick, 2014; Galiani et weaknesses lie that would curtail movement towards al., 2015; Kugler et al., 2017; Bernal et al., 2015; formalization and maximization of the benefits Fajnzylber et al., 2011; Mihaylova and Poff, 2018). generated from an intervention. These interventions are often expensive, have mixed The recognition of the factors of formality serves as a results, and have limited transferability, keeping a framing for understanding the types of relationships widespread programmatic approach to informality that may be occurring in the market and how out of reach (Bruhn and McKenzie, 2014; Floridi certain market features may be pushing against the et al., 2019). Bruhn and McKenzie (2018), in a desired outcomes of a given intervention. Future literature review, note that interventions providing research is needed to gain a better understanding information alone or paired with other cost of how the factors interact with the degrees of reductions have limited impact on formalization. informality. For example, Bruhn (2013) notes that Even when formalization did take place, the costs of with the implementation of one-stop registration the government interventions were high while the in Mexico, 14.9% informal business owners with benefits for businesses were unclear. In an impact characteristics similar to formal ones (e.g. older, evaluation conducted in Benin, Benhassine et al. more educated, head of household, etc.) formalized (2016) found that businesses which formalized as their businesses, while only 6% of those business a result of a combination of government incentives, owners with characteristics similar to wage workers did not appear to benefit much from this status in formalized (e.g. younger, less educated, unmarried, the first two years afterwards. While they accessed etc.). The individual business characteristics (e.g. more business training and paid lower taxes, they number of employees, use of bookkeeping, etc.), were not more likely to have business bank accounts, a factor of formality, was shown to be influential gain new customers, have higher profits or sales, or in rates of formalization, although appears to hire additional workers. encompass only a part of the story as many other businesses did not formalize. Similarly, increased enforcement efforts have shown some small positive changes in the rates of Part of understanding the variability of factors of formalization, as seen in Brazil (de Andrade et al., formality and the mixed results experienced by 2013). But they often do little to generate benefits formalization efforts is tied to the heterogeneity of the for the business. The benefits of formalization are informal businesses themselves (Berner et al. 2012; often not large enough except for those businesses Floridi, Wagner, and Cameron 2016; Williams and pursuing new opportunities that may require Shahid 2016; Floridi, Demena, and Wagner 2019). 6 | RE-THINKING THE APPROACH TO INFORMAL BUSINESSES: TYPOLOGIES, EVIDENCE AND FUTURE EXPLORATION Clarity in how we discuss informality and agreed- characteristics and lead to differing rates of upon terminology of the different types of businesses formalization with potentially varying effects across that fall under the informality umbrella would allow the three dimensions. for a more focused study (Diaz et al., 2018; Adoho and Doumbia, 2018; Henley et al., 2006; Fields, Table 1 elucidates the factors to be taken into 2011; Kanbur and Keen, 2014). The development consideration, but it also serves as an evidence map of an informal sector classification into which all for aggregating data with specific characteristics. businesses can be placed could help in this regard. This structure will help organize the metadata, the Stein et al. (2013) took a leading step towards this, contextual factors of an intervention, and further noting that businesses can be grouped based on their understanding of the different dimensions of willingness and/or capacity to formalize. informality impacted. Table 1 outlines a structure for mapping business Broadening the Scope of Study differentiation and dimensions of informality – detailing the classification of informal businesses to Understand More Factors of and those factors that influence whether a business Formality is willing and able to formalize. The previously Multiple avenues of exploration exist within this mentioned influencing factors of formality may context of business differentiation, which support be combined with the business differentiation to a more complete understanding of the influences serve as the context for the system. Factors will experienced by an informal business and potential be viewed differently by businesses with different Table 1. Possible Future Studies Grouped by Dimension of Informality Addressed and Known Factors of Formalization Present Dimension(s) of Informality Business Differentiation Matrix Legal Fiscal Labor Business Characteristics (# of employees, bookkeeping, productivity, capital, etc.) Internal Factors Entrepreneur Characteristics of Formality (age, skilled, educated, gender, etc.) Business Purpose (subsistence, growth, etc.) Market Conditions (access to credit, market linkages, infrastructure, etc.) Costs of Doing Business & Institutional Conditions (Corruption, trust, public services, etc.) Labor External Factors (skills, availability, wages, etc.) of Formality Business Culture/Tradition (Tax morale, trust, consumer confidence, discriminatory practices) Business Relationships (associations, clusters, etc.) Source: Authors’ elaboration. RE-THINKING THE APPROACH TO INFORMAL BUSINESSES: TYPOLOGIES, EVIDENCE AND FUTURE EXPLORATION | 7 policy approaches. The four interconnected areas of legal status. Identifying the effects of clustering on research include: (1) informal clusters, (2) support business performance is difficult to separate from without a goal of formalization, (3) simplified, general market trends (Chhair and Newman, 2014), intermediate or temporary legal statuses, and (4) but there are various examples of clusters’ positive behavioral insights. These four areas of research results for informal sector participants including were selected for their limited, but developing allowing new entrants with less experience to start evidence base with regard to formalization, as well as a business (Mano et al., 2011), reducing “search their incorporation of additional factors of formality and reach costs” to give informal businesses access beyond those traditionally researched. Figure 2 to customers and traders; and accessing scale shows a categorization of reforms and interventions economies using division of labor (Mano et al. studied to date, as well as the four areas, highlighted 2011; Nadvi and Barrientos 2004). Other benefits in green, subject for additional research with regard specific to small, low-income, and therefore often to their effect on formalization. informal businesses include increased profits (Fajnzylber et al., 2006), increased employment Informal Clusters (Nadvi and Barrientos, 2004; Sonobe et al., 2013), increased incomes to workers (Nadvi and The benefits and structure of clusters allow them to Barrientos, 2004; Sandee, 2002; Vissere, 1999; serve as a channel for delivering interventions that Schmitz, 1999), increased market linkages (Mukim, support informal businesses, by both (i) efficiently 2013), productivity spillovers within the cluster reaching many businesses, coordinating through (Chhair and Newman, 2014), increased government a central body that works with the cluster, and (ii) communication (Nadvi and Barrientos, 2004), and facilitating an eventual transition to a more formal increased coordination to support productivity Figure 2. Highlighting Areas for Potential Additional Research in Relation to Areas Already Studied (Grouped by Corresponding Formality Factors) Categorization of Reforms and Interventions Previously studied and proposed for additional future study Business & Entrepreneur Characteristics Previously studied Access to trainings Subject for additional study Support without Formalization of Firm pursuing formalization Supporting increased rates of Institutions Cost of Doing Business formalization among those firms and Government well-suited for it One-stop-shops / Access to information registration costs Enforcement / Penalties Business Culture / Tradition Tax reform and Tax incentives Markets Behavioral insights to Access to credit support formalization Simplified, Intermediate and Temporary Legal / Targeting Informal Tax Statuses Clusters Source: Authors’ elaboration. 8 | RE-THINKING THE APPROACH TO INFORMAL BUSINESSES: TYPOLOGIES, EVIDENCE AND FUTURE EXPLORATION (Weijland, 1999; Nadvi and Barrientos, 2004). indirect effect on formalization. The research on Given that the benefits realized from clustering are this subject, however, typically does not focus also often associated with formalization, informal on informality as an outcome and hence does not businesses in a cluster may be more likely to both specifically assess the extent to which formalization recognize the benefits of formalization and to have eventually occurs. The informal sector can be greater capacity and willingness to formalize. targeted and supported in many ways, including through financing (Degryse, Lu, and Ongena 2013), At the same time, evidence of clusters’ impact on extending social protections (Da Costa et al. 2011), formalization is limited. Focusing interventions managerial trainings (La Porta and Shleifer 2014), on clusters of businesses could utilize formal- or improved public service delivery (Ghani and informal business linkages and network effects to Kanbur 2015). help generate large amounts of evidence on policy or intervention effectiveness in a short amount of time King, Braimmah, and Brown 2015; Fajnzylber, Maloney, and Montes-Rojas 2006; Nadgrodkiewicz Box 1. COVID-19 in Context and Siddiqui 2011). Specific public services and cluster support programs can be efficiently made The concern with informality is relevant available to many businesses (formal or informal) during the economic crises tied to the simultaneously (Yoshino et al., 2011; Zeng, 2008; containment of COVID-19, but for many Otsuka and Sonobe, 2011). countries and their residents, economic In understanding the perception of clusters by crises are a recurring way of life. In these businesses, Mukim (2013) makes the distinction cases, it may be more appropriate for that informal and formal businesses often view governments to promote the informal clusters differently, as informal businesses see the sector for its employment capacity, cluster as a market opportunity in and