Do business environment reforms encourage informal firms to formalise?

This article examines the role of business environment reform in formalising the informal economy.

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This year’s Doing Business report, Doing Business in 2014, is out. It is always interesting to see which countries have moved up or down in the annual rankings –– as problematic as the methodology of rankings is, it is still a potent source of debate on the relative need for reform.

This year, World Bank highlights that the results of the DB assessment shows that “the gap between the developed and developing worlds is narrowing as countries such as Rwanda, Philippines, and the Russian Federation improve regulations to foster entrepreneurship and trade”. This year, a higher number of reforms (18% more) were recorded:

This pick-up in pace of regulatory reform is good news particularly for small and medium-size businesses – the main job creators in many parts of the world.

In Africa, 66 percent of countries enacted at least one reform last year, compared with 33 percent in 2005.  Nine African countries are among the top 20 most improved in terms of business regulations since 2009: Benin, Burundi, Cote d’Ivoire, Ghana, Guinea-Bissau, Liberia, Rwanda, Sierra Leone, and Togo.

It is particularly interesting to see the comments made about business regulation reforms and the informal economy.

The report also finds a relationship between the degree of black market or “informal” business activity and the Doing Business ranking – the worse the score, the higher the degree of informality.

This link is explored in a number of policy domains:

When examining the factors affecting business registration, the report claims “there is a strong positive association between minimum capital requirements and the percentage of firms in economies who say that the informal economy severely constrains their growth. If entry costs are prohibitively high, entrepreneurs might be disinclined to formalise their businesses” (p. 44). However, the report prefaces many of these claims by indicating that the results “are based on correlations and cannot be interpreted as causal” (p 43).

A strong negative relationship between the number of years that firms operate without formal registration and the burden of minimum capital requirements is also reported. Based on this relationship, higher minimum capital requirements for business registration are considered to be associated with longer periods when firms operate without formal licenses.

The case of Mexico is cited, where simplified business registration was found to increase the number of registered firms by five percent and employment by 2.2 percent. Informal business owners, particularly “those with an entrepreneurial drive”, were 14.3 percent more inclined to formally register their businesses.

The report also argues that there is a connection between informality and levels and administration of taxation. Citing the World Bank Enterprise Surveys it is reported that in the majority of the 121 economies surveyed businesses consider tax rates to be among the top five constraints to their business, and tax administration to be among the top eleven. “Overly complicated tax systems encourage evasion and are associated with larger informal sectors, more corruption and less investment” (p. 101).

Finally, the report links informality with efficient contract enforcement. An essential element of a business-friendly environment is efficient contract enforcement: “It reduces informality, improves access to credit and increases trade” (p. 110). A reported study of 27 economies found that the informal sector’s share in overall economic activity decreases with better contract enforcement quality – as measured by a country-wide measure of rule of law and the firm perceptions of the fairness of courts.

All this is well and good, but it is an over-simlification to suggest that bad business environments are the only cause of informality. While there is a clear link, the dynamics of the informal economy can’t be isolated to this alone. In 2010-11 I was commissioned by the Donor Committee for Enterprise Development to look at the connection between business environment reform and informality. This work culminated in guidance for donors that want to promote formalisation.

A key point presented in this work is:

Because there are different drivers of informality, there are different starting points and priorities for reform programs. For example, reforms designed to address informality that is created by war and conflicts will differ from those used to address informality created by exclusion or inequality. While business environment reform is not the only intervention required to address the concerns of informality, donor and development agencies should pay greater attention to understanding these distinctions and to ensuring that not all reforms targeting the informal economy are pursued in the same way (p. 1).

The latest Doing Business report is clearly in danger of presenting a one-size-fits-all solution to the problem of informality. Yes, poor business environments discourage compliance, but there are many other factors that lead to a decision to not comply. Distinguishing those “with an entrepreneurial drive” may be important in this, but so too are issues such as access to related to the inclusiveness of markets and the dialogue between business and governments.