The Cost of Informality

– This article was originally published by Ashesh Shrestha in the Himalayan Times on the February 24, 2019.

Microenterprises generally function within the informal economy of a country. Amongst a range of 410-550 million Micro, Small and Medium Enterprises (MSMEs) globally, approximately 15-19 percent fall in the formal bracket. A large portion amounting to approximately 70-80 percent are operating in the informal economy. In context of Nepal, 93 percent of all MSMEs are categorised under micro enterprises, majority of which continue to work in the informal economy. Various reports indicate that most small firms in the developing countries are informal as they have not been registered as a legal entity. However, these informal microenterprises have a huge contribution in the National income and employment generation and if given a chance to come into the formal bracket, they have high chances off scaling up their production activities, contributing more to the economy. But, due to their informal status they face various challenge and hence are not able to grow at all.

Despite the fact that these informal enterprises do not have to bear the cost of regulation, they tend to be less productive than formal enterprises. Informal firms face problems such as financing, regulatory/legal obstacles, uninsured property rights making them less productive. The major problem faced by micro firms operating in the informal sector is the access to finance, a feat that has contributed to a high degree of stagnation in the firms. Inability to register property and assets adds to the lack of collaterals required for borrowing from banks, financial institutions and other micro-lending agencies which might be offering credit at lucrative payback options. The availability of the access to credit empowers the entrepreneurs to execute their innovative ideas improving the business environment; resulting into the Schumpeterian process of ‘Creative Destruction’ of making the economy vibrant. However, the lack of such facility results in stagnation of the economy it operates in.

Studies have shown that more than one-third of the micro firms face problem of access to finance, of which the majority are operating informally. Furthermore, micro firms seeking for relatively small credit face high transaction costs and high-risk premiums as they have less credibility and less collateral to offer. In addition, when these firms are operating in the informal sector, it is almost impossible to get loans from the Banking and Financial Institutions (BFIs). The informal enterprises do get credits from informal sources like family and friends, money lenders, however the price of borrowing, i.e. interest rates are comparatively higher, thus increasing the cost and further affecting the financial stability of the business.

Another problem that informal enterprises face has been identified as the lack of property rights. According to Hernando De Soto, a Peruvian Economist, the unreported and unrecorded economic activities deprive the informal enterprise owners from access to the formal system that gives them legal ownership of their property. So, the absence of a legal identity inhibits the expansion of their respective businesses via increase in the capital stock.

Another problem that comes with informality is vulnerability. The informal enterprises are vulnerable to harassment by the inspection officials of the government and are even forced to pay a bribe to look away. As per the study conducted by Lieberman, Mukherjee and Nenova, most of the informal firms in developing economies pay around 20 percent of their revenues to government officials in the form of bribes. Hence, 20 percent of the total revenue is amounted as the cost of being informal. More importantly, this might affect the growth of these firms as they would prefer to scale down their operations to remain shadowed from the inspections conducted by authorities. Looking at the cost of being informal, an important question may arise. Why don’t these informal enterprises get legally registered and become formal instead?

A research conducted by Loayz and Rigolini, identify excessive regulations as one of the major hindrances to formality. They establish that regulations are fixed cost to the businesses. The cost of meeting the regulatory compliances is fixed irrespective of the production. The cost of binding by the regulations is fixed and, largely sunk. There are relatively higher barriers to enter into the formal sector in the form of the lengthy procedures, increased number of days, higher registration fees etc. in low income developing countries. Additionally, these enterprises are reluctant to register and are instead operating their businesses informally, not only because of the hassles faced by them while registering their business but also because of the various compliances to be met while operating the business. These micro businesses lack expertise in maintaining books of account, understanding the tax system and calculating the taxable amount. Furthermore, they again have to spend a lot of their time and labour to complete the process of getting tax clearance, which they can invest in productive activities. The cost of formalisation to these enterprises is higher that the visible benefits that they can accrue by legally registering their business.
Hence, in order to bring these informal microenterprises into the formal sector and help them scale up and grow, the cost of registration and the cost of meeting various compliances during the process of operation should be reduced.