of itself, while boosting the quality of employment with formal businesses are more interested in clustering social protection supports. The integration in order to have better access to markets elsewhere. of this resiliency effort with the described Interventions geared towards informal clusters, clusters approach may be well-suited to such as information on strategies and requirements the COVID-19 crisis. Clusters with informal to reach new customers, may then serve to re-orient businesses are often less structured than the perceptions of these informal businesses, such their formal counterparts (King, Braimah, that the cluster is not an end itself, but a means to and Brown 2015) making coordination an end. Interventions for informal clusters will be more difficult. However, coordination needed to further this understanding. is most likely to develop in the face of a collective threat to the businesses’ continuation (Nadvi and Barrientos, 2004). Support Without the Goal of It is at these critical junctures where Formalization policymakers seeking ways to provide The study of informal sector support without the support to their economies may serve a goal of formalization, which may incidentally lead coordination role that would not otherwise to formalization, is an area of broad relevance across have been supported by businesses. This developing and emerging economies. This approach could include collecting feedback for policy works to increase understanding of the kind of reform, direct support provision such as support an informal business needs most, and how access to market linkages, credit needs, the support may help to increase productivity. With equipment needs, skills development, etc an increase in productivity follows the assumed RE-THINKING THE APPROACH TO INFORMAL BUSINESSES: TYPOLOGIES, EVIDENCE AND FUTURE EXPLORATION | 9 The studies note the often-heterogeneous effects given time period the business would be required to and unintended outcomes. For example, De Mel, pay the requisite costs of formalization to continue McKenzie, and Woodruff (2011) conduct an enjoying the potential benefits. For example, in intervention providing improved access to credit for Mexico, the Regimen de Incorporación Fiscal high-return microenterprises. However, credit did not (RIF) status offers tax, insurance, social security reach the highest return businesses as was hoped but and credit benefits that gradually phase out over 10 those businesses with the most household assets, a years (González, 2015). characteristic of the businesses that was not initially controlled for in the delivery of the intervention. In comparison, simplified legal or tax statuses Taking business differentiation into account in may serve to help legalize the status quo, in that future interventions may increase the effectiveness although few changes are required on the part of the of the support provided. Additional research will be informal business, the government gains data for needed to help distinguish when a support may lead understanding businesses as it helps them access to formalization and when it will be provided only to government supports, credit, and market linkages. promote enhanced productivity and incomes. Simplified legal or tax statuses are more attainable for microentrepreneurs that would otherwise not consider formalization, such as those not pursuing Simplified, Intermediate and Temporary growth. There have been a few variations of this Legal / Tax Statuses approach. For example, in Brazil, the SIMPLES Reduced costs of formalization may serve as a status serves as a simplified taxation system for stepping-stone to greater realization of benefits small and micro enterprises (Fajnzylber, Maloney, such as improved business growth, increased and Montes-Rojas 2011), and the MEI status productivity, and tax revenue gains and to better serves as a simplified legal status for individual economic data for policymakers due to increased microentrepreneurs (Zucco et al., 2020). As tracking of business activity. This may be achieved mentioned earlier, in 17 African states, a simplified through simplified, intermediate or temporary legal legal status was launched called the entreprenant statuses for informal businesses.2 and was offered to small informal businesses (Benhassine et al., 2016). An intermediate legal status could be used for informal businesses before or as they transition to Additional research is needed and will help address full formal status. Such an intermediate status could questions regarding the type of businesses that make these businesses eligible for certain targeted adopt these statuses, how well targeted the reforms technical assistance. It could also provide a grace are in terms of businesses growth potential, and the period during which the informal business may be extent to which further support is required for the able to receive the benefits of formalization without benefits of a simplified, intermediate, or temporary the associated costs. This would help the business legal status to be realized. understand the potential benefits to be realized and act as an upfront investment on the part of the Behavioral Insights government with a view toward fostering long- term productivity and tax revenue gains through The increased integration of behavioral insights increased formalization. Temporary status would and the search for new insights on decision-making also address the issue of hyperbolic discounting by beyond “rational” economics have rapidly expanded entrepreneurs when resources are scarce. After a in the past decade (Alm and Torgler, 2012; Mahmud 2 A step beyond the simplified legal status is a hybrid legal form termed the ‘Simplified Stock Corporation’ (SAS) implemented in some Latin American countries such as Mexico and Colombia. It blends the forms of partnerships and corporations, providing increased flexibility to management, legal protections and low cost of formalization (OAS, 2014). 10 | RE-THINKING THE APPROACH TO INFORMAL BUSINESSES: TYPOLOGIES, EVIDENCE AND FUTURE EXPLORATION et al., 2017; Shapiro, 2015), and have been studied aimed at formalization. Interventions would serve increasingly in relation to the informal economy. to address either individual-level behavioral factors D’Hernoncourt and Méon (2012) find a negative (such as the present bias,5 which may be addressed relationship in developing countries between size by a temporary legal status) or applying behavioral of the informal economy and level of generalized insights to improve delivery of an already developed trust. Williams et al. (2016) find in Pakistan that formalization intervention, taking into account higher perceived levels of public sector corruption common heuristics, cognitive overload, confirmation increases the likelihood of a business operating bias, self-efficacy, etc. which may stand in the way of informally. Researchers also note how ‘rules of a profit-maximizing decision to formalize. thumb’, status-quo biases, and stress alter payoff structures as perceived by informal businesses Through these types of behavioral insights, factors (Skaperdas, 2003) ; that influence of less tangible of formality may come to be better understood, factors of formality such as the political economy, supporting more cost-effective development and government stability, and rule of law (Alm and delivery of reforms. A greater understanding of Torgler, 2006) on the decision to formalize; and the the payoff structure facing informal businesses in opportunity for the use of ‘nudges’ to alter business regard to formalization can support policymakers in behavior (Thaler and Sunstein, 2008). the design and adoption of appropriate policies. Whether and to what extent informal businesses Conclusion value elements of formalization, is a question that has not been sufficiently studied. Mukorera (2019) in The previously described areas of research Zimbabwe took a first step towards this by analyzing and piloted interventions: informal clusters, informal businesses’ perception of 20 internal and behavioral insights, support without explicit goal external growth inhibiting factors and the willingness of formalization, and simplified, intermediate and of businesses to formalize given these factors. They temporary legal statuses should be considered as find that several factors were statistically significant interconnected. While we define these approaches including institutional imperfections, the registration separately, together they support continuous policy process, lack of access to technology, market improvement with an updated approach to the constraints, and lack of management skills. In a informal sector that recognizes its importance, seeks different approach, Mahmud et al. (2017) studied ways to work with it, and where reasonable, support informal workers’ willingness to pay for specific job growth out of it. benefits associated with formal employment. Still, there are very few studies that have investigated the The next step is to design and implement pilot perception of benefits of formalization by businesses interventions using the features of the four approaches. through tools of behavioral science such as journey Business differentiation will serve as an overarching mapping,3 gamification, or mystery shopping.4 These framework applied to the interventions. Learnings tools serve as a diagnostic to identify the behavioral from the proposed approaches can in turn affect how obstacles to formalization and would be followed businesses are differentiated, further enabling the by the implementation of behavioral interventions recognition of the characteristics and opportunities that 3 Journey mapping is used to visualize the process an individual goes through to accomplish a goal. The mapping process can help policy makers recognize existing obstacles and create opportunities for reform. This could be simulated in practice with a temporary legal status for informal businesses. 4 In mystery shopping, businesses or governments can ask anonymous individuals to take part in a shopping or service experi- ence, without the business or government knowing, and provide feedback on the experience. This can serve to complement the development of a journey map or identify other consumer/citizen preferences. 5 Related to hyperbolic discounting, present bias notes the tendency to prefer a smaller amount of something now rather than a larger amount later. RE-THINKING THE APPROACH TO INFORMAL BUSINESSES: TYPOLOGIES, EVIDENCE AND FUTURE EXPLORATION | 11 signal the appropriate policy response. While these engaging with other intermediaries working directly will be promising areas of exploration, they do not with informal businesses or recruiting members of the represent an exhaustive accounting of all remaining informal economy itself. areas of research; they can serve as a starting point for using and orienting existing areas of research To conclude, the pursuit of the best approach to to better inform our approach to informality. Such reducing informality is ongoing. The path ahead interventions will not be without their challenges. has been well-framed by previous research, but Data collection on informal businesses can be an opportunities remain to re-think the approach to expensive and difficult process that may require informality, how we view it, and how we go about addressing it. 12 | RE-THINKING THE APPROACH TO INFORMAL BUSINESSES: TYPOLOGIES, EVIDENCE AND FUTURE EXPLORATION Bibliography Adoho, F. and Doumbia, D. 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RE-THINKING THE APPROACH TO INFORMAL BUSINESSES: TYPOLOGIES, EVIDENCE AND FUTURE EXPLORATION | 19 Country Author(s) Reform/ Intervention Scale of impact Takeaway Mexico Bruhn (2013) One-stop-shop municipal Of Informal business owners with characteristics Different informal business owners level business registration similar to formal ones - 14.9% formalized their respond differently to reforms. Also businesses reforms were limited – only municipal registrations. Informal business owners with characteristics similar to wage workers - 6% shifted to wage employment Kaplan, Piedra, One-stop-shop municipal Start-ups increased by 5% per month but effect Significant obstacles of lack of access Seira (2011) level business registration is concentrated in first 15 months following to credit, taxes, scarcity of marketable implementation. ideas limit the impact of business entry deregulation. Bruhn (2011) One-stop-shop municipal Number of registered businesses increased Business registration deregulation level business registration 5% as a result of former wage employees did not entice informal businesses to starting businesses – not because unregistered register. Significant obstacles of lack businesses decided to register. Wage of access to credit, taxes, scarcity of employment also increased 2%. Income of marketable ideas limit the impact of incumbent firms decreased by 3% due to business entry deregulation. increased competition. Portugal Branstetter et al. Reduced time and cost to Number of firms registered increased by 17%. Entry deregulation has spurred (2013) register firm Created about 7 new jobs a month per 100,000 registration by less qualified firms. county inhabitants in eligible industries Rwanda, Liberia, Economist IC 15 reforms implemented IC reforms have plausibly facilitated the Broad economic considerations were South Sudan, Africa for business registration. establishment of about 11,000 new operation the most common motivations for Burkina Faso, Registration times have firms, of which 9,400 in Rwanda and 1,700 in registering (‘wanting to expand’, ‘better Sierra Leone been reduced to just 2-3 Liberia (after removing those short-lived firms access to customers/ suppliers’, ‘better days. Registration servic- – 40% survived in Rwanda since post reform access to finance’) with participating es have been decentral- registration, 63% in Liberia). Sierra Leone and in public procurement appearing as a ized in all countries, and South Sudan, trends in business registrations recurrent theme. Element of necessity the functions of business are quite erratic and no relationship with IC was present in Rwanda (‘There is no registries broadened in reforms can be established. The same applies future for companies that are operating some cases. to Burkina Faso. informally’) 20 | RE-THINKING THE APPROACH TO INFORMAL BUSINESSES: TYPOLOGIES, EVIDENCE AND FUTURE EXPLORATION Country Author(s) Reform/ Intervention Scale of impact Takeaway Benin Benhassine et al. Launch of simplified legal Very few informal firms registered for this new Firms which formalize do not appear to (2016) status, entreprenant, and status after the legal status was launched. But benefit much from this status in the first includes tax registration. personalized visits to firms coupled with an two years afterwards. They access explanation of benefits and assistance filling more business training and pay lower Includes the simplified out formed induced 9.6% of informal firms taxes due to a tax exemption, but legal status mentioned to formalize, and adding access to business are not more likely to have business above, in addition to per- training, bank accounts, and tax mediation bank accounts, gain new customers, sonal visit with explanation services increased this to 16.3%. have higher profits or sales, or hire of benefits of new status additional workers. and help applying, Includes 2 and 1, as well as access to business training, bank accounts and tax mediation. Georgia Bruhn and Introduction of preferential The new tax regime increased the number of Findings indicate that the design of Loeprick (2014) tax regimes for Georgian newly registered formal firms below the eligibility presumptive tax regimes may indeed micro and small businesses threshold of GEL 30,000 by 18‐30%. This effect be an instrumental policy tool to in 2010 is limited to the first year of the introduction of the encourage