Registering for Growth: Tax and the Informal Sector
by Christopher Woodruff
Roughly half of all non-agricultural workers in developing countries work in very small enterprises with fewer than five employees. Indeed, between one-quarter and one-third of the non-agricultural workforce in most low- and lower-middle-income countries is self-employed (Gollin 2002). Most of these micro-enterprises operate without registering as legal entities and, as a result, are a part of what is commonly referred to as the informal sector. Informal activity is estimated to comprise a much larger share of the economies of low-income countries – on average around 42% of GDP in a sample of 31 low- and lower-middle-income countries – than a comparable sample of 32 higher-income countries (22% of GDP) in the Organisation for Economic Co-operation and Development (OECD).
Why is such a high proportion of the labour force in lower-income countries employed in the informal sector? De Soto (1989) famously proposed that governments – and Peru’s specifically – push firms into the informal sector by raising the barriers and costs of formalization. By excluding firms from the formal sector, these barriers stifle entrepreneurship and reduce the dynamism of the private sector. Others (Levy 2008) have claimed that the high levels of informality represent an escape by small firms. This ‘exit’ view leads to a vicious cycle: firms escape because the state does not make formal status appealing. For example, financial markets and courts may be dysfunctional, and public procurement processes may be corrupt. But by being in the informal sector, firms avoid paying taxes that would provide resources the state might use to improve the provision of these goods, or to force firms to become formal. In this view, informality may still stifle entrepreneurship, as firms sometimes remain small deliberately to avoid attracting the attention of regulators and tax collectors.
If high rates of taxation push economic activity out of the formal economy, one would expect to see more informal activity in countries with higher tax collections. However, just the opposite is the case. Across countries, there is a strong negative correlation between state revenue and informal activity. Indeed, another characteristic of low-income countries is that tax collection by governments is very low. Government revenue averages 18% of GDP in the sample of low- and lower- middle-income countries in the OECD, compared with 33% of GDP in the higher-income countries. Figures 1 and 2 highlight the relationship between informality and tax collection for the sample of OECD and low-income countries, respectively. For the full sample, the correlation is around -0.52. In other words, informality is low where government revenues are high. This suggests that lower tax collections reflect a weaker capacity of the state to enforce rules or provide benefits that induce firms to join the formal sector.
Raising awareness of the perceived benefits of registration with owners of small firms can often be a policy challenge. But governments could certainly make the transition from the informal to the formal sector much easier for firms by lowering the costs of completing the registration process. This would help to alter the cost-benefit calculation facing small firms.Increasing the formalization rates of small firms is unlikely to offer governments a substantial new source of revenue in the short run. However, immediate tax revenues should not be the only factor that governments take into account when deciding on enforcement levels. The results from the fieldwork in Sri Lanka suggest that the tendency of many firms to remain in the informal sector can hamper their expansion, while achieving formal-sector status appears to generate a more favourable attitude towards government among owners. Given the size of the informal sector in developing countries, these findings could have significant policy implications for future economic growth.