Why informal enterprises operate informally? How can they be formalized?

The importance of the informal economy can be traced by its contribution to the economy as a whole. Due to lack of sound empirical data related to informal enterprises, their size and contribution cannot be known with certainty, but researchers have tried to estimate the size and contribution of the informal sector by using various techniques.

According to a study conducted by Huitfeldt and Jutting, on an average half of the jobs in the non-agriculture sector in the emerging and developing world are informal. In some regions, including the Sub- Saharan region and South Asia, the rate is as high as 80 percent of the non-agricultural jobs.

The existence of the informal economy in Nepal is not certain. Various tentative figures have been provided. It has been estimated that 93 percent of the micro enterprises, 5.7 percent of the small enterprises and 1.3 percent of the medium enterprises are operating in the informal sector. According to the National Coordinator of the ILO’s project ‘Way out of Informality: Formalizing Informal Economy,’ informal economy accounts for 38 percent of Nepal’s GDP which is currently approximated to be 14 billion dollars.

A major portion of the workforce in the informal sector are self-employed street vendors and hawkers. While creating jobs for themselves and reducing unemployment rate in Nepal, these people have a major contribution in Nepal’s national income.

It would not be wrong to conclude that their contribution is large enough for enticing us to make effort and investment on developing policies and infrastructure that is favorable to them.  But it is quite disheartening to see various local governments in Nepal doing the opposite. They are instead being chased out by not allowing them to vend on the streets, without providing any alternatives.

Instead of chasing the informal enterprises out of business, the government should first try to understand why these enterprises choose to operate informally. Various studies have identified excessive regulations as one of the major hindrances to formality. There are relatively higher barriers to enter the formal sector–lengthy procedures, increased number of days, higher registration fees among others in low income developing countries like Nepal.

Instead of chasing the informal enterprises out of business, the government should first try to understand why these enterprises choose to operate informally. 

These studies establish that regulations are a fixed cost to businesses. The cost of meeting the regulatory compliances are fixed irrespective of the production. A cross-country study conducted by Djankov et al found out that on an average the official cost of registration is 34 percent of the Gross Domestic Product (GDP) per capita.

On an average, it involves 10.17 steps and 63.05 business days to get a business registered. This includes the official time and cost and excludes the bribes and administrative delays which also tend to be high in developing countries. Thus, the enterprises must contribute a certain amount of its produce in order to meet the designated regulations. This directly hampers small businesses with relatively low output. So, only the workers and firms with higher output have the incentives to meet regulations, as it would account for a small portion of their total production.

Another barrier that has been identified is the prolonged regulation that needs to be accounted for to remain formal.  The obligations to retain the legality status might prove to be a barrier to get formalized at first. In the case of micro-enterprises, with relatively low economic transactions, declaration and payment of taxes might have a smaller impact on them being formalized but book-keeping might be costly which affects the decision to formalize.  The compliances which they will have to meet post-registration is in itself a hindrance behind formalization.

In order to resolve these issues and help informal enterprises grow, we need to set up a policy framework specifically targeting these informal and microenterprises. Registration process for these enterprises should be made easy. They should not have to visit multiple government agencies for several days just to register their business.

If the registration process could be entirely done at the local level by charging a nominal fee, the formalization would be cheap for them. Tax compliance should be made easy wherein multiple levels of government are not involved in collecting various types of taxes. Tax related matters of micro enterprises should be entirely handled by the local government.

In conclusion, the overall cost of formalization should be reduced so that informal businesses can enter the formal sector and make larger contributions to employment and economic growth.

Ashesh Shrestha ​​is a researcher at Samriddhi Foundation, an economic policy think tank based in Kathmandu. The views expressed in this article are the author’s own and do not represent the views of the organization. [email protected]