Friday, June 14, 2013

How much do firms want to stay informal?

In developing economies, a substantial fraction of the economy stays informal, that is, unregulated, untaxed and unprotected. Why so? One could argue that they want to avoid red tape and corruption. Or they may find the the benefits of formality, like better access to credit or payment systems, courts and insurance, do not outweigh the costs being visible to the state, like workplace regulation, taxes and competition with untaxed businesses.

Suresh de Mel, David McKenzie and Christopher Woodruff perform an experiment in Sri Lanka wherein firms are offered various incentives to formalize, from simple administrative help to lump-sum payments corresponding to two months of profits. Helping with the red tape does not change much, however payments got up to half of the firms to formalize. The threshold to formalization seems rather low in monetary terms, and may also include some path-dependence. From post-experiment interviews with participating firms, the authors learned that the formal firms not change their profits much, but owners felt more legitimacy and they report more confidence in the state. Thus, they are unlikely to return to informality. And if this were to happen at a greater scale, I surmise this would have importance scale effects in formalization, as formal businesses would fear less informal competition. Formalizing an economy may thus be relatively cheap to achieve.

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