tax registration, the goal reform. Authors find a robust effect of the small of the Georgian policy reforms, it also business tax regime on formal firm creation in suggests that such reforms are, at any year. When looking at abuse risks, results best, a small piece in a much bigger show no significant evidence of strategic sorting. puzzle. Tax compliance only lasts for the first year after the new regime was introduced. Brazil Andrade et al. Firms in Belo Horizonte Authors find zero or negative impacts of The results show most informal (2013) were randomized to a information and free cost treatments, and a firms won’t formalize unless forced control group or one of four significant but small increase in formalization to do so, suggesting formality treatment groups, some from inspections. Our LATE estimates of the offers little private benefit to them, received information on impact of actually receiving an inspection are but the tax revenue benefits to the how to formalize; others much bigger, giving a 21-27 percentage point governments of bringing firms of receiving information and increase in the likelihood of formalization this size into the formal system more free registration costs than offset the costs of inspections. along with the use of an accountant for a year; the third group was assigned to receive an enforcement visit RE-THINKING THE APPROACH TO INFORMAL BUSINESSES: TYPOLOGIES, EVIDENCE AND FUTURE EXPLORATION | 21 Country Author(s) Reform/ Intervention Scale of impact Takeaway Fajnzylber et al. The SIMPLES program re- Evaluation of SIMPLES found that it induced This could be partly the result of the (2011) duced the required taxes about 7% more firms to register and increased reform and partly a result of the fact that and social contributions for tax payments by 3.1 to 4.6%. Firms that became more productive firms assess they can micro and small businesses formal had 55-57% higher revenues and 45-49% benefit from being formal. Those that by up to 8%. higher profits. register appear more likely to have a permanent location and aim for a larger scale of business. Almeida and Labor law enforcement Law enforcement reduces informal employment Enforcement of labor regulation in the Carneiro (2005) is implemented varyingly by firms. However, it also reduces the firm’s form of fines can be effectively used across municipalities (al- wages, productivity and investment. Authors as a tool for fighting informality. But, though is the same on the argue that this is due to the firm’s limited access informal employment is an important books) to flexible labor. source of unregulated labor for Brazilian firms, allowing them to operate more efficiently, and increasing their incentives to invest in new technology. Malawi Campos et al. Randomly allocated firms All three treatments had extremely large impacts The results highlight the advantages (2015, 2018) into a control group and on business registration, with 75% of those offered of separating business and tax three treatment groups: 1) assistance receiving a business registration registration, but also the need to assist a group offered assistance certificate. Information and assistance has firms in benefiting from their new formal for costless business reg- a limited impact on tax registration. Business status. istration, 2) a group offered registration alone has no impact for either men assistance with costless or women on bank account usage, savings, or business registration and credit. Combination of formalization assistance separate tax registration, and the bank information session results in and 3) a group offered as- significant impacts on having a business bank sistance for costless busi- account, financial practices, savings, and use of ness registration, informa- complementary financial products. tion session at a bank that ended with the offer of busi- ness accounts 22 | RE-THINKING THE APPROACH TO INFORMAL BUSINESSES: TYPOLOGIES, EVIDENCE AND FUTURE EXPLORATION Country Author(s) Reform/ Intervention Scale of impact Takeaway Bangladesh De Giorgio et al. Authors implement an ex- Up to three months from the intervention, only up The effects are generally small in level, (2015) periment in which firms are to 17% of the firms declare to be registered in the leaving open the question of why many visited by representatives treatment group versus 13 percent in the control firms still do not register. who deliver an official let- group (post intervention), an even smaller share ter form the Bangladesh can give us their registration number of TIN (3.4% national Tax Authority stat- vs. 1.1%) and even fewer firms are able to show ing that the firm is not reg- us a valid tax ID card (3.1% vs. .9%). Authors istered and the threatening also find that only larger revenue firms at baseline punishment if it fails to reg- respond to the threat and register ister. Sri Lanka De Mel et al. Provide information, reim- Information about the registration process and Most firms do not view the benefits (2013) burse registration costs, or reimbursement of direct costs does not increase as exceeding the costs. 