Formalising the informal economy

The informal economy is a globally prevalent phenomenon, but nowhere more visible and contributive to activity than in the developing and transition economies. The Organisation for Economic Co-operation and Development (OECD) estimates that the informal sector contributes about 42% to output in Africa, 41% in Latin America, 35% in the transition economies of Europe, compared to 13.5% in OECD countries. The informal economy largely accounts for those who cannot find work in the formal economy, with a disproportionate number of them women, the youth and the disadvantaged groups. Indeed, it is estimated that 84% of women in sub-Sahara Africa are employed by the informal sector.

Formalisation is a gradual process, hence, there is a continuum between the formal and the informal. There are few organisations that follow all the regulatory rules and there are few that follow none of the rules. In-between both ends of the spectrum are those that pick and choose what rules to follow based on a cost-benefit analysis. Many of these organisations will only follow the formalization rule book up to the point where the potential benefits outweigh the costs.

The informal sector seems to only provide temporary solution to poverty amelioration, as coincidentally, countries with higher share of informal economy also have the lowest per capita income, while countries with the highest per capita income have smaller informal sectors. Although formalisation is not the magical silver bullet that will cure all economic woes and reduce poverty, but on the long-run, it is expected that it will broaden the tax base (potentially permitting lower tax rates), provide higher quality, better paid and more sustainable jobs, reduce the cash economy and provide more resources for financial intermediation by the formal financial institutions, and also build investor confidence, thereby, increasing investment.

Although anecdotal evidence suggests formalisation is a win win situation for both the private enterprise and the government in the long-run, yet, many of the issues that militate against the ease of doing business in many of the developing countries also prevent the formalisation of these economies. There is a strong global body of evidence that suggests regulatory, administrative and corruption barriers exert the most compelling influence against formalisation.

Regulatory barriers are inordinate requirements put in place by governments that do not appreciate or understand the impact of every extra procedure and compliance on businesses, particularly, those regulations that have no bearing on the standard of goods and services. The small and medium enterprises are usually the most affected by these obstacles. Over the years, poor quality regulation and laws have created a web of inconsistencies and complexities that have become insurmountable for businesses seeking formality.

Administrative barriers stem from the procedures for enforcing regulations. Bureaucratic obstructions, abuse of authority, excessive paper work and inefficiency/delayed decisions are some of the barriers faced on a daily basis by businesses. These administrative barriers take their roots from some salient causes- lack of capacity on the part of the regulators, archaic ways of working that are no longer relevant in the 21st century, complex procedures, and over-centralisation of authority. In many cases, the public servants do not understand the needs of the private sector, and erroneously assume the role of control and enforcement, rather than facilitator of processes and procedures. They become the new obstacle and oracle that need to be worshipped and appeased. The role that public servants arrogate to themselves often breeds contempt and corruption, hence, general distrust of the public sector.

Corruption is also a major deterrent to formalisation, as businesses try to avoid corrupt public officials by staying off tax rolls and registers. Corruption erodes the little trust businesses repose in their governments, and leads the informal enterprises to the conclusion that their long-term prospects in the formal economy are poor. Reducing and simplifying regulatory and administrative requirements limits opportunities for corruption, but this also explains why government officials that benefit from these complexities will be reluctant to pursue such reforms.

Thankfully, there are already established frameworks for improving formalisation. The indicators in the global competitiveness and ease of doing business reports are a good place to start. Compelling body of evidence shows strong correlation between positive performances on those indicators and improvements in level of formalisation. Although correlation does not preclude causation, indicators in those frameworks have also been identified as the main catalysts for formalisation.

Governments and regulators can take practical steps to educate their employees on their roles as facilitators of processes and procedures. Including formalisation incentives in the enterprise service promotion may also go a long way in bringing the informal sector into the formal fold. Tax administration, rather than tax rates, is often more cited as a barrier to formalisation; this can be further simplified. Single taxes, with different payment options (one-off or installment), should be considered for SMEs. Government should also avoid retroactive taxation for businesses that formalise, as enterprises will be reluctant to formalise if they expect a large tax bill. 

Finally, the government needs to start engaging businesses in discussions on the use of their taxes, and how businesses will benefit from enhanced services as evidence suggests improved compliance rate when businesses are aware of what they are getting in return for their payments.

Olugbenga A. Olufeagba