36% of firms directly pay firms to register. registration. Payments equivalent to one half to said that they had yet to see any one month of the median firm's profits leads to benefit from registering. Very few firms registration of around one fifth of firms. Follow up claimed to have obtained a loan, or to surveys 15 - 31 months later show higher mean have received a government contract profits, but largely in a few firms which grew as a result of formalizing. rapidly. Colombia Galiani et al. Workshops for prospective While a workshop treatment had no effect on These results indicate that substantial (2015) formal sector entrants and firms' formalization decisions, meetings with CCB reductions in the fixed costs of arranges personalized agents raised the likelihood that a business would operating formally are not effective meetings for them with begin to operate formally by 5.5 percentage in formalization choices, since such agents from the Bogota points for all the firms that were invited at random reductions had no lasting effect on Chamber of Commerce. to participate in this arm of the intervention and formalization decisions. The CCB eliminated the by 32 percentage for the firms that accepted the costs of the initial procedure invitation. Second, the effect on the treatment of registering as a formal firms did not persist over time. After a year enterprise and provided of formal operation, it disappeared. Mostly exemptions from relevant small firms benefited from the law, few micro- taxes during the first years enterprises benefited and many were unaware of after formalization. the law. Kugler et al. Under Colombia’s 2012 Colombia’s payroll tax reform increased the Evidence that formal employment (2017), Bernal et reform, payroll taxes were number of formal jobs by over 3 percent and increases when labor taxes are lowered. al. (2015) reduced by 13.5 percent- increased wages by between 1.9 and 4.4 age points. percent, with most of the impact among small and medium-sized enterprises. Steiner and Forero (2015), Anton (2014), and Hernandez (2012) find that the tax reform reduced informality by between 1.4 and 4.2 percent RE-THINKING THE APPROACH TO INFORMAL BUSINESSES: TYPOLOGIES, EVIDENCE AND FUTURE EXPLORATION | 23 Country Author(s) Reform/ Intervention Scale of impact Takeaway China DeGryse et al. A review of the impacts Informal finance is associated with a higher It may be the case that a certain amount (2011) of informal vs. formal sales growth rate for small firms, and lower sales of informal finance enhances the growth finance options (not an growth rate for large firms. Authors identified of small firms due to the informal intervention) a complementary effect between informal and financier’s advantages in screening formal finance for small firms, but no such potential borrowers and tracking effect for large firms. Informal finance offers borrower performance. Notably, the informational and monitoring advantages, while role of informal finance does not scale formal finance offers relatively inexpensive funds. up with firm size, and may even turn detrimental for the growth of larger firms. Senegal Mihaylova and Senegal’s parliament passed As a direct result of the new tax regulations, informal Utilizing market cooperation, firms can Poff (2018) & CIPE legislation to reform the Sen- sector operators have reported a decreasing number protect against costly harassment draft report egal Tax Code for a more of disputes with local authorities. On average, streamlined tax code for UNACOIS’s national headquarters intervened in SMEs with tax rates more over 200 cases per year. Within one year of the new proportional to their profit Code taking effect, UNACOIS has been involved in margins. only two such cases. Lima, Peru Bettcher et al. The new business registry During 1991-1994, 382,100 new businesses An improved business environment will (2009) & CIPE coordinated procedures of were registered during those three years. The foster businesses to register and pay draft report the agencies under one roof registered businesses saved $692.5 million in taxes. and drastically reduced na- red tape and created 557,770 new formal jobs. tional registration require- Government tax revenues increased by $1.2 ments such as: billion. The number of Lima’s small and micro • From 289 days to 1 day businesses grew from 72,606 in 1993 to 160,040 • From $1,200 to $174 in costs in 1996, and 300,000 in 2004. Serbia USAID Serbia New Law on Inspections More than 23,000 entrepreneurs registered. There Threat of being caught as unregistered (2017) & CIPE Oversight started inspec- were 22% more newly-registered entrepreneurs is a significant incentive to register. draft report tions of unregistered busi- per month in 2015 compared to the previous nesses. year. Informal employment dropped from 23.2% at the end of 2014 to 19.4% at the end of 2015. In 2017, 81% of surveyed businesses said that inspections were well trained, up from 62% in 2013. In addition, public trust in inspections improved (70% positive vs. 30% negative in December 2015, compared to 48% positive vs. 52% negative in July 2014) 24 | RE-THINKING THE APPROACH TO INFORMAL BUSINESSES: TYPOLOGIES, EVIDENCE AND FUTURE EXPLORATION Indonesia Rothenberg et al., One-stop-shops for busi- Authors find no evidence that a large-scale It appears many firms prefer to remain (2015) ness registration program program designed to reduce registration costs informal, consistent with the dual increased formality rates. economy and rational exit theories of